T.C. Memo. 2010-198
UNITED STATES TAX COURT
WILLIAM J. DUNN, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 17290-06. Filed September 13, 2010.
Frank J. Yong and J. Ellsworth Summers, Jr., for
petitioner.1
Jeffrey S. Luechtefeld, for respondent.
1
Petitioner was represented by Elizabeth Opalka when he
filed his petition. On Jan. 3, 2007, Donald W. Wallis was
substituted for Ms. Opalka as counsel for petitioner. On Sept.
21, 2009, Frank J. Yong was substituted for Mr. Wallis as counsel
for petitioner.
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MEMORANDUM FINDINGS OF FACT AND OPINION
THORNTON, Judge: Respondent determined the following
deficiencies in and penalties on petitioner’s Federal income
taxes:
Accuracy-Related Penalty
Year Deficiency Sec. 6662(a)
2002 $177,658 $35,532
2003 140,820 28,164
2004 192,463 38,493
The issues for decision are: (1) Whether petitioner is
entitled to deduct expenses, mostly relating to airplane rentals,
use, and maintenance, incurred by his wholly owned S corporation,
Dunn Property Management, Inc. (DPM); (2) whether petitioner’s
pass-through losses from DPM and his single-member limited
liability company, Dunn Equipment Leasing, L.L.C. (DEL), are
subject to the passive activity loss restrictions of section 469;
and (3) whether petitioner is liable for a section 6662(a)
accuracy-related penalty for each year at issue.2
FINDINGS OF FACT
The parties have stipulated some facts, which we so find.
When he petitioned the Court, petitioner resided in Florida.
2
All section references are to the Internal Revenue Code
(Code) in effect for the years at issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure.
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A. Petitioner’s Background
Petitioner is a 1976 graduate of the U.S. Air Force Academy
and a 1980 graduate of Georgetown University Medical School.
After serving some years as an Air Force flight surgeon, in 1988
he left active duty for the private practice of ophthalmology in
Bangor, Maine. While working and living there with his family,
he commuted in his private plane to Cleveland, Ohio, for a
fellowship program in retina and vitreous surgery. Since 1991 he
has been employed as a retinologist by the Florida Retina
Institute, P.A. (FRI), a Florida professional corporation of
which he is a vice president and shareholder.
FRI has a number of offices throughout northeast Florida and
Georgia. Petitioner’s medical practice is concentrated primarily
in FRI’s Daytona Beach office, which is in the general vicinity
of his residence, and in Palm Coast, a short distance away.
Petitioner typically works at FRI about 4-1/2 days each week and
takes 6 to 8 weeks of vacation each year.
In addition to practicing medicine with FRI, petitioner
participates in drug treatment studies for two major drug
companies and serves on their advisory boards. Sometimes he
travels to Miami or Atlanta to participate in these advisory
boards. These companies pay petitioner consultant’s fees and
reimburse his travel expenses, typically on the basis of airline
coach fares.
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As described more fully below, during the years at issue
petitioner also pursued aviation interests and real estate
activities.
B. Petitioner’s Aviation Interests
Petitioner has been an aviation enthusiast since childhood.
At age 14 he took his first flying lesson, and at age 17--the
youngest age permitted by the Federal Aviation Administration
(FAA)--he obtained his private pilot’s license. At the Air Force
Academy he frequently flew military aircraft, and he completed a
pilot indoctrination course.
In 1986 petitioner purchased his first airplane, a 1969 Aero
Commander, which he flew for training and attending medical
meetings. In 1990 he traded up to a 1968 Mooney M20F, which he
used for, among other things, attending medical meetings,
commuting between Bangor, Maine, and Cleveland, Ohio, and taking
his family on trips. Because the Mooney was only a four-seater,
he decided he needed a larger aircraft that would allow him to
“take everybody on a trip” with greater safety, range, and speed.
Consequently, in 1996 he traded up to a Cessna 414, which he used
for, among other things, “flying my children around and business
associates” and for trips from his Florida home to his Air Force
reserve duty station in Washington, D.C.
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In 2000 petitioner and his wife divorced. She got the
Cessna 414. Petitioner decided to replace it with a Mitsubishi
MU-2.
C. Dunn Equipment Leasing, LLC
The Mitsubishi dealer referred petitioner to Louis M.
Meiners, Jr. (Meiners), for advice about placing the new airplane
in a holding company for asset and liability protection and to
minimize State taxes. Meiners was a certified public accountant
(C.P.A.) and attorney with his own CPA firm in Indianapolis,
Indiana (the Meiners firm), that specialized in tax-planning
services. Meiners was also president of Advocate Aircraft
Taxation Consulting Co. (Advocate), an aviation consulting
business with about 35 employees including CPAs, attorneys,
paralegals, and support staff. Advocate assists its clients in
complying with Treasury regulations, FAA regulations, and State
aviation-related regulations.
In 2000 petitioner engaged Advocate for advice about income
taxes and about acquiring an aircraft in such a manner as to
reduce sales or use taxes. Following Advocate’s advice,
petitioner formed DEL, a limited liability company organized
under Indiana law. During the years at issue, petitioner was
DEL’s only member and employee. DEL paid petitioner no salary.
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D. DEL’s Purchase and Lease of the Mitsubishi to Petitioner
On or about July 1, 2000, DEL purchased a Mitsubishi MU-2
aircraft (the Mitsubishi) for about $630,000. The purchase was
financed by a loan that petitioner personally guaranteed. On
July 20, 2000, DEL, as owner, and petitioner, as operator,
entered into an aircraft lease. Pursuant to the lease,
petitioner agreed to lease the Mitsubishi from DEL for a term
ending December 31, 2004, and to make the following fixed rental
payments: $5,000 on July 20, 2000; $225,000 by August 19, 2000;
and $5,000 at yearend 2000, 2001, 2002, and 2003.3 In addition,
petitioner was responsible for all maintenance, service, and
insurance on the Mitsubishi.
Petitioner’s Florida residence is in a “fly-in/fly-out”
community; i.e., one with a private airport for use by its
residents. An airplane hangar adjoins petitioner’s residence.
The Mitsubishi was stored in this hangar.
E. Dunn Property Management
In September 2001 petitioner incorporated DPM under the laws
of Nevada. The articles of incorporation list DPM’s purpose as
“PROPERTY MANAGEMENT”. Petitioner was DPM’s sole officer,
3
Petitioner testified that the $225,000 payment was made to
“maximize state tax savings by doing a large prepayment of the
lease payment”. Other than this testimony, there is no evidence
that petitioner actually made any of the scheduled lease payments
to DEL.
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director, and shareholder. DPM elected for Federal income tax
purposes to be treated as an S corporation.
F. DEL’s Lease of the Cessna Citation to Petitioner and DPM
In July 2002, in a reverse like-kind exchange facilitated by
Advocate, DEL sold the Mitsubishi for about $545,000 and
purchased a Cessna Citation aircraft (the Citation) for about
$810,000. The purchase was financed with a loan that petitioner
personally guaranteed. The Citation, like the Mitsubishi before
it, was kept at petitioner’s home in Florida.
The parties amended the preexisting aircraft lease between
DEL and petitioner to substitute the Citation for the Mitsubishi.
Also, on July 3, 2002, DEL, as owner, and DPM, as operator,
entered into aircraft rental agreement, whereby DEL rented to DPM
the nonexclusive right to use and operate the Citation. The DPM
rental agreement stated that DPM was renting the Citation in
furtherance of its “primary, non-transportation business and its
employee benefits.” DPM agreed to pay DEL rent of $175 per hour
of flight time. In 2002, 2003, and 2004, DPM paid DEL aggregate
rents of $54,400, $26,968, and $26,058, respectively. DPM also
paid costs of using and maintaining the aircraft.
On November 1, 2004, DEL, as owner, and petitioner, as
operator, entered into another rental agreement whereby DEL
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granted petitioner nonexclusive rights to use and operate the
Citation for a rental rate of $700 per hour of flight time.4
G. Real Estate Owned by Petitioner Directly
During the years at issue petitioner owned in his own name,
in addition to his Florida residence, interests in the following
three real properties.
1. Mountain Air Country Club Residence
In 1996 petitioner and his wife purchased this residential
unit for about $380,000. It is near Burnsville, North Carolina,
in Mountain Air Country Club, an exclusive “fly-in/fly-out”
community with its own landing strip and amenities such as golf,
swimming, and tennis. Pursuant to his divorce agreement in 2000,
petitioner gained outright ownership of the property. Petitioner
typically used the property about six to eight times each year
with family and friends. Generally, he and his family or friends
would fly there in the Mitsubishi or, later, in the Citation.
2. Mountain Air Country Club Building Lot
In 2001 petitioner purchased this unimproved lot, also in
Mountain Air Country Club, for $319,000.
3. Miami Beach Condominium
In 2004 petitioner and his girlfriend purchased this
property for $539,500. She lived in the condominium while
4
Apart from petitioner’s testimony, there is no evidence
that petitioner paid DEL such rents in 2004.
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attending school in Miami. Petitioner would visit using the
Citation.
H. Property Management Agreement Between DPM and Petitioner
On January 1, 2003, DPM and petitioner entered into an asset
management agreement, which stated that petitioner retained DPM
to manage designated assets for annual compensation calculated as
the sum of 1 percent of the asset value of non-income-producing
properties and 10 percent of the income on income-producing
properties. The annual payment was due no later than June 30 of
the year following the year in which the management services were
rendered.5 The asset management agreement indicates that it
covers petitioner’s two North Carolina country club properties.
I. Real Property Owned by DPM
During the years at issue, DPM purchased ownership interests
in the following four real properties, all of which it still
possessed at the end of 2004.
1. Ormond Beach, Florida, Apartment
In May 2002 DPM purchased this property for $72,500. For an
undisclosed period during the years at issue, DPM leased this
apartment to tenants for $875 per month under a monthly rental
agreement. DPM employed a property management company to collect
5
The record indicates that in May 2004 petitioner wrote DPM
a $15,000 check for 2003 management fees. The record does not
indicate whether petitioner paid DPM any management fees for
2004.
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rent and handle day-to-day management duties and routine
maintenance. DPM paid the property management company 10 percent
of the rental income generated by the property. Petitioner drove
to the Ormond Beach property about once a month in his Lexus
automobile, which DPM leased from him.
2. Key Largo, Florida, Condominium
In August 2002 DPM purchased this condominium for $749,900.
The property includes amenities such as a pool, a spa, tennis
courts, and a deepwater marina. DPM employed property management
companies, which marketed the property for rent, collected the
rent for the property, and enforced the rental agreements with
tenants. The property managers were authorized to handle minor
repairs, but DPM handled major repairs. The property managers
were also responsible for day-to-day duties such as changing
linens, booking reservations, and handling the arrival and
departure of guests. For its services DPM paid the property
management companies 30 to 40 percent of total rental revenues.
Petitioner flew to the Key Largo property four to six times
each year in the Citation. According to his testimony, he would
engage in “global oversight” of the property to make sure it was
being maintained and marketed according to the management
agreements. On these visits, which typically lasted from Friday
night through Sunday night, he would stay in DPM’s condominium if
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it was vacant. Otherwise he would stay in another unit on the
property for a discounted rate.
3. Lake Mary, Florida, Property
In June 2003 DPM and one of petitioner’s professional
colleagues purchased, as 50-50 coowners, an unimproved parcel of
land in Lake Mary, Florida, adjacent to one of FRI’s properties.
Petitioner visited the property four to six times each year in
his Lexus automobile, which DPM leased from him.
4. Telluride, Colorado, Condominium
In June 2004 DPM purchased this unit in a resort hotel with
amenities such as ski-in/ski-out access, a spa, restaurants, a
swimming pool, and a gym. DPM engaged a property management
company which handled day-to-day duties such as changing the
linens, housekeeping, marketing the property for rent, booking
reservations, and collecting rent. As payment for its services
DPM paid the property management company 50 percent of total
rental revenues. DPM’s responsibilities for the property
included making decisions regarding the marketing, occasionally
inspecting the property, and staying apprised of the current real
estate market. In 2004 petitioner flew to this property twice in
the Citation.
J. Tax Reporting
The Meiners firm prepared DPM’s Form 1120S, U.S. Income Tax
Return for an S Corporation, for each year at issue. On these
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returns DPM reported net losses from rental real estate
activities (hereinafter sometimes referred to as rental losses)
and, separately, net losses from nonrental activities, which it
labeled “ordinary” income losses (hereinafter sometimes referred
to as nonrental losses), as follows:
Year Nonrental Losses1 Rental Losses2
2002 $173,912 $36,123
2003 150,478 65,393
2004 160,502 141,872
1
In calculating these nonrental losses, DPM
reported no gross receipts for 2002 or 2003. For 2004
DPM reported gross receipts of $15,000, representing
“management fees” that petitioner paid to DPM. In
calculating its nonrental losses, DPM reported
deductions as shown in appendix A. Most of these
deductions appear to be aviation related.
2
In calculating these rental losses, DPM claimed
deductions shown in appendix B.
On Schedules K-1, Shareholder’s Share of Income, Credits,
Deductions, etc., DPM reported these losses as passing through to
petitioner.
CPA firms other than the Meiners firm prepared petitioner’s
Forms 1040, U.S. Individual Income Tax Return, for the years at
issue, although the Meiners firm helped prepare certain schedules
relating to airplane expenses and also prepared grouping
elections. For 2002, on Schedule E, Supplemental Income and
Loss, of his Form 1040 petitioner claimed the aggregate $210,035
of DPM pass-through losses (i.e., $173,912 of nonrental losses
plus $36,123 of rental losses) as nonpassive losses which he
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offset against other income, principally wages, to report
adjusted gross income of $897,451. For 2003 and 2004 on
Schedules E petitioner claimed the DPM pass-through nonrental
losses as nonpassive losses, which he offset against other
income, principally wages, to report adjusted gross income of
$793,448 for 2003 and $702,654 for 2004. For 2003 and 2004 he
treated the DPM rental losses as passive losses and deducted them
only to the extent of other real estate rental income that he
received from FRI ($5,808 in 2003 and $3,995 in 2004).
On Schedules C, Profit or Loss From Business, attached to
his Forms 1040, petitioner also claimed net losses from DEL as
follows:
2002 2003 2004
Expenses:
Depreciation $174,701 $167,313 $286,863
Insurance 36,600 -- --
Interest 17,114 31,601 28,051
Hangar 1,100 -- --
Taxes and licenses -- 28 603
Legal and professional -- 5,000 5,000
services
Total expenses 229,515 203,942 320,517
Gross receipts 54,400 26,968 26,058
Net loss 175,115 176,974 294,459
The Meiners firm provided petitioner’s tax return preparer the
information used to prepare the Schedules C relating to DEL’s
leasing activities.
Petitioner, on his 2003 Form 1040, and DPM, on its 2003 and
2004 Forms 1120S, elected to group the activities of DPM and DEL
for purposes of the section 469 passive activity loss limitations
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and for purposes of section 183.6 The Meiners firm prepared
these grouping elections for petitioner.
K. Notice of Deficiency
In the notice of deficiency, respondent disallowed the DPM
pass-through losses and petitioner’s DEL Schedule C losses on
grounds that it had not been established that any amounts were
incurred and paid for ordinary and necessary business purposes or
in an activity entered into for profit or with respect to
property held for the production of income. Alternatively,
respondent determined that DPM’s pass-through losses and the DEL
Schedule C losses were attributable to passive activities and
subject to the section 469 limitations. More particularly,
respondent made separate adjustments for DPM’s rental and
nonrental pass-through losses and for the DEL Schedule C losses
as more fully described below.
1. DPM Rental Pass-Through Losses
Respondent disallowed in their entirety the DPM rental
losses that petitioner claimed ($36,123 for 2002, $5,808 for
2003, and $3,995 for 2004) and determined that petitioner should
have reported pass-through rental income equal to DPM’s gross
rents ($4,361 for 2002, $28,752 for 2003, and $29,269 for 2004).
6
As related to the sec. 469 grouping, the elections on these
various returns stated identically: “Taxpayer hereby elects to
group equipment rental activity identified as Dunn Equipment
Leasing, Inc., with Dunn Property Management, Inc., its lessee in
the original grouping as an appropriate economic unit pursuant to
Regulation § 1.469-4(d)(1)(C).”
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As a result of these adjustments, respondent determined that
petitioner’s taxable income should be increased $40,484 for 2002,
$34,560 for 2003, and $33,264 for 2004; i.e., the sum of the
disallowed losses and the unreported gross rents. For 2002
respondent further determined that the DPM pass-through rental
losses, which petitioner had claimed as nonpassive losses on his
2002 Form 1040, should be recharacterized as passive losses for
purposes of section 469. For 2003 and 2004 respondent determined
that no such recharacterization was required, because
petitioner’s 2003 and 2004 Forms 1040 properly showed the DPM
pass-through rental losses as passive.
2. DPM Nonrental Losses
Respondent disallowed in their entirety the DPM nonrental
pass-through losses ($173,912 for 2002, $150,478 for 2003, and
$160,502 for 2004) and determined that petitioner should have
reported as income the gross amount of DPM’s nonrental income
(zero for 2002 and 2003, and $15,000 for 2004). As a result of
these adjustments, respondent determined that petitioner’s
taxable income should be increased by $173,912 for 2002, $150,478
for 2003, and $175,502 for 2004; i.e., the sum of the disallowed
losses and the unreported gross income. Respondent further
determined that all the DPM nonrental pass-through losses were
subject to the section 469 passive activity loss limitations.
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3. DEL Schedule C Losses
On grounds that petitioner had failed to establish that any
amounts were paid for ordinary and necessary business purposes or
in an activity entered into for profit or with respect to
property held for the production of income, respondent disallowed
in their entirety the Schedule C business expense deductions that
petitioner claimed with respect to his DEL activity, resulting in
corresponding increases to his taxable income ($229,515 for 2002,
$203,942 for 2003, and $320,517 for 2004). Respondent further
determined that any profits or losses allowable with respect to
his DEL activity were attributable to a passive activity.
4. Section 6662(a) Penalty
Respondent determined that for each year at issue petitioner
was liable for a section 6662(a) accuracy-related penalty for
substantial understatement of income tax.
OPINION
I. Introduction
Petitioner, a retinologist and a licensed pilot, claims
substantial losses attributable to airplanes that DEL, his
single-member LLC, owned and that he flew, allegedly on behalf of
DPM, his wholly owned S corporation. More particularly,
petitioner claims Schedule C losses from DEL’s activity of
leasing the airplanes to DPM and petitioner. Petitioner also
claims substantial pass-through losses from DPM. They comprise:
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(1) Rental losses, attributable to DPM’s expenses of renting real
estate that it owned, and (2) nonrental losses, attributable
mainly to DPM’s leasing, using, and maintaining at least one of
the airplanes.
As previously described, in the notice of deficiency
respondent disallowed all the Schedule C deductions for DEL
business expenses and DPM pass-through losses on various
alternative grounds. In this proceeding, respondent has modified
his positions. Respondent now concedes that DEL and DPM paid the
disputed expenses. Respondent continues to maintain, however, as
he did in the notice of deficiency, that the aviation-related
expenses giving rise to the DPM nonrental losses were not
ordinary and necessary expenses incurred in a trade or business.
He no longer presses this contention, however, with regard to the
DPM rental activity or with regard to DEL’s activity. Respondent
continues to assert that DEL was not engaged in an activity for
profit, but he no longer presses this argument with regard to
DPM. As in the notice of deficiency, respondent maintains that
any allowable losses from either petitioner’s DEL activity or his
DPM activities are subject to the passive activity loss
restrictions of section 469. But respondent now concedes the
adjustments of $34,560 and $33,264 for 2003 and 2004,
respectively, with respect to the DPM pass-through losses
attributable to its rental activities, noting that petitioner
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correctly reported these pass-through losses as passive for 2003
and 2004.7
II. Burden of Proof
The taxpayer generally bears the burden of proving the
Commissioner’s determinations erroneous. Rule 142(a). In
particular, the taxpayer bears the burden of substantiating the
amount and purpose of each item claimed as a deduction. See
Higbee v. Commissioner, 116 T.C. 438, 440 (2001); Hradesky v.
Commissioner, 65 T.C. 87, 90 (1975), affd. per curiam 540 F.2d
821 (5th Cir. 1976).
Section 7491(a)(1) provides that if, in any court
proceeding, a taxpayer introduces credible evidence with respect
to any factual issue relevant to ascertaining the taxpayer’s
proper tax liability, the Commissioner shall have the burden of
proof with respect to that issue. Credible evidence is evidence
the Court would find sufficient upon which to base a decision on
the issue in the taxpayer’s favor, absent any contrary evidence.
See Higbee v. Commissioner, supra at 442. Section 7491(a)(1)
applies, however, only if the taxpayer complies with all
7
The notice of deficiency similarly determined that
petitioner had correctly reported the 2003 and 2004 DPM rental
losses as passive but nevertheless determined an increase in
petitioner’s tax liabilities resulting from the disallowance of
the DPM rental losses for failure to establish that they
represented ordinary and necessary business or investment
expenses. In conceding this issue, respondent has waived any
issue as to whether the DPM rental expenses should be disallowed
entirely.
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substantiation and recordkeeping requirements under the Code and
cooperates with the Commissioner’s reasonable requests for
witnesses, information, documents, meetings, and interviews.
Sec. 7491(a)(2)(A) and (B).
As discussed infra, our decision turns primarily on two
issues: (1) Whether DPM’s airplane expenses were ordinary and
necessary; and (2) whether petitioner’s DPM and DEL pass-through
losses are subject to the passive activity loss restrictions of
section 469. As to the first issue, respondent concedes that
petitioner has substantiated the amounts of the disputed expenses
but contends, and we agree, that petitioner has failed to
substantiate business purposes independent of substantial
personal purposes for the flights. Whether petitioner’s failure
in this regard be viewed as failure to satisfy the substantiation
prerequisite of section 7491(a)(2)(A) or as failure to present
credible evidence sufficient for the Court to render a decision
in his favor, the result is the same--the burden of proof remains
with petitioner.
The passive loss issue involves mixed questions of law and
fact. With respect to critical factual issues, particularly as
to the number of hours petitioner might have engaged in his DPM
and DEL activities, petitioner has, again, failed to substantiate
these matters or to present credible evidence sufficient for the
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Court to render a decision in his favor. The burden of proof as
to this issue also remains with petitioner.
Respondent bears the burden of production with respect to
penalties. See sec. 7491(c). We discuss this matter infra.
III. Deductibility of DPM’s Airplane Expenses
A. The Parties’ Contentions
Respondent contends that the DPM nonrental losses (i.e., the
losses attributable to DPM’s activities other than renting its
real estate properties) are nondeductible under section 162(a)
because they are not attributable to the conduct of any trade or
business. Alternatively, respondent contends that the DPM
nonrental losses are nondeductible under either section 162(a) or
section 212 because they do not represent ordinary and necessary
business expenses but rather primarily personal expenses.8
Characterizing respondent’s discussion of the trade or
business requirement of section 162(a) as “inapposite” and
thereby implicitly conceding that the DPM nonrental activity was
not a trade or business, petitioner contends on brief that DPM’s
deduction of the disputed expenses was based not upon section
162(a) but upon section 212(2).9 Petitioner contends that DPM’s
8
Respondent argues alternatively that even if DPM’s
aircraft-related expenses were ordinary and necessary business
expenses, petitioner’s deduction of these expenses would be
limited by the sec. 469 passive activity loss limitations. We
address these arguments in pt. IV, infra.
9
Petitioner’s contentions are inconsistent with the manner
(continued...)
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main activity was holding real estate for appreciation. He
contends that the disputed expenses represent ordinary and
necessary travel expenses that were integral to DPM’s managing,
conserving, and maintaining properties that it owned during the
years at issue and were also necessary for DPM’s investigating
prospective investment properties. He contends that his need to
travel on DPM’s behalf by private plane was “obvious” because
otherwise it would have been inefficient or infeasible for him to
pursue his far-flung real estate investment activities while at
the same time conducting his full-time medical practice. Thus,
he contends, the disputed expenses are deductible under section
212(2) as DPM’s ordinary and necessary expenses.
B. General Legal Principles
An eligible small business corporation that elects S
corporation status is generally exempt from corporate income tax.
See sec. 1363(a). Instead, the S corporation’s shareholders must
9
(...continued)
in which he treated the disputed expenses on his tax returns for
the years at issue. On his returns petitioner treated these
items not as miscellaneous itemized deductions under sec. 212 but
as reductions in arriving at adjusted gross income, presumably
pursuant to sec. 162(a). If we were to agree with petitioner’s
argument that the disputed expenses are deductible as
miscellaneous itemized deductions under sec. 212 (which we do
not), collateral computational effects (i.e., subjecting them
under sec. 67(a) to the 2-percent floor of adjusted gross income
and under sec. 68 to reduction for high-income individuals) would
likely reduce the value of these miscellaneous itemized
deductions to petitioner. See infra text accompanying note 11.
Because we conclude, for reasons discussed infra, that the
disputed expenses are not ordinary and necessary, we need not
consider these issues further.
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report pro rata shares of the S corporation’s taxable income,
losses, deductions, and credits. Sec. 1366(a)(1)(A); sec.
1.1366-1(a), Income Tax Regs.10 An S corporation item generally
retains its character for the shareholder. Sec. 1366(b). With
certain exceptions, an S corporation’s taxable income is computed
in the same manner as an individual’s. Sec. 1363(b).
Unless expressly provided in the Code, no deduction is
allowed for personal expenses. Sec. 262(a). Section 162(a)
allows a deduction for “all the ordinary and necessary expenses
paid or incurred during the taxable year in carrying on any trade
or business”. Section 212(1) and (2) provides that an individual
may deduct ordinary and necessary expenses paid or incurred for
the production or collection of income or for the management,
conservation, or maintenance of property held for the production
of income.
Generally, sections 162(a) and 212 provide, with respect to
the respective classes of activities to which they pertain,
“coextensive” deductions. Trust of Bingham v. Commissioner, 325
U.S. 365, 374 (1945) (discussing statutory predecessors of
sections 162(a) and 212(1) and (2)). In some circumstances,
however, a section 212 deduction might be less beneficial than a
10
The shareholder may not take into account S corporation
losses and deductions for any taxable year in excess of the
shareholder’s adjusted basis in the S corporation’s stock and
debt. Sec. 1366(d)(1). Respondent does not contend that
petitioner’s basis in DPM was insufficient to support the pass-
through losses in question.
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section 162(a) deduction. For instance, as miscellaneous
itemized deductions, section 212 deductions, unlike section
162(a) deductions, are deductible only to the extent they exceed
2 percent of the taxpayer’s adjusted gross income and for high-
income individuals are subject to reduction.11 Secs. 67(a), 68;
see 1 Bittker & Lokken, Federal Taxation of Income, Estates and
Gifts, par. 20.5.1, at 20-115 through 20-117 (3d ed. 1999)
(discussing various other circumstances in which deductibility
under section 212 may be less beneficial than under section
162(a)).
To be deductible under either section 162(a) or 212,
expenses must be ordinary and necessary. Under the section 212
regulations, this means that the expenses must be “reasonable in
amount and must bear a reasonable and proximate relation to the
production or collection of taxable income or to the management,
conservation, or maintenance of property held for the production
of income.” Sec. 1.212-1(d), Income Tax Regs.; see Trust of
11
For reasons such as these, to effect flowthrough of
deductions from an S corporation to a shareholder, itemized
deductions under sec. 212, unlike deductions under sec. 162(a),
must be separately stated rather than aggregated with the S
corporation’s other items of income, deductions, losses, and
credits. See secs. 1363(b)(2) (disallowing in the computation of
an S corporation’s taxable income deductions referred to in sec.
703(a)(2), which includes, in subpar. (E) thereof, itemized
deductions under sec. 212), 1366(a)(1); sec. 1.1366-1(a)(2)(vi),
Income Tax Regs. The character of such separately stated items
is determined in the hands of the shareholder as if they were
“incurred in the same manner as incurred by the corporation.”
Sec. 1366(b).
- 24 -
Bingham v. Commissioner, supra at 373 (articulating a
substantially identical standard with respect to the statutory
predecessor of section 212). If substantial business and
personal motives exist for owning and maintaining property, it is
necessary to allocate the expenditures.12 Internatl. Artists,
Ltd. v. Commissioner, 55 T.C. 94, 105 (1970); Richardson v.
Commissioner, T.C. Memo. 1996-368.
C. Analysis
During 2002 and 2003, of the three real properties in which
DPM held ownership interests, only one--the Key Largo
condominium--was a destination to which petitioner flew himself
in one of the airplanes in question. He made these trips, he
testified, four to six times a year on DPM’s behalf, staying
weekends. In 2004 DPM also acquired a resort property in
Telluride, Colorado; in 2004 petitioner flew there twice and
12
Pursuant to sec. 274(d)(4), stringent substantiation is
required for deductions with respect to “listed property”, which
includes passenger automobiles and “any other property used as a
means of transportation”; e.g., airplanes. Sec. 280F(d)(4)(A)(i)
and (ii). These rules require the taxpayer to maintain adequate
records or sufficient corroborating evidence to establish each
element of an expenditure, including business purpose. See sec.
274(d); sec. 1.274-5T(b)(6), (c)(2)(i), Temporary Income Tax
Regs., 50 Fed. Reg. 46016, 46017 (Nov. 6, 1985). If the listed
property is used for both personal and business purposes, no
deduction is allowed unless the taxpayer establishes the business
purpose. Kinney v. Commissioner, T.C. Memo. 2008-287; sec.
1.274-5T(b)(6)(i)(B), Temporary Income Tax Regs., 50 Fed. Reg.
46016 (Nov. 6, 1985). Although these rules would seem germane to
the deductibility of DPM’s airplane expenses, respondent has not
cited or relied upon the sec. 274(d) substantiation rules.
Accordingly, we likewise do not rely upon them in our analysis.
- 25 -
stayed for periods undisclosed in the record. For the years at
issue DPM claimed airplane expenditures ranging from $150,478 to
$175,502.13
Clearly, these large airplane expenditures were not wholly
attributable to the approximately 20 flights that petitioner made
during the years at issue to DPM’s Key Largo and Telluride
properties. In fact, according to petitioner’s flight logs,
which are in evidence, during the years at issue petitioner made
over 350 flights in the airplanes.14 He has offered into
evidence a redacted version of his flight logs that, according to
his testimony, omits “personal trips” and includes only “business
trips”. These redacted flight logs show about 250 flights that
13
Respondent characterizes these expenses as being
“predominately related to petitioner’s aircraft”. Appearing to
agree with this characterization, petitioner states that “the
bulk” of these expenses are expenses related to airplane travel.
The disputed expenses appear to include some relatively small
nonaviation items; e.g., “Auto and truck expense”. See app. A.
On the basis of petitioner’s testimony and in the absence of
other evidence, we infer that “Auto and truck expense” includes
the expense of DPM’s purportedly leasing petitioner’s Lexus from
him, so that he could drive it, allegedly on DPM’s behalf, to the
Ormond Beach and Lake Mary, Fla., properties. Petitioner has not
advanced independent arguments with respect to such nonaviation
items but, like respondent, has contented himself with treating
all the disputed expenses as being aviation related.
14
DPM reported as “Rent expense” $54,400, $27,607, and
$32,058, for 2002, 2003, and 2004, respectively. See app. A.
Although the record is not explicit on this point, it would
appear that these are the amounts that DPM paid DEL as rent for
the airplanes. The record does not establish the reasonableness
of such rents between these related entities. As discussed
infra, it appears that a substantial portion of the rents
represents petitioner’s personal use of the airplanes.
- 26 -
he took in the airplanes. According to petitioner’s own
reckoning, then, at least 100 of his flights were for personal
purposes. Insofar as we can tell from the record, however (and
petitioner does not contend otherwise), all the flights,
including those that petitioner concedes to have been personal,
are included in the aviation expense deductions that DPM claimed
for the years at issue. The record does not reflect that
petitioner reimbursed DPM for any of these flights.
Another problem brought to light by these flight logs is
that petitioner is claiming as part of DPM’s airplane
expenditures the cost of 22 flights that he made between January
1 and June 16, 2002, in the Mitsubishi, before DEL acquired the
Citation in July 2002. DEL and DPM entered into the lease
agreement for the Citation on July 3, 2002. Insofar as the
record shows, DEL never leased the Mitsubishi to DPM. Petitioner
has not explained why any of the Mitsubishi expenses represent
expenses of DPM rather than of petitioner.
Furthermore, it appears that petitioner has counted as
“business flights” numerous flights, both in the Mitsubishi and
in the Citation, that he made to the North Carolina country club
in which he owned a vacation home and a building lot. In the
flight logs the purpose of these flights is generally described,
without elaboration, as “Inspect Property” or as
“Training/Inspect Property”. Apparently, petitioner
- 27 -
characterizes these as business flights partly because of the
asset management agreement whereby DPM purportedly agreed to
manage these properties on petitioner’s behalf. The asset
management agreement, however, was executed on January 1, 2003,
and so has no bearing on flights petitioner made before then.
More fundamentally, we do not perceive any significant purpose,
apart from hoped-for tax benefits, in petitioner’s purportedly
arranging for DPM to manage his properties. Because petitioner
was the sole officer, director, and shareholder of DPM, which had
no employees, this agreement was tantamount to petitioner’s
agreeing, for a fee, to “manage” his properties for himself. Nor
are we impressed with petitioner’s suggestion that he should be
allowed to deduct the expenses of flying to his vacation home
because he hoped someday to sell it at a profit.15
In the redacted flight logs the purpose of many of the so-
called business trips is listed simply as “Training”. For many
years before forming DPM and DEL, petitioner had regularly taken
training flights to acquire flying licenses and to satisfy
insurance standards. We are unconvinced that the “Training”
flights were not primarily for personal purposes.16 See Noyce v.
15
Similarly, we see no DPM-related purpose to a July 30,
2004, flight, included in petitioner’s redacted flight logs, in
which petitioner flew with his girlfriend and his daughter to
make an offer on the Miami Beach condominium that he and his
girlfriend would eventually coown in their own names.
16
In some instances, the flight logs manifest personal
(continued...)
- 28 -
Commissioner, 97 T.C. 670, 693 (1991) (treating training flights
as personal).
Indeed, we do not believe that even the 20 or so flights
that petitioner made to two of the properties that DPM owned were
devoid of substantial personal motivations. After all, these
were resort properties managed by professional management
companies. Although petitioner testified that he performed
“global oversight” at these properties, his description of this
activity (“looking at the big picture, taking care of maintenance
items, et cetera, that type of thing”) does not persuade us that
any such activity would have much interfered with his personal
motives for his frequent weekends at the Key Largo condominium or
for his two trips to the Telluride, Colorado, condominium during
2004.
Petitioner suggests that in evaluating whether the disputed
expenses were ordinary and necessary, we should take into account
not only the airplane trips he made to the two properties that
DPM owned but also the more numerous airplane trips he claims to
have made to investigate other prospective real estate
16
(...continued)
purposes for the “Training” flights. For instance, a “Training”
trip to Miami, Fla., on Aug. 14, 2002, is described in the
unredacted version of the flight logs as having the purpose of
“pick up daughter”. A “Training” trip to Chapel Hill, N.C., on
Sept. 27, 2002, is described in the unredacted version of the
flight logs as having the purpose of “visit Lisa”. Even in
instances where a personal purpose is not made manifest, however,
we are not convinced that personal motives were absent.
- 29 -
investments, allegedly on DPM’s behalf. He has failed to
substantiate, however, that any such investigatory expenses
relating to new investment opportunities rather than to the
maintenance of existing investments qualify for deduction under
section 212. See Bick v. Commissioner, T.C. Memo. 1978-390 (and
cases cited therein).
In Noyce v. Commissioner, supra, this Court held that Intel
Corp.’s vice chairman, a licensed pilot, was entitled to deduct
unreimbursed expenses of using his private airplane in the course
of his employment with Intel. The Court held that these were
ordinary and necessary expenses incurred in the taxpayer’s trade
or business as a corporate official, finding that he had not
voluntarily assumed the travel expenses, that his official duties
required extensive and frequent travel, that his access to the
airplane enabled him to significantly reduce his travel time,
that he traveled by aircraft only when there was business
advantage in doing so, and that the cost of replicating his
travel schedule and time savings via commercial charter carrier
would have exceed the costs of operating his airplane. Id. at
685-688; see also Richardson v. Commissioner, T.C. Memo. 1996-368
(holding that the taxpayer was entitled to deduct airplane
expenses incurred by his S corporation as ordinary and necessary
expenses that contributed to the efficiency and productivity of
the corporation’s trade or business).
- 30 -
Unlike the taxpayers in Noyce and Richardson, petitioner
does not contend that the disputed expenses were incurred in the
conduct of any trade or business.17 More fundamentally, unlike
the taxpayers in Noyce and Richardson, petitioner has failed to
identify business purposes independent of substantial personal
purposes for any of the flights in question.18 Rather, the
evidence convinces us that for all the flights in question
petitioner had substantial personal motives emanating from his
lifelong interest in flying airplanes. From this perspective,
this case bears some similarity to Henry v. Commissioner, 36 T.C.
879 (1961). In that case, a lawyer sought to deduct, as ordinary
and necessary business expenses, the costs of acquiring and
maintaining his yacht. He claimed that he used the yacht to
17
Moreover, petitioner has not claimed, and the evidence
does not suggest, that he incurred the disputed expenses in the
conduct of his trade or business of being an employee of FRI.
The evidence does not show that petitioner used the airplane as
part of his FRI employment or that any such use would not have
represented his voluntary assumption of FRI’s expenses, rendering
them nondeductible to him. Cf. Noyce v. Commissioner, 97 T.C.
670, 683-685 (1991) (concluding that the taxpayer personally
incurred airplane expenses pursuant to Intel’s written travel
reimbursement policy requiring its officers to incur certain
expenses for Intel’s benefit without reimbursement).
18
In Noyce v. Commissioner, supra at 681-682, the taxpayer’s
personal use of the airplane was 45.6 hours out of a total 147.4
hours, and the taxpayer claimed no deduction for this personal
use. The Court in Noyce also disallowed expenses for flight
hours attributable to maintenance, training, and delivery on the
grounds that these flight hours did not represent business use.
Id. at 693. Similarly, in Richardson v. Commissioner, T.C. Memo.
1996-368, the taxpayer’s use of the airplane is described as
“minor”, and the taxpayer paid the actual cost associated with
this personal use.
- 31 -
promote his business. In disallowing the expenses the Court
noted the taxpayer’s strong personal interest in yachting and
stated:
In determining that which is “necessary” to a
taxpayer’s trade or business, the taxpayer is
ordinarily the best judge on the matter, and we would
hesitate to substitute our own discretion for his with
regard to whether an expenditure is “appropriate and
helpful,” in those cases in which he has decided to
make the expenditure solely to serve the purposes of
his business. * * * But where, as in this case, the
expenditures may well have been made to further ends
which are primarily personal, this ordinary constraint
does not prevail; petitioner must show affirmatively
that his expenses were “necessary” to the conduct of
his professions. * * * We do not think petitioner has
shown that the expenses of acquiring and maintaining a
yacht were “necessary” to the conduct of his
professions. [Id. at 884.]
Petitioner has failed to show that the disputed expenses
were ordinary and necessary expenses of DPM rather than his
personal expenses. Accordingly, petitioner is not entitled to
deduct the claimed DPM nonrental pass-through losses pursuant to
section 212 or otherwise.19
19
On reply brief, petitioner appears to concede that some of
the flights for which he claimed deductions were personal and
states that “these expenses, at a minimum, would have to be
allocated based on the use”. He also acknowledges that “if it
were true” (and we find that it is true) that DPM deducted the
total airplane expenses without allocating any portions to
petitioner’s personal use, this “oversight or error should be
corrected.” Petitioner suggests that this “oversight or error”
should be corrected “as part of the computations that will be
made under Rule 155(b) * * * in accordance with the findings and
conclusions of this Court.” We disagree. In accordance with our
findings and conclusions supra, no allocation of the disputed
expenses is warranted.
- 32 -
IV. Passive Activity Limitations
A. The Parties’ Contentions
Respondent contends that during the years at issue DPM’s
only activity was renting real estate and that DEL’s only
activity was leasing airplanes. Accordingly, respondent contends
that under section 469(c)(2) petitioner’s activities with respect
to DEL and the DPM rental activity were per se passive activities
and his claimed losses therefrom are subject to the section
469(a) passive activity loss restrictions.20 Respondent further
argues that whether or not these rental activities are deemed per
se passive, all petitioner’s DPM and DEL activities were in fact
passive because petitioner failed to materially participate in
them.
Petitioner contends that all his activities--including his
medical professional activities, his medical research activities,
his real estate investment activities, and the ownership and use
of airplanes--should be regarded as a “single activity” for
purposes of section 469. From this perspective, he suggests,
DPM’s rental activities were merely “incidental” to its
investment activities, and DEL’s airplane rental activities
should be disregarded altogether, since “no one other than
Petitioner ever used the aircraft in connection with any
20
As previously noted, respondent concedes the adjustments
with respect to the 2003 and 2004 DPM rental losses, on the
ground that petitioner correctly treated these losses as passive
on his 2003 and 2004 returns. See supra note 7.
- 33 -
activity.” Accordingly, he contends, neither DEL’s nor DPM’s
activities should be treated as per se passive rental activities.
He further contends that he meets the material participation test
for these various activities, whether viewed separately or as a
group, and that accordingly the disputed losses are not subject
to the section 469 restrictions.
B. General Legal Principles
Section 469(a)(1) disallows any deduction for a “passive
activity loss”, defined generally as the amount each year by
which the aggregate losses from all passive activities exceed
aggregate income from all passive activities.21 Sec. 469(d)(1).
Generally, a passive activity is one involving the conduct of a
trade or business in which the taxpayer does not materially
participate. Sec. 469(c)(1). Subject to certain exceptions, a
“rental activity” is treated as a per se passive activity without
regard to whether the taxpayer materially participates. Sec.
469(c)(2), (4). A “rental activity” is one in which payments are
principally for the use of tangible property. Sec. 469(j)(8).
Generally, one or more trade or business activities or
rental activities may be treated as a single activity if the
21
By its terms, sec. 469 applies to individuals and various
specified entities but not to conduits such as partnerships and S
corporations. See sec. 469(a)(2). For purposes of sec. 469, the
character of each item of gross income and deduction allocated to
a taxpayer from a partnership or S corporation is determined by
reference to the taxpayer’s participation in the activity. Sec.
1.469-2T(e)(1), Income Tax Regs., 53 Fed. Reg. 5718 (Feb. 25,
1988).
- 34 -
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. As an exception to this general
rule, however, an activity involving the rental of real property
and an activity involving the rental of personal property
generally may not be treated as a single activity. Sec. 1.469-
4(d)(2), Income Tax Regs.
C. Analysis
1. Petitioner’s Grouping Arguments
On their 2003 returns petitioner and DPM elected to group
DPM’s and DEL’s activities for purposes of section 469. Insofar
as the record shows, no grouping election was made before 2003.
And contrary to petitioner’s assertions on brief, no election was
ever made, for any year, to group these activities with his
medical practice employment or his medical research activities.
Indeed, such an election would have been inappropriate for a
variety of reasons.
In the first instance, petitioner does not contend and the
record does not show that during the years at issue his medical
research activities constituted a “trade or business” so as to be
eligible for grouping with his other activities under the
regulations.22 See sec. 1.469-4(c)(1), Income Tax Regs. As
22
Although petitioner testified that he reported
consultant’s fees from his medical research activities as
additional income on his tax returns, we find no such additional
(continued...)
- 35 -
previously discussed, we have also concluded that petitioner, by
insisting that DPM has claimed its nonrental expenses under
section 212 and by characterizing as “inapposite” respondent’s
complaint that DPM did not meet the trade or business requirement
of section 162(a), has effectively conceded that DPM’s nonrental
activities did not constitute a trade or business during the
years at issue. Accordingly, petitioner’s medical research
activities and DPM’s nonrental activities are ineligible for
grouping with petitioner’s other activities.
But even if we were to assume, for the sake of argument,
that all the activities which petitioner seeks to group
constituted either trades or businesses or rental activities, we
would nevertheless conclude that these activities do not
constitute an “appropriate economic unit” within the meaning of
the regulations. Id. The regulations provide that whether
activities constitute an appropriate economic unit for grouping
depends upon all the relevant facts and circumstances, with these
five factors receiving the greatest weight:
(i) Similarities and differences in types of
trades or businesses;
22
(...continued)
income reported on his returns for the years at issue.
Petitioner’s generalized testimony about his medical research
activities leaves us in doubt as to the exact periods during
which he might have been involved in these activities. But even
if we were to assume, for the sake of argument, that he was
involved in these activities during the years at issue, the
record does not establish that they would have constituted a
trade or business.
- 36 -
(ii) The extent of common control;
(iii) The extent of common ownership;
(iv) Geographical location; and
(v) Interdependencies between or among the
activities (for example, the extent to which the
activities purchase or sell goods between or among
themselves, involve products or services that are
normally provided together, have the same customers,
have the same employees, or are accounted for with a
single set of books and records). [Sec. 1.469-4(c)(2),
Income Tax Regs.]
Petitioner conducted his medical practice as an employee of
FRI. Being an employee may be a trade or business. Putoma Corp.
v. Commissioner, 66 T.C. 652, 673 (1976), affd. 601 F.2d 734 (5th
Cir. 1979). Petitioner has made no showing, however, that his
trade or business of being an employee of FRI or any putative
trade or business involving his medical research satisfies any of
these grouping factors, with the possible exception of the
geographical factor. It is not apparent to us that petitioner
used the airplanes to any significant degree in his medical
practice, based a short distance from his residence, or to what
extent he might have used the airplanes in any medical research
activities during the years at issue. His central argument, as
we understand it, is that using the airplanes was helpful to his
medical employment and his medical research because it minimized
the time he would lose from these activities while pursuing other
activities, such as real estate activities (and, we infer,
vacations). But any such connection does not suffice to make his
- 37 -
various activities an “appropriate economic unit”. We reject
petitioner’s suggestion that all his activities should be grouped
for purposes of section 469.23
2. DEL’s Rental Activity
Apart from his grouping argument, which we have rejected,
petitioner has advanced no reason for us to conclude that DEL’s
activity was not in fact, as petitioner and DPM expressly
characterized it in their grouping elections, an “equipment
rental activity”. Petitioner has not shown that respondent erred
in treating DEL’s rental activity as per se passive under section
469(c)(2) and (4). Consequently, we hold that the Schedule C
losses petitioner claimed with respect to DEL’s activities are
subject to the passive activity loss limitations.24
23
Consequently, we also reject as without legal or factual
basis petitioner’s argument that “as a result of the grouping
pursuant to the elections, it is appropriate to merge together,
and to ignore the separateness of, the aircraft rental income
received and the aircraft rental expense paid.” Taken to its
logical conclusion, petitioner’s argument might suggest that the
transactions or entities in question should be collapsed or
disregarded and viewed, in substance, as signifying nothing more
than petitioner’s attempt to garner tax deductions by renting his
airplanes to himself. But because respondent has not pursued
this precise argument, neither do we.
24
We note that this holding will result in a smaller
increase to petitioner’s taxable income with respect to this item
than respondent determined in the notice of deficiency, which
disallowed petitioner’s Schedule C DEL deductions entirely for
failure to establish that any amounts had been paid or incurred
for ordinary and necessary expenses. In this proceeding,
respondent concedes that the DEL expenses were paid or incurred
and has not argued that the DEL expenses were not ordinary and
necessary. Rather, respondent has sought only to limit the DEL
(continued...)
- 38 -
3. DPM’s Rental Activity
For 2003 and 2004 petitioner reported the DPM rental losses
as passive, and respondent has conceded any adjustment with
respect to these items for these years. Respondent continues to
challenge, however, petitioner’s treating the 2002 DPM rental
losses as nonpassive. Respondent contends that the 2002 DPM
rental activity was per se passive under section 469(c)(2) and
(4). Petitioner disagrees, contending that, at least for 2002
(the only year for which petitioner reported the DPM rental
activity as nonpassive), DPM’s rental activity was incidental to
its primary activity of holding investment properties for future
appreciation.25 We need not decide whether DPM’s rental activity
24
(...continued)
deductions on the grounds that they represent passive activity
losses under sec. 469 and, alternatively, that the DEL activity
was an “activity not engaged in for profit” within the meaning of
sec. 183(c). If respondent’s alternative sec. 183 contention
were sustained, the result would be to limit petitioner’s DEL
deductions to DEL’s gross income for each year at issue. See
sec. 183(a) and (b). As discussed in more detail infra, in
petitioner’s circumstances this result is functionally equivalent
to applying the sec. 469 restrictions to petitioner’s DEL losses.
Consequently, we need not and do not address respondent’s
alternative sec. 183 contentions.
25
Under temporary regulations, an activity involving the use
of tangible property is not treated as a rental activity for a
taxable year if rental of the property is treated as incidental
to a nonrental activity. Sec. 1.469-1T(e)(3)(ii)(D), Temporary
Income Tax Regs., 53 Fed. Reg. 5702 (Feb. 25, 1988). Rental of
property is treated as incidental to an activity of holding the
property for investment only if the principal purpose of holding
the property is to realize gain from the appreciation of the
property and the gross rental income from the property is less
than 2 percent of the lesser of (i) the unadjusted basis of the
(continued...)
- 39 -
was “incidental”, because even if it were, to avoid the section
469 restrictions petitioner would still need to show that he
materially participated in this activity. As discussed below,
petitioner has not shown that he materially participated in any
of the DPM activities (or for that matter, the DEL activities)
for any year, whether they be considered singly or together.
4. Lack of Material Participation
Material participation is defined generally as regular,
continuous, and substantial involvement in the business
operations. Sec. 469(h)(1). The regulations identify these
seven situations in which an individual will be treated as
materially participating in an activity:
(1) The individual participates in the activity
for more than 500 hours during such year;
(2) The individual’s participation in the activity
for the taxable year constitutes substantially all of
the participation in such activity of all individuals
(including individuals who are not owners of interests
in the activity) for such year;
(3) The individual participates in the activity for
more than 100 hours during the taxable year, and such
individual’s participation in the activity for the taxable
year is not less than the participation in the activity of
any other individual (including individuals who are not
owners of interests in the activity) for such year;
(4) The activity is a significant participation
activity (within the meaning of paragraph (c) of this
section) for the taxable year, and the individual’s
25
(...continued)
property, or (ii) the fair market value of the property. Sec.
1.469-1T(e)(3)(vi)(B)(2), Temporary Income Tax Regs., 53 Fed.
Reg. 5703 (Feb. 25, 1988).
- 40 -
aggregate participation in all significant participation
activities during such year exceeds 500 hours;
(5) The individual materially participated in the
activity (determined without regard to this paragraph
(a)(5)) for any five taxable years (whether or not
consecutive) during the ten taxable years that immediately
precede the taxable year;
(6) The activity is a personal service activity (within
the meaning of paragraph (d) of this section), and the
individual materially participated in the activity for any
three taxable years (whether or not consecutive) preceding
the taxable year; or
(7) Based on all of the facts and circumstances (taking
into account the rules in paragraph (b) of this section),
the individual participates in the activity on a regular,
continuous, and substantial basis during such year.
[Sec. 1.469-5T(a), Temporary Income Tax Regs., 53 Fed.
Reg. 5725-5726 (Feb. 25, 1988).]
The regulations also provide that the last-described “facts and
circumstances” test requires that the individual’s participation
in the activity exceed 100 hours during the taxable year.26 Sec.
1.469-5T(b)(2)(iii), Temporary Income Tax Regs., 53 Fed. Reg.
5726 (Feb. 25, 1988).
On brief petitioner claims that he meets the third, fourth,
sixth, and seventh of these tests. He has directed us, however,
to no evidence or proposed findings to show that he meets the
26
Although the regulations permit a taxpayer to establish
the extent of his participation by “any reasonable means”, sec.
1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727
(Feb. 25, 1988), a postevent “ballpark guesstimate” does not
suffice, see Lee v. Commissioner, T.C. Memo. 2006-193; 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.
- 41 -
quantitative requirements for the third, fourth, or seventh test,
as applied to his activities separately. Petitioner’s reliance
on all four tests appears to be partly or (in the case of the
sixth test) wholly premised on the notion that all his activities
should be grouped together so as to constitute, in the aggregate,
a personal service activity. For the reasons discussed above, we
reject this premise.
D. Summary of Conclusions
We conclude and hold that petitioner’s DEL and DPM
activities were passive. Consequently, pursuant to section
469(d), for each year at issue he may not deduct losses from
these passive activities to the extent that his aggregate losses
from all his passive activities exceed his aggregate income from
these activities. Application of this rule in calculating
petitioner’s tax liability requires some consideration of the
interplay among petitioner’s various activities in the light of
our holdings.
For each year at issue, petitioner engaged in three passive
activities: (1) The DPM nonrental activity; (2) the DPM rental
activity; and (3) the DEL activity. We have disallowed the DPM
nonrental losses for failure to show that the disputed expenses
were ordinary and necessary. Consequently, petitioner is allowed
no loss, passive or otherwise, with respect to the DPM nonrental
activity. For 2002 and 2003 petitioner reported no income from
- 42 -
the DPM nonrental activity. For 2004, however, petitioner
reported $15,000 of income from the DPM nonrental activity;
pursuant to our earlier holding, petitioner is allowed no
deductions against this income. For 2004, then, the result of
our holding DPM’s nonrental activity to be passive is partly to
“free up” $15,000 of passive income to be added to petitioner’s
aggregate income from all passive activities and thereby to
increase by $15,000 the aggregate losses petitioner is allowed to
claim with respect to all his passive activities for 2004.27
V. Accuracy-Related Penalties
Respondent determined that for each year at issue petitioner
is liable for an accuracy-related penalty pursuant to section
6662(a) and (b)(2) for substantial understatement of income tax.
Respondent bears the burden of production with respect this
27
As previously noted, we have declined to address
respondent’s alternative argument under sec. 183 that
petitioner’s DEL activity was not engaged in for profit. Our
reason for declining to address this alternative argument was
that, even if it were sustained, it would not affect petitioner’s
tax liabilities in any way different from our holding that the
DEL losses were subject to the sec. 469 restrictions. In the
light of the discussion supra, that conclusion requires some
further elaboration. If we had held that the DEL losses were
subject to the sec. 183 limitation, those losses would have been
allowable only to the extent of DEL’s gross income for each year
and consequently would not have been available to absorb the
$15,000 of “freed up” passive income from the DPM nonrental
activity in 2004. But because the DPM rental activity generated
more than $15,000 of losses in excess of income from that
activity, those losses are available to offset the $15,000 of
“freed up” passive income from the DPM nonrental activity,
independent of any effect that our treatment of the DEL losses,
as being limited by either sec. 183 or 469, might have upon the
calculation.
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penalty. Sec. 7491(c). To meet this burden, respondent must
produce evidence establishing that it is appropriate to impose
this penalty. Once respondent has done so, the burden of proof
is upon petitioner. See Higbee v. Commissioner, 116 T.C. at 449.
Section 6662(a) and (b)(2) imposes a 20-percent
accuracy-related penalty on any portion of a tax underpayment
that is attributable to any substantial understatement of income
tax, defined in section 6662(d)(1)(A) as an understatement that
exceeds the greater of 10 percent of the tax required to be shown
on the return or $5,000. The exact amount of petitioner’s
understatement will depend upon the Rule 155 computation, taking
into account respondent’s concessions and in accordance with our
findings and conclusions. To the extent that those computations
establish, as seems almost certain, that petitioner has a
substantial understatement of income tax, respondent has met his
burden of production. See Prince v. Commissioner, T.C. Memo.
2003-247.
The accuracy-related penalty does not apply with respect to
any portion of the underpayment if it is shown that the taxpayer
had reasonable cause and acted in good faith. Sec. 6664(c)(1).
Petitioner contends that he had reasonable cause and acted in
good faith because in reporting his taxes for the years at issue
he relied in good faith on advice from the Meiners firm, which
prepared DPM’s Forms 1120S and numerous schedules and tables that
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were incorporated into petitioner’s Forms 1040. He also contends
that he relied upon Advocate, which advised him in forming DEL
and DPM and in preparing necessary documents.
Reliance on a professional tax adviser’s advice may
demonstrate reasonable cause and good faith if, taking into
account all the facts and circumstances, the reliance was
reasonable and the taxpayer acted in good faith. Sec. 1.6664-
4(b)(1), (c)(1), Income Tax Regs. Reliance on a tax adviser may
be reasonable and in good faith if the taxpayer establishes: (1)
The adviser was a competent professional with sufficient
expertise to justify reliance; (2) the taxpayer provided
necessary and accurate information; and (3) the taxpayer actually
relied in good faith on the adviser’s judgment. Neonatology
Associates, P.A. v. Commissioner, 115 T.C. 43, 99 (2000), affd.
299 F.3d 221 (3d Cir. 2002). The advice must not be based on
unreasonable factual or legal assumptions and must not
unreasonably rely on representations, statements, findings, or
agreements of the taxpayer or any other person. Sec. 1.6664-
4(c)(1)(ii), Income Tax Regs.
Our determinations regarding petitioner’s tax deficiencies
turn on two key issues: (1) Whether DPM’s nonrental expenses
were ordinary and necessary expenses; and (2) whether his DPM and
DEL activities were passive activities. Petitioner has not shown
that he provided his tax advisers necessary and accurate
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information as to certain critical matters regarding these
issues. Moreover, it appears that his advisers unreasonably
relied on certain of his representations.
More particularly, the disputed airplane expenses, reported
as ordinary and necessary expenses of DPM, emanate from the
flight logs that petitioner maintained. Meiners testified that
these flight logs were a “logbook format that we provide to our
clients as an example of what they can use to meet the
documentation requirements.” It appears, however, that the
Meiners firm accepted at face value petitioner’s characterization
of all his flights as business related.
Similarly, the evidence indicates that it was petitioner,
not his tax advisers, who decided whether to characterize his
activities as passive or nonpassive. Meiners testified: “The
client would tell us whether or not it was passive or nonpassive.
* * * We would have to ask the client. We would have no way of
knowing without. * * * If the client told us it was passive,
fine. It was passive. If the client tells us -- you know, we
don’t know unless the client tells us.” Judging from this
testimony, it appears that on this critical issue the tax
advisers relied upon petitioner, rather than the other way
around.
As petitioner acknowledges on brief, he is “highly educated
and sophisticated and possesses extensive business experience.”
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Accordingly, as petitioner concedes, “the standard of care that
must have been exercised by the Petitioner is a high one.” We
are not convinced that petitioner met that high standard of care.
We hold that for each year at issue petitioner is liable for a
section 6662(a) penalty insofar as the Rule 155 calculations show
a substantial understatement of income tax.
To reflect the foregoing and respondent’s concessions,
Decision will be entered
under Rule 155.
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APPENDIX A
DPM Nonrental Loss Deductions
2002 2003 2004
Repairs & maintenance -- $22,506 $54,591
Rent expense $54,400 27,607 32,058
Taxes & licenses 600 25 125
Depreciation -- 1,056 1,353
Other deductions:
Auto & truck expense 2,038 3,075 3,075
Avionics 2,630 -- --
Fuel 57,567 55,210 53,143
Landing fees permits 3,092 -- --
Maintenance Aircraft 30,575 -- --
Real estate fees 160 -- --
Training 22,850 1,724 1,794
Charts & maps -- 279 81
Dues & subscriptions -- 1,045 --
Flight planning fees -- 162 --
Hanger rent -- 6,000 --
Insurance -- 24,310 20,910
Legal & professional -- 375 1,300
Management fees -- 1,800 1,800
Meals & entertainment -- 526 261
Miscellaneous -- 488 430
Oil -- 58 --
Other rent -- 213 --
Ramp & landing fees -- 179 106
Postage -- -- 339
Supplies -- 46 1,307
Telephone -- 788 725
Tie down parking -- 543 770
Transportation -- 200 200
Travel -- 2,263 1,134
Total 173,912 150,478 175,502
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APPENDIX B
DPM Rental Loss Deductions
2002 2003 2004
Advertising $196 -- --
Auto & travel 1,414 $319 --
Cleaning & maintenance 692 -- --
Commissions 261 4,858 --
Insurance 4,027 1,773 $1,965
Interest 4,578 21,837 66,883
Repairs -- 1,118 6,082
Taxes 1,382 14,863 13,529
Utilities 503 1,183 2,087
Depreciation 20,829 33,685 67,228
Other deductions 6,602 14,509 13,367
Total 40,484 94,145 171,141