United States Tax Court

United States Tax Court

T.C. Memo. 2025-51

JAMES M. ROOT AND VALERIE K. ROOT,

Petitioners

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent

__________

Docket No. 176-22.

Filed May 22, 2025.

__________

Edward C. Duckers, Kevin T. Pearson, and Michael L. Such, for

petitioners.

Kara L. Davidson Duyck and Catherine J. Caballero, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

TORO, Judge: In this deficiency case, petitioners, James M. and

Valerie K. Root, contest the Commissioner’s disallowance of net

operating loss carryovers under section 172 1 for the taxable years 2017

and 2018. They also challenge the determination of an accuracy-related

penalty under section 6662(a) for each year.

According to the Roots, the carryovers arose from the 2014 closure

or abandonment of a guest lodge on the Roots’ property in Klamath

County, Oregon. The Commissioner contends that the Roots did not

engage in a trade or business, within the meaning of sections 165(c)(1)

1 Unless otherwise indicated, statutory references are to the Internal Revenue

Code, Title 26 U.S.C. (I.R.C. or Code), in effect at all relevant times, regulation

references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all

relevant times, and Rule references are to the Tax Court Rules of Practice and

Procedure.

Served 05/22/25

2

[*2] and 172(d)(4), involving the lodge and therefore that they are not

entitled to deductions for losses related to the lodge.

For the reasons discussed below, we find that the Roots did not

engage in a trade or business involving the lodge by 2014, and, therefore,

they are not entitled to the carryovers claimed for 2017 and 2018. 2 We

further find that the Roots are liable for the accuracy-related penalty for

each year.

FINDINGS OF FACT

The following facts are derived from the pleadings, the parties’

First and Second Stipulation of Facts with attached Exhibits, and

testimony admitted into evidence at trial. Mr. and Mrs. Root lived in

Oregon when they filed their Petition.

I.

Background on the Roots and the Property

Mr. and Mrs. Root built a family business into a fruit processing

enterprise. Mr. Root came from a family business of fruit growers,

packers, and shippers. He attended Oregon State University, where he

obtained a degree in food science and technology, and then earned a

master’s in business administration from Oregon University. Returning

to his family’s industry, Mr. Root, alongside Mrs. Root, built up Sabroso,

a fruit puree company. Mr. Root worked at Sabroso for 33 years; he and

Mrs. Root owned and operated it together for 20 years. The Roots sold

Sabroso in 2008.

More than a decade before selling Sabroso, the Roots began to

develop ideas for a recreational ranch in Oregon. A ranch would merge

the Roots’ interests—Mr. Root loved to fish, and Mrs. Root enjoyed

2 The Roots argue for the first time in their reply brief that their losses are also

deductible under section 165(c)(2), which provides a deduction for losses incurred in a

transaction entered into for profit. By failing to raise this argument in their opening

brief, the Roots have forfeited it, and the Court will not consider it. See Considine v.

Commissioner, 74 T.C. 955, 969–70 (1980) (declining to consider an argument first

advanced in a reply brief because it was “untimely”); see also Burlington N. & Santa

Fe Ry. Co. v. Vaughn, 509 F.3d 1085, 1093 n.3 (9th Cir. 2007) (stating that the parties

“waived [an] argument by raising it for the first time in their reply brief”); Alterman

v. Commissioner, T.C. Memo. 2018-83, at *29 (concluding that the taxpayers were not

entitled to a deduction when they failed to “properly brief” the issue). The argument

would not appear to help the Roots in any event. See Todd v. Commissioner, 77 T.C.

246, 248–49 (1981), aff’d per curiam, 682 F.2d 207 (9th Cir. 1982); see also infra

Opinion Part II.

3

[*3] equestrian activities, cooking, and other ranch-related activities.

As Mr. Root explained at trial:

I had developed a keen interest in fly fishing, and my wife

was raised on a smaller farm cattle ranch, and she brought

the horsemanship and working dog experience. We

married those two ideas for what we thought would be a

multi-purpose natural resource lodge.

Tr. 26.

In 1995 and 1998, the Roots purchased two parcels of land in

Klamath County. The properties included a pasture, farmland, and

waterways. After purchasing the land, the Roots took steps to make

improvements, including restoration of the waterways for fishing. In or

around 2002, the Roots purchased two additional parcels of land. The

first included a 76-acre parcel, known as the Klamath Agency property,

which housed historic buildings. The second, a 10-acre parcel, included

a residence where the Roots primarily stayed when on the ranch. We

refer to all four parcels, taken together, as the property.

II.

Construction of the Lodge and Discovery of Problems

In September 2000, the Roots entered into an agreement with

Larry Pearson, A.I.A., P.C., to act as the architect for a “Lodge/Residence

(including a semi-attached guest wing and a semi-attached council

house)” and a barn on the property. Ex. 11-J, at 1. Construction began

after June 2003, when the Roots entered into a residential construction

agreement with J.E. Simpson Construction, a local contractor. The

scope of work under that agreement included the “construction of the

main house, the council house, [and] the garage.” Ex. 14-J, at 21. 3 When

construction on the lodge 4 began, the property was zoned solely for farm

use. Commercial construction on the property was prohibited without

permission from the county.

3 The scope of work also included a reference to a “guest/bunk house,” but an

addendum to the agreement appears to have excluded the “guest house” from the scope

of work. Ex. 14-J, at 22.

4 The Commissioner maintains that the structure was intended to be a house

for the Roots’ personal use. The Roots, by contrast, maintain that the structure was

intended for business use. Although at trial Mr. Root frequently referred to the

structure as the house, in view of our disposition, we need not resolve the parties’

factual dispute on this point. Our use of the term “lodge” should not be understood

otherwise.

4

[*4] In April 2005, the Roots entered into a contract with Peace Design

under which the company agreed to provide “services . . . [in connection]

with the interiors of your new home.” Ex. 13-J, at 1. Later in 2005, the

Roots obtained a personal homeowner’s policy to cover the lodge for the

period from September 30, 2005, through September 30, 2006. They

added fine art and jewelry coverage to the policy on January 9, 2006.

The homeowner’s policy was subsequently renewed for two additional

years.

In May 2006, the lodge received a certificate of completion. But

shortly after the construction was completed, things began to go awry.

By the end of 2006, snow and rain caused the lodge to flood, revealing

defects in its windows, roofing, and weatherproofing. In 2007, the Roots

discovered hundreds of bats living in the walls of the lodge, along with

rats and mice. The infestations caused a foul odor within the lodge.

Later, it also became clear that the foundation of the lodge was defective.

The Roots eventually hired a forensic architect to evaluate the

lodge. In the course of his work, the forensic architect found that the

lodge’s main fireplace was structurally unsound. The large boulders

used in the fireplace were simply stacked on top of each other. The rebar

that should have been included in the structure was omitted, putting

users of the lodge at great risk in the event of an earthquake. The

forensic architect reported the fireplace defect to Klamath County. In

2010, after receiving reports of the defects and inspecting the property,

county officials condemned the lodge as unsuitable for occupancy.

III.

Conditional Use Permit for Additional Future Construction

After they discovered some of the defects at the lodge, but before

the lodge was condemned, the Roots still hoped to remediate the lodge’s

construction problems. They also hoped to expand the structures on the

property. In 2009, they obtained a conditional use permit from the

Klamath County Planning Department to build additional structures on

the property near the existing lodge. The permit referred to the existing

lodge as a “dwelling” on an “existing cattle ranch.” The permit, as

amended, would have allowed an additional building with up to 20 guest

rooms, alongside a new barn, parking, and other functional necessities.

The structures contemplated in the permit were never built.

5

[*5] IV.

Condemnation of the Lodge and Aftermath

After the lodge was condemned in 2010, the Roots eventually lost

faith in the project. The lodge was subsequently demolished, although

the record is unclear as to when the demolition occurred.

V.

Litigation Concerning the Construction of the Lodge

Once the lodge’s construction defects became apparent, the Roots

pursued litigation to recover their losses. In 2009, the Roots filed a

demand for arbitration against Larry Pearson, A.I.A., P.C., and J.E.

Simpson Construction. The Roots and Larry Pearson settled in 2011, in

an agreement that referred to the lodge as a “high-end custom home.”

Ex. 28-J, at 1. The Roots also reached a settlement with J.E. Simpson

Construction.

Then, in 2011, the Roots filed complaints against the various

subcontractors involved in the construction of the lodge. The Roots

received a favorable judgment and monetary award in 2014.

While litigating, the Roots did not seek to recover business losses

or damages related to a business. Ultimately, the Roots recovered

approximately $3 million through arbitration and litigation but paid

approximately $4 million in legal fees.

VI.

Activities on the Property

The lodge never hosted overnight guests. As Mr. Root pointed

out, when asked at trial why the Roots never obtained an innkeeper’s

license for the lodge: “We didn’t have a viable structure to keep guests.

We hadn’t gotten that far.” Tr. 55. Mrs. Root echoed the same point

when asked whether the Roots had hospitality software to check in

guests. She candidly replied, “No, we weren’t that far along. We would

have had to have that.” Tr. 82.

The Roots did, however, sporadically host events on the property.

Before building the lodge, they hosted ESPN’s “Fly Fishing of the World”

television show and two Crater Lake National Park fundraising events.

They also hosted the National Amateur Retriever Dog Trials. After

construction was completed, and while they were finding defects at the

lodge, they held a fundraiser for the National Fish and Wildlife

Foundation, two horse reining competitions, and an open house for local

fishing guides, anglers, and hunters. The Roots also opened the

property twice to birders from a local nature conservancy. All told,

6

[*6] between 2002 and 2009, the Roots held about a dozen events on the

property, none of which involved stays at the lodge. These events were

by invitation only. The record reflects no payments to the Roots for these

events.

In addition to hosting occasional events, the Roots once donated

a stay at the lodge to the Jackson Hole One Fly Foundation. Because

the lodge was uninhabitable, however, the recipients stayed at the

Roots’ personal residence.

The Roots did not engage in any television or print advertising for

the lodge. They did not hire employees for the lodge, purchase

hospitality software, or build a website to book stays. They had no

innkeeper’s or food handler’s license.

VII.

Tax Returns and Examination

The Roots filed Form 1040, U.S. Individual Income Tax Return,

for taxable year 2014 on October 8, 2015. On the Form 1040, Mr. Root’s

occupation was described as “CEO” and Mrs. Root’s as “Retired.” The

return included Schedule C, Profit or Loss From Business, that listed

Mr. Root’s principal business as “Root Properties LLC,” a consulting

business (according to the business code the Roots provided in box B)

using the name “Jim Root & Company.” 5 The Schedule C reflected over

$300,000 of gross receipts and approximately $10,000 of net profit. The

Schedule C did not mention any hospitality activities or reflect any

losses related to the Roots’ lodge.

In May 2018, the Roots filed Form 1040X, Amended U.S.

Individual Income Tax Return, for 2014, claiming a loss under

sections 165 and 167 of $5,147,035. They calculated this amount by

adding together the total design and construction costs of the lodge and

the legal fees associated with the subsequent litigation, and then

subtracting the recovery from litigation and settlements. Jamie M.

5 The Roots had registered the business name “The Root Ranch” with the State

of Oregon in 1999, but the record does not show a business by that name being listed

in any Schedules C filed with the federal income tax returns for taxable years before

2014. We note that State of Oregon registry of business names lists the principal place

of business for The Root Ranch at a slightly different address (the street number is

shown as 42025) from the address where the lodge was located (the street number for

the lodge was 42020). We cannot tell from the record what precisely was located at the

first address (i.e., No. 42025).

7

[*7] Rayburn, a certified public accountant with Rayburn & Rayburn,

LLP, CPAS, prepared the amended return.

The Roots filed Forms 1040 for the taxable years 2017 and 2018.

On their 2017 return, the Roots claimed a net operating loss carryover

from 2014 of $3,738,774. On their 2018 return, they claimed a net

operating loss carryover from 2014 of $3,305,040.

The Commissioner examined the Roots’ 2017 and 2018 returns.

At the conclusion of the examination, the Commissioner issued a Notice

of Deficiency disallowing the claimed net operating loss carryovers in

full and determining a deficiency for each year. In addition, the

Commissioner determined a 20% accuracy-related penalty under

section 6662(a) for each year. 6 Before the issuance of the Notice of

Deficiency, the revenue agent assigned to the Roots’ examination made

the initial determination to assert penalties against the Roots, and that

determination was approved, in writing, by the revenue agent’s

immediate supervisor.

The Roots timely petitioned our Court for redetermination.

OPINION

I.

Burden of Proof

The Commissioner’s determinations in a Notice of Deficiency are

generally presumed correct, and the taxpayer bears the burden of

proving those determinations erroneous. See Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933); Merkel v. Commissioner, 192 F.3d

844, 852 (9th Cir. 1999), aff’g 109 T.C. 463 (1997). The taxpayer bears

the burden of proving entitlement to any deduction claimed. INDOPCO,

Inc. v. Commissioner, 503 U.S. 79, 84 (1992). Thus, a taxpayer claiming

a deduction on a federal income tax return must demonstrate that the

Code authorizes the deduction and must maintain records sufficient to

enable the Commissioner to determine the correct tax liability. See

I.R.C. § 6001; Hradesky v. Commissioner, 65 T.C. 87, 89–90 (1975), aff’d

per curiam, 540 F.2d 821 (5th Cir. 1976); Treas. Reg. § 1.6001-1(a).

6 The Commissioner determined that section 6662 applied because the Roots

had an underpayment attributable to a substantial understatement of income tax

under section 6662(b)(2). In the alternative, the Commissioner determined that the

underpayment was attributable to negligence or disregard of rules or regulations

within the meaning of section 6662(b)(1).

8

[*8] If the taxpayer puts forth credible evidence with respect to any

factual issue relevant to ascertaining the taxpayer’s liability and meets

certain other requirements, the burden of proof shifts to the

Commissioner as to that issue. I.R.C. § 7491(a)(1) and (2). The Roots

do not seek, and the record does not support, a shift in the burden of

proof here.

II.

Net Operating Loss Carryover Deductions

Section 172(a) allows as a deduction for a taxable year an amount

equal to the aggregate of (1) the net operating loss carryovers to that

year and (2) the net operating loss carrybacks to the year. See Metro

One Telecomms., Inc. v. Commissioner, 704 F.3d 1057, 1059–60 (9th Cir.

2012), aff’g 135 T.C. 573 (2010). Section 172(c) defines a net operating

loss as the excess of deductions over gross income, computed with

certain modifications specified in section 172(d). See, e.g., United

Dominion Indus., Inc. v. United States, 532 U.S. 822, 825 (2001); Metro

One Telecomms., Inc. v. Commissioner, 704 F.3d at 1060; Keith v.

Commissioner, 115 T.C. 605, 620 (2000) (reviewed). Specifically, with

respect to individuals, section 172(d)(4) limits the net operating loss

deductions which are not attributable to a trade or business. “As a result

of subsections (c) and (d) of section 172, the basic category of an

individual’s losses that may constitute net operating losses is losses from

the conduct of a trade or business.” Laney v. Commissioner, T.C. Memo.

1997-403, 1997 WL 563381, at *13, aff’d, 168 F.3d 482 (4th Cir. 1999).

“A taxpayer who claims a net operating loss deduction bears the

burden of establishing both the existence of the net operating loss and

the amount that may be carried over to the year involved.” Chico v.

Commissioner, T.C. Memo. 2019-123, at *39 (citing Keith, 115 T.C.

at 621), aff’d, No. 20-71017, 2021 WL 4705484 (9th Cir. Oct. 8, 2021).

Moreover,

[i]t is well settled that we may determine the correct

amount of taxable income or net operating loss for a year

not in issue (whether or not the assessment of a deficiency

for that year is barred) as a preliminary step in

determining the correct amount of a net operating loss

carryover to a taxable year in issue.

Lone Manor Farms, Inc. v. Commissioner, 61 T.C. 436, 440 (1974), aff’d,

510 F.2d 970 (3d Cir. 1975) (unpublished table decision).

9

[*9] “Taxpayers cannot rely solely on their own income tax returns to

establish the losses they sustained.” Barker v. Commissioner, T.C.

Memo. 2018-67, at *13 (citing Wilkinson v. Commissioner, 71 T.C. 633,

639 (1979)), aff’d, 853 F. App’x 571 (11th Cir. 2021). “To meet [their]

burden [the Roots] must introduce convincing evidence that [they]

incurred [a net operating loss] in the taxable [year 2014] . . . .” See Amos

v. Commissioner, T.C. Memo. 2022-109, at *7 (quoting Power v.

Commissioner, T.C. Memo. 2016-157, at *14), aff’d, No. 23-10532, 2024

WL 1406646 (11th Cir. Apr. 2, 2024).

The Roots assert that the losses they incurred with respect to the

lodge were losses incurred in a trade or business and were deductible for

2014 under section 165(c)(1). For the reasons stated below, we find that

the Roots were not engaged in a trade or business within the meaning

of section 165(c)(1) by 2014. Accordingly, they were not entitled to a

deduction under section 165(c)(1) for the losses they claimed for that

year and had no net operating loss to carry over to 2017 and 2018.

A.

Legal Background: Losses Incurred in a Trade or Business

Section 165 generally allows taxpayers to deduct unreimbursed

losses sustained during the taxable year. I.R.C. § 165(a). For individual

taxpayers, section 165(c) limits the deduction to three categories of

losses: (1) losses incurred in a trade or business; (2) losses incurred in

any transaction entered into for profit, though not connected with a

trade or business; and (3) certain casualty losses. To deduct a trade or

business loss under section 165(c)(1), a taxpayer must be engaged in a

trade or business. See Weston v. Commissioner, T.C. Memo. 2025-16,

at *11; Sandoval v. Commissioner, T.C. Memo. 2010-208, 2010 WL

3719257, at *3.

Neither the Code nor the regulations provide a generally

applicable definition of the term “trade or business.” Commissioner v.

Groetzinger, 480 U.S. 23, 27 (1987). “Determining the existence of a

trade or business ‘requires an examination of the facts in each case.’”

Estate of Morgan v. Commissioner, T.C. Memo. 2021-104, at *13–14

(quoting Commissioner v. Groetzinger, 480 U.S. at 36).

The Supreme Court and our Court have applied the same

standard under both section 162(a) and section 165(c)(1) to determine

whether a trade or business exists. See United States v. Generes, 405

U.S. 93, 103 (1972) (discussing the consistency of the meaning of “trade

or business” across sections 162, 166, and 165); see also Bick v.

10

[*10] Commissioner, T.C. Memo. 1978-390, 37 T.C.M. (CCH) 1591, 1593.

The U.S. Court of Appeals for the Ninth Circuit, where this case would

ordinarily be appealable, see I.R.C. § 7482(b)(1), has also indicated that

the term “trade or business” carries a uniform meaning across

sections 162(a) and 165(c)(1), see DePinto v. United States, 585 F.2d 405,

408 (9th Cir. 1978); Hirsch v. Commissioner, 315 F.2d 731, 736–37 (9th

Cir. 1963), aff’g T.C. Memo. 1961-256. 7

In examining the facts of each case to determine the existence of

a trade or business we have focused on three factors. Estate of Morgan,

T.C. Memo. 2021-104, at *14. First, the taxpayer must undertake an

activity intending to earn a profit; second, the taxpayer must be

regularly and actively engaged in the activity; and third, the taxpayer’s

business activities must actually have commenced. See, e.g., id. (first

citing Weaver v. Commissioner, T.C. Memo. 2004-108, 2004 WL 938293,

at *6; and then citing McManus v. Commissioner, T.C. Memo. 1987-457,

54 T.C.M. (CCH) 475, 479–80, aff’d, 865 F.2d 255 (4th Cir. 1988)

(unpublished table decision)).

Failing to satisfy any of these

requirements is dispositive. Wegener v. Commissioner, T.C. Memo 201998, at *13 (citing Jafarpour v. Commissioner, T.C. Memo. 2012-165, slip

op. at 15).

7 The Roots resist uniformity between sections 162(a) and 165(c)(1), arguing

that, because section 162(a) requires expenses to be incurred in the “carrying on” of a

trade or business, it imposes additional requirements compared to section 165(c)(1).

As a result, they argue, they qualify for a 165(c)(1) loss even if they did not “carry on”

a trade or business. The decisions discussed in the text, from the Supreme Court, the

Ninth Circuit, and our Court, do not support this line of argument.

The Roots also highlight section 195 as a potential indicator that section 165

does not require a trade or business to have commenced. Section 195 requires

taxpayers to capitalize startup expenditures. Taxpayers may elect to deduct up to

$5,000 in startup expenditures “for the taxable year in which the active trade or

business begins” and the remainder over 15 years. I.R.C. § 195(b)(1) (emphasis added).

If a taxpayer disposes of the business before the end of the 15-year period, the taxpayer

may be able to deduct the remaining deferred expenses as a loss under section 165.

I.R.C. § 195(b)(2). On the Roots’ reading, section 195(b)(2) contemplates a section 165

deduction for expenses incurred before a trade or business commences. But

section 195(b)(1) provides a deduction beginning only in the year in which a trade or

business begins. And section 195(b)(2) contemplates an additional section 165

deduction only “to the extent allowable under section 165.” Read in harmony, sections

195 and 165 both contemplate that a trade or business will have commenced by the

time a taxpayer deducts startup expenses. See Estate of Morgan, T.C. Memo. 2021104, at *15–16, *21 n.9.

11

[*11] B.

Whether the Roots’ Business Activities Actually Commenced

by 2014

We begin our analysis by considering the third factor, which

addresses timing. The following oft-quoted test offers guidance:

[E]ven though a taxpayer has made a firm decision to enter

into business and over a considerable period of time spent

money in preparation for entering that business, he still

has not “engaged in carrying on any trade or business”

within the intendment of section 162(a) until such time as

the business has begun to function as a going concern and

performed those activities for which it was organized.

Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir.

1965), vacated and remanded on other grounds per curiam, 382 U.S. 68

(1965); see also Madison Gas & Elec. Co. v. Commissioner, 72 T.C. 521,

566 (1979) (concluding that Richmond Television Corp. was correctly

decided), aff’d, 633 F.2d 512 (7th Cir. 1980).

That is, “a taxpayer must show ‘more than initial research into or

investigation of business potential’ to cross the threshold into ‘carrying

on a trade or business.’” Estate of Morgan, T.C. Memo. 2021-104, at *14

(quoting Glotov v. Commissioner, T.C. Memo. 2007-147, 2007 WL

1702618, at *2). “Crossing that threshold does not require that the

business succeed, but [the taxpayer] must engage in business.” Id.

at *15 (citing Cabintaxi Corp. v. Commissioner, 63 F.3d 614, 620–21 (7th

Cir. 1995), aff’g in part, rev’g in part, and remanding T.C. Memo. 1994316).

As we have observed before, “[t]he taxpayer must make the

preliminary choices of whether to enter into business and which

business to enter. If the taxpayer has not made these choices, at the

most he is still incurring investigatory costs.” Id. at *17. Once the

taxpayer makes these choices, the next step is getting the business to

“function as a going concern and perform[] those activities for which it

was organized.” Richmond Television Corp., 345 F.2d at 907. This is

the step that allows the taxpayer to claim a deduction under section 165.

See Estate of Morgan, T.C. Memo. 2021-104, at *17.

A taxpayer’s business need not generate revenue for the business

to have commenced, but the business must perform the activities for

which the venture was organized. See Cabintaxi Corp. v. Commissioner,

12

[*12] 63 F.3d at 620. In Cabintaxi, the U.S. Court of Appeals for the

Seventh Circuit held that a corporation organized to sell and install

automated transportation systems, and which had made an effort to sell

systems to North American cities, was in the trade or business of

distributing such systems. Id. Even though the corporation had not

successfully sold its product, the Seventh Circuit determined that the

corporation’s agreement to sell, coupled with bona fide efforts to do so,

caused the business to commence. Id. at 620–21 (citing McManus, 54

T.C.M. (CCH) at 481).

We have previously addressed whether abandoned lodgings that

were never completed such that they could be offered to tenants could

generate losses from a trade or business. In Todd, 77 T.C. at 246–47, a

taxpayer purchased land in Long Beach, California, and hired

contractors to develop plans for an apartment building. High interest

rates caused the taxpayer to postpone construction, and eventually Long

Beach rezoned the property so that the taxpayer could not build. Id.

at 247. The taxpayer then sought to deduct losses stemming from

payments to the contractors as well as payments for permits and

licenses. Id. We held that because the taxpayer’s “plans to enter the

business of renting apartments were never realized . . . the loss incurred

as a result of the abandonment of those plans was not attributable to a

trade or business.” Id. at 250. The Ninth Circuit affirmed our decision

“[e]ssentially upon the basis of the Tax Court’s opinion.” Todd v.

Commissioner, 682 F.2d at 208.

The Roots’ lodge endeavor closely tracks that of the taxpayer in

Todd. Although the Roots did complete some construction on their

property, the lodge was never brought to a state in which guests could

stay or tenants could rent it. As the Roots themselves agree, “the Lodge

was never in a condition in which it could be used to provide exclusive

upmarket lodging for paying guests.” Pet’r’s Op. Br. 21; see also Tr. 55

(“We didn’t have a viable structure to keep guests. We hadn’t gotten

that far.”). Even if it had been suitable to house guests, the Roots never

opened the lodge up to potential guests.

Further, throughout its existence, the lodge lacked the tools and

infrastructure to accept customers. There was no website or booking

portal for the lodge. The kitchen did not have the necessary permitting

to offer food to customers. And there was no system for billing any lodge

guests. Beyond just lacking revenue, the Roots’ lodge was never capable

of operating as a business. See Richmond Television Corp., 345 F.3d

at 907; cf. Cabintaxi Corp. v. Commissioner, 63 F.3d at 620–21. Simply

13

[*13] put, the Roots never realized their plans of operating a guest lodge

on their property.

Moreover, we held in Todd, 77 T.C. at 250, that the “policy

underlying the enactment of the net operating loss provisions supports

the conclusion that [Mr. Todd’s] venture did not constitute a trade or

business for purposes of section 172(d)(4).” Section 172 allows a

business “to set off its lean years against its lush years.” Libson Shops,

Inc. v. Koehler, 353 U.S. 382, 386 (1957). But the Roots had no lush

years, because they never began to operate their lodge as a going

concern. As in Todd, the Roots’ “plans to construct [their lodge] did not

even advance to the point where the venture could offer the potential to

produce profits or losses . . . . At the time [the Roots] abandoned this

venture, the loss[es] [they] suffered could not be considered anything

other than the product of an investment that went awry.” See Todd, 77

T.C. at 251. Sections 165 and 172 do not support deductions for such

losses.

The Roots resist the conclusion that their planned lodge business

never began. They offer several potential times when they claim their

business commenced, ranging from 1995, when they purchased the land,

to 2009, when they obtained the conditional use permit to undertake

additional construction on the property. We take these in turn.

First, the Roots suggest that the business began in 1995 when

they purchased the land and had the idea to open a guest lodge. This

plainly fails to meet the standard set out in Richmond Television Corp.

The Roots claimed they planned to open a guest lodge to house overnight

guests. Certainly, such a business could not “perform[] those activities

for which it was organized” before construction on any housing had

begun. See Richmond Television Corp., 345 F.2d at 907; see also Todd,

77 T.C. at 250 (finding that no trade or business existed when

construction on apartment building had not begun and therefore

apartments could not be rented); Goodwin v. Commissioner, 75 T.C. 424,

439 (1980) (holding that two partnerships formed to build and operate

low-income housing were not carrying on trade or business before

projects were completed and tenants moved in), aff’d, 691 F.2d 490 (3d

Cir. 1982) (unpublished table decision).

On brief, the Roots maintain that “a trade or business can begin

as early as the purchase of the property that will be used in the trade or

business.” Pet’r’s Op. Br. 16. They cite Woody v. Commissioner, T.C.

14

[*14] Memo. 2009-93, 97 T.C.M. (CCH) 1484, aff’d, 403 F. App’x 519

(D.C. Cir. 2010), as support. The Roots’ reliance on Woody is misplaced.

To start, Woody held that the taxpayer was not engaged in a trade

or business when he incurred the expenses at issue before the Court. Id.

at 1487–88. Given its disposition, the case can offer no holding as to

what might be sufficient to constitute a trade or business.

But even apart from this doctrinal point, the Roots misread the

case. It is true that the Court observed (as the Roots note) “that

Mr. Woody’s activities did not rise to the level of a trade or business

until, at the earliest, the time he purchased the Randolph Street

property on December 30 of the year in suit.” See id. at 1487. That

formulation, taken out of context, might be read to suggest that the mere

purchase of property to be used in a trade or business might suffice to

commence a trade or business. But both the phrase “at the earliest” and

the very next sentence in Woody cast significant doubt on that inference.

Immediately after the sentence the Roots quote, the Court stated:

More likely, Mr. Woody’s activities did not rise to the level

of a trade or business until he held the Randolph Street

property out for rent sometime after the close of the year in

suit. See Charlton v. Commissioner, 114 T.C. 333, 338

(2000) (holding that the mere purchase of property did not

constitute an active trade or business since the property

was not rented or held out for rent until a subsequent year).

Id. In short, a careful reading of Woody undercuts, rather than supports,

the Roots’ position here.

Second, the Roots suggest that their trade or business started in

2003, once they had hired an architect and contractor and had begun

developing the lodge. This suggestion also runs against the Richmond

Television Corp. standard, for the same reasons as those that apply to

the 1995 date. See Richmond Television Corp., 345 F.2d at 907; Todd,

77 T.C. at 250. While the lodge was being designed and built, the

purported business could not have performed the purpose for which it

was organized. See Todd, 77 T.C. at 250; see also Madison Gas & Elec.

Co., 72 T.C. at 566–67 (rejecting an argument that the issuance of a

construction permit marked the commencement of a trade or business).

The Roots rely on 379 Madison Ave., Inc. v. Commissioner, 60

F.2d 68 (2d Cir. 1932), rev’g 23 B.T.A. 29 (1931), for the proposition that

a project need not be finished or fully utilized for its intended purpose

15

[*15] for a trade or business to exist. We have no quarrel with that

general proposition. But the Roots overread 379 Madison Avenue. The

taxpayer in that case had “not only acquired a leasehold and prosecuted

the erection of its building, but it employed real estate brokers, made

leases of space to prospective tenants, and collected nearly $50,000 of

rentals paid in advance.” Id. at 69. The Roots’ activities here fall far

short of those of the taxpayer in 379 Madison Avenue. See id.; see also

Todd, 77 T.C. at 250 n.4 (distinguishing 379 Madison Avenue on similar

grounds).

Third, the Roots propose 2006, when they hosted an open house

at the lodge, as a possible opening time. We have held that, in the guest

housing industry, free hosting is insufficient to satisfy the

commencement criterion. See Baldwin v. Commissioner, T.C. Memo.

2002-162, 2002 WL 1377741, at *12–14. Unlike the activities in

Baldwin, the Roots’ open house did not even amount to free hosting:

Their lodge never hosted overnight guests at all. And the record offers

no support for the view that the lodge was held open to the public or

became capable of developing into a revenue-producing business after

the open house. At bottom, the lodge was never capable of hosting

paying guests. See Todd, 77 T.C. at 250.

Fourth and finally, the Roots point to the period in 2009 when

they obtained a conditional use permit for the property as the latest

timeframe the business began. While failure to obtain a required license

may be evidence that a trade or business is not yet viable, obtaining a

license is usually insufficient to demonstrate that a business has

commenced. See Jackson v. Commissioner, 864 F.2d 1521, 1526 (10th

Cir. 1989) (“Merely possessing the legal capability to sell . . . by obtaining

a license . . . without actual efforts to sell the products[] is insufficient to

constitute carrying on a trade or business for purposes of section 162.”),

aff’g 86 T.C. 492 (1986); Estate of Miller v. Commissioner, T.C. Memo.

1991-515, 62 T.C.M. (CCH) 997, 1008 (stating that a lack of licensure

demonstrates a business’s inability to have commenced), aff’d, 893 F.2d

232 (5th Cir. 1993); see also Estate of Morgan, T.C. Memo. 2021-104,

at *18–20 (following Jackson v. Commissioner, 864 F.2d at 1526). In the

Roots’ case, the issuance of the conditional use permit did not signal that

the business was up and running. See Estate of Morgan, T.C. Memo.

2021-104, at *18–20. The permit allowed the Roots to construct on the

property a new building with up to 20 guest rooms, as well as a barn.

The new guest ranch building, independent of the existing lodge, was

never built. Nor is there any evidence to suggest that, once the Roots

obtained their permit, the lodge opened to the public or began

16

[*16] performing “those activities for which it was organized.”

Richmond Television Corp., 345 F.2d at 907.

See

To summarize, although the Roots hosted some events on their

property between 1995 and 2009, none of them included overnight stays

at the lodge. Even when the Roots donated an overnight stay at their

lodge, the guests ultimately stayed on another location on the property.

Hosting on the property was occasional and isolated and insufficient to

demonstrate the operation of a guest lodge.

See Baldwin v.

Commissioner, 2002 WL 1377741, at *14.

Because the Roots’ business activities with respect to the lodge

did not commence by 2014, their lodge-related losses were not incurred

in a trade or business for purposes of section 165(c)(1).

C.

Whether the Roots Were Regularly and Actively Engaged in

the Lodge Activity

We turn next to the second factor. As already noted, a taxpayer

must engage in an activity with continuity and regularity to show that

the activity rises to the level of a trade or business. Commissioner v.

Groetzinger, 480 U.S. at 35. To prove regular and active involvement, a

taxpayer must show “extensive business activity over a substantial

period as opposed to a one-time venture or investment.” Jafarpour, T.C.

Memo. 2012-165, slip op. at 15 (first citing Stanton v. Commissioner, 399

F.2d 326, 329–30 (5th Cir. 1968), aff’g T.C. Memo. 1967-137; and then

citing McManus, 54 T.C.M. (CCH) 475). Sporadic activities do not meet

the level of activity required for the existence of a trade or business.

Commissioner v. Groetzinger, 480 U.S. at 35. Evidence that the

taxpayer was engaged in other jobs or businesses is also relevant,

though it does not necessarily preclude the existence of a trade or

business. See Wright v. Commissioner, 31 T.C. 1264, 1267 (1959), aff’d

per curiam, 274 F.2d 883 (6th Cir. 1960).

Even if we were to assume (just for the sake of our analysis) that

the Roots’ lodge activity had actually commenced before the lodge’s

demolition, the Roots were neither regularly nor actively engaged in the

activity during that period.

At trial, the Roots described a small number of events held on

their property while the lodge was being constructed and shortly

thereafter. They did not, however, present any evidence regarding the

amount of time or attention these events required for planning,

preparation, and hosting. Given how infrequently the events occurred,

17

[*17] it seems doubtful that they would have required regular

involvement on par with that required to conduct a trade or business.

Nor did the Roots demonstrate regular involvement in another manner,

such as by showing that they had hired employees to undertake business

activities on their behalf.

Further, during the acquisition of the property and the

construction of the lodge, the Roots owned and operated a fruit

processing business, Sabroso. They sold Sabroso in 2008, roughly two

years after the lodge received a certificate of completion. Presumably,

owning and operating an active business took substantial time and

attention from the Roots. But the Roots have not demonstrated how

they allocated their time between Sabroso and the lodge during the

years of construction.

And after the 2008 sale of Sabroso—when the Roots might have

had more time to devote to the lodge—Mr. Root continued serving as the

chief executive officer of Jim Root & Co. Moreover, by that time, the

lodge’s defects had become apparent. Beyond their activities in

pursuing construction remediation and ultimately recovery for their

losses, the Roots have not shown that they were regularly and actively

engaged in the running of the lodge, either before or after selling their

other business.

The Roots thus have failed to meet their burden to show regular

and active engagement in lodge-related endeavors. As a result, even if

the lodge activity had commenced by 2014, it did not constitute a trade

or business of the Roots.

D.

Conclusion on Net Operating Loss Carryovers

In short, we cannot find that the Roots entered into a trade or

business with respect to their lodge by 2014. In addition, even assuming

for the sake of analysis that the lodge business did commence at some

point after the lodge received a certificate of completion, the Roots

nevertheless failed to demonstrate that they were regularly and actively

involved with the lodge at the level of a trade or business. 8

Consequently, they may not deduct their losses under section 165(c)(1)

and have failed to establish the existence of a net operating loss for 2014.

8 In view of these conclusions, we need not decide whether the Roots undertook

the activities here intending to earn a profit (the first requirement discussed in

Opinion Part I.A).

18

[*18] As a result, they have no net operating loss carryovers from 2014

into their 2017 and 2018 taxable years.

III.

Accuracy-Related Penalties

Section 6662(a) imposes an accuracy-related penalty equal to 20%

of the portion of an underpayment of tax required to be shown on a

return that is attributable to any substantial understatement of income

tax. See I.R.C. § 6662(a), (b)(2). An understatement of income tax is

“substantial” if it exceeds the greater of “10 percent of the tax required

to be shown on the return for the taxable year” or “$5,000.” I.R.C.

§ 6662(d)(1)(A).

The penalty for a substantial understatement of income tax

applies to any portion of an underpayment in a carryover year that is

attributable to a “tainted item” in the year the carryback loss arose (loss

year). Treas. Reg. § 1.6662-4(c)(1). The determination of whether an

understatement is substantial for a carryover year is made with respect

to the return of the carryover year. Id. “Tainted items” are taken into

account with items arising in a carryover year to determine whether the

understatement is substantial for that year. A “tainted item” generally

is any item for which there is neither substantial authority nor adequate

disclosure with respect to the loss year. Id. subpara. (3)(i). 9

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

production with respect to the liability of an individual for any penalty.

See Higbee v. Commissioner, 116 T.C. 438, 446 (2001). The record shows

that the Roots’ understatements of income tax for 2017 and 2018

exceeded the threshold amount under section 6662(d)(1)(A), so the

Commissioner has met the burden of production.

The Commissioner must also show compliance with the

procedural requirements of section 6751(b)(1). See I.R.C. § 7491(c);

Laidlaw’s Harley Davidson Sales, Inc. v. Commissioner, 29 F.4th 1066,

1072–74 (9th Cir. 2022), rev’g and remanding 154 T.C. 68 (2020); see

also Kraske v. Commissioner, 161 T.C. 104, 111 (2023) (“We accordingly

hold that Laidlaw’s Harley Davidson is squarely on point, and pursuant

to the Golsen doctrine we will follow it in this case.”). See generally

Golsen v. Commissioner, 54 T.C. 742, 756–57 (1970), aff’d, 445 F.2d 985

(10th Cir. 1971). Section 6751(b)(1) provides that no penalty shall be

assessed unless “the initial determination” of the assessment was

9 The Roots make no argument with respect to adequate disclosure, so we do

not discuss this aspect of the regulation further.

19

[*19] “personally approved (in writing) by the immediate supervisor of

the individual making such determination.” The parties have stipulated

that the immediate supervisor of the revenue agent who made the initial

determination to assert penalties against the Roots approved the

determination of penalties under section 6662, in writing, before the

Notice of Deficiency was issued. Accordingly, the Commissioner has

satisfied the burden with respect to the supervisory approval

requirement of section 6751(b)(1), and the Roots do not contend

otherwise.

A.

Absence of Substantial Authority

The penalty for a substantial understatement of income tax under

section 6662(b)(2) does not apply to any portion of the understatement

attributable to “the tax treatment of any item by the taxpayer if there is

or was substantial authority for such treatment.”

I.R.C.

§ 6662(d)(2)(B)(i); CF Headquarters Corp. v. Commissioner, No. 2232112, 164 T.C., slip op. at 19 (Mar. 4, 2025) (reviewed); Treas. Reg.

§ 1.6662-4(c)(3)(i). “In evaluating whether a taxpayer’s position

regarding the treatment of a particular item is supported by substantial

authority, the weight of authorities in support of the taxpayer’s position

must be substantial in relation to the weight of the authorities

supporting contrary positions.” CF Headquarters Corp., 164 T.C., slip

op. at 19 (citing Treas. Reg. § 1.6662-4(d)(3)(i)). For purposes of

determining whether substantial authority exists for a taxpayer’s

treatment of an item, authority includes the Code, the regulations,

caselaw, and certain IRS administrative pronouncements. Id. (citing

Treas. Reg. § 1.6662-4(d)(3)(iii)).

The Roots have not persuaded us that substantial authority

supported their position. As our discussion above illustrates, the

circumstances in the authorities the Roots cite are too dissimilar to their

circumstances to provide substantial authority for their position.

Accordingly, we conclude the Roots lacked substantial authority for

their net operating loss claim.

B.

Absence of Reasonable Cause

No penalty is imposed under section 6662 with respect to any

portion of an underpayment “if it is shown that there was a reasonable

cause for such portion and that the taxpayer acted in good faith with

respect to [it].” I.R.C. § 6664(c)(1). The Roots have the burden to

establish reasonable cause. See United States v. Boyle, 469 U.S. 241,

20

[*20] 245 (1985); see also Cooper v. Commissioner, 877 F.3d 1086, 1095

(9th Cir. 2017), aff’g 143 T.C. 194 (2014); Neonatology Assocs., P.A. v.

Commissioner, 115 T.C. 43, 98 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

“The determination of whether a taxpayer acted with reasonable

cause and in good faith is made on a case-by-case basis, taking into

account all pertinent facts and circumstances.” Treas. Reg. § 1.66644(b)(1). Generally, “the most important factor is the extent of the

taxpayer’s effort to assess [his] proper tax liability.” Id. Circumstances

that may indicate reasonable cause and good faith include “an honest

misunderstanding of fact or law that is reasonable in light of all of the

facts and circumstances, including the experience, knowledge, and

education of the taxpayer.” Id.

The Roots argue that they had reasonable cause for the

underpayment of tax for 2014 because they lacked experience in tax and

relied on tax advisers in amending their 2014 return and in filing their

returns for 2017 and 2018. To show that their reliance on tax advisers

constitutes reasonable cause, the Roots must show that their reliance

was reasonable. Boyle, 469 U.S. at 250–51; Treas. Reg. § 1.6664-4(b)(1)

(“[A taxpayer’s reliance on] professional advice . . . constitutes

reasonable cause and good faith if, under all the circumstances, such

reliance was reasonable and the taxpayer acted in good faith.”).

Our Court applies a three-prong test to determine whether a

taxpayer reasonably relied on professional advice. Specifically, we

analyze whether “(1) [t]he adviser was a competent professional who had

sufficient expertise to justify reliance, (2) the taxpayer provided

necessary and accurate information to the adviser, and (3) the taxpayer

actually relied in good faith on the adviser’s judgment.” Neonatology

Assocs., P.A., 115 T.C. at 99; see also Cooper v. Commissioner, 877 F.3d

at 1095. Reasonable reliance on a professional “is a fact-specific

determination with many variables, but the question ‘turns on “the

quality and objectivity of the professional advice obtained.”’” Am. Boat

Co. v. United States, 583 F.3d 471, 481 (7th Cir. 2009) (quoting Klamath

Strategic Inv. Fund, LLC v. United States, 472 F. Supp. 2d 885, 904 (E.D.

Tex. 2007), aff’d sub nom. Klamath Strategic Inv. Fund ex rel. St. Croix

Ventures v. United States, 568 F.3d 537 (5th Cir. 2009)).

On the record before us, we are unable to determine that the

Roots reasonably relied on tax advisers in preparing the return or

pursuing the positions reflected in the return. The record does not

demonstrate the qualifications of the advisers, the nature of the Roots’

21

[*21] communications with them, or the quality or objectivity of the

advice the Roots received. These facts are necessary to our analysis, and

it was the Roots’ burden to provide them. This they did not do. The

Roots did not call the tax preparer from Rayburn & Rayburn LLP to

testify at trial, and Mr. Root testified to not understanding the

conversations between them.

C.

Conclusion on Accuracy-Related Penalties

In view of the foregoing, we sustain the determination of the

accuracy-related penalties. 10

IV.

Conclusion

As discussed above, we find that the Roots were not engaged in a

trade or business with respect to the lodge by 2014 and had no net

operating loss for that year. As a result, the Roots were not entitled to

net operating loss carryovers into the 2017 and 2018 taxable years.

Accordingly, we sustain the Commissioner’s determination on this issue

as well as on the accuracy-related penalties.

We have considered all of the parties’ arguments and, to the

extent not discussed above, conclude they are irrelevant, moot, or

without merit.

To reflect the foregoing,

Decision will be entered for respondent.

10 In the alternative, the Commissioner determined accuracy-related penalties

of 20% of the portion of the Roots’ underpayments attributable to negligence or

disregard of rules or regulations. See I.R.C. § 6662(b)(1). Because we have sustained

the substantial understatement penalties, we need not address whether the Roots’

underpayments were attributable to negligence or disregard of rules or regulations.