Fowler v. Comm'r

T.C. Memo. 2002-223

UNITED STATES TAX COURT

WILLIAM C. AND CHERYL M. FOWLER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 11885-98. Filed September 6, 2002.

John Edward Ritzert, Jr., and J. Carlton Howard, Jr., for

petitioners.

Bradley C. Plovan, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge: Respondent determined deficiencies and

accuracy-related penalties with respect to petitioners’ Federal

income tax as follows:
 - 2 -

Penalty, I.R.C.
Year Deficiency Sec. 6662(a)

1994 $35,283 $3,683
1995 17,023 3,202

The issues presented are: (1) Whether rental real estate

losses claimed by petitioners are subject to the passive activity

loss limitations under section 469; (2) whether interest paid on

tax deficiencies is deductible as Schedule C business expenses;

and (3) whether petitioners are liable for accuracy-related

penalties 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.

Petitioners’ mailing address at the time of the filing of the

petition was Cudjoe Key, Florida. Petitioners filed joint

Federal income tax returns for 1994 and 1995.

United Air Temp

Petitioner William C. Fowler (petitioner) was employed by

and the president of United Air Temp, Air Conditioning and

Heating, Inc. (United Air Temp). Petitioner Cheryl M. Fowler

(Mrs. Fowler) was employed as a corporate executive for United

Air Temp. United Air Temp was a closely held C corporation that

was 100-percent owned by petitioner.
 - 3 -

During the years in issue, United Air Temp was a heating and

air conditioning contractor with branch offices in Maryland and

Virginia. United Air Temp sold and installed central heating

systems, central air conditioning systems, indoor air quality

systems, attic fans, humidifiers, hot water tanks, gas

fireplaces, gas logs for fireplaces, and central vacuum systems.

United Air Temp worked with architects and general contractors in

connection with its business. United Air Temp also installed

duct work; installed line sets; installed radiators; framed and

cut walls; cut floors and ceilings; built chases and bulkheads;

cut holes in roofs and repaired roofs; installed water and gas

pipes; installed registers; installed electrical lines,

connections, and controls; upgraded electrical systems; installed

flute pipes and venting; demolished concrete slabs and installed

replacement slabs; removed oil tanks; installed thermostats;

built fireplaces; and performed masonry, carpentry, and

electrical work.

Some of the work performed by United Air Temp required

building permits, and the building permits were issued either to

United Air Temp or to its customers. Central heating or air

conditioning systems that have been installed in a residence as

permanent improvements are structural components of such building

and are real property. None of United Air Temp’s installations

was temporary.
 - 4 -

Petitioner kept electronic calendars of his activities. He

planned his activities about a month in advance and would enter

in his calendar the activities that he planned to accomplish. He

entered on the calendar the date and time, including the

beginning and ending times based upon his estimate of length of

each activity, and the description of the planned activity. He

did not go back and correct his calendar entries to reflect the

actual time spent or to reflect a change in his planned activity.

In preparation for trial in October 2001, petitioner reviewed his

calendars and supplemented the entries with handwritten notations

based on his recollection.

Based on petitioner’s calendar entries, petitioner prepared

summaries of his time spent working at United Air Temp.

Petitioner’s summaries estimate that he worked at United Air Temp

about 664 hours and 712.5 hours in 1994 and 1995, respectively.

Generally, petitioner estimated that he worked in the office an

average of 2 or 3 days per week for approximately 10 to 15 hours

per week. Unrecorded activities included petitioner’s telephone

conversations with Dorin Ivanescu, executive vice president of

United Air Temp, outside of business hours that occurred about 4

to 10 times each month, with calls lasting an average of 10 to 15

minutes each, or approximately 30 hours per year.
 - 5 -

Real Estate Rental Activities

Petitioners owned the following rental real estate

properties: (1) A farm and buildings in New York (New York

property), (2) an apartment building in Pennsylvania (apartment

building), (3) a commercial building in Pennsylvania (commercial

building), and (4) a rental unit in Florida (Florida property).

Petitioner’s work on the rental properties included roofing

repair, electrical, heating system repairs, heating system

replacement, foundation work, and routine maintenance. Based on

petitioner’s calendar entries, petitioner prepared summaries of

the hours spent on each of the rental real estate activities.

In addition to the activities recorded in his calendar, he

computed an estimate of the hours spent traveling to and from the

rental properties and estimated the hours that he spent on

administrative tasks. Petitioner estimated that his travel time

from the Washington, D.C., area to Pennsylvania and New York was

about 7 hours each way and to Florida was about 21 hours each

way. In 1994, petitioner made four trips to Florida and eight

trips to either New York or Pennsylvania. In 1995, petitioner

made two trips to Florida and nine trips to either New York or

Pennsylvania. Petitioner estimated that each year he spent

approximately 80 to 100 hours on administrative work that related

to the rental activities.
 - 6 -

Petitioner’s estimate of the hours that he spent on real

estate rental activities is as follows:

1994 1995

New York property 456.0 409.0
Apartment building 229.0 --
Commercial building 163.5 17.0
Florida property 357.0 336.5
Travel 280.0 210.0
Administrative 70.0 80.0
Total 1,555.5 1,052.5

Mrs. Fowler performed administrative services related to the

rental properties. She reviewed mail and invoices, made deposits

of rental income, prepared accounting records, prepared checks to

pay rental expenses, filed business records, maintained and

backed up computerized accounting records, compared actual

expenses with budgeted expenditures, and met with the certified

public accountant in connection with the preparation of income

tax returns. Mrs. Fowler did not keep a calendar or a log of the

hours that she spent performing these activities, but she

estimated that she spent about 600 hours a year on these

administrative tasks.

Petitioners used the services of independent contractors to

assist in the management and maintenance of the rental

properties. Petitioners hired a manager for the apartment

building. The manager was responsible for answering telephone

calls, collecting rents, and depositing the monthly checks. The

manager was paid a percentage of the money that she collected.
 - 7 -

For the Florida property, petitioners had independent

contractors that they would call to perform work if they were not

physically present to do the repairs or maintenance. Petitioners

hired Katherine Morgan to landscape and Sandy Chief to perform

maintenance on the Florida property.

The New York property was approximately 129 acres and

consisted of two houses, two storage units, a workshop, farmland,

and a tree plantation. Neither of the houses on the New York

property was rented in 1994 and 1995. A portion of the grounds

was arable and was farmed by Dan Zittle in 1994 and 1995.

Petitioners did not receive any rents on the New York property in

1994 and received $2,326 in rent on the New York property in

1995. For the New York property, petitioners hired an individual

to do simple tasks such as trimming around the buildings and

plowing snow from driveways. Petitioners also hired an

excavating contractor, a plumber, and an electrician.

Petitioners claimed rental losses of $45,676 and $51,206 in

1994 and 1995, respectively, on their Schedule E, Supplemental

Income and Loss. Petitioners did not elect to aggregate their

real property rental activities for purposes of section 469.

Interest Expense

Respondent examined petitioners’ 1989, 1990, and 1991 income

tax returns and proposed adjustments to petitioners’ Schedule A,

Itemized Deductions, and Schedule C, Profit or Loss From
 - 8 -

Business, for those years. Respondent determined additional

income taxes of $40,076, $34,827, and $28,967 for 1989, 1990, and

1991, respectively.

The Schedule C adjustments arose from the operation of a

sole proprietorship, “United Contractors”, that was a trade or

business. Adjustments to petitioners’ 1989 income tax return

totaled $125,688, of which $111,515 arose from adjustments to

Schedule C. Adjustments to petitioners’ 1990 income tax return

totaled $106,896, of which $86,082 arose from adjustments to

Schedule C. All of the adjustments to petitioners’ 1991 income

return related to adjustments to Schedule C.

In 1994, petitioners paid interest of $21,979.19 to the U.S.

Treasury, of which $18,230.72 and $1,155.78 for 1989 and 1990,

respectively, related to adjustments to Schedule C. In 1995,

petitioners paid interest of $14,288.90, of which $6,899.63 and

$5,721.12 for 1990 and 1991, respectively, related to adjustments

to Schedule C.

Petitioners claimed a deduction for “other interest” of

$43,874 and $2,887 in 1994 and 1995, respectively, on their

Schedule C for interest that related to United Contractors.

Tax Return Preparation

Petitioners’ Federal income tax returns were prepared by

Thompson Greenspon & Company, P.C., of which Wilbert Thomas

Miller III (Miller) is a tax partner. Miller is also a certified
 - 9 -

public accountant. Miller discussed with petitioner the

qualifications and definition of a real estate professional for

purposes of section 469(c)(7), and he inquired about petitioner’s

involvement in United Air Temp and petitioners’ involvement in

their real estate rental activities. Form 8275-R, Regulation

Disclosure Statement, was prepared and filed with petitioners’

1994 Federal income tax return to disclose that petitioners were

taking a position inconsistent with that of the Internal Revenue

Service with regard to interest paid on tax deficiencies.

OPINION

Rental Properties

The deductibility of the losses from petitioners’ rental

properties depends on: (1) Whether petitioner qualifies as a

real estate professional under section 469(c)(7) and, if so,

(2) whether petitioner materially participated in each rental

activity.

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
 - 10 -

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). Sec. 1.469-9(e)(1), Income

Tax Regs.

Petitioners argue that they are entitled to deduct their

losses from their real estate rental properties because

petitioner qualifies as a real estate professional under section

469(c)(7) and that the real estate rental activities are a trade

or business in which petitioner and Mrs. Fowler materially

participated.

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

to support his assertion that he was a real estate professional

pursuant to section 469(c)(7) in either 1994 or 1995 or to

support a finding that he and Mrs. Fowler materially participated

in each of the real estate activities.

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
 - 11 -

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.

In the case of a joint return, the above requirements for

qualification as a real estate professional are satisfied if and

only if either spouse separately satisfied these requirements.

Sec. 469(c)(7)(B). Thus, if either spouse qualifies as a real

estate professional, the rental activities of the real estate

professional are not a per se passive activity under section

469(c)(2). Instead, the real estate professional’s rental

activities would be treated as a passive activity under section

469(c)(1) unless the taxpayer materially participated in the

activity.

Material participation is defined as involvement in the

operations of the activity that is regular, continuous, and

substantial. Sec. 469(h)(1). 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

rental real estate activity. Sec. 469(c)(7)(A). Petitioner did

not make a timely election to treat all interests in rental real

estate as a single rental real estate activity. In determining
 - 12 -

whether a taxpayer materially participates, the participation of

the spouse of the taxpayer shall be taken into account. Sec.

469(h)(5).

Petitioners claim that petitioner spent 1,555.5 hours and

1,052.5 hours in 1994 and 1995, respectively, on rental real

estate properties. Petitioners’ estimate of the hours of work

done on rental properties is based on petitioner’s calendar

entries, petitioner’s estimate of hours spent traveling to and

from the rental properties, and petitioners’ estimate of hours

spent performing administrative work.

Petitioners also claim that petitioner worked at United Air

Temp a total of 694 hours and 742.5 hours in 1994 and 1995,

respectively, and that all of these hours were related to real

property trades or businesses under section 469(c)(7)(D)(ii)

because petitioner was an employee of United Air Temp.

Petitioners assert that United Air Temp is a real property trade

or business under section 469(c)(7)(D)(i) because more than 50

percent of its gross receipts is derived from real property

trades or businesses.

Section 469(c)(7)(D)(ii) provides:

(ii) Personal services as an employee.–-For
purposes of [qualifying as a real estate professional
under] subparagraph B, personal services performed as
an employee shall not be treated as performed in real
property trades or businesses. The preceding sentence
shall not apply if such employee is a 5-percent owner *
* * in the employer.
 - 13 -

Respondent agrees that petitioner owned more than 5 percent of

United Air Temp in 1994 and 1995 and satisfies the requirements

of section 469(c)(7)(D)(ii). Thus, petitioner can include

personal services performed as an employee of United Air Temp

provided that such activities are related to real property trades

or businesses. However, respondent argues that petitioner’s

activities as an employee of United Air Temp are not all related

to real property trades or businesses.

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).

We need not decide whether petitioner’s personal services as

an employee of United Air Temp are related to a real property

trade or business or whether United Air Temp is a real property

trade or business because petitioner has not established by

reasonable means that petitioner spent more than 750 hours in

real property trades or businesses.

“Personal Services” generally means “any work performed by

an individual in connection with a trade or business”.

Sec. 1.469-9(b)(4), Income Tax Regs. Work done by an individual
 - 14 -

in the individual’s capacity as an investor in an activity is not

generally treated as participation in the activity. Sec. 1.469-

5T(f)(2)(ii)(A), Temporary Income Tax Regs., 53 Fed. Reg. 5727

(Feb. 25, 1988).

With respect to the evidence that may be used to establish

hours of participation, section 1.469-5T(f)(4), Temporary Income

Tax Regs., supra, 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.

We believe that the methods that petitioner used to

approximate the time that he spent performing services in real

property trades or businesses are not reasonable within the

meaning of section 1.469-5T(f)(4), Temporary Income Tax Regs.,

supra. Petitioners’ estimates are based on petitioner’s calendar

entries and do not reliably or reasonably reflect the hours that

petitioner actually devoted to United Air Temp or to his rental

real estate activities. Petitioner assigned hours to the

activities in his calendar before the activities occurred, and

his estimates were not later adjusted to reflect the actual

duration of the activities. In preparation for trial in 2001,
 - 15 -

petitioner made notations on his calendars based on his

recollection of the activities occurring in 1994 and 1995.

However, these handwritten notations that were prepared years

later are not reliable. This Court has previously noted that,

while the regulations are somewhat ambivalent concerning the

records to be maintained by taxpayers, they do not allow a

postevent “ballpark guesstimate”. Bailey v. Commissioner, T.C.

Memo. 2001-296; Carlstedt v. Commissioner, T.C. Memo. 1997-331;

Speer v. Commissioner, T.C. Memo. 1996-323; Goshorn v.

Commissioner, T.C. Memo. 1993-578. Petitioners attempt to

distinguish the facts of this case from those cited by arguing

that petitioner’s calendars are reliable because the calendars

were prepared in advance of his activities for his work at United

Air Temp and his rental properties. We conclude that this case

and the cases cited are not distinguishable. In any event,

petitioners’ reconstruction and assertions of time spent are not

credible in the context of the types of properties, the amount of

rent received, and the services allegedly performed.

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). Therefore, we need not

address whether petitioner spent more than 50 percent of his time

in real estate trades or businesses under section

469(c)(7)(B)(i).
 - 16 -

Because petitioner does not qualify as a real estate

professional under section 469(c)(7), petitioners’ real estate

rental activities are treated as per se passive activities under

section 469(c)(2) regardless of material participation by

petitioners. See sec. 469(c)(4). Thus, we need not decide

whether petitioners materially participated in each real estate

rental activity. Even if petitioner were a real estate

professional under section 469(c)(7), petitioners would not meet

the material participation requirements of section 1.469-5T(a),

Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25, 1988),

based on the following considerations. Petitioners did not elect

to aggregate their real property rental activities and must show

that they meet the material participation requirements with

respect to each real estate rental property. Petitioners rely on

the same calendars, estimates of their travel time, and their

personal testimony to prove the hours that they worked on each of

their real estate rental properties. Petitioners retained a

manager for their apartment building and utilized the services of

independent contractors to maintain their rental properties.

Petitioners’ travel to their Florida property of 168 hours and

84 hours in 1994 and 1995, respectively, appears also to be

personal trips to stay at another Florida property owned by

petitioners. Petitioners did not spend more than 100 hours on
 - 17 -

activities related to the apartment building and commercial

building in 1995.

Petitioners made general estimates of the hours that each

spent on administrative work, and those estimates were neither

supported by calendar entries nor calculated with respect to each

real estate rental property. Activities performed by Mrs. Fowler

would be aggregated with those of petitioner for purposes of the

material participation requirement of section 469(c)(1)(B). See

sec. 469(h)(5). However, several of the administrative

activities that petitioners performed are investor-related

activities and, thus, are not treated as participation in the

activity. See sec. 1.469-5T(f)(2)(ii)(A), Temporary Income Tax

Regs., 25 Fed. Reg. 5697 (Feb. 25, 1988).

Interest

Respondent disallowed petitioner’s deductions of $43,874 and

$2,887 in 1994 and 1995, respectively, for “other interest” that

petitioners claimed on Schedule C for United Contractors. The

amounts deducted represent deficiency interest that petitioners

paid on tax deficiencies that related to their unincorporated

Schedule C business. Respondent’s disallowance is based on

section 163(h)(2)(A), which generally disallows a deduction for

personal interest, and on section 1.163-9T(b)(2)(i)(A), Temporary

Income Tax Regs., 52 Fed. Reg. 48409 (Dec. 22, 1987), which
 - 18 -

interprets personal interest to include interest paid on

individual tax deficiencies.

Section 163(h) generally provides:

SEC. 163. INTEREST.

* * * * * * *

(h) Disallowance of Deduction for Personal
Interest.--

(1) In general.–-In the case of a taxpayer
other than a corporation, no deduction shall be
allowed under this chapter for personal interest
paid or accrued during the taxable year.

(2) Personal interest.–-For purposes of this
subsection, the term “personal interest” means any
interest allowable as a deduction under this
chapter other than–-

(A) interest paid or accrued on
indebtedness properly allocable to a trade or
business (other than the trade or business of
performing services as an employee) * * *

Section 1.163-9T(b)(2)(i)(A), Temporary Income Tax Regs., supra,

provides:

Section 1.163-9T. Personal interest (temporary).--

* * * * * * *

(b) Personal interest–-

* * * * * * *

(2) Interest relating to taxes–-(i) In
general. Except as provided in paragraph (b)(2)(iii)
of this section, personal interest includes interest–-

(A) Paid on underpayments of individual
Federal, State or local income taxes and on
indebtedness used to pay such taxes (within the meaning
 - 19 -

of section 1.168-8T), regardless of the source of the
income generating the tax liability * * *

Petitioners maintain that they are entitled to deduct their

tax deficiency interest as a business expense on their Schedule C

because section 1.163-9T(b)(2)(i)(A), Temporary Income Tax Regs.,

supra, is invalid and interest on indebtedness is properly

allocable to a trade or business under section 163(h)(2)(A).

Petitioners rely on this Court’s opinions in Redlark v.

Commissioner, 106 T.C. 31 (1996), revd. 141 F.3d 936 (9th Cir.

1998), and Kikalos v. Commissioner, T.C. Memo. 1998-92, revd. 190

F.3d 791 (7th Cir. 1999), despite their reversal because the

appeal in the instant case lies to the Court of Appeals for the

Eleventh Circuit, which has yet to address the issue presented

here. See Golsen v. Commissioner, 54 T.C. 742, 757 (1970), affd.

445 F.2d 985 (10th Cir. 1971).

Subsequent to trial and the submission of briefs in this

case, the Court addressed the same issue with similar facts in

Robinson v. Commissioner, 119 T.C. ___ (2002). In Robinson, the

Court revisited the issue of whether deficiency interest that

taxpayers paid in connection with their unincorporated Schedule C

business was deductible. We reconsidered our conclusions in

Redlark and Kikalos and held that section 1.163-9T(b)(2)(i)(A),

Temporary Income Tax Regs., supra, was valid.

For the reasons set forth in Robinson, we similarly conclude

in the instant case that petitioners may not deduct the interest
 - 20 -

that they paid with respect to their Federal income tax

deficiency. The interest paid on petitioners’ individual tax

deficiency is personal interest regardless of the source of the

income generating the tax liability. The Courts of Appeals for

the Fourth, Sixth, Seventh, Eighth, and Ninth Circuits have

reached the same conclusion. Kikalos v. Commissioner, 190 F.3d

791 (7th Cir. 1999), revg. T.C. Memo. 1998-92; McDonnell v.

United States, 180 F.3d 721, 723 (6th Cir. 1999); Allen v. United

States, 173 F.3d 533, 538 (4th Cir. 1999); Redlark v.

Commissioner, 141 F.3d 936 (9th Cir. 1998), revg. 106 T.C. 31

(1996); Miller v. United States, 65 F.3d 687, 691 (8th Cir.

1995).

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)(1). Respondent determined that petitioners are

liable for the accuracy-related penalty under section 6662(a)

based on petitioners’ negligence or disregard of rules or

regulations in the preparation of their 1994 and 1995 tax

returns.

Section 1.6662-3(c)(1), Income Tax Regs., provides an

exception to the penalties imposed under section 6662(b)(1) when

the taxpayer adequately discloses a position contrary to that of
 - 21 -

the Internal Revenue Service. Adequate disclosure includes a

properly completed and filed Form 8275–R. Sec. 1.6662-3(c)(2),

Income Tax Regs. Petitioners filed a Form 8275-R to disclose

their position regarding the deductibility of interest.

With respect to the section 469 issue, petitioners did not

attempt disclosure and, in any event, the disclosure exception

under section 1.6662-3(c)(1), Income Tax Regs., does not apply.

Sec. 1.6662-3(c)(1), Income Tax Regs. We are satisfied from the

testimony, however, that petitioners relied on the advice of

Miller with respect to the passive activity losses that they

claimed. We conclude that petitioners are not liable for the

accuracy-related penalties imposed under section 6662.

We have considered all of the remaining arguments that have

been made by petitioners 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

petitioners as to the

accuracy-related penalties.