T.C. Memo. 2002-35
UNITED STATES TAX COURT
SIDNEY C. SHAW, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 2799-00. Filed February 6, 2002.
H. Craig Pitts, for petitioner.
Edith F. Moates, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN, Judge: Respondent determined deficiencies and
accuracy-related penalties with respect to petitioner’s Federal
income tax as follows:
Penalty, I.R.C.
Year Deficiency Sec. 6662(a)
1995 $75,255 $15,051
1996 103,514 20,703
- 2 -
The issues presented are: (1) Whether losses claimed by
petitioner are subject to the passive activity loss limitations
under section 469 and (2) whether petitioner is liable for the
accuracy-related penalty under section 6662(a). Unless otherwise
indicated, all section references are to the Internal Revenue
Code in effect for the years in issue.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulated
facts are incorporated in our findings by this reference.
Petitioner resided in Stillwater, Oklahoma, at the time of filing
the petition. He owned real estate investment properties,
interests in various business entities, gasoline-hauling
trailers, and an airplane.
Petitioner researched properties and operational businesses.
He developed a business model and consulted with his banker,
construction supervisor, and operations managers. He either
purchased the property individually or purchased the property
indirectly through an entity in which he held an ownership
interest. Petitioner then developed the land, renovated the
existing building, or inventoried the property for future
development. Petitioner leased many of his properties to Shaw’s
Gulf, Inc. (Shaw’s Gulf), or its affiliates, and Shaw’s Gulf
managed the day-to-day business operations.
- 3 -
Shaw’s Gulf
Petitioner was a 44.9-percent shareholder of Shaw’s Gulf and
was its president during the years in issue. As president,
petitioner reviewed the monthly financial statements, approved
the annual budget, approved the remodeling projects, and signed
the checks. Shaw’s Gulf paid petitioner compensation of
$64,883.62 and $64,884.00 for 1995 and 1996, respectively, for
his services related to Shaw’s Gulf.
Shaw’s Gulf was in the business of operating convenience
stores, gas stations, carwashes, and Western Sizzlin’
restaurants. During the years in issue, Shaw’s Gulf leased
properties from petitioner and managed the operations of the
businesses located on those properties. The convenience stores
that were leased from petitioner and operated by Shaw’s Gulf
were: Buy N Bye #2, Buy N Bye #6, Buy N Bye #7, Buy N Bye #12,
Buy N Bye #13, and Conoco Cmart #16. Shaw’s Gulf also rented an
office building located in Stillwater from petitioner that was
used as Shaw’s Gulf’s headquarters. In 1996, Shaw’s Gulf also
leased from petitioner and operated a Western Sizzlin’ restaurant
located in Ponca City, Oklahoma (Western Sizzlin’ PC), and a
convenience store with a large carwash located in Ponca City.
Shaw’s Gulf paid gross rents to petitioner of $739,875 and
$976,954 for 1995 and 1996, respectively.
- 4 -
In addition to the real estate that Shaw’s Gulf leased from
petitioner, Shaw’s Gulf also leased properties from entities in
which petitioner held an ownership interest. During the years in
issue, Shaw’s Gulf operated Texaco Food Mart #5, a gas station
and convenience store, that was leased from RS&M Properties II
(RS&M). Petitioner was a 55-percent partner and the designated
tax matters partner of RS&M during the years in issue.
Shaw’s Gulf leased Buy N Bye #10, a convenience store, from
R&S Partnership (R&S). Petitioner was a 50-percent partner of
R&S during the years in issue, and petitioner contributed the
Bye N Bye #10 convenience store to R&S sometime prior to the
years in issue.
In 1996, Shaw’s Gulf leased the Western Sizzlin’ restaurant
located in Stillwater (Western Sizzlin’ SW) from S.C. Shaw, Ltd.
(Shaw Ltd.), an S corporation of which petitioner was the sole
shareholder.
Shaw’s Gulf operated a convenience store at a truck stop
located in Billings, Oklahoma, that was owned by Luttrell Oil
Company (Luttrell). Petitioner was a shareholder and president
of Luttrell during the years in issue. He reviewed the financial
statements and tax bills of Luttrell, but he did not have much
involvement in the day-to-day operations of Luttrell.
- 5 -
Petitioner’s compensation from Luttrell was $34,718.30 and
$34,872.00 for 1995 and 1996, respectively.
Shaw’s Gulf also leased and operated four other convenience
stores in which petitioner held no direct nor indirect ownership
interest in the property.
Barden Kellum (Kellum), vice president of operations,
managed the day-to-day operations of Shaw’s Gulf and its
affiliates and was responsible for the maintenance of the
properties leased by Shaw’s Gulf. Kellum consulted with
petitioner either by telephone or in person approximately 3 to
5 hours a week.
Shaw’s Gulf also leased a house located in Stillwater from
R&S. Petitioner contributed the house to R&S sometime prior to
the years in issue. Kellum was not responsible for any of the
residential rentals because petitioner hired an agency to manage
the residential rentals.
C&A Trucking
C&A Trucking was a subsidiary of Shaw’s Gulf. C&A Trucking
was in the transportation business; on a call-and-carry basis, it
delivered petroleum products. About 25 to 35 percent of C&A
Trucking’s business was from Shaw’s Gulf. Stephen Shaw, general
manager of C&A Trucking, managed the day-to-day business
operations, dispatch, and billing.
- 6 -
Petitioner was a shareholder and the president of C&A
Trucking during the years in issue. Petitioner was not involved
in the day-to-day operations of C&A Trucking but did meet with
Stephen Shaw for about 3 hours three times a month to review the
numbers, sign the checks, and review the business volume. C&A
Trucking paid petitioner compensation of $16,180.50 and
$16,221.00 in 1995 and 1996, respectively, for his services
related to C&A Trucking.
C&A Trucking rented gasoline-hauling trailers (Over the Road
Trailers) and a warehouse located in Stillwater from petitioner.
C&A Trucking paid petitioner gross rents of $172,251 and $313,657
in 1995 and 1996, respectively.
Shaw Ltd.
Petitioner was the sole shareholder of Shaw Ltd., which was
an S corporation, during the years in issue. During the years in
issue, Shaw Ltd. was in the business of operating a Dairy Queen
restaurant. In 1995, Shaw Ltd. owned and operated the Western
Sizzlin’ SW restaurant that was later leased to and operated by
Shaw’s Gulf in 1996.
The Dairy Queen restaurant was built and opened for business
in 1994. Shaw Ltd. owned the building and the equipment of the
Dairy Queen restaurant, but the land on which the Dairy Queen
restaurant stood was leased from SDQ LLC. Petitioner was a
- 7 -
33.33-percent member and the designated tax matters partner of
SDQ LLC during the years in issue. The day-to-day operations of
the Dairy Queen restaurant were managed by Kent Russell
(Russell).
Petitioner renovated the Dairy Queen restaurant in 1995.
Petitioner purchased a new cash register system and added a salad
display case. The renovations consisted of relocating the
fountain area to create a separate area for customers to get
their drinks, installing new tile, and adding a mop sink closet.
The renovation work was done at night so that the restaurant
could remain open.
During the first 14 weeks of 1995, petitioner was involved
in the renovation project and operations of the Dairy Queen
restaurant. He spent about 7 hours a week at the restaurant
busing tables, cooking hamburgers, and fixing the balls in the
playroom. Petitioner met with Russell every morning to review
the food and labor costs. After the first 14 weeks of 1995,
petitioner spent about 3 hours a day at the restaurant observing
operations. In 1996, petitioner spent about 3 hours a week at
the Dairy Queen restaurant.
Petitioner contributed Western Sizzlin’ SW to Shaw Ltd. in
May 1995. In 1996, Shaw Ltd. leased Western Sizzlin’ SW to
Shaw’s Gulf, and Shaw’s Gulf took over the business operations of
- 8 -
Western Sizzlin’ SW. Bob Palmer (Palmer), manager of Western
Sizzlin’ SW, continuously managed the day-to-day operations of
the Western Sizzlin’ SW restaurant during the years in issue.
In 1995, Shaw Ltd. made renovations to Western Sizzlin’ SW.
The renovations consisted of expanding the seating area,
extending the entry to create a cashier area, relocating the
restrooms, adding a cleaning closet, and expanding the parking
lot. The renovation work was done at night so that the
restaurant could remain open.
Petitioner met with Palmer regularly, about 14 hours a week
during the 15-week construction period, to discuss the
renovations and business operations of the Western Sizzlin’ SW
restaurant. Petitioner made the final decisions on the
operations and policy of the Western Sizzlin’ SW restaurant,
including the type of food served, the meat quality, the
seasoning used on the steaks, the use of a vacuum tumbler to
marinate the steaks, the baking of fresh bread, the addition of
scatter bars throughout the restaurant, and the addition of a
cotton candy machine and desserts to the buffet. After the
renovations were completed in August 1995, petitioner met with
Palmer occasionally, about 3 hours a week, to review and discuss
the financial statements. In 1996, petitioner ate dinner at the
restaurant 3 nights a week.
- 9 -
Gregory Webb (Webb), an employee of Shaw’s Gulf, was the
construction supervisor responsible for overseeing the day-to-day
construction of the Dairy Queen and Western Sizzlin’ SW
remodeling projects. Webb worked with petitioner on the design,
drawings, and cost of the projects. Petitioner approved all of
the details of the renovation projects, set up lines of credit
with vendors, found subcontractors, set up the bank account, and
signed the checks for the cost of construction. During
construction, Webb met with petitioner for about an hour on a
daily basis to discuss the progress and problems encountered on
the remodeling projects.
Petitioner took trips for the purpose of improving his
business operations. He attended conventions, observed the
operations and facilities of other restaurants, and met with
other franchise owners. The trips he took in his airplane are
documented in his airplane flight log. The airplane flight log
recorded the dates of travel, points of departure and arrival,
hours of flight duration, and remarks on the purpose of the
trips. Petitioner’s flight and travel time that related to Shaw
Ltd. was 110 hours in 1995. Petitioner kept calendars for the
years in issue, but they were discarded at the end of each
calendar year.
- 10 -
Lease Agreements
Petitioner usually represented both sides of the lease
transactions between himself and Shaw’s Gulf. Petitioner signed
the lease agreements as the legal owner of the property, as
lessor, and as the legal representative of Shaw’s Gulf, as
lessee, for the following properties: Buy N Bye #2, Buy N
Buy #6, Buy N Buy #7, Buy N Bye #12, Buy N Bye #13, Western
Sizzlin’ PC, and the airplane. Kellum signed as the legal
representative of Shaw’s Gulf, as lessee, on the leases for
Western Sizzlin’ SW, Conoco Cmart #16, and the office building
located in Stillwater.
Petitioner had an appraisal done for each property he owned
and used the appraisal to determine the rental price. He
generally set the rental price based on the appraisal value and
added a 12-percent return. Kellum and Webb calculated the
numbers that assisted petitioner in determining whether he could
own, develop, and lease a particular property to Shaw’s Gulf.
Kellum typed some of the lease documents but did not research
what the fair rental value of properties would have been.
The lease agreements included the land, building, fixtures,
and equipment at the specified location. The lease agreements
also provided that Shaw’s Gulf would be responsible for the
repairs and maintenance of each property and that improvements
made by the lessee would revert to the lessor upon termination of
the lease. The lease agreements for Buy N Bye #2, Buy N Bye #6,
- 11 -
Buy N Bye #7, Buy N Bye #12, Buy N Bye #13, Conoco Cmart #16, and
the office building located in Stillwater provide:
Lessee covenants and agrees to carry and maintain the
buildings, equipment, and improvements upon the said
premises in the same conditions as they now are and to
deliver the same to the Lessor upon the termination of
this lease in the same condition in which they are now,
normal and usual wear and tear alone expected. Lessee
may construct additions and improvements upon the
premises, which said additions and improvements are to
be maintained at Lessee’s expense to the termination of
the lease when they become property of the Lessor.
The lease agreement for Western Sizzlin’ PC provides:
REPAIRS. The LESSEE shall, at its own expense, make
all necessary repairs and replacements to the Leased
Premises * * * fixtures and all other appliances and
their appurtenant equipment * * *
ALTERATIONS AND IMPROVEMENTS. * * * All additions,
alterations and improvements made in or to the leased
premises by either the LESSOR or the LESSEE, shall
become property of the LESSOR and be surrendered with
the Leased Premises at the termination of the Lease.
* * *
Airplane Lease Activity
Petitioner purchased a new TBM 700, single engine, propeller
airplane in 1993. Petitioner leased the airplane to Shaw’s Gulf
during the years in issue. Petitioner signed the lease
agreement, as lessor, and as the president of Shaw’s Gulf, as
lessee. The lease agreement provided that “Shaw Gulf, Inc. shall
keep the airplane in good condition and shall make all repairs
necessary for its good operation at * * * [its] own expense” and
required monthly rental payments of $7,000. The lease agreement
also required Shaw’s Gulf to insure the airplane against loss.
- 12 -
Shaw’s Gulf deducted the rental expense and all the repairs and
maintenance expense relating to the airplane. Petitioner
included the rental income and deducted the mortgage interest and
depreciation expense related to the airplane.
Tax Reporting
Petitioner’s individual tax return and the tax returns of
petitioner’s business entities were prepared by petitioner’s
accountant, who was a certified public accountant, tax
practitioner, and had a real estate background. Petitioner met
with his accountant regularly and discussed his business
activities.
On petitioner’s Schedule E, Supplemental Income and Loss, he
reported income and losses from his ownership interests as
nonpassive:
Entity 1995 1996
RS&M $29,814 $29,814
R&S 27,869 25,236
SDQ LLC 21,981 19,247
Shaw, Ltd. (139,623) (108,691)
Net nonpassive income/(loss) $(59,959) $(34,394)
Based on petitioner’s assumption that he qualified as a real
estate professional under section 469(c)(7), petitioner reported
his net income and loss from his rental property on Schedule E as
nonpassive:
- 13 -
Property 1995 1996
Over the Road Trailers $22,357 $16,489
Warehouse (Stillwater) 600 600
Buy N Bye #7 32,128 34,791
Buy N Bye #6, #12, #13 306,272 330,688
Conoco Cmart #16 52,644 87,868
Office building (Stillwater) (6,838) 20,688
Carwash (Ponca City) -- 21,000
Buy N Bye #2 (24,856) (14,446)
Western Sizzlin’ PC -- (114,811)
Airplane (355,147) (255,096)
Total nonpassive income/(loss) $27,160 $127,771
Petitioner did not attach to his 1995 or 1996 tax return an
election to treat all interests in rental real estate as a single
rental real estate activity.
Notice of Deficiency
Respondent’s examination of petitioner’s tax liability
commenced on May 13, 1997. A statutory notice of deficiency for
1995 and 1996 was mailed to petitioner on December 8, 1999. In
the notice of deficiency, respondent disallowed petitioner’s
losses for 1995 and 1996.
OPINION
Respondent reclassified petitioner’s Schedule E activities
from nonpassive to passive activities and disallowed the losses
claimed by petitioner based on the passive loss limitations under
section 469. In deciding whether petitioner is allowed to deduct
his losses, we must address multiple issues. The deductibility
of the losses from petitioner’s ownership interest in Shaw Ltd.
depends on whether petitioner materially participated in Shaw
- 14 -
Ltd. The deductibility of the losses from his rental properties
depends on: (1) Whether petitioner had net income from self-
rented property under section 1.469-2(f)(6), Income Tax Regs.;
(2) whether petitioner qualifies as a real estate professional
under section 469(c)(7); and (3) whether petitioner’s airplane
lease activity was a passive activity under section 469(c)(2).
Section 469 generally disallows for the taxable year any
passive activity loss. Sec. 469(a). A passive activity loss is
defined as the excess of the aggregate losses from all passive
activities for the taxable year over the aggregate income from
all passive activities for that year. Sec. 469(d)(1). A passive
activity is any trade or business in which the taxpayer does not
materially participate. Sec. 469(c)(1). Rental activity is
treated as a per se passive activity regardless of whether the
taxpayer materially participates. Sec. 469(c)(2), (4). Under
section 469(c)(7)(B), the rental activities of a taxpayer in the
real property business (real estate professional) are not per se
passive activities under section 469(c)(2) but are treated as a
trade or business and subject to the material participation
requirements of section 469(c)(1).
Petitioner contends, for the first time in his posttrial
brief, that he is entitled to deduct his losses in 1995 and 1996
because Shaw’s Gulf, Shaw Ltd., petitioner’s real estate rental
activities, and petitioner’s airplane lease activity constitute a
- 15 -
single trade or business activity in which petitioner materially
participated.
Respondent argues that petitioner’s desire to combine his
various activities into a single trade or business activity under
section 1.469-4(c), Income Tax Regs., represents a new issue that
cannot be raised for the first time on brief. Respondent asserts
that to permit petitioner to raise this new issue on brief would
result in unfairness, surprise, and prejudice to respondent.
We have held that issues raised for the first time on brief
will not be considered by the Court when surprise and prejudice
are found to exist. See Seligman v. Commissioner, 84 T.C. 191,
198-199 (1985), affd. 796 F.2d 116 (5th Cir. 1986). Petitioner
had numerous opportunities to raise his new theory, and the
failure to raise this issue when he could have done so waives the
argument. See Aero Rental v. Commissioner, 64 T.C. 331, 338
(1975). Petitioner’s attempt to regroup his activities is
belated and will not be accepted. In any event, his argument is
factually and legally flawed under section 1.469-4(e)(1), Income
Tax Regs., and section 1.469-4(d)(2), Income Tax Regs.
Respondent alternatively argues that petitioner’s proposed
grouping of activities is inconsistent with petitioner’s actual
grouping of activities as reported in 1994, 1995, and 1996.
Section 1.469-4(e)(1), Income Tax Regs., states, in general, that
“once a taxpayer has grouped activities under this section, the
- 16 -
taxpayer may not regroup those activities in subsequent taxable
years”. Respondent also explains that petitioner is unable to
group his real estate rental activities with his airplane
activity because, under section 1.469-4(d)(2), Income Tax Regs.,
an “activity involving the rental of real property and an
activity involving the rental of personal property * * * may not
be treated as a single activity”. We agree with respondent.
Material Participation in Shaw Ltd.
Respondent reclassified the income and loss from
petitioner’s Schedule E ownership interests from nonpassive to
passive activities and disallowed the net passive loss of $59,959
and $34,394 in 1995 and 1996, respectively, pursuant to section
469:
Entity 1995 1996
RS&M $29,814 $29,814
R&S 27,869 25,236
SDQ LLC 21,981 19,247
Shaw Ltd. (139,623) (108,691)
Net passive income/(loss) $(59,959) $(34,394)
The effect of respondent’s reclassification was to disallow
a portion of the losses from Shaw Ltd. Petitioner can deduct the
losses from his ownership interest in Shaw Ltd. of $139,623 and
$108,691 in 1995 and 1996, respectively, if petitioner can
demonstrate that he materially participated in Shaw Ltd. during
1995 or 1996.
- 17 -
Material participation is defined as involvement in the
operations of an activity that is regular, continuous, and
substantial. Sec. 469(h)(1). As explained in section 1.469-
5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25,
1988), a taxpayer can satisfy the material participation
requirement if the individual meets any one of the seven
regulatory tests:
(1) The individual participates in the activity for
more than 500 hours during such year;
* * * * * * *
(4) The activity is a significant participation
activity * * * for the taxable year, and the
individual’s aggregate participation in all significant
participation activities during such year exceeds 500
hours;
* * * * * * *
(7) Based on all of the facts and circumstances * * *,
the individual participates in the activity on a
regular, continuous, and substantial basis during such
year.
“Participation” generally means any work done in an activity
by an individual who owns an interest in the activity.
Sec. 1.469-5(f)(1), Income Tax Regs. Work done by the individual
is not treated as participation in the activity if such work is
not of a type that is customarily done by an owner of such
activity and one of the principal purposes for performing such
work is to avoid the passive activity limitations of section 469.
- 18 -
Sec. 1.469-5T(f)(2)(i), Temporary Income Tax Regs., 53 Fed. Reg.
5726 (Feb. 25, 1988).
Work done by an individual in the individual’s capacity as
an investor in an activity is not treated as participation in the
activity for purposes of this section unless the individual is
directly involved in the day-to-day management or operations of
the activity. Sec. 1.469-5T(f)(2)(ii)(A), Temporary Income Tax
Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988). Work done as an
investor includes: (1) Studying and reviewing financial
statements or reports on operations of the activity;
(2) preparing or compiling summaries or analyses of the finances
or operations of the activity for the individual’s own use;
and (3) monitoring the finances or operations of the activity in
a nonmanagerial capacity. Sec. 1.469-5T(f)(2)(ii)(B), Temporary
Income Tax Regs., supra.
Petitioner contends that in 1995 he met the 500-hour
requirement under section 1.469-5T(a)(1), Temporary Income Tax
Regs., supra, and in 1996 his participation in significant
participation activities exceeded 500 hours under section 1.469-
5T(a)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5726 (Feb. 25,
1988). Respondent argues: (1) Petitioner failed to establish by
reasonable means the hours he devoted to Shaw Ltd. and
(2) petitioner’s activities that were related to Shaw Ltd.
- 19 -
consisted of investor type activities that are not treated as
participation in an activity.
With respect to the evidence that may be used to establish
hours of participation, section 1.469-5T(f)(4), Temporary Income
Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988), provides:
The extent of an individual’s participation in an
activity may be established by any reasonable means.
Contemporaneous daily time reports, logs, or similar
documents are not required if the extent of such
participation may be established by other reasonable
means. Reasonable means for purposes of this paragraph
may include but are not limited to the identification
of services performed over a period of time and the
approximate number of hours spent performing such
services during such period, based on appointment
books, calendars, or narrative summaries.
While the regulations are somewhat ambiguous concerning the
records to be maintained by taxpayers, they do not allow a
postevent “ballpark guesstimate”. Carlstedt v. Commissioner,
T.C. Memo. 1997-331; Speer v. Commissioner, T.C. Memo. 1996-323;
Goshorn v. Commissioner, T.C. Memo. 1993-578. Petitioner’s
recollection and estimate of the hours that he participated in
Shaw Ltd. are reasonable and are corroborated by the testimony of
Webb and Palmer. However, based on the description of the
activities that petitioner performed, the hours that are related
to investor type activities such as monitoring the operations and
reviewing financial statements are not treated as participation
because petitioner was not involved in the day-to-day operations
of the restaurants. Rather, the day-to-day operations of the
- 20 -
Dairy Queen restaurant were managed by Russell and the day-to-day
operations of Western Sizzlin’ SW were managed by Palmer. The
activities that will be considered as participation in Shaw Ltd.
are petitioner’s involvement in the renovations and initial
operations of his restaurants in 1995. Petitioner spent about 7
hours a week during the 14-week construction period on activities
related to the Dairy Queen restaurant, or 98 hours, and he spent
about 14 hours a week during a 15-week construction period on
activities related to the Western Sizzlin’ SW restaurant, or 210
hours. Petitioner’s flight and travel time related to Shaw Ltd.
was 110 hours in 1995. Petitioner’s 418 hours of participation
in Shaw Ltd. do not meet the material participation test for
1995. Petitioner has conceded that he did not participate in
Shaw Ltd. for 500 hours in 1996.
Petitioner’s argument that he spent more than 500 hours in
significant participation activities in 1996 impermissibly
combines his hours of participation in Shaw Ltd. with his hours
of participation in his rental activities. Section 1.469-
5T(c)(1)(i), Temporary Income Tax Regs., 53 Fed. Reg. 5726
(Feb. 25, 1988), provides that a significant participation
activity must be a trade or business activity, not a rental
activity.
- 21 -
Rental Activities
Petitioner reported his property rentals as nonpassive
activities during the years in issue based on the assumption that
he qualified as a real estate professional under section
469(c)(7). Respondent determined that petitioner was not a real
estate professional and reclassified petitioner’s rental
activities as passive activities.
Respondent also determined that the properties leased to
Shaw’s Gulf and C&A Trucking were self-rented properties pursuant
to section 1.469-2(f)(6), Income Tax Regs. The self-rented
property rule contained in section 1.469-2(f)(6), Income Tax
Regs., states:
Property rented to a nonpassive activity. An amount of
the taxpayer’s gross rental activity income for the
taxable year from an item of property equal to the net
rental activity income for the year from that item of
property is treated as not from a passive activity if
the property–-
(i) Is rented for use in a trade or business
activity * * * in which the taxpayer materially
participates * * * for the taxable year * * * [Emphasis
added.]
Under the self-rented property rule, the net rental income from
self-rented property is treated as nonpassive income and the net
rental losses are treated as passive losses, even though the
rental activities are passive activities. Respondent
reclassified the net rental income from the following properties
as nonpassive:
- 22 -
Property 1995 1996
Over the Road Trailers $22,357 $16,489
Warehouse (Stillwater) 600 600
Buy N Bye #7 32,128 34,791
Buy N Bye #6, #12, #13 306,272 330,688
Conoco Cmart #16 52,644 87,868
Office building (Stillwater) -- 20,688
Carwash (Ponca City) -- 21,000
Total nonpassive income $414,001 $512,124
The result to petitioner is that his passive losses from his
other rental properties are subject to the passive loss
limitations under section 469. The following rental losses were
disallowed by respondent:
Property 1995 1996
Buy N Bye #2 $24,856 $14,446
Office building (Stillwater) 6,838 -–
Western Sizzlin’ PC –- 114,811
Airplane 355,147 255,096
Total passive losses $386,841 $384,353
Petitioner contends that the application of section 1.469-
2(f)(6), Income Tax Regs., is arbitrary, capricious, and contrary
to the Code because similarly situated properties are treated
differently solely on the basis of whether they show a profit or
loss for the year. Petitioner argues that the regulations
produce an inequitable result and are not appropriate where
multiple properties are leased to a single business enterprise.
This Court has previously addressed the validity of section
1.469-2(f)(6), Income Tax Regs., and held that the
recharacterization of net income from self-rented property was
- 23 -
not arbitrary, capricious, or manifestly contrary to the statute.
Krukowski v. Commissioner, 114 T.C. 366, 369-370 (2000);
Schwalbach v. Commissioner, 111 T.C. 215, 219-224 (1998); see
also Sidell v. Commissioner, T.C. Memo. 1999-301, affd. 225 F.3d
103 (1st Cir. 2000). Congress granted the Secretary of the
Treasury the authority to prescribe regulations as may be
necessary or appropriate to carry out the provisions of section
469, including regulations “which specify what constitutes an
activity, material participation, or active participation for
purposes of this section, * * * [and] requiring net income or
gain from a limited partnership or other passive activity to be
treated as not from a passive activity”. Sec. 469(l)(1), (3).
In Krukowski v. Commissioner, supra at 369, the Court stated:
We disagree with petitioner that the
recharacterization rule is invalid. The
recharacterization rule is a legislative regulation,
see Schwalbach v. Commissioner, 111 T.C. 215, 220
(1998) (the Secretary had to comply with the
Administrative Procedure Act (APA), 5 U.S.C. sec.
553(b) and (c) (1994), when he prescribed sec. 1.469-
2(f)(6), Income Tax Regs., because the rules contained
therein are legislative rather than interpretive); see
also Fransen v. United States, 191 F.3d 599, 600 (5th
Cir. 1999); thus, it is invalid only if it is
arbitrary, capricious, or manifestly contrary to the
statute, see Chevron, U.S.A., Inc. v. Natural Resources
Defense Council, Inc., 467 U.S. 837, 844 (1984); see
also McKnight v. Commissioner, 99 T.C. 180, 183 (1992)
[affd. 7 F.3d 182 (5th Cir. 1993)].
The recharacterization rule is not arbitrary,
capricious, or manifestly contrary to the statute. It
was prescribed by the Secretary pursuant in part to the
specific grant of authority stated in section 469(l)
- 24 -
that allows him to prescribe all necessary or
appropriate regulations to carry out the provisions of
section 469 * * * [Fn. ref. omitted.]
The Court cited the following passage from the legislative
history to support its holding:
The conferees intend that this authority be exercised
to protect the underlying purpose of the passive loss
provision, i.e., preventing the sheltering of positive
income sources through the use of tax losses derived
from passive business activities.
Examples where the exercise of such authority may
(if the Secretary so determines) be appropriate include
the following * * * (2) related party leases or sub-
leases, with respect to property used in a business
activity, that have the effect of reducing active
business income and creating passive income * * *.
[H. Conf. Rept. 99-841, at 147 (1986), 1986-3 C.B.
(Vol. 4) 147.]
Petitioner argues that the Court has not previously
considered the inequity of recharacterizing net income from
self-rented properties where self-rented properties with losses
are not recharacterized. We disagree. The taxpayers in Sidell
v. Commissioner, supra, faced a similar situation where one self-
rented property generated a net loss and the other self-rented
properties generated net income. The taxpayers argued that the
properties were either contiguous to or located across the street
from each other and that the ownership of the properties was
separate from the business for valid business reasons. The Court
held that section 1.469-2(f)(6), Income Tax Regs., was valid
- 25 -
pursuant to the Secretary’s delegated regulation-making
authority.
Without the application of section 1.469-2(f)(6), Income Tax
Regs., taxpayers would be able to substitute passive income from
self-rented properties for nonpassive income, such as wages or
dividends from a personal service or closely held corporation, in
order to offset their passive losses from other activities.
Where the taxpayer controls both sides of the transaction, such
arrangements require special scrutiny.
We do not agree with petitioner that section 1.469-2(f)(6),
Income Tax Regs., has produced an inequitable result. Petitioner
is a sophisticated businessperson who owned multiple properties,
held ownership interests in several businesses, and served as the
president of Shaw’s Gulf and C&A Trucking. Petitioner controlled
both sides of the rental transactions between himself,
individually, as lessor, and as an officer of the respective
businesses, as lessee. As lessor, he knew the appraised value,
the mortgage interest expense, and the depreciation expense on
each property. He had control over establishing the amount of
rent and chose a 12-percent return. Petitioner had nontax
business reasons for retaining ownership of the rental properties
individually and outside of his businesses.
Petitioner must accept the tax consequences of his business
decisions and the manner in which he chose to structure his
- 26 -
business transactions. The Supreme Court has observed that
“while a taxpayer is free to organize his affairs as he chooses,
nevertheless, once having done so, he must accept the tax
consequences of his choice, whether contemplated or not and may
not enjoy the benefit of some other route he might have chosen to
follow but did not.” Commissioner v. Natl. Alfalfa Dehydrating &
Milling Co., 417 U.S. 134, 148-149 (1974) (citations omitted).
We sustain respondent’s determination that the net rental
income from the real estate properties rented to Shaw’s Gulf and
C&A Trucking should be reclassified as nonpassive income.
Petitioner argues, in the alternative, that his real estate
activities were nonpassive activities because he qualifies as a
real estate professional under section 469(c)(7) and his real
estate rental activities are a trade or business in which he
materially participated.
Respondent disallowed the following real estate rental
losses based on the passive loss limitations under section 469:
Property 1995 1996
Buy N Bye #2 $24,856 $14,446
Office building (Stillwater) 6,838 -–
Western Sizzlin’ PC –- 114,811
Total passive losses $31,694 $129,257
Respondent maintains that the real estate rental activities
generating a net loss are per se passive activities under section
469(c)(2) because petitioner has not presented adequate evidence
- 27 -
to support his assertion that he was a real estate professional
pursuant to section 469(c)(7) in either 1995 or 1996 or to
support a finding that he materially participated in each of the
real estate properties.
Under section 469(c)(7)(B), a taxpayer qualifies as a real
estate professional and is not engaged in a passive activity
under section 469(c)(2) if:
(i) more than one-half of the personal services
performed in trades or businesses by the taxpayer
during such taxable year are performed in real property
trades or businesses in which the taxpayer materially
participates, and
(ii) such taxpayer performs more than 750 hours of
services during the taxable year in real property
trades or businesses in which the taxpayer materially
participates.
Thus, if the taxpayer qualifies as a real estate
professional, the rental activities of the real estate
professional are exempt from classification as a passive activity
under section 469(c)(2). Instead, the real estate professional’s
rental activities are treated as a passive activity under section
469(c)(1) unless the taxpayer materially participated in the
activity. Sec. 1.469-9(e)(1), Income Tax Regs. For purposes of
determining whether a taxpayer materially participated in a trade
or business, this requirement must be met with respect to each
interest in rental real estate unless the taxpayer makes an
election to treat all interests in rental real estate as a single
- 28 -
rental real estate activity. Sec. 469(c)(7)(A); sec. 1.469-
9(e)(1), Income Tax Regs. Petitioner did not make a timely
election to treat all interests in rental real estate as a single
rental real estate activity.
Real property trades or businesses are defined in section
469(c)(7)(C) as “any real property development, redevelopment,
construction, reconstruction, acquisition, conversion, rental,
operation, management, leasing, or brokerage trade or business.”
A trade or business includes being an employee. Putoma Corp. v.
Commissioner, 66 T.C. 652, 673 (1976), affd. 601 F.2d 734 (5th
Cir. 1979).
Petitioner asserts that he devoted more than 750 hours to
real property trades or businesses because his “activities show a
meaningful involvement in real property trades or business” and
he bases this on the following: (1) He was the general
contractor on three projects in 1995 and two projects in 1996;
(2) he spent a significant amount of time looking for additional
real estate to purchase; (3) he owned 20 real estate properties
in 1995 and 21 in 1996; (4) he purchased five real estate
properties in 1995 and four in 1996; (5) he sold two parcels of
real estate in 1995; and (6) he spent over $395,870 and $597,000
in construction costs in 1995 and 1996, respectively. The number
of properties owned, sold, or purchased or the amount of money
- 29 -
spent on construction costs does not quantify the number of hours
that petitioner spent on real estate activities.
Petitioner attempted to recollect his participation in his
real estate activities at trial and attempted to summarize his
estimates from trial in his brief. Petitioner asserts that his
hours of participation in his real estate activities were 1,425.5
and 1,494.4 in 1995 and 1996, respectively.
Respondent argues that petitioner has not established by
reasonable means that he spent more than 750 hours in real
property trades or businesses. We agree. Petitioner has not
recorded the number of hours spent in any activity and has
discarded his calendars. His attempt to reconstruct or estimate
his hours through testimony such as that described above produces
a generalized description of his activities and a vague
approximation--or “ballpark guesstimate”--of his hours. His
testimony regarding his real estate activities is inadequate and
unpersuasive under the circumstances. His estimated hours of
participation in real estate activities are unreasonable.
The airplane flight logs that document petitioner’s flight
time would be a credible source and reasonable means to
demonstrate petitioner’s activities and hours spent in real
estate activities; however, petitioner’s flight time that was
related to his real estate activities in 1995 and 1996 does not
- 30 -
provide a sufficient number of hours to meet the 750-hour
participation requirement.
Because petitioner does not meet the 750-hour requirement of
section 469(c)(7)(B)(ii), he is not a real estate professional
for purposes of section 469(c)(7)(A), and his real estate rental
activities are treated as passive activities under section
469(c)(2). As such, it is not necessary for us to address
whether petitioner spent more than 50 percent of his time in real
estate trades or businesses or whether he materially participated
in each real estate rental. Even so, the lease agreements
executed by petitioner would not require much involvement by
petitioner during the lease term because the leased premises
included the land, building, fixtures, and equipment, and the
lessee was required to repair and maintain the property.
Further, Kellum was responsible for the repairs and maintenance
of the properties leased to Shaw’s Gulf, and petitioner hired an
agency to manage the residential rentals.
Airplane Lease Activity
Respondent disallowed the airplane rental losses of $355,147
and $255,096 in 1995 and 1996, respectively, and maintains that
the leasing of personal property is a passive activity under
section 469(c)(2) and subject to the passive activity loss
limitations under section 469.
- 31 -
Petitioner argues that the airplane was an essential part of
his real estate operations and that the costs he incurred should
be allowable as trade or business expenses under section 162.
Petitioner asserts that he used the airplane for the
“professional chase of properties”, such as the purchase of real
estate, research to develop his properties, and attendance at
business meetings.
A rental activity is a per se passive activity regardless of
whether the taxpayer materially participates in the activity.
Sec. 469(c)(2), (4). Rental activity, as defined in section
469(j)(8), is “any activity where payments are principally for
the use of tangible property.” Here, the rental of petitioner’s
airplane to Shaw’s Gulf for monthly lease payments of $7,000 was
a rental activity under section 469(j)(8) and, thus, a passive
activity under section 469(c)(2).
Petitioner argues that, while, in form, the agreement is a
lease, the substance of the transaction resembles an
expense-sharing agreement with Shaw’s Gulf, Shaw Ltd., and C&A
Trucking. We disagree. The lease agreement did not provide for
expense-sharing. Rather, the lease provided that the lessee
would maintain and repair the airplane and insure the airplane
against loss. Shaw’s Gulf, as lessee, deducted the repairs and
maintenance expenses related to the airplane.
- 32 -
Petitioner was on both sides of the transaction and reported
the income and expense of the airplane lease activity as a rental
activity on his Schedule E. Petitioner chose to structure and
report his airplane leasing activity as a rental activity during
the years in issue and must accept the tax consequences related
to that form. See Commissioner v. Natl. Alfalfa Dehydrating &
Milling Co., 417 U.S. 134, 148-149 (1974). He cannot belatedly
recharacterize it to secure greater tax benefits. Id. We
conclude that the airplane lease activity was a passive activity,
and the rental losses are limited to the extent of passive
activity income under section 469.
Penalties
Section 6662(a) imposes a 20-percent accuracy-related
penalty where the taxpayer’s underpayment of tax is attributable
to negligence or disregard of rules or regulations. See also
sec. 6662(b).
Respondent determined that petitioner is liable for the
accuracy-related penalty under section 6662(a) because petitioner
was negligent in the preparation of his 1995 and 1996 tax
returns. Respondent maintains that petitioner’s tax returns
contained errors, petitioner failed to maintain adequate books
and records, and petitioner ignored the self-rental rules of
section 1.469-2(f)(6), Income Tax Regs. Petitioner argues that
he was not negligent, that he made a reasonable attempt to comply
- 33 -
with the provisions of the Internal Revenue Code, and that he
took a position that was well founded in law and fact.
Good faith reliance on the advice of counsel or a qualified
accountant can, in certain circumstances, be a defense to the
accuracy-related penalty for negligence. See Schwalbach v.
Commissioner, 111 T.C. 215, 230-231 (1998); Ewing v.
Commissioner, 91 T.C. 396, 423-424 (1988), affd. without
published opinion 940 F.2d 1534 (9th Cir. 1991).
Petitioner consulted with his accountant who prepared his
tax returns for the years in issue. Petitioner’s reliance on the
representations of his accountant was reasonable. We conclude
that petitioner is not liable for the accuracy-related penalties
imposed under section 6662.
We have considered all of the remaining arguments that have
been made by petitioner for a result contrary to that expressed
herein, and, to the extent not discussed above, they are without
merit.
To reflect the foregoing,
Decision will be entered
for respondent as to the
deficiencies and for
petitioner as to the
accuracy-related penalties.