UNITED STATES TAX COURT

T.C. Memo. 2012-207

UNITED STATES TAX COURT

LOGENE L. FOSTER AND AGNES M. FOSTER, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 3576-10.

~ Filed July 23, 2012.

Kenneth Alan Love, for petitioners.

Benjamin J. Peeler and Lewis A. Boöth, for respondent.

'

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Judge: Respondent determined deficiencies in the Federal income

tax of Logene L. Foster (petitioner) and Agnes M. Foster and penalties as follows:

SERVED JUL 2 3 2012

Year

Deficiency

Penalty

Sec. 6662(a)

2004

2005

2006

$32,061

24,865

22,383

$6,412.20

4,973.00

4,476.60

By amended answer, respondent asserts increased deficiencies as follows:

YgLr

Deficiency

Penalty

Sec. 6662(a)

2004

200Ò

2006

$53,240

43,772

41,123

$10,648.00

8,754.40

8,224.60

The issues for de ision are: (1) whether petitioners engaged in a horse

racing, training, and bree ing activity (horse activity) with the objective of making

a profit within the meanin of section 183; (2) whether petitioners are entitled to

certain deductions pursu

to section 162 with respect to petitioner's law firm;

and (3) whether petitio ers are liable for accuracy-related penalties under section

6662(a). Unless othergis indicated, all section references are to the Internal

Revenue Code (Code) i e

et for the years in issue, and all Rule references are to

the Tax Court Rules of r ctice and Procedure.

-3FINDINGS OF FACT

Some ofthe facts have been stipulated, and the stipulated facts are

incorporated in our findings by this reference. Petitioners resided in Texas at the

time the petition was filed.

Petitioner is a lawyer who has profitably headed his own firm, the Foster

Law Firm, for more than three decades. Since 1984 petitioners also have operated

a horse racing, training, and breeding activity, first as L&A Quarter Horses and

later as L&A Racing (L&A). Petitioner Agnes Foster keeps the books for the law

firm and the horse activity. Two of petitioners' sons, Lynn Foster and Lonnie

Foster, are lawyers and work at petitioner's law firm. Another son, Lawrence

Foster, is a professional horse trainer.

Petitioners' Horse Activity

When petitioner was growing up his family had horses, and from a young

age he rode and trained horses. In 1984 one of petitioners' friends, who owned

and raced quarter horses, convinced petitioners to buy a quarter horse from him to

race. Shortly thereafter, petitioners sought business and tax advice from a certified

public accountant with respect to pursuing their horse activity.

In 1984 petitioners also bought a home with approximately 12 acres of land

and a barn for $375,000 to accommodate their horse activity. They made a

number of improvements t6 the property, including building stalls in the barn,

adding fences, building n exercise track and a round pen for breaking and

training horses, and installing a horse walker. Many of the improvements to their

property to accommodate tae horses were made by petitioners and their three sons.

A 2010 appraisal, which i cluded the residential portion of the property, indicated

that this property had appreciated in value to $550,000.

Petitioners and th ir three sons attended races in which their horses ran,

helped when their mare

aled; mucked stalls; and fed, galloped, walked, and

bred the horses: Petitioi ers themselves spent more than 20 hours during the week

and on weekends working with and caring for the horses. Two of their sons,

Lonnie and Lawrence, learned to break and train horses and obtained their

trainer's licenses. Petiti ners eventually primarily employed Lawrence to care for

and train their horses.

Through the years petitioners continued to buy and race quarter horses and

. consult with professional t~ainers and veterinarians regarding their horses. They

bought some broodmares and began breeding horses, both for their own racing

activity and to sell. Petitioners eventually began racing thoroughbred horses in

addition to quarter horses.

-5Petitioners maintained a separate checking account for L&A and during the

years in issue used QuickBooks software to track income and expenses. Beyond

that, however:petitioners maintained few business records. Their business plan

consisted of little more than generalized goals for the horse activity and a narrative

account of significant events that occurred in the operation.

To reduce expenses, petitioners sometimes fed the horses mule feed instead

of horse feed; performed some of their own veterinary work such as worming; had

Lawrence, rather than a farrier, shoe the horses; and sold horses when the horses

were no longer able to race. However,,there were no records that substantiated the

cost-reducing effects these measures had on the horse operation.

Petitioners experienced some setbacks with their horse activity. Some of

their horses became ill, were injured, or died. Also, the State of Texas failed to

pass much-hoped-for legislation allowing video gambling at the State's

horseracing tracks, causing Texas horseracing purses to be less than those of

surrounding States.

In 1996 petitioners' returns were audited by the Internal Revenue Service

(IRS) in relation to the horse activity for 1992, 1993, and 1994. The IRS

contended that petitioners were not engaged in the horse activity for profit within

-6the meaning of section 133 Petitioners requested review by the IRS Office of

Appeals, and the IRS event ally conceded the section 183 issue.

By 2004 petitioneFS Were considering ending the horse activity. The activity

had sustained substantial lo ses every year of its operation and Lawrence, who by

this time was training only or petitioners, was thinking about starting a hauling

business. However, petitioners decided to try pinhooking horses because they

knew of some people "who had done real good" with pinhooking. Pinhooking

involves buying a young hc rse and training it to the point it can begin racing, then

selling the horse to someone else who will actually race it. They began

pinhooking around 2005 btt also continued with their previously unprofitable

activities of racing and breeding.

Although petitioners have reported losses for the horse activity every year

from 1984 through 2009 tl ey do not know the total amount of their losses

because they did not retain records of losses for years before 2002. However,

considering only years 2002 through 2009, petitioners' losses have been

substantial:

-7Year

Net loss from

horse activity

2002

2003

2004

2005

2006

2007

2008

2009

Total

($166,447)

(118,486)

. (88,221)

(79,108)

(71,987)

(76,213)

(54,204)

(69,078) .

(723,744)

Petitioner's Law Firm

In contrast to the horse activity, petitioner's law firm has been profitable

through the years. Until 2003 petitioners owned the building in which the law

firm is located. In 2003 petitioners sold the building to the Foster Law Firm, P.C.,

an S corporation owned by petitioners' sons, Lynn and Lonnie, both of whom are

lawyers who work as independent contractors for petitioner's law firm. Petitioner

did not want to deal with tenants and maintenance of the building any longer, and

his sons viewed the sale as a natural step in their father's transition to eventual

retirement from practicing law. Lynn and Lonnie obtained bank financing for the

purchase, and the bank required that they and petitioners personally guarantee the

loan.

-8The law firm re ai ed in the same building after the sale, and petitioners

claimed deductions report d on the law firm's Schedules C, Profit or Loss From

Business, for rent paym n s to their sons' S corporation in the following amounts

for the years in issue: $30,000 for 2004, $24,500 for 2005, and $28,600 for 2006.

Additionally, the law firm made payments of $3,155 (rounded to the nearest whole

number) to the building's :11ortgage lender in 2005 which petitioners treated as

lease payments, bringing t1e total payment amount for 2005 to $27,655.

Petitioner's law firm and the S corporation had no written rent or lease agreement

during the years in issue.

Petitioners also made payments from the law firm to their three sons during

the years in issue. Paymerts of $98,074.52, $89,900.64, and $88,361.15 were

made to Lonnie for contra t legal services for 2004, 2005, and 2006, respectively.

Lynn was paid $106,475.9 , $108,591.84, and $102,931.08 for contract legal

services for 2004, 2005,

d 2006, respectively. L wrence was paid $26,000,

$25,500, and $22,000 f r 004, 2005, and 2006, respectively, for performing

various tasks at the law fi

. Petitioners did not claim deductions for these

payments on their tax re u s.

In addition to their spbstantial income from the law firm, petitioners receive

other income, such as Social Security benefits and distributions from a Keogh

-9account. The following table shows petitioners' total income reported for 2002

through 2006;

Year

Law firm

income

Other income

Total income

2002

2003

2004

2005

2006

$261,225

213,587

203,502

161,340

178,634

$23,364

23,902

84,761

60,173

67,042

$284,589

237,489

288,263

221,513 *

245,676

The IRS commenced an examination of petitioners' joint tax returns for

2004, 2005, and 2006. On November 12, 2009, respondent sent petitioners a

notice of deficiency disallowing the loss deductions with respect to their horse

activity. Petitioners filed a petition for redetermination with this Court on

February 12, 2010.

In an amended answer to the.petition filed on January 11, 2011, respondent

asserted increased deficiencies and penalties based on allegations that the law

firm's rent payments to petitioners' sons' S corporation should be disallowed and

that petitioners underreported the income of the law firm on their Schedules C for

the years in issue. Respondent alleged, and petitioners have conceded, that the

amounts of unreported income for the law firm were $233,889 for 2004, $229,000

for 2005, and $217,898 for 2006. As an offset, however, the parties have agreed

-10that petitioners are entitled to additional deduçtions with respect to the law firm

for amounts paid to Lynn 1nd Lonnie for cóntract legal services for the years in

ISSue.

OPINION

Horse Activity

Respondent dete

ined that petitioners' horse activity was not an activity

engaged in for profit wi in the meaning of section 183 and disallowed loss

deductions they claimed on Schedule F, Profit or Loss From Farming, for the years

in issue. Petitioners counter that they engaged in the horse activity with an intent

to realize a profit.

Under section 183(a), if an activity is not engaged in for profit, no deduction

attributable to that activity is allowed except to the extent provided by section

183(b). In relevant part, section 183(b) allóws those deductions that would have .

been allowable had the activity been engaged in for profit only to the extent of

gross income derived from the activity (reduced by deductions attributable to the

activity that are allowable without regard to whether the activity was engaged in

for profit).

Section 183(c) d

nes an activity not engaged in for profit as "any activity

other than one with res

; tö which deductions are allowable for the taxable year

- 11 under section 162 or under paragraph (1) or (2) of section 212." For expenses to

be deductible under section 162, Trade or Business Expenses, or section 212,

Expenses for.Production of Income, and not subject to the limitations of section

183, taxpayers must show that they engaged in the activity with the primary

objective of making a profit. Westbrook v. Commissioner, 68 F.3d 868, 875 (5th

Cir. 1995), aff'g T.C. Memo. 1993-634.

Under section 183(d), in the case of an activity consisting in major part of

the breeding, training, showing, or racing of horses, if the gross income derived

from the activity exceeds the deductions for any two of seven consecutive taxable

years, then the activity shall be presumed to be engaged in for profit, unless the

Commissioner establishes to the contrary. See Golanty v. Commissioner, 72 T.C.

411, 425 (1979), aff'd without published opinion, 647 F.2d 170 (9th Cir. 1981).

Petitioners have reported losses for L&A for every year from 1984 through 2009;

therefore, the presumption does not apply in this case.

The expectation of a profit need not be reasonable, but the taxpayer must

conduct the activity with the actual and honest objective of making a profit.

Keanini v. Commissioner, 94 T.C. 41, 46 (1990). Greater weight is given to

objective facts than to a taxpayer's self-serving statement of intent. Kina v.

Commissioner, 116 T.C. 198, 205 (2001); sec. 1.183-2(a) and (b), Income Tax

- 12 Regs. Evidence from ýears subsequent to the years in issue is relevant to the

extent it creates inference regarding a taxpayer's requisite profit objective in

earlier years. See Hoyle 3 . Commissioner, T.C. Memo. 1994-592; Smith v.

Commissioner, T.C. M rr o. 1993-140...

Generally, taxpayers bear the burden of proving that the requisite profit

objective exists. Rule 142(a); Westbrook v. Commissioner, 68 F.3d at 876. The

burden of proof may shift to the Commissioner if the taxpayers establish that they

complied with the requ re nents of section 7491(a)(2)(A) and (B) to substantiate

items, to maintam required records, and to cooperate fully with the

Commissioner's reaso

e requests. However, we decide this issue on the

preponderance of the e id nce and, therefore, the burden of proof is not relevant.

See Estate of Black v. Commissioner, 133 T.C. 340, 359 (2009); Knudsen v.

Commissioner, 131 T.C. 185, 189 (2008).

Section 1.183-2(b), Income Tax Regs., provides a nonexclusive list of

factors to be weighed when considering whether a taxpayer is engaged in an

activity for profit. These fàctors are: (1) the manner in which the taxpayer carried

on the activity; (2) the expertise of the taxpayer or his advisers; (3) the time and

effort expended by the t x ayer in carrying on the activity; (4) the expectation that

the assets used in the activity may appreciate in value; (5) the success of the

- 13 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, that are earned from the activity; (8) the financial status

of the taxpayer; and (9) whether elements of personal pleasure or recreation are

involved in the activity. All facts and circumstances are to be taken into account,

and no single factor or mathematical preponderance of factors is determinative.

Westbrook v. Commissioner, 68 F.3d at 876. We address the most relevant factors

in determining petitioners' intent objectively.

Carrying on the activity in a businesslike manner, such as by maintaining .

complete and accurate books and records, conducting the activity in a manner

similar to other activities of the same nature which are profitable, and makirig

changes in operations to adopt new techniques or abandon unprofitable methods

are factors that may indicate a profit objective. Sec. 1.183-2(b)(1), Income Tax

Regs. Businesslike conduct is characterized by careful and thorough investigation

of the profitability of a proposed venture, monitoring of a venture in proy,ress, and

attention to problems that arise over time. See Ronnen v. Commissioner, 90 T.C.

74, 93 (1988); Taube v. Commissioner, 88 T.C. 464, 481-482 (1987).

Petitioners contend that they maintained complete and accurate books and

records. However, other than income and expense statements prepared with

I

- 14 QuickBooks software ànd a "business plan" that included only generalized goals

for the operation and a year-by-year narrative account of notable events occurring

in the horse activity, petit oners produced virtually no business records. The

business plan created by petitioners does not include budgets, economic forecasts

or other analyses demonstrating financial management or planning of the activity

and appears intended on1 to comply with regulations under section 183 in

anticipation of tax ben fit . Petitioners also did not retain any business records for

years before 2002 and, co sequently, are unable to determine with any accuracy

the total losses they ha e ncurred in the horse activity since its beginning in 1984.

The absence of accurate books and records does not conclusively establish

the lack of a profit obje ti e, see De Boer v. Commissioner, T.C. Memo. 1996174, but there was scan evidence that petitioners used the few records that they

did maintain for the i

oitant purposes of "cutting expenses, increasing profits,

and evaluating the overall performance of the operation", see Golanty v.

Commissioner, 72 T.C. at 30. They appear to have maintained income and

expense statements in ord r to memorialize transactions for tax reporting

purposes, rather than to analyze expenses or determine profitability. See Keatina

v. Commissioner, T.C. Memo. 2007-309, aff'd, 544 F.3d 900 (8th Cir. 2008);

Dodge v. Commissioner, T.C. Memo. 1998-89, aff'd without published opinion,

- 15 188 F.3d 507 (6th Cir. 1999). This conclusion is supported by petitioner's

testimony that he "really wasn't keeping up [with] the losses particularly."

Petitioners' recordkeeping fell short of being businesslike in other respects

that this Court has deemed important in determining whether taxpayers have the

requisite profit objective. They did not produce separate records for each of their

horses to demonstrate that they tracked breeding results and racing performance.

See Dodge v. Commissioner; T.C. Memo. 1998-89. They also did not produce any

records that showed that they reviewed each of their specific horse-related

activities of quarter horse racing, thoroughbred racing, breeding, and pinhooking

to assess which were more profitable. See Ballich v. Commissioner, T.C. Memo.

1978-497.

Perhaps the most important indication of whether an activity is being

performed in a businesslike manner is whether the taxpayer implements metheids

for controlling losses, including efforts to reduce expenses and generate inconie.

See Dodge v. Commissioner, T.C. Memo. 1998-89. Petitioners argue that they

worked to reduce their expenses, including at times feeding the horses mule feed

instead of horse feed; döing some öf their own veterinary work; and having their

trainer son Lawrence, rather than a farrier, shoe the horses. However, they

provided no evidence regarding how much they reduced their expenses, if any, by

- 16 implementing these measures. See Dennis v. Commissioner, T.C. Memo. 2010|

216 (the taxpayer demonst·ated a profit objective with respect to reducing

expenses where he provided calculations showing the cost-reducing effects of

performing certain veterintry and horse care services himself).

Petitioners' failure to produce any significant income was a key factor in

their failure to earn a profit. See Dodge v. Commissioner, T.C. Memo. 1998-89.

Petitioners contend that hey made changes in their operations over the years in an

effort to increase their income. Those changes involved adding quarter horse

breeding, thoroughbred racing, and pinhooking to their initial activity of quarter

horse racing. There was little in the record, however, that established that these

changes were irnplemented for the purpose of making the activity profitable rather

than for other noneconoini reasons, and petitioners did not produce any evidence

demonstrating that they m de a careful and thorough investigation of the potential

profitability of any of thes changes before making them. See Taube v.

Commissioner, 88 T.C. t 481.

Furthermore, specifi activities that had proven unprofitable were not

expeditiously abandoned. See Wesinger v. Commissioner, T.C. Memo. 1999-372

(the lack of a profit objective was indicated where the taxpayer failed to

expeditiously abandon a bt siness technique that had not been profitable). As of

- 17 2004, the first year in issue here, petitioners considered abandoning the horse

activity altogether but instead continued with a new speculative venture. After

petitioners began pinhooking, they still were racing and breeding horses, activities

in which they had incurred substantial losses. In fact, during 2006 their racing

expenses increased dramatically from immediately prior years. On balance, we are

not persuaded that petitioners carried on their horse activity in a businesslike

manner. This factor negates a profit objective.

The taxpayers' expertise, research, and study of an activity, as well as their

consultation with experts, may be indicative of a profit motive. See sec. 1.1832(b)(2), Income Tax Regs. Petitioners had extensive knowledge about horses and

the horse industry, partly because of petitioner's years of breaking and training

horses, but also from their continued study of bloodlines and breeding, training,

and racing techniques. Furthermore, during the course of the horse activity,

petitioners consulted with persons who were knowledgeable about horse racing,

training, and breeding, including professional trainers and veterinarians. See

Givens v. Commissioner, T.C. Memo. 1989-529 (a profit objective wás indicated

where the taxpayer sought and acquired advice in all aspects of Tennessee walking

horse breeding from experienced owners, trainers, and a veterinarian). Petitioners

also sought business and tax advice from an accountant when they began their

-18horse activity. In the face of mounting losses, it would have been prudent to seek

further business advicè; however, on balance we believe this factor slightly favors

petitioners.

The taxpayers' devation of much of their personal time and effort to

carrying on an activity may indicate a profit motive, particularly if the activity

does not involve subst t al personal or recreational aspects. Sec. 1.183-2(b)(3),

Income Tax Regs. Alt ough both petitioners also were involved in working at the

law firm, they spent möre than 20 hours during the week and on weekends

working in their horse act.vity, often performing manual and menial tasks such as

feeding and walking the

rses and mucking stalls. See Givens v. Commissioner,

T.C. Memo. 1989-529 ( e taxpayer demonstrated the requisite profit objective

where he spent two to f ur hours daily and more time on weekends doing chores

and maintenance in his ho se activity). This factor favors petitioners.

An expectation that assets used in the activity will appreciate may indicate a

profit motive even if the taxpayers derive no profit from current operatiðns. Sec.

1.183-2(b)(4), Income Tax Regs. Petitioners argue that they expected the horses

that they owned to appreciate because of successful racing and breeding.

Petitioners provided no records for 2004, but computer printouts provided for

2005 and 2006 indicate that during those years petitioners sold a number öf horses

-19for more than they had paid for them. The printouts, however, were not

substantiated with receipts, bills of sale, or other records. Petitioners also contend

that they expected the 12-acre property on which they conducted their horse

activity to appreciate, and the 2010 appraisal indicated that the property had

increased in value from $375,000 at the time of purchase to $550,000.

However, a profit objective may be inferred from such expected

appreciation of the activity's assets only where the appreciation exceeds operating

expenses and is sufficient to recoup the accumulated losses of prior years. See

Golanty v. Commissioner, 72 T.C. at 427-428; Hillman v. Commissioner, T.C.

Memo. 1999-255. The appreciation of petitioners' horse activity assets does not

begin to approach the amounts of losses petitioners have reported since the

beginning of their horse activity. Furthermore, the 12-acre property also is

petitioners' principal residence, and much of its appreciation likely is-attributable

to the residential portion of the property rather than the portion used in the horse

activity. This factor is neutral.

A history of continued losses with respect to the activity may indicate the

lack of a profit motive. See sec. 1.183-2(b)(6), Income Tax Regs. While a series

of losses during the initial or startup stage of an activity may not necessarily

indicate a lack of a profit motive, a record of large losses over many years is

- 20 persuasive evidence that a taxpayer did not have such a motive. Golanty v.

Commissioner; 72 T.C. a 426; Bessenvey v. Commissioner, 45 T.C. 261, 274

(1965), aff'd, 379 F.2d 252 (2d Cir. 1967). An activity's cumulative losses should

not be of such a magni)ude that an overall profit on the entire operation, including

recoupment of past losses, could.not possibly be achieved. Bessenyey v.

Commissioner, 45 T.C at 274. If losses are sustained because of unforeseen or

fortuitous circumstances beyond the control of the taxpayer, such losses would not

be an indication of the lack of a profit motive. See sec. 1.183-2(b)(6), Income Tax

Regs.

Petitioners have realized no profits whatsoever in more than 25 years of

engaging in their horse ac:ivity. They argue, however, that their losses are not an

indication that they lac a profit objective because the losses have been caused by

factors beyond their co trol. Those factors include injury, illness, and death of a

number of their horses and the failure of legislation that would have allowed video

lottery terminals (slot mac ines) at horseracing tracks in the State of Texas. We

acknowledge that horseracing, breeding, and training are highly speculative

activities, but these eve ts hardly account for an unbroken string of more than 25

years of losses.. Further gre, petitioners did not show that their horse activity

would have been profit bl if events beyond their control had not occurred. S_e_e

-21Burger v. Commissioner, 809 F.2d 355, 360 n.8 (7th Cir. 1987), aff'g T.C. Memo.

1985-523.

Petitioners further contend that they could potentially earn a substantial

profit with one outstanding horse. The possibility of a speculative profit in a

taxpayer's horse activity, however, is insufficient to outweigh the absence of

profits for a sustained period of years. See Chandler v. Commissioner, T.C.

Memo. 2010-92 (the possibility of a speculative profit did not outweigh more than

20 years of losses reported for the taxpayer's horse activity); McKeever v.

Commissioner, T.C. Memo. 2000-288 (11 consecutive years of horse activity

losses failed to indicate that the taxpayer had a profit objective even though there

was the possibility of a speculative profit). This factor strongly favors respondent.

Substantial income from sources other than the activity may indicate that the

activity is not engaged in for profit. See sec. 1.183-2(b)(8), Income Tax Regs.

This is particularly true if the losses from the activity generate substantial tax

benefits. Golanty v. Commissioner, 72 T.C. at 429. A taxpayer with substantial

income unrelated to the activity can more readily afford a hobby. See Wesley v.

Commissioner, T.C. Memo. 2007-78. Petitioners' substantial income from the law

firm and other sources has allowed them to continue their horse activity in spite of

more than 25 years of losses, and the activity also has generated generous tax

- 22 savings in the form of r et losses that offset that income. This factor favors

respondent.

Finally, the presence of personal motives and recreational elements in

carrying on an activity may indicate that the activity is not engaged in for profit.

Sec. 1.183-2(b)(9), Incom Tax Regs. Petitioners contend that the horse activity,

particularly mucking stall , was hard work rather than pleasure. We do not

believe, however, that etitioners and their sons would have continued the losing

horse activity for more than 25 years unless they received satisfaction from the

work. It is more likely h t such satisfaction, rather than a profit objective,

accounts for their persistence. This factor does not favor petitioners but is neutral.

After weighing all

e facts and circumstances in the light of the relevant

factors, we conclude th t etitioners did not engage in their horse activity for the

years in issue with the req isite profit objective. The many years of losses without

a meaningful plan for rdcouping;them are most persuasive. Accordingly, we

sustain respondent's disallowance of the loss deductions relating to the horse

activity under section 183.

.

Law Firm Deductions Unc er Section 162

If the Commissio 1er Talses new matters or asserts increased deficiencies in

his answer to the taxpayers' petition, the Commissioner bears the burden of proof

- 23 on those issues. See Rule 142(a); Truesdell v. Commissioner, 89 T.C. 1280, 12921293 (1987). Respondent first raised the issues of the law firm's unreported

income and the disallowance of petitioners' claimed deductions for the law firm's

rent payments in his amended answer; therefore, respondent has the burden of

proof on these issues.

Payments to Petitioners' Sons

Inasmuch as petitioners have conceded that they underreported the law

firm's gross income for the years in issue, respondent has carried the burden of

proof with respect to such income. Petitioners assert that the amounts of .

unreported income consisted of payments for services provided by their sons that

petitioners subtracted from the law firm's gross.income before reporting that

income on their tax returns. Petitioners now argue that the unreported income

should be offset by deductions for those payments not claimed on their tax returns.

Respondent, however, seeks the increased deficiency only with respect to

payments made to Lawrence; respondent does not dispute the deductibility of

payments made to Lynn and Lonnie for contract legal services.

Section 162(a) allows a deduction for ordinary and necessary expenses paid

or incurred.by a taxpayer in carrying on any trade or business. In general,

payments made or incurred by a trade or business for personal services rendered

- 24 are ordinary and necessary business expenses and may be deducted under section

162(a). The burden of sh wing entitlement to a claimed deduction is on the

taxpayer. See Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Taxpayers

must maintain records sufficient to substantiate the amounts and purposes of

deductions claimed. _S_ee sec. 6001; Hradesky v. Commissioner, 65 T.C. 87, 89-90

(1975), aff'd per curiam, 540 F.2d 821 (5th Cir. 1976).

Petitioner s have.produced no records substantiating the work that Lawrence

performed at the law firm In the event a taxpayer establishes thát he or she

incurred a deductible e pense but is unable to substantiate the precise amount, the

Court may approximat t e amount of the expense. Cohan v. Commissioner, 39

F.2d 540, 543-544 (2d ii. 1930). The Court, however, must have sufficient

evidence upon which to rr ake a reasonable estimate to apply the Cohan rule.

Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). Petitioners' evidence

regarding the duties Lawrence performed for the law firm consisted ðnly of

generalized testimony that he transported boxes of documents for petitioner and

drove petitioner to worl . Petitioners provided no details establishing Lawrence's

duties, how many hours he worked, or on what basis he was paid during the years

at issuer Therefore, we have no reasonable basis for applying the Cohan rule, and

-25 we conclude that petitioners are not entitled to any deductions for payments made

from the law firm to their son Lawrence.

Rent Payments .

The S corporation bought the office building in which the law firm is

located from petitioners in 2003. Subsequently, the law firm made rent payments

to the S corporation of $30,000 for 2004, $27,655 for 2005 (which included

building mortgage payments made by petitioners and treated as rent payments),

and $28,600 for 2006. Petitioners claimed deductions for these payments on their

Schedules C for the law firm for the years in issue.

Respondent contends that the sale of the building was a tax-motivated

transaction by which petitioners transferred an asset to their sons at less than fair

market value, increased the depreciable basis of a building that had previously

been fully depreciated, avoided recapture of depreciation; and allegedly entered

into an oral lease but did not comply with the terms of the lease they describe.

According to respondènt, these factors indicate that the sale had no economic

substance and thus petitioners' deductions for rent payments should be disallowed

by the Court. Petitioners assert nontax reasons for the sale ofthe building and

actual transfer of ownership.

- 26 Respondent further argues that "[i]n substance the petitioners have achieved

a significant increase in th: deductions against the Schedule C income of the [law

firm], while passing a significant family owned asset to the next generation with

* * * little or no tax consequence to the petitioners' sons."

A transaction ma be disregarded as lacking in economic substance where

there is no legitimate business purpose and the transaction is motivated only by a

desire to minimize taxes. See W.H. Armston Co. v. Commissioner,.188 F.2d 531,

533 (5th Cir. 1951), a_ff_g 12 T.C. 539 (1949). Where there is a legitimate

business purpose, however, the transaction will be recognized as having economic

substance even though tax-saving purpose is also present. See L.W. TildensInc.

v. Commissioner, 192 F 2c 704, 708-709 (5th Cir. 1951), rev'g a Memorandum

Opinion of this Court dated March 16, 1950, 9 T.C.M. (CCH) 219 (1950).

Respondent relies or W.H. Armston Co. In that case a closely held

corporation, a construction company whose majority owners were husband-andwife stockholders, sold so1ì1e heavy equipment to the stockholder wifé who then

leased the equipment baçk to the corporation.. The Court of Appeals for the Fifth

Circuit determined that the purported sale had no legitimate business purpose

other than as a device for n inimizing the corporation's tax liability as a result of

deductions for the lease ayments. The court consequently held that the lease

- 27 payments made to the wife were constructive dividends that were not deductible as

ordinary and necessary business expenses by the corporation. In holding that the

purported sale should be disregarded for tax purposes, the court noted that the wife

was primarily a housewife with no independent income of her own who relied on

the advice of her husband in anything she did relating to the corporation.

Here, unlike the stockholder wife in W.H. Armston Co., petitioners' sons,

Lynn and Lonnie, have income of their own and were required to join petitioners

in personally guaranteeing the loan used to purchase the building. Except for

building payments of $3,155 made by petitioners that were treated as rent

payments, the S corporation or petitioners' sons made the building's mortgage

payments, and their sons also took out an additional loan to have improvements

made, to the building. Furthermore, the testimony at trial established that there was

a legitimate business purpose for the sale of the building: Petitioner was tired of

having to deal with tenants and maintenance ofthe building, and petitioners' sons,

who were lawyers that worked at their father's law firm, viewed purchasing the

building as a natural step in their father's transition to eventual retirement from his

law practice.

Whether the sale of the building was at a less-than-arm's-length price,

whether some of the deductions that petitioners have claimed in relation to the

- 28 building were properly deductible on the Schedules C of the law firm, and whether

a fair market rent as bei g charged are issues that might bear more scrutiny.

However, respondent has asserted only that the rent payments are not allowable

because the transaction w s purely tax motivated. Respondent has not persuaded

us that the transaction lac ed economic substance. Thus the rent deductions for

payments actually made a e not disallowed.

Section 6662(a) Accuracy Related Penalties

Section 6662(a) änd (b)(1) and (2) imposes a 20% accuracy related penalty

on any underpayment of Federal income tax attributable to a taxpayer's negligence

or disregard of rules or regulations or substantial understatement of income tax.

Section 6662(c) defines n gligence as including any failúre to make a reasonable

attempt to comply with th provisions of the Code and defines disregard as any

careless, reckless, or inten ional disregard. Disregard of rules or regulations is

careless if the taxpayer does not exercise reasonable diligence to determine the

correctness of a tax ret

position that is contrary to the rule or regulatioñ. Sec.

1.6662-3(b)(2), Income Tax Regs. An understatement of income tax is substantial

if it exceeds the greater of 10% of the tax required to be shown on the return or

$5,000. Sec. 6662(d)(1 (Á).

- 29 Under section 7491(c), the Commissioner bears the burden of production

with regard to penalties and must come forward with sufficient evidence

indicating that it is appropriate to impose penalties. Higbee v. Commissioner, 116

T.C. 438, 446 (2001). Considering the substantial amounts of unreported income

and the erroneous loss deductions that petitioners claimed for the years in issue,

respondent has satisfied the burden ofproducing evidence that the penalties are

appropriate.

Once the Commissioner has met the burden of production the taxpayer must

come forward with persuasive evidence that the penalties are inappropriate

because he or she acted with reasonable cause and in good faith. Sec. 6664(c)(1);

Higbee v. Commissioner, 116 T.C. at 447-448. The decision as to whether a

taxpayer acted with reasonable cause and in good faith is made on a case-by-case

basis, taking into account all of the pertinent facts and circumstances. See sec.

1.6664-4(b)(1), Income Tax Regs.

Petitioners have not shown reasonable cause for claiming the erroneous loss

deductions for their horse activity or underreporting the law firm's income with

respect to amounts paid to their son Lawrence. As to the horse activity, petitioriers

rely solely on the fact that the IRS conceded the section 183 issue during their first

audit for tax years 1992 through 1994.

- 30 A failure by the o

issioner to disallow similar deductions in a prior

year's audit.of a taxpayer's return may be a factor to be considered with respect to

the imposition of the acciracy-related penalty. See Stewart v. Commissioner, T.C.

Memo. 2002-199; Sheehy v. Commissioner, T.C. Memo. 1996-334. However,

petitioners' first audit yas conducted more than 10 years earlier when the horse

activity arguably was still within its startup phase during which losses could be

expected. In subseque t ears, petitioners continued to sustain significant losses,

but did not seek compe e t advice regarding whether they should have continued

to treat their horse actiti

as being engaged in for profit. Petitioner's testimony

indicated only that they talked with a certified public accountant and "a few

people" at a time undisclosed in the record. Petitioners gave no details regarding

what information they provided to the accountant or what the accountant's advice

was. The accountant did not:testify. As to petitioners' underreporting of the law

firm's income with respiect to amounts paid to their son Lawrence, they produced

no evidence proving thát they sought or relied upon competent advice in relation

to the unjustified practiöe af omitting from gross receipts income distributed to

their sons.

Petitioners' tax retu Tis for the years in issue were prepared by a

bookkeeping and tax sewi::e, not a certified public accountant, and petitioners

- 31 gave no details about the information they provided to their tax return preparer or

whether their tax return preparer was competent to prepare their tax returns.

Therefore, we sustain the penalties on the recomputed and increased deficiencies

with respect to the disallowed horse activity losses and the unreported law firm

income related to payments made to petitioners' son Lawrence.

In reaching our conclusions, we have considered all arguments made by the

parties and, to the extent not mentioned above, we conclude they are moot,

irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered under

Rule 155.