T.C. Summary Opinion 2009-174
UNITED STATES TAX COURT
JOHN ANTHONY LEONE AND MARY L. SPENCER-LEONE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 1221-08S. Filed November 24, 2009.
John Anthony Leone and Mary L. Spencer-Leone, pro sese.
Ashley P. Vaughan, for respondent.
VASQUEZ, Judge: This case was heard pursuant to the
provisions of section 74631 of the Internal Revenue Code in
effect when the petition was filed. Pursuant to section 7463(b),
the decision to be entered is not reviewable by any other court,
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
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and this opinion shall not be treated as precedent for any other
case.
Respondent determined deficiencies in petitioners John Leone
(Mr. Leone) and Mary Spencer-Leone’s (Mrs. Leone) Federal income
taxes and accuracy-related penalties as follows:
Penalty
Year Deficiency Sec. 6662(a)
2004 $5,675 $1,135.00
2005 14,252 2,850.40
2006 4,625 925.00
Afer concessions, the issues for decision are:2 (1) Whether
petitioners’ drag racing activity was an activity engaged in for
profit under section 183(a); (2) whether capital gain from the
sale of rental property should have been reported on petitioners’
2005 Federal income tax return; and (3) whether petitioners are
liable for the accuracy-related penalty under section 6662(a).
Background
Some of the facts have been stipulated and are so found.
The stipulation of facts, the supplemental stipulation of facts,
and the attached exhibits are incorporated herein by this
2
The notice of deficiency disallowed all expenses relating
to the drag racing activity. In respondent’s pretrial
memorandum, respondent conceded the expenses related to the drag
racing activity up to the amount of income from the activity.
The notice of deficiency contains adjustments to itemized
deductions (changes to the medical expenses and miscellaneous
deductions) for 2004 to 2006. These are computational
adjustments and are affected by the outcome of the issues to be
decided; we do not separately address them.
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reference. At the time petitioners filed the petition, they
resided in Texas.
Racing Activities
During the years in issue petitioners were involved in a
drag racing activity. In each of the years petitioners were
full-time employees of the U.S. Postal Service. Mr. Leone was 53
at the time of trial and has been interested in car racing since
he was a teenager. With a self-proclaimed “natural attraction to
fast cars”, Mr. Leone was “captivated” by the races he watched on
television while growing up. Mrs. Leone’s interest in drag
racing emerged in 2002 when she started dating Mr. Leone.
Although Mr. Leone was unsure of whether he began his drag
racing activity at the end of 2002 or the beginning of 2003, he
first reported this activity on his Schedule C, Profit or Loss
From Business, under the name “First Strike Racing Team” (First
Strike) on his individual 2002 Federal income tax return and
described the activity as “racing”. For years 2003 to 2006
petitioners filed joint returns with the same business name and
Schedule C activity description. Petitioners reported the
following income, expenses, and net losses from the drag racing
activity for 2002 to 2006:
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Year Gross Income Expenses Gain (Loss)
2002 $200 $17,915 ($17,715)
2003 1,285 20,220 (18,935)
2004 708 21,706 (20,998)
2005 4,570 25,912 (21,342)
2006 7,700 25,719 (18,019)
Total 14,463 111,472 (97,009)
Petitioners reported they were entitled to refunds on their 2004,
2005, and 2006 joint income tax returns.3 Respondent disputes
the drag racing activity expenses exceeding income generated from
the activity for years 2004, 2005, and 2006.
Petitioners’ business plan for First Strike centered on
winning as many “grassroots” level races as possible to offset
their expenses while gaining enough acclaim and exposure to
attract large sponsors. When deciding to enter a race,
petitioners would weigh the purse size and their chances of
winning against their total expenses. Petitioners did not have a
written business plan and did not solicit any professional
business advice.
Petitioners’ racing activity generated income from: (1) cash
prizes for winning or place finishing in races;4 and (2) gift
certificates from local auto parts stores for petitioners’
displaying one of their race cars in front of the store.
Petitioners’ cash prizes for drag racing activities from 2004
3
Petitioners reported they were entitled to the following
refunds: $6,099 for 2004, $6,901 for 2005, and $5,631 for 2006.
4
Different cash prize amounts are awarded depending on
whether one wins or places in a race, with the prize amount being
larger the higher one finishes.
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through 2006 is as follows:
• 2004: one place finish;
• 2005: three place finishes; and
• 2006: one or two wins, one or two place finishes.
Petitioners received an undisclosed amount of gift certificates
from local auto parts stores in 2005 and 2006. Additionally, in
2006 petitioners received $4,600 from the sale of a broken
engine.5
Petitioners claimed the following deductions on their
Schedules C for 2004, 2005, and 2006:
2004 2005 2006
Advertising $819 $1,129 $1,370
Car and truck expenses 5,457 3,934 4,895
Commissions and fees 720 1,600 1,510
Depreciation 10,610 2,880 1,728
Office expenses 200 2,800 1,940
Lease of business property 1,416 1,514 1,561
Supplies 324 8,733 9,200
Taxes and licenses –- 200 240
Travel expenses 1,200 -- --
Other expenses 960 3,122 3,275
Petitioners did not establish a budget for expenses, keep
financial books or records, or maintain a separate bank account
for First Strike.
5
Mr. Leone testified he routinely broke at least two
engines a year but that he “had enough spare parts on hand to
piece [an engine] together to keep [racing]”.
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Petitioners had two race cars: a 2000 Chevy Dragster6 and a
1969 Chevelle. They also owned a 2004 Cross Country.7
Petitioners initially referred to their race cars as “dragsters”
but later clarified that the Chevelle was just a “regular race
car” they used in drag races.8
Petitioners placed their Chevelle into service in January
2004. They reported 100 percent business use and a basis of
$18,000 and claimed depreciation deductions for 2004, 2005, and
2006. Petitioners acquired the Chevy Dragster for $23,000 in
2001 and sold it for $19,000 in 2003. Mr. Leone built one of his
cars with the aid of a local speed shop for around $22,000. Upon
quitting the activity in late 2006 or 2007, he sold the car for
around $10,000. Mr. Leone did not specify which car he built or
to whom he sold it. No record of this alleged sale was
presented.
6
Mr. Leone described the Chevy Dragster as a 32-foot
“long-rail” with a backside engine and topside spoiler.
7
Petitioners never mentioned the Cross Country during
their testimony; however, it is listed as an asset on their 2005
and 2006 returns. The 2005 and 2006 returns show they placed the
Cross Country into service in December of 2004, listed no basis,
and used the standard mileage rate deduction for the Cross
Country in 2005 and 2006, claiming 9,100 business miles in 2005
and 11,000 business miles in 2006. It is unclear from the record
whether the Cross Country is a race car.
8
Petitioners used the term “dragster” when discussing
their cars.
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During the years in issue Mr. Leone spent approximately 10
to 25 hours per week on the drag racing activity, Mrs. Leone
spent approximately 10 hours per week on the drag racing
activity, and occasionally friends helped with the drag racing
activity. Petitioners worked on the drag racing activity either
at the storage area where they kept the drag racing cars or at
their home. During the years in issue petitioners did not keep a
time log or calendar of these hours.
Petitioners were the only drivers for First Strike. When
Mrs. Leone would race, Mr. Leone would “de-tune” the race car and
restrict its maximum speed.
Petitioners participated in approximately 10 races per year.
Some of the races had a cash prize of $8,000 to $10,000. The
largest prize petitioners received from any particular race was
$1,500. The races were sponsored by the International Hot Rod
Association and took place in different cities around the
southwestern United States. Petitioners did not provide records
of race participation despite having stated they possessed such
records.
Petitioners did not conduct a written cost analysis for any
of the races in which they participated. Petitioners did not
provide any documents or records to show what changes, if any, to
improve profitability were made.
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Petitioners discontinued their drag racing activity in 2007.
Although they enjoyed the sport, the losses were too great.
Petitioners liquidated the assets from their drag racing
activity.
Sale of Rental Home
In 1992 Mr. Leone purchased a property in El Paso, Texas.
He used it as his primary residence until 2002. During June 2002
Mr. Leone converted it into a rental property. In December of
2003 he agreed to sell it to a coworker for $54,000. Title
complications delayed the closing of the sale, and petitioners
did not receive the funds from the sale of the home until July
2005.
Petitioners included the expected proceeds from the sale of
the home on their 2003 return and reported that the sale had
closed on December 15, 2003. Petitioners reported they had
received $54,000 for the house and sustained an $11,237 ordinary
loss on the sale of the property.9
Petitioners did not receive the proceeds from the sale of
the home until 2005. Petitioners received $51,640.97 for the
home.
9
On their 2003 Form 4797, Sales of Business Property, part
I, Sales or Exchanges of Property Used in a Trade or Business and
Involuntary Conversions From Other Than Casualty or Theft--Most
Property Held More Than 1 Year, petitioners reported their rental
property had a basis of $69,000, they had deducted depreciation
of $3,763, and they sold the home for $54,000.
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Petitioners reported $54,000 as the selling price on their
2003 return because it was the initially agreed-upon price.
Petitioners reported $69,000 as the basis because it was the
value assigned to the rental property by the El Paso County tax
assessor. Subsequently, the parties stipulated that petitioners
had a $20,400 initial basis in the property.
Petitioners subtracted $3,763 of depreciation from their
basis to calculate the $11,237 ordinary loss reported on their
2003 joint tax return. Petitioners claimed rental home
depreciation deductions on their tax returns for 2002 and 2003
totaling $5,471; Mr. Leone deducted $2,016 of depreciation for
2002 on his individual tax return, and the Leones deducted $3,455
of depreciation for 2003 on their joint tax return. No
explanation was given for the disparity in the depreciation
amounts.
Discussion
I. Activity Not Engaged In for Profit
Section 183(a) provides generally that, if an activity is
not engaged in for profit, no deduction attributable to such
activity shall be allowed except as provided in section 183(b).
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 section 212.”
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The Court of Appeals for the Fifth Circuit, to which an
appeal in this case would lie but for section 7463(b), has held
that for a deduction to be allowed under section 162 or 212(1) or
(2), a taxpayer must establish that he engaged in the activity
with the primary purpose and intent of realizing an economic
profit independent of tax savings. Westbrook v. Commissioner, 68
F.3d 868, 875 (5th Cir. 1995), affg. T.C. Memo. 1993-634.
The expectation of profit need not have been reasonable;
however, the taxpayer must have entered into the activity, or
continued it, with the objective of making a profit. Hulter v.
Commissioner, 91 T.C. 371, 393 (1988); sec. 1.183-2(a), Income
Tax Regs. Whether the requisite profit objective exists is
determined by looking at all the surrounding facts and
circumstances. Keanini v. Commissioner, 94 T.C. 41, 46 (1990);
sec. 1.183-2(b), Income Tax Regs. Greater weight is given to
objective facts than to a taxpayer’s mere statement of intent.
Thomas v. Commissioner, 84 T.C. 1244, 1269 (1985), affd. 792 F.2d
1256 (4th Cir. 1986); sec. 1.183-2(a), Income Tax Regs.
Petitioners bear the burden of proof.10 See Rule 142(a).
Section 1.183-2(b), Income Tax Regs., provides a list of
factors to be considered in the evaluation of a taxpayer’s profit
objective: (1) The manner in which the taxpayer carries on the
10
Petitioners have neither claimed nor shown that they
satisfied the requirements of sec. 7491(a) to shift the burden of
proof to respondent with regard to any factual issue.
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activity; (2) the expertise of the taxpayer or his advisers; (3)
the time and effort expended by the taxpayer in carrying on the
activity; (4) the expectation that assets used in the activity
may appreciate in value; (5) the success of the taxpayer in
carrying on other similar or dissimilar activities; (6) the
taxpayer’s history of income or losses with respect to the
activity; (7) the amount of occasional profits, if any, from the
activity; (8) the financial status of the taxpayer; and (9)
elements of personal pleasure or recreation. This list is
nonexclusive, and the number of factors for or against the
taxpayer is not necessarily determinative. Rather, all facts
and circumstances must be taken into account, and more weight may
be given to some factors than to others. Id.; cf. Dunn v.
Commissioner, 70 T.C. 715, 720 (1978), affd. 615 F.2d 578 (2d
Cir. 1980).
Petitioners assert the losses from their drag racing
activity in 2004, 2005, and 2006 are deductible because they
engaged in the activity for profit. Respondent asserts
petitioners’ drag racing activity in 2004, 2005, and 2006 was not
engaged in for profit. After considering the factors in section
1.183-2(b), Income Tax Regs., we agree with respondent and
conclude petitioners’ drag racing activity in 2004, 2005, and
2006 was not engaged in for profit and, accordingly, petitioners
are not entitled to deduct losses incurred in such activity.
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A. Manner in Which the Activity Is Conducted
Section 1.183-2(b)(1), Income Tax Regs., provides that
carrying on an activity in a businesslike manner may be
indicative of a profit objective. The regulation further
identifies three practices consistent with businesslike
operations: (1) Maintaining complete and accurate books and
records; (2) conducting the activity in a manner substantially
similar to that of profitable businesses of the same nature; and
(3) changing operational methods and techniques to improve
profitability. See id. The Tax Court has found establishing a
business plan to be a fourth practice evidencing businesslike
operations. See Sanders v. Commissioner, T.C. Memo. 1999-208.
Petitioners did not maintain any financial books or ledgers
for their racing activity and had no records of the races in
which they raced. In addition, petitioners did not keep a budget
of their expenses or record how much income they received or from
where it was generated. This lack of elementary business
practices indicates a lack of profit objective. See Snoddy v.
Commissioner, T.C. Memo. 1991-251 (stating that “we think a
serious business operation would have kept records to show races
petitioner entered, and what his winnings were in each race”);
Woods v. Commissioner, T.C. Memo. 1985-233 (finding that a
taxpayer who did not maintain a formal general ledger, accounts
receivable ledger, accounts payable ledger, or asset ledgers in
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stock racing activity did not operate in a businesslike manner);
Whitener v. Commissioner, T.C. Memo. 1979-415 (finding that a
taxpayer who kept no business books or records did not conduct
his stock car racing activity in a businesslike manner).
Petitioners’ alleged efforts to improve profitability by
changing their methods and techniques of conducting their drag
racing activity is not substantiated by the record. Mr. Leone
testified that he received advice from fellow racers on various
racing issues and as a result he and his wife were more frugal in
advertising First Strike. However, no evidence was presented to
show what changes were made or when they were implemented.
Further, petitioners’ tax returns reveal their advertising
expenses steadily increased each year from 2004 to 2006. Cf.
Dwyer v. Commissioner, T.C. Memo. 1991-123 (finding indication of
profit objective for taxpayer’s financing son’s auto racing
career where taxpayer changed operating methods, tried new
approaches, and discontinued methods that did not work).
Petitioners testified that they intended to make First
Strike a profitable business by winning races as often as
possible in hopes of attracting a large sponsor. Petitioners did
not present a written business plan. A lack of a formal written
business plan is not determinative of a lack of profit objective.
See Sanders v. Commissioner, supra. Nevertheless, some
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indication of a plan for success (i.e., profitability) should be
given. Id.
Given the substantial costs associated with operating
petitioners’ drag racing team, more than petitioners’ vague and
wishful representation that they would be profitable by winning
often is needed to conclude petitioners had a plan to make a
profit. See id.; Spear v. Commissioner, T.C. Memo. 1994-354
(finding unpersuasive a business plan for racing activity that
consisted solely of the taxpayer’s claiming it would take 10
years before the activity would become profitable). This factor
weighs against finding petitioners’ drag racing activity was
engaged in for profit.
B. Expertise
A taxpayer’s expertise, research, and study of an activity,
as well as his consultation with experts, may be indicative of a
profit intent. Sec. 1.183-2(b)(2), Income Tax Regs. Taxpayers
should not only familiarize themselves with the undertaking, but
should also consult or employ an expert, if needed, for advice on
how to make the operation profitable. Burger v. Commissioner,
809 F.2d 355, 359 (7th Cir. 1987), affg. T.C. Memo. 1985-523.
Courts have made clear that the focus is upon expertise and
preparation with regard to the economic aspects of the particular
business. Wesinger v. Commissioner, T.C. Memo. 1999-372 (citing
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Golanty v. Commissioner, 72 T.C. 411, 432 (1979), affd. without
published opinion 647 F.2d 170 (9th Cir. 1981)).
Petitioners had no experience managing a drag racing team.
Despite incurring significant losses and rarely winning or
placing, petitioners never solicited the aid of any professional
business advisers. Petitioners did receive advice from fellow
drag racers, but no evidence was presented to suggest these drag
racers were experts or had experience with the business side of
racing. This factor weighs against finding petitioners’ drag
racing activity was engaged in for profit.
C. Time and Effort Expended
The fact that a taxpayer spends much time and effort in
conducting an activity may indicate that he or she has a profit
objective, particularly if the activity does not have substantial
personal or recreational aspects. Sec. 1.183-2(b)(3), Income Tax
Regs.
During the years in issue petitioners were both employed
full time by the U.S. Postal Service. Petitioners devoted their
time after work hours and on weekends to First Strike.
Petitioners did not maintain a professional crew, received
sporadic help from friends, and were the only drivers for First
Strike. The activity primarily consisted of Mr. Leone’s working
on the cars, petitioners’ driving to races, and the races
themselves. Although the record does indicate petitioners spent
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time (outside of their full-time postal employment) on their drag
racing activity, this does little to support petitioners’ claim
that it was a serious activity engaged in for profit. See Snoddy
v. Commissioner, T.C. Memo. 1991-251 (finding lack of support for
a profit motive in a car racing activity when the taxpayer was a
full-time manager at an auto parts store, mainly worked on the
car after hours and on weekends, enlisted volunteers to help with
working on the car and serve in the “pit”, and had an independent
driver). Further, it is clear this activity had substantial
recreational aspects for Mr. Leone. This factor weighs against
finding petitioners’ drag racing activity was engaged in for
profit.
D. The Expectation That Assets May Appreciate in Value
A taxpayer may intend, despite the lack of profit from
current operations, that an overall profit will result when
appreciation in the value of assets used in the activity is
realized. Bessenyey v. Commissioner, 45 T.C. 261, 274 (1965),
affd. 379 F.2d 252 (2d Cir. 1967); sec. 1.183-2(b)(4), Income Tax
Regs.
Petitioners routinely broke at least two drag racing car
engines per year, a fact that seems inconsistent with their claim
that the drag racing cars would appreciate in value. Petitioners
sustained a loss when they sold the Chevy Dragster in 2003.
Petitioners presented no evidence regarding the appreciation of
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their remaining assets. This factor weighs against finding
petitioners’ drag racing activity was engaged in for profit.
E. Success in Similar or Dissimilar Activities
If a taxpayer has previously engaged in similar activities
and made them profitable, this success may show that the taxpayer
has a profit objective, even though the activity is presently
unprofitable. Sec. 1.183-2(b)(5), Income Tax Regs. Success in
unrelated activities may also be indicative of a profit objective
in the challenged activity. See Daugherty v. Commissioner, T.C.
Memo. 1983-188 (finding that a taxpayer who started and
maintained a profitable screws product company had reason to
believe he would be successful in a farming activity).
Conversely, a lack of such experience does not necessarily
indicate the activity was not engaged in with the objective of
making a profit. Arwood v. Commissioner, T.C. Memo. 1993-352.
Petitioners had no previous experience in any other businesses.
This factor is neutral.
F. History of Income or Loss and Potential
for Profitability
A record of substantial losses over several years may be
indicative of the absence of a profit objective. See Golanty v.
Commissioner, supra. The amount of profits in relation to the
amount of losses incurred, and in relation to the amount of the
taxpayer’s investment and the value of the assets used in the
activity, may provide useful criteria in determining the
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taxpayer’s intent. Sec. 1.183-2(b)(7), Income Tax Regs. An
occasional small profit from an activity generating large losses,
or from an activity in which the taxpayer has made a large
investment, would not generally be determinative that the
activity is engaged in for profit. Id.
Petitioners suffered an uninterrupted history of losses from
their drag racing activity from 2002 through 2006 and never
turned a profit. Petitioners invested $111,472 in their drag
racing venture yet earned only $14,463 and sustained a net loss
of $97,009.
Furthermore, it does not appear petitioners would have had
the ability to recoup their losses or make a profit.
Petitioners have not produced any evidence to suggest they were
close to securing a large sponsor. In petitioners’ case the
potential for profitability through winning races alone seems
implausible. Petitioners participated in about 10 races a year,
with some purses in the range of $8,000 to $10,000. However,
petitioners’ winnings suggest they were limited to winning small
races with small purses. See Dwyer v. Commissioner, T.C. Memo.
1991-123 (finding a profit objective for a taxpayer involved in a
stock car racing activity where, inter alia, the taxpayer could
conceivably recoup past losses and turn a profit because purses
averaged hundreds of thousands of dollars). This factor weighs
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against finding petitioners’ drag racing activity was engaged in
for profit.
G. Financial Status
Substantial income from sources other than the activity in
question, particularly if the activity’s losses generate
substantial tax benefits, may indicate that the activity is not
engaged in for profit. See sec. 1.183-2(b)(8), Income Tax Regs.
Petitioners’ annual combined income was approximately
$100,000 from their employment as U.S. postal workers.
Petitioners derived substantial tax benefits from deducting the
losses associated with their Schedule C activity. First Strike’s
losses offset roughly one-fifth of petitioners’ income and
resulted in petitioners claiming refunds for each year. This
factor weighs against finding petitioners’ drag racing activity
was engaged in for profit.
H. Elements of Personal Pleasure
The absence of personal pleasure or recreation relating to
the activity in question may indicate the presence of a profit
objective, but the mere fact that a taxpayer derives personal
pleasure from a particular activity does not, per se, demonstrate
a lack of a profit objective. See Rinehart v. Commissioner, T.C.
Memo. 1998-205; sec. 1.183-2(b)(9), Income Tax Regs. However,
should the likelihood of profit be small compared to the
possibility for gratification, the latter possibility may be the
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primary motivation for the activity. Filios v. Commissioner,
T.C. Memo. 1999-92 (citing White v. Commissioner, 23 T.C. 90, 94
(1954), affd. per curiam 227 F.2d 779 (6th Cir. 1955)), affd. 224
F.3d 16 (1st Cir. 2000).
Petitioners readily admitted they enjoyed racing. Despite
petitioners’ substantial losses and small chance to turn a
profit, petitioners continued to race. Petitioners spent their
time repairing the drag racing cars and driving to various cities
to participate in drag races. We have previously stated that
automobile racing is often engaged in for amusement and as a
hobby, and that this tends to militate against a finding that the
activity was engaged in for profit. Whitener v. Commissioner,
T.C. Memo. 1979-415 (citing McLean v. Commissioner, 285 F.2d 756
(4th Cir. 1961), affg. per curiam T.C. Memo. 1960-128).
Petitioners’ approach to their drag racing activity suggests they
viewed drag racing as a recreational getaway rather than a
profit-earning activity. This factor weighs against finding
petitioners’ drag racing activity was engaged in for profit.
I. Conclusion
Petitioners did not conduct their drag racing activity in a
businesslike manner. They had an extended, uninterrupted period
of substantial losses and had no practical possibility of
recouping their losses and turning a profit. Furthermore, there
was a substantial recreational aspect to petitioners’ drag racing
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activity. Accordingly, we hold that petitioners’ drag racing
activity was not engaged in for profit during 2004, 2005, and
2006, and section 183(b)(2) prohibits any deduction of expenses
greater than the gross income derived from the activity.
II. Sale of Rental Property
Section 61(a) defines gross income to include all income
from whatever source derived, and section 61(a)(3) specifically
provides that gross income includes gains derived from dealings
in property. Section 1001(a) provides that the gain from the
sale of property shall be the excess of the amount realized
therefrom over the taxpayer’s adjusted basis in the property.
Section 1001(b) defines the amount realized from the sale or
other disposition of property as the sum of any money plus the
fair market value of the property received. See also sec.
1.1001-1(a), Income Tax Regs. Petitioners sold their rental home
in 2005 for gross proceeds of $51,640.97. Accordingly,
petitioners realized $51,640.97 for the sale of their rental home
in 2005.
Section 1012 provides that a property’s adjusted basis shall
be the cost of such property, and cost is defined as the amount
paid for the property in cash or other property. Sec. 1.1012-
1(a), Income Tax Regs. In addition, section 1016(a)(2) provides
that the basis should be adjusted for depreciation deductions.
Mr. Leone paid $20,400 in 1992 for his rental home and deducted
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$5,47111 of depreciation for 2002 and 2003. In 2003 petitioners
had an adjusted basis of $14,929.
When petitioners received $51,640.97 in 2005 for the sale of
their rental property, they recognized a gain of $36,711.97. See
sec. 1001(c). Because this was a sale of qualified section 1231
property and petitioners had no other section 1231 property
dispositions, the gain is taxed at 2005 capital gain rates.12
See sec. 1231(a)(1), (b); sec. 1.1231-1(a), (c), Income Tax Regs.
III. Accuracy-Related Penalty
Respondent determined that petitioners are liable for
accuracy-related penalties under section 6662 for 2004, 2005, and
2006. Respondent argues that petitioners are liable for the
section 6662 accuracy-related penalty attributable to one or more
of the following: (1) Negligence or disregard of rules or
regulations; (2) substantial understatement of income tax; and
11
For 2002 Mr. Leone deducted depreciation of $2,016, and
for 2003 petitioners deducted depreciation of $3,455.
12
On brief respondent argued that the tax benefit rule
dictates that petitioners’ 2005 income should be increased by
$11,237 (the amount of the ordinary loss deducted on the sale of
the property in 2003). We consider the tax benefit rule to be a
new matter because it would require the presentation of different
evidence from the evidence required to tax petitioners on the
gain resulting from the sale of their house in 2005. The tax
benefit rule and 2003 were not referenced in the statutory notice
of deficiency, and respondent never amended his answer. We find
that this issue is not before the Court. See Foil v.
Commissioner, 92 T.C. 376, 418 (1989), affd. per curiam 920 F.2d
1196 (5th Cir. 1990); Markwardt v. Commissioner, 64 T.C. 989, 997
(1975).
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(3) substantial valuation misstatement (overstatement). See sec.
6662(b). Respondent has not alleged a substantial valuation
misstatement for 2004, 2005, or 2006.
Section 7491(c) provides that the Commissioner bears the
burden of production with respect to the liability of any
individual for additions to tax and penalties. The
Commissioner’s burden of production under section 7491(c) is to
produce evidence that it is appropriate to impose the relevant
penalty, addition to tax, or additional amount. Swain v.
Commissioner, 118 T.C. 358, 363 (2002); see also Higbee v.
Commissioner, 116 T.C. 438, 446 (2001). If a taxpayer files a
petition alleging some error in the determination of an addition
to tax or a penalty, the taxpayer’s challenge will succeed unless
the Commissioner produces evidence that the addition to tax or
the penalty is appropriate. Swain v. Commissioner, supra at 363-
365. The Commissioner, however, does not have the obligation to
introduce evidence regarding reasonable cause or substantial
authority. Higbee v. Commissioner, supra at 446-447.
Section 6662(a) imposes a penalty in an amount equal to 20
percent of the portion of the underpayment of tax attributable to
one or more of the items set forth in section 6662(b), including
negligence or disregard of rules or regulations and substantial
understatement of income tax. “Negligence” includes any failure
to make a reasonable attempt to comply with the provisions of the
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internal revenue laws and is the failure to exercise due care or
the failure to do what a reasonable and prudent person would do
under the circumstances. Sec. 6662(c); Neely v. Commissioner, 85
T.C. 943, 947 (1985); sec. 1.6662-3(b)(1), Income Tax Regs.
“Disregard” includes any careless, reckless, or intentional
disregard of rules or regulations. Sec. 6662(c); sec. 1.6662-
3(b)(2), Income Tax Regs. An “understatement” of income tax is
the difference between the amount of tax required to be shown on
the return and the amount of tax actually shown on the return.
Sec. 6662(d)(2)(A). A “substantial understatement” exists if the
understatement exceeds the greater of (1) 10 percent of the tax
required to be shown on the return for a taxable year, or (2)
$5,000. Sec. 6662(d)(1)(A).
The section 6662(a) accuracy-related penalty does not apply
with respect to any portion of an underpayment if it is shown
that there was reasonable cause for such portion and that the
taxpayer acted in good faith with respect to such portion. Sec.
6664(c)(1). The determination of whether a taxpayer acted with
reasonable cause and in good faith depends on the pertinent
facts and circumstances. Sec. 1.6664-4(b)(1), Income Tax Regs.
The most important factor is the extent of the taxpayer’s effort
to assess his or her proper tax liability. Id.
Petitioners do not contest the penalties relating to their
drag racing activity. Accordingly, we sustain the section 6662
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penalties with regard to petitioners’ drag racing activity for
2004, 2005, and 2006. See sec. 7491(c).
However, petitioners contend that they are not liable for
the portion of the accuracy-related penalty for 2005 related to
the sale of their rental home. They claim they already paid tax
for 2003 relating to the sale of their rental home13 and were
simply following the advice of their tax adviser.
Petitioners’ failure to report the gain from the sale of
their rental home in 2005 was negligent. See sec. 6662(c); sec.
1.6662-3(b)(1) and (2), Income Tax Regs.
Petitioners claim their understatement was reasonable and in
good faith because they relied upon the advice of their tax
return preparer, Ms. Barton, when reporting the sale of their
rental home for 2003. Reliance on a return preparer may relieve
a taxpayer from the addition to tax for negligence where the
taxpayer’s reliance is reasonable. Freytag v. Commissioner, 89
T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th Cir. 1990), affd.
501 U.S. 868 (1991). A taxpayer, however, is not relieved from
liability for the addition to tax for negligence merely by
shifting the responsibility to a tax professional. Enoch v.
Commissioner, 57 T.C. 781, 802 (1972). Reliance on an expert is
not an absolute defense but is a factor to be considered.
13
On their income tax return for 2003, petitioners
reported a loss from the sale of the rental property and received
a tax benefit.
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Freytag v. Commissioner, supra at 888. A taxpayer’s reliance
must be in good faith and demonstrably reasonable. Ewing v.
Commissioner, 91 T.C. 396, 423 (1988), affd. without published
opinion 940 F.2d 1534 (9th Cir. 1991); Freytag v. Commissioner,
supra at 888-889. In such a case, a taxpayer will be entitled to
rely upon an expert’s advice, even if the advice should prove to
be erroneous. Jackson v. Commissioner, 86 T.C. 492, 539 (1986),
affd. on other issues 864 F.2d 1521 (10th Cir. 1989); Brown v.
Commissioner, 47 T.C. 399, 410 (1967), affd. per curiam 398 F.2d
832 (6th Cir. 1968).
The ultimate responsibility for a correct return lies with
the taxpayer, who must furnish the necessary information to the
agent who prepared the return. Enoch v. Commissioner, supra at
802. In other words, reliance upon expert advice will not
exculpate a taxpayer who supplies the return preparer with
incomplete or inaccurate information. Lester Lumber Co. v.
Commissioner, 14 T.C. 255, 263 (1950).
Petitioners stated they informed Ms. Barton that the sale
did not close until 2005 but did not think they provided her with
the closing papers. Accordingly, petitioners have not
established that they acted in good faith or had reasonable cause
in failing to report capital gain from the sale of their rental
home. See Green v. Commissioner, 507 F.3d 857, 872 (5th Cir.
2007) (upholding imposition of section 6662 penalty even though
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taxpayer consulted a professional because “there was no evidence
as to what * * * [the taxpayer] told the preparer, what the
preparer told * * * [the taxpayer], and whether or not * * * [the
taxpayer’s] reliance on any advice from the preparer was
reasonable.”), affg. T.C. Memo. 2005-250. Given this lack of
evidence, we sustain respondent’s determination of the section
6662(a) penalty.
To reflect the foregoing,
Decision will be entered
under Rule 155.