T.C. Summary Opinion 2003-96
UNITED STATES TAX COURT
EUGENE J. AND KATHRYN A. SCHUMACHER, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 18776-02S. Filed July 23, 2003.
Paul J. Quast, for petitioners.
Blaine C. Holiday, for respondent.
DINAN, Special Trial Judge: This case was heard pursuant to
the provisions of section 7463 of the Internal Revenue Code in
effect at the time the petition was filed. The decision to be
entered is not reviewable by any other court, and this opinion
should not be cited as authority. Unless otherwise indicated,
subsequent section references are to the Internal Revenue Code in
- 2 -
effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure.
Respondent determined deficiencies in petitioners’ Federal
income taxes of $20,582 and $21,861 for the taxable years 1998
and 1999, respectively.
The issue for decision is whether petitioner husband’s
(petitioner’s) leasing activity is “insubstantial” in relation to
his S corporation business activity, such that petitioners may
group the activities for purposes of the section 469 passive
activity loss rules pursuant to section 1.469-4(d)(1)(A), Income
Tax Regs.1
Some of the facts have been stipulated and are so found.
The stipulations of fact and the attached exhibits are
incorporated herein by this reference. Petitioners resided in
Arlington, Minnesota, on the date the petition was filed in this
case.
Petitioner is the majority owner of Pro Flight Center, Inc.,
(PFC), an S corporation which was incorporated in February 1996.
After acquiring the assets of the former Stensin Aviation, PFC
began its business activity at the Beaver County Airport in
Beaver Falls, Pennsylvania, on March 15, 1996. The assets
acquired from Stensin Aviation included five airplanes, a fuel
1
Petitioners do not dispute any other adjustments in the
statutory notice of deficiency.
- 3 -
truck, a fuel farm, tools, office equipment, parts, fuel, and
oil. PFC’s principal business activities from the time of its
inception have been flight training, aircraft rental, charter
services, and aircraft sales. PFC’s principal place of business
is at the Beaver County Airport.
During the years in issue, petitioner owned 90 percent of
the shares of PFC, while Fred A. Neppach owned the remaining 10
percent. During this time, petitioner participated in PFC on a
full-time basis as a manager, flight instructor, and mechanic,
while also holding the corporate offices of president, treasurer,
and assistant secretary. Mr. Neppach served as PFC’s general
manager, vice president, and secretary. Mr. Neppach, who had
received his interest in PFC in exchange for future services,
never contributed capital to PFC, and in 2000 he transferred all
of his shares to petitioner for no consideration.
Beginning in 1997, petitioner began acquiring additional
equipment which he determined was necessary in order to continue
the operation of PFC. Petitioner decided to purchase the
equipment himself and lease it to PFC because petitioner felt
that the company could not have afforded to make the purchases,
and because if petitioner had “let the company buy the equipment,
he [Mr. Neppach] would automatically have 10 percent of the
equipment”. Petitioner felt this was undesirable because Mr.
- 4 -
Neppach had no “financial equity” in the corporation at that
time.
Petitioner used personal retirement funds and commercial
loans to make the equipment purchases. In 1997, petitioner
purchased an airplane at a cost of $38,000 in order to lease it
to PFC. This plane subsequently was sold in 1998 for $48,000, at
a gain of $17,600. In 1998, petitioner purchased two airplanes
and two airplane engines for lease to PFC. The cost of the
airplanes totaled $279,000, and the cost of the engines totaled
$60,000. Written leases were executed between petitioner and PFC
under which PFC was responsible for operating and maintenance
expenses, including fuel, repairs, insurance, and taxes.
Payments required under the leases ranged from $1,000 per month
to $2,000 per month per aircraft. PFC made actual lease payments
to petitioner of $7,000 in 1997, $9,500 in 1998, and $34,940 in
1999. These payments were significantly less than what was
required under the leases; for example, the leases required
payments totaling $40,100 in 1998. The equipment leased to PFC
was used exclusively by PFC. In addition to the aircraft leased
to PFC by petitioner and the five aircraft acquired from Stensin
Aviation, PFC leased five more aircraft from other parties.
On PFC’s Federal income tax returns for the years in issue,
the following income was reported and deductions claimed:
- 5 -
1998 1999
Gross receipts $120,156 $1,092,295
Cost of goods sold 235,988 359,295
Gross profit (loss) (115,832) 733,000
Other income 684,336 -0-
Total income 568,504 733,000
Deductions 701,594 801,676
Income (loss) (133,090) (68,767)
The classification of certain income as “other income” in 1998
rather than “gross receipts”, as was done in 1999, was not the
result of a change in PFC’s operations during those years. The
“Balance Sheets per Books” filed with these returns reflected the
following year-end asset costs and values:
1998 1999
Cost of depreciable assets 503,996 510,360
Less accumulated depreciation (335,532) (404,699)
Other assets 250,423 233,490
Total assets 418,887 339,151
PFC has reported operating losses in each year since its
inception. Petitioner’s share of these losses, as a 90 percent
owner, were as follows: $32,789 in 1996, $202,609 in 1997,
$119,781 in 1998, and $61,808 in 1999. Because petitioner’s
adjusted basis in his PFC stock during the years in issue was
zero, petitioner was unable to deduct these losses in full. As
of the end of 1998, petitioner’s suspended loss was $244,179, and
as of the end of 1999, petitioner’s suspended loss was $275,987.
Petitioners filed joint Federal income tax returns for
taxable years 1998 and 1999. With each of these returns,
petitioners filed a Schedule C, Profit or Loss From Business, for
- 6 -
petitioner’s airplane leasing activity. On these forms,
petitioners reported the following:
1998 1999
Gross receipts $9,500 $34,940
Depreciation expense 61,500 98,320
Mortgage expense 13,471 14,521
Legal/professional expense -0- 108
Profit (loss) (65,471) (78,009)
Petitioners also reported that petitioner materially participated
in the leasing activity in each year.
In the statutory notice of deficiency, respondent determined
that petitioner’s Schedule C leasing activity was a passive
activity subject to the provisions of section 469. Respondent
accordingly limited the losses allowable to petitioners with
respect to the activity to the extent of petitioners’ passive
income. This resulted in the disallowance of deductions for
losses of $47,8712 in 1998 and $78,009 in 1999.
Pursuant to section 469(a), a passive activity loss
generally is not allowed as a deduction for the year in which it
is sustained. 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). Passive activities
2
Although the record is not clear, the disallowed loss in
1998--which is less than the Schedule C loss of $65,471--
apparently reflects the $17,600 gain from the sale of the
airplane which petitioner had purchased to lease to PFC.
- 7 -
generally are those activities which involve the conduct of a
trade or business in which the taxpayer does not materially
participate. Sec. 469(c)(1). Rental activities generally are
presumptively passive, without regard to whether the taxpayer
materially participates in the activity. Sec. 469(c)(2), (4).
Subject to statutory and regulatory exceptions not applicable
here, a rental activity is “any activity where payments are
principally for the use of tangible property”. Sec. 469(j)(8).
Pursuant to the regulations issued under section 469,
certain activities may be grouped into a single activity for
purposes of ascertaining whether the resulting combined activity
is a passive activity under that section. The regulations state
the general rule that
One or more trade or business activities or rental
activities may be treated as a single activity if the
activities constitute an appropriate economic unit for the
measurement of gain or loss for purposes of section 469.
Sec. 1.469-4(c)(1), Income Tax Regs. A taxpayer who is a
shareholder of an S corporation may group the activity of that S
corporation with an activity conducted directly by the taxpayer.
Sec. 1.469-4(d)(5)(i), Income Tax Regs.
Whether activities constitute an “appropriate economic unit”
depends upon all the relevant facts and circumstances, giving the
greatest weight to (1) similarities and differences in the types
of trades or businesses, (2) the extent of common control, (3)
the extent of common ownership, (4) geographical location, and
- 8 -
(5) interdependencies between the activities. Sec. 1.469-
4(c)(2), Income Tax Regs. Taxpayers may use “any reasonable
method of applying the relevant facts and circumstances in
grouping activities.” Id. However, there are limitations
imposed on taxpayers’ ability to group certain activities. Sec.
1.469-4(d), Income Tax Regs. The limitation applicable to the
case at hand provides:
(1) Grouping rental activities with other trade or
business activities--
(i) Rule. A rental activity may not be
grouped with a trade or business activity unless
the activities being grouped together constitute
an appropriate economic unit under paragraph (c)
of this section and--
(A) The rental activity is insubstantial
in relation to the trade or business
activity;
(B) The trade or business activity is
insubstantial in relation to the rental
activity; or
(C) Each owner of the trade or business
activity has the same proportionate ownership
interest in the rental activity, in which
case the portion of the rental activity that
involves the rental of items of property for
use in the trade or business activity may be
grouped with the trade or business activity.
Sec. 1.469-4(d)(1), Income Tax Regs. The regulations do not
define the term “insubstantial”.
The dispute in this case has been narrowly drawn by the
parties: The sole issue we must decide is whether the leasing
activity is insubstantial in relation to the PFC activity within
- 9 -
the meaning of section 1.469-4(d)(1)(A), Income Tax Regs. If it
is, petitioners may group petitioner’s leasing activity with the
PFC activity, thereby allowing petitioners to categorize as non-
passive, and therefore deduct, the losses incurred by
petitioner’s leasing activity. Because respondent does not
dispute that the two activities are an appropriate economic unit,
we need not address the specific factors enumerated in section
1.469-4(c)(2), Income Tax Regs.
In arguing that the leasing activity was not insubstantial
in relation to the PFC activity, respondent makes several
comparisons between them, highlighting the income, losses, cost
of depreciable assets, and basis of assets in both activities.
In arguing that the leasing activity was insubstantial in
relation to the PFC activity, petitioners focus both on
“quantitative” comparisons similar to those focused on by
respondent, as well as on other “qualitative” factors. See
generally Glick v. United States, 96 F. Supp. 2d 850 (S.D. Ind.
2000).
The parties’ comparison of the value of the assets of each
activity is not determinative under the particular facts of this
case. Merely because the rental activity in this case involved
the rental of assets with high values does not make the primary
trade or business activity less substantial in relation to that
rental activity. Most importantly, a comparison of the value of
- 10 -
the assets does not take into account the value of equipment that
PFC leased from parties other than petitioner but that was
instrumental to PFC’s operations.
We find that, in ascertaining whether the leasing activity
was insubstantial in relation to the PFC activity, the most
significant fact in this case is that petitioner created and
operated the leasing activity solely for PFC’s benefit. In
furtherance of this goal, petitioner spent very little time
conducting the affairs of the leasing activity in comparison with
the very substantial amount of time and effort expended by
petitioner in carrying on PFC’s business. The leasing activity
was intended to, and in fact did, provide a service solely to
PFC. Its purpose was to enhance PFC’s ability to generate
business, maintain PFC’s viability as an ongoing concern, and
possibly enable PFC to become profitable in the future, not to
provide an income stream independently from PFC. Consistent with
this purpose, the leasing activity had gross receipts of $9,500
in 1998 and $34,940 in 1999, compared to PFC’s gross receipts and
other income of $804,492 and $1,092,295 in each respective year.
Based on the record in this case, we find that petitioner’s
leasing activity was insubstantial in relation to the PFC
activity. Accordingly, we do not sustain respondent’s
determination that the leasing activity was a passive activity
subject to the provisions of section 469.
- 11 -
Reviewed and adopted as the report of the Small Tax Case
Division.
To reflect the foregoing,
Decision will be entered
under Rule 155.