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T.C. Memo. 2023-100

THOMAS D. CONRAD AND MARGARET JOAN CONRAD,

Petitioners

COMMISSIONER OF INTERNAL REVENUE,

Respondent

—————

Docket No. 7692-13.

Filed August 7, 2023.

—————

Thomas D. Conrad, pro se.

Courtney S. Bacon, for respondent.

TABLE OF CONTENTS

MEMORANDUM FINDINGS OF FACT AND OPINION ..................... 4

FINDINGS OF FACT .............................................................................. 6

FMC ownership; FMC’s management of hedge fund; FMC’s

use of the Conrads’ condominium and house; FMC’s yacht;

FMC’s airplane ................................................................................. 7

II.

Tax reporting .................................................................................. 12

2008 returns ............................................................................ 12

FMC’s 2008 tax return .................................................... 12

The Conrads’ 2008 tax return ......................................... 14

2009 returns ............................................................................ 15

FMC’s 2009 tax return .................................................... 15

Served 08/07/23

[*2]

The Conrads’ 2009 tax return ......................................... 17

III. Notice of deficiency and determination of accuracy-related

penalties under section 6662(a) ..................................................... 19

Audit and penalty approval form ........................................... 19

Notice of deficiency ................................................................. 20

2008 .................................................................................. 20

2009 .................................................................................. 22

IV. Trial proceedings ............................................................................ 24

OPINION ................................................................................................ 26

It is unnecessary to determine who has the burden of proof

regarding deficiencies. .................................................................... 27

II.

FMC cannot deduct depreciation for its yacht and its airplane

but can deduct expenses for storage, maintenance, and

upkeep of both and for the costs of Dr. Conrad’s flying

lessons. ............................................................................................ 27

We sustain the disallowance of depreciation deductions

FMC claimed for its yacht. ..................................................... 28

The expenses for the storage, maintenance, and upkeep

of FMC’s yacht are deductible. ............................................... 28

FMC cannot deduct depreciation for its airplane. ................. 38

FMC can deduct expenses for the storage, maintenance,

and upkeep of its airplane, as well as the cost of Dr.

Conrad’s flying lessons............................................................ 41

A summary of the allowed deductions related to the

yacht and airplane for 2008 and 2009.................................... 44

III. For both 2008 and 2009 the Conrads can deduct portions of

the expenses related to their residences. ....................................... 44

2008 ......................................................................................... 56

[*3]

The Conrads’ 2008 tax return ......................................... 58

The notice of deficiency ................................................... 59

The IRS’s primary litigating position ............................. 60

The IRS’s alternative litigating position ........................ 61

The Court’s conclusion .................................................... 61

2009 ......................................................................................... 66

The Conrads’ 2009 rental income from FMC ................. 68

Residence deductions....................................................... 68

The Conrads’ 2009 tax return.................................. 69

The notice of deficiency ............................................ 71

The IRS’s primary and alternative litigating

positions.................................................................... 72

The Court’s conclusion ............................................. 72

IV. The interest deduction claimed on Mrs. Conrad’s 2009

Schedule C is deductible for FMC, not Mrs. Conrad..................... 77

The Conrads’ liability for section 6662 accuracy-related

penalties for the years at issue ...................................................... 78

The IRS bears the burden of production, and Dr. Conrad

bears the burden of persuasion. ............................................. 80

The requirements of section 6751(b)(1) are met for a

substantial understatement but not for negligence. ............. 81

Substantial Understatement .......................................... 81

Negligence ........................................................................ 82

The Conrads are liable for penalties for substantial

understatements if the parties’ Rule 155 computations

show that the Conrads substantially understated their

tax liabilities for 2008 and 2009 (but no penalty is

imposed on the portions of the underpayments

[*4]

attributable to the deductions claimed for depreciation

of the yacht and the airplane because these portions are

attributable to reasonable cause and good faith). ................. 84

MEMORANDUM FINDINGS OF FACT AND OPINION

MORRISON, Judge: Respondent (who we refer to as the IRS)

issued a notice of deficiency to petitioners, Thomas D. Conrad (Dr.

Conrad) 1 and Margaret Joan Conrad (Mrs. Conrad), for 2008 and 2009,

the tax years at issue. The IRS determined tax deficiencies of $134,250

for 2008 and $73,132 for 2009 and accuracy-related penalties under

section 6662(a)2 of $26,850 for 2008 and $14,626 for 2009. The Conrads

timely filed a Petition for redetermination under section 6213(a). We

have jurisdiction under section 6214(a). 3

The parties have resolved some issues through concessions. 4 The

remaining issues and our holdings are summarized below.

1. FMC’s deductions related to its yacht and its airplane. The Conrads

were 51.25% owners of Financial Management Corporation (FMC), a

1 Dr. Conrad has a Ph.D. in business.

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

Code, Title 26 U.S.C. (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. All dollar

amounts are rounded to the nearest dollar.

3 Section 7482(b) governs the venue for appeal from a decision of this Court. In

general, if a petitioner is an individual taxpayer, the appellate venue is the circuit in

which the petitioner resided when the petition was filed. § 7482(b)(1)(A). If, however,

the petitioner does not reside within the United States at the time the petition is filed,

the appellate venue will be the U.S. Court of Appeals for the D.C. Circuit unless the

parties agree to one of the other circuit courts (except for the U.S. Court of Appeals for

the Federal Circuit). § 7482(b)(1) (flush language). The parties stipulated that the

Conrads resided in Panama when they filed their Petition on April 5, 2013. An appeal

of the decision in this case would thus go to the D.C. Circuit unless the parties agreed

to one of the other regional circuits. See § 7482(a) and (b)(1) (flush language) and (2);

28 U.S.C. § 1294.

4 The Conrads concede that they failed to report (1) a $262,489 taxable

distribution from an IRA for 2008 and (2) $5,520 and $1,535 of rental income for 2008

and 2009, respectively. These conceded rental income amounts are unrelated to the

Conrads’ renting of portions of their residences during 2008 and 2009 (which remains

at issue in this case). The IRS concedes that the Conrads (1) did not receive $6 of

royalty income in 2009 and (2) substantiated $3,330 of rental expenses related to the

2008 rental income that they failed to report.

[*5] subchapter S corporation. FMC owned a yacht and an airplane

during the years at issue. On its Forms 1120S, U.S. Income Tax

Return for an S Corporation, FMC deducted depreciation for the

yacht and the airplane in the total amounts of $959,265 (for 2008)

and $281,347 (for 2009). We sustain the IRS’s disallowance of the

depreciation deductions. FMC also deducted nondepreciation

expenses for the yacht and the airplane. For 2008 FMC deducted

$256,934 for the storage, maintenance, and upkeep of the yacht and

the airplane (an amount that also included the cost of training Dr.

Conrad to fly the airplane). For 2009 FMC deducted $21,893 for the

storage, maintenance, and upkeep of the yacht and the airplane. We

allow these nondepreciation deductions.

2. The Conrads’ deductions related to the rental use of their homes. In

addition to being 51.25% shareholders in FMC, during the years at

issue Dr. Conrad provided management services to FMC, and in 2009

Mrs. Conrad provided accounting services to FMC. Both Dr. Conrad

and Mrs. Conrad provided their services as independent contractors.

During the years at issue the Conrads rented portions of their

residences, a condominium in Florida from 2008 until July 2009 and

a house in Georgia for the remainder of 2009, to FMC. On Dr.

Conrad’s Schedule C, Profit or Loss From Business, attached to their

tax return for 2008, the Conrads deducted $222,207 for the business

use of the condominium. On Dr. Conrad’s 2009 Schedule C the

Conrads deducted $288,000 for the business use of the condominium

and the house. On Mrs. Conrad’s 2009 Schedule C the Conrads

deducted $48,542 for total condominium fees and $43,200 for total

rent paid for the house. The notice of deficiency determined that in

2008 the condominium was not Dr. Conrad’s principal place of

business and consequently disallowed the $222,207 deduction for the

expenses of the business use of the condominium. On the other hand,

the notice of deficiency allowed an $18,443 deduction from Schedule

E, Supplemental Income and Loss (a deduction the Conrads had not

claimed on that schedule), for renting the condominium to FMC. The

notice of deficiency determined that in 2009 neither the

condominium nor the house was Dr. Conrad’s principal place of

business and consequently disallowed the $288,000 deduction for the

expenses of the business use of these residences. The notice of

deficiency also determined that the condominium fees and rent for

the house were not ordinary and necessary expenses of Mrs. Conrad’s

accounting business and consequently disallowed the $48,542

deduction for condominium fees and the $43,200 deduction for rent.

However, the notice of deficiency allowed a $3,885 Schedule C

[*6] deduction for Mrs. Conrad’s use of the condominium and the house

for her accounting business. The IRS also argues that the Conrads

failed to report the $104,333 of rental income received from FMC in

2009. For 2008 we hold that the Conrads are entitled to (1) $184,010

of mortgage interest as an itemized deduction and (2) $144,000 of

their mortgage interest as a rental-property deduction. For 2009 we

hold that the Conrads are entitled to (1) $61,983 of mortgage interest

and real estate taxes as itemized deductions; (2) $100,448 of their

residence expenses as rental-property deductions; and (3) $3,885 of

their residence expenses as a business-use-of-home deduction on

Mrs. Conrad’s Schedule C (consistent with the concession in the

notice of deficiency). We further hold that the Conrads reported the

$104,333 of rental income from FMC on their 2009 return.

3. Interest expenses incurred on debt related to FMC’s yacht. On Mrs.

Conrad’s Schedule C for 2009 the Conrads deducted $7,582 of

interest related to FMC’s yacht. We hold that the $7,582 is deductible

for FMC at the S corporation level. 5 As the Conrads are 51.25%

owners of FMC, their share of the $7,582 interest deduction is $3,886.

4. Accuracy-related penalties. The notice of deficiency determined that

the Conrads were liable for accuracy-related penalties under section

6662(a) for the years at issue. We hold that the Conrads are liable for

an accuracy-related penalty on a portion of their underpayment for

2008 and a portion of their underpayment for 2009 if the parties’ Rule

155 computations show that the Conrads substantially understated

their income tax liabilities for the years at issue. In any event, the

Conrads are not liable for any penalties as to the portions of the

underpayments attributable to depreciation deductions for the yacht

and the airplane. For those portions the Conrads had reasonable

cause and acted in good faith.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The

Stipulation of Facts and the Supplemental Stipulation of Facts

(hereinafter Supplemental Stipulation) are incorporated herein by

reference.

5 Had FMC claimed the interest deduction originally, it would have been

claimed on its 2009 Form 1120S.

[*7] I.

FMC ownership; FMC’s management of hedge fund; FMC’s

use of the Conrads’ condominium and house; FMC’s yacht;

FMC’s airplane

Dr. Conrad and Mrs. Conrad collectively owned 51.25% of FMC,

a subchapter S corporation during both years at issue. 6 FMC was the

general partner and general manager of World Opportunity Master

Fund (WOMF), a hedge fund that managed investments through its 15

managers who were located in the United States and six other countries.

For its services to WOMF, FMC received annual compensation equal to

2% of WOMF’s total assets. Dr. Conrad was the president of FMC and

made executive decisions on its behalf, such as the hiring and firing of

WOMF’s managers. Dr. Conrad contends that he was an independent

contractor of FMC rather than an employee. 7 In its notice of deficiency, 8

Answer to the Conrads’ Petition, and posttrial briefs, the IRS does not

contend that Dr. Conrad was an employee of FMC rather than an

independent contractor. Accordingly, we find that Dr. Conrad was not

an employee of FMC.

Dr. Conrad organized FMC in 1961 and has worked for FMC on

and off since that time. In 2003 the Conrads took out a mortgage to buy

a 17-room, 7,500 square foot condominium in Florida. The Conrads lived

in the condominium and rented a portion of the condominium to FMC

for FMC’s office use. FMC paid the Conrads rent for use of this space.

However, this space was never exclusively used by FMC. The Conrads’

extended family would occasionally visit the Conrads at the

6 We need not determine who owned the remaining 48.75% of FMC during 2008

and 2009 because the identities of the other shareholders do not affect our resolution

of this case.

7 This assertion is consistent with the way that the Conrads and FMC reported

Dr. Conrad’s compensation from FMC during the years at issue, i.e., (1) FMC issued

Forms 1099–MISC, Miscellaneous Income, to Dr. Conrad instead of Forms W–2, Wage

and Tax Statement; (2) FMC did not withhold income tax or employee FICA tax from

its payments to Dr. Conrad, nor did it pay employer FICA tax to the IRS for its

compensation payments to him; and (3) Dr. Conrad reported those payments as

compensation on his Schedules C.

8 In the notice of deficiency, the IRS disallowed deductions claimed on Dr.

Conrad’s Schedule C, the portion of a return on which a taxpayer reports independent

contractor income, and the IRS determined an increase in Dr. Conrad’s selfemployment income corresponding to the amount of the disallowed deductions. Thus,

the notice of deficiency implicitly treated Dr. Conrad as an independent contractor of

FMC, not as an employee. See § 1402(c)(3) (defining trade or business for the purpose

of computing self-employment income as excluding the performance of services as an

employee). Nothing in the Answer claims that Dr. Conrad is an employee of FMC.

[*8] condominium during the years at issue. While at the condominium,

the extended family members made personal use of the rooms located in

portions set aside for FMC’s office use. The condominium was used in

the manner described in this paragraph from its purchase in 2003 until

its sale in June 2009.

In 2003 FMC bought a yacht. Its purpose for buying the yacht was

to allow Dr. Conrad, on behalf of FMC, to travel up and down the East

Coast of the United States to meet current and prospective clients of

WOMF. The yacht was 65 feet long. It had three bedrooms, three

bathrooms, an office, and a living area.

During the summer of 2003 the Conrads took a 71-day round trip

on FMC’s yacht (on behalf of FMC) between Florida and Maine, stopping

at cities along the way to meet with current and prospective clients of

WOMF. The guests engaged in such activities as steering, navigating,

cleaning, and fueling the yacht because FMC did not hire a professional

crew for these tasks. Over the 71-day trip, approximately 20 guests

stayed overnight aboard the yacht. Each guest stayed on the yacht

between three and ten nights. While on the yacht, Dr. Conrad met and

entertained the guests. Dr. Conrad also used the onboard office every

day of the trip for work as president of FMC. When the yacht returned

to Florida at the end of the trip in the summer of 2003, FMC listed the

yacht for sale. Neither FMC nor the Conrads ever used the yacht again.

For most of his life Dr. Conrad had used airplanes for traveling

on distant business trips because of a condition which made it difficult

for him to drive a car over long distances. For 40 years Dr. Conrad

owned 9 and personally flew dozens of airplanes. He flew these airplanes

primarily to solicit and acquire customers across the United States.

Occasionally, Dr. Conrad would also lease these airplanes to third

parties; the leases were particularly profitable for him in the 1990s.

In early 2008 FMC acquired an Eclipse airplane for

approximately $1 million. Dr. Conrad intended to use the airplane in

FMC’s business by piloting it himself as he had done with his previous

airplanes. He traveled to Albuquerque, New Mexico, to take possession

of the airplane on FMC’s behalf and to be trained to fly it. Dr. Conrad

underwent a training program in Albuquerque to gain his license to fly

9 Dr. Conrad testified that “of the last 40 years, [he] actually owned 27

airplanes.” It is unclear whether Dr. Conrad meant that he personally owned these

airplanes or that he owned the airplanes through companies he owned. We make no

finding as to who owned the airplanes other than FMC’s airplane.

[*9] the airplane but failed the program. Still determined to earn his

license to pilot the airplane, Dr. Conrad had the airplane flown during

the early summer of 2008 from Albuquerque to Florida, where the

Conrads lived at the time. Dr. Conrad hoped to continue his training

closer to home. However, shortly after returning to Florida around June

2008, Dr. Conrad traveled to Europe where he suffered the first of a

series of three heart attacks. For 15 months Dr. Conrad was in such poor

health that he was prevented from continuing flight training.

During 2008 FMC still owned the airplane and continued to incur

expenses for its storage, maintenance, and upkeep. During 2008 FMC

also incurred expenses for Dr. Conrad’s flying lessons. FMC rented its

airplane to third-party lessees during 2008 for their short-term use. The

record does not reveal how much rent FMC received.

During 2008 FMC still owned the yacht and continued to incur

expenses for its storage, maintenance, and upkeep.

During 2008 FMC paid Dr. Conrad $222,207 for his management

services as president of FMC.

In 2008 the Conrads rented a portion of the condominium to FMC

for FMC’s office use. 10 FMC paid the Conrads $144,000 of rent in 2008.

FMC’s payment for rent was in addition to the $222,207 that FMC paid

Dr. Conrad for his management services as president of FMC.

Dr. Conrad offered into evidence what appears to be a drawing that

purportedly shows the individual rooms within the condominium. The drawing is

similar to a floor plan in that it shows each individual room within the house (e.g.,

“master bedroom”, “master bathroom”, etc.). In the margins next to the drawing, Dr.

Conrad wrote that the condominium’s total area was 7,500 square feet. However, the

drawing does not provide any information allowing us to calculate the square footage

of each room. On the drawing, Dr. Conrad shaded 13 of the rooms that were

purportedly used by FMC and left unshaded 4 rooms purportedly used solely by the

Conrads for personal purposes. For tax purposes the Conrads divided their expenses

that were claimed on Dr. Conrad’s 2008 and 2009 Forms 8829, Expenses for Business

Use of Your Home, relating to the condominium (e.g., mortgage interest, real estate

taxes, utilities) evenly between their personal use of the condominium and FMC use.

As will be discussed infra note 11, the Conrads used the same allocation method for

expenses reported on Dr. Conrad’s 2009 Form 8829 that they incurred relating to the

house that they rented and used as their personal residence during the second half of

2009. For reasons discussed infra OPINION, Part III.A.5 and III.B.2.d, we accept the

Conrads’ allocation method for dividing the condominium expenses between their

personal use and FMC use.

[*10] During 2008 the Conrads paid mortgage interest expenses related

to the condominium of $328,010.

In July 2009 the Conrads moved out of the condominium and into

a rental house in Georgia. As they had done with the condominium, the

Conrads leased a portion of the house to FMC for FMC’s office use. 11 The

record does not reveal whether any of the Conrads’ extended family used

the rented portion of the house for personal purposes.

The Conrads received from FMC total rent of $104,333 in 2009,

but the record does not reveal how much of this rent was for the use of

the condominium and how much was for the use of the house. For

reasons discussed infra note 44, we need not make a finding about such

attributions.

The Conrads paid the following expenses for the condominium

and the house in 2009:

11 Dr. Conrad offered into evidence a floor plan of the house. It shows that the

house had (1) a first floor, (2) a basement, (3) a covered porch, and (4) two garages. The

total combined area of the first floor and basement was 8,495.6 square feet. Including

the covered porch and the two garages, the floor plan shows that the total area of the

house was 9,662.1 square feet. Dr. Conrad highlighted portions of the floor plan that

purportedly show the areas that the Conrads rented to FMC. We are not able to

calculate the exact total area of the house rented to FMC because the floor plan does

not show all the measurements needed to complete the calculation. We note, however,

that the highlighted portions appear to have been approximately half of the house. We

need not determine the exact total area of the house that was rented to FMC. For tax

purposes the Conrads allocated half of the house expenses that were reported on Dr.

Conrad’s 2009 Form 8829 to FMC use and the other half of the house expenses to their

personal use. For reasons discussed infra OPINION, Part III.B.2.d, we accept the

Conrads’ allocation method for dividing the house expenses between their personal use

and FMC use.

[*11]

Type of expense

Related to house or

condominium

Amount

of expense

Mortgage interest

Condominium

$81,889

Real estate taxes

Condominium

42,076

Condominium fees

Condominium

24,271

House

43,200

Insurance

Unknown

3,526

Utilities

Unknown

7,510

Other expenses

Unknown

61,812

Rent

These last three expenses were attributable to the residences, but the

record does not reveal which of these expenses are attributable to only

the condominium, to only the house, or to both properties. For reasons

discussed infra note 44, we need not make a finding about such

attributions.

In 2009 Mrs. Conrad operated an accounting sole proprietorship.

There is little detail in the record about her accounting business. Dr.

Conrad credibly testified that Mrs. Conrad provided accounting services

to FMC in 2009 as an independent contractor.

In 2009 FMC paid the Conrads (1) $104,333 of rent, (2) $183,667

for Dr. Conrad’s management services as president of FMC, and

(3) $81,267 for Mrs. Conrad’s accounting services to FMC.

During 2009 FMC still owned the yacht and continued to incur

expenses for its storage, maintenance, and upkeep. FMC did not sell the

yacht until after 2009. The record does not reveal the year of the sale.

During 2009 FMC still owned its airplane and continued to incur

expenses for its storage, maintenance, and upkeep. FMC also rented its

airplane to third-party lessees during 2009 for their short-term use. The

record does not reveal how much rent FMC received.

In January 2010 Dr. Conrad resumed his attempts to obtain his

license to pilot FMC’s airplane after recovering from the heart attacks

[*12] that he suffered beginning in June 2008; however, he again failed

to obtain his license. This being his second failure, in 2010 Dr. Conrad

abandoned his efforts to obtain a license to pilot the airplane himself.

Few pilots were licensed to fly the airplane. As a result, it was

impractical to have FMC regularly hire pilots to operate it. In 2010 FMC

sold it.

II.

Tax reporting

2008 returns

FMC’s 2008 tax return

For 2008 FMC filed Form 1120S claiming $970,370 of

depreciation deductions for all its assets. The parties have stipulated

that of the $970,370 in total depreciation claimed by FMC, $959,265

related to the yacht and the airplane. The stipulation does not state how

much of the $959,265 related to the yacht versus the airplane. We need

not determine how much of the $959,265 relates to the yacht versus the

airplane because we hold that for 2008 FMC is not entitled to deduct

depreciation for either asset. See infra OPINION, Part II.A and II.C.

FMC’s 2008 Form 1120S also deducted $761,576 on line 19, Other

deductions. A statement included in the return, “TY 2008 Other

Deductions Schedule,” broke the $761,576 into various categories,

including $78,017 for “marine expense” and $178,917 for “aviation

expense.” Paragraph 18 of the Supplemental Stipulation states that

FMC “took” a deduction of $256,934 for storage, maintenance, and

upkeep of both FMC’s airplane and yacht. Arithmetically, $256,934 is

the sum of $78,017 (the amount reported as “marine expense”) and

$178,917 (the amount reported as “aviation expense”). This equality

implies that the $256,934 deduction referred to in paragraph 18 of the

Supplemental Stipulation consists of $78,017 for the storage,

maintenance, and upkeep of the yacht and $178,917 for the storage,

maintenance, and upkeep of the airplane.

However, the IRS proposed a finding of fact in its opening brief

that the $256,934 deduction referred to in paragraph 18 of the

Supplemental Stipulation included the expenses of flying lessons. Dr.

Conrad did not object to this proposed finding of fact. Furthermore, the

proposition that the $256,934 deduction included the flying-lessons

expense is consistent with Dr. Conrad’s credible testimony that FMC

deducted the flying-lessons expense on its Form 1120S for 2008.

Although Dr. Conrad did not testify where on its return FMC reported

[*13] the expense for flying lessons, it would make sense for that

expense to have been included with the $256,934 deduction because one

of the two components of the $256,934 deduction was “aviation

expenses.” It is therefore appropriate for us to recognize that the

$256,934 amount referred to in paragraph 18 of the Supplemental

Stipulation includes the expense for flying lessons even though that

paragraph states that the amount comprises only the expenses of

storage, maintenance, and upkeep of FMC’s airplane and yacht. See

Rule 91(e) (stating that the Court will permit a party to contradict a

stipulation “if justice requires”). We therefore find that the $256,934

amount deducted by FMC comprises (1) the cost of storage,

maintenance, and upkeep of FMC’s yacht and airplane and (2) the cost

of Dr. Conrad’s flying lessons.

We cannot conclusively determine how much of the $256,934

deduction referred to in paragraph 18 of the Supplemental Stipulation

was for flying lessons. We need not make this determination, for two

reasons. First, we hold that the IRS has waived any argument that the

storage, maintenance, and upkeep expenses of $256,934 for the yacht

and the airplane (and flying lessons) were not incurred. See infra

OPINION, Part II.B and II.D. Second, we hold that for 2008 the entire

amount of $256,934 for the storage, maintenance, and upkeep of FMC’s

yacht and airplane (as well as for flying lessons) is deductible. See id.

On its 2008 Form 1120S, FMC deducted $1,197 as an interest

expense on line 13. It is unclear from the return whether this amount is

intended to correspond to an interest expense related to the yacht. 12 Also

on its Form 1120S, FMC deducted $144,000 on line 11 as “Rents.” This

$144,000 payment is for FMC’s renting of a portion of the Conrads’

condominium.

Overall, FMC reported an “ordinary business loss” of $1,258,079

for 2008 on line 21 of its 2008 Form 1120S. The computation of this

amount on the return included the $959,265 of depreciation deductions

related to the yacht and the airplane and the $256,934 for the storage,

maintenance, and upkeep of FMC’s yacht and airplane (as well as for

flying lessons).

12 The deductibility of the $1,197 of interest is not at issue because the notice

of deficiency did not disallow the $1,197 of interest deductions and because the

Conrads do not contend in their Petition that FMC underreported its interest-expense

deduction and that the correct amount of the deduction was greater than $1,197.

[*14]

The Conrads’ 2008 tax return

For 2008 the Conrads filed a joint return. They did not report any

wages or salaries on their Form 1040, U.S. Individual Income Tax

Return, for compensation for Dr. Conrad’s services as president of FMC.

Nor did they claim unreimbursed employee business-expense

deductions on their Schedule A, Itemized Deductions, for Dr. Conrad’s

role as president of FMC. The Conrads reported income of $222,207 on

Dr. Conrad’s 2008 Schedule C for his services as president of FMC. 13

They also reported rental income of $144,000 on their 2008 Schedule E

for their renting of the condominium to FMC.

On their 2008 Schedule A the Conrads deducted home mortgage

interest of $216,556. On Dr. Conrad’s 2008 Schedule C the Conrads

reported a deduction for the “business use of your home” of $222,207.

The Form 8829 attached to Dr. Conrad’s Schedule C shows that the

$222,207 amount was computed as follows: (1) the Conrads reported

that they paid $164,006 of mortgage interest on the condominium

allocable to Dr. Conrad’s sole proprietorship; (2) further condominium

deductions from business use were limited to $58,201; (3) there was a

$114,520 operating-expense carryforward from 2007 related to business

use of residences; (4) the allowable corresponding deduction was

$58,201; (5) further deductions for business use of the condominium

were limited to zero; (6) the depreciation expense for business use of the

condominium for 2008 was $72,724; (7) the carryforward of depreciation

expense and excess casualty loss for business use from 2007 was

$314,667; (8) there was an operating-expense carryforward to 2009 of

$56,319; and (9) there was a carryforward of depreciation expense and

excess casualty loss to 2009 of $387,391. Adding the $216,556 of

mortgage interest reported on the Conrads’ Schedule A and the $164,006

of mortgage interest reported on Dr. Conrad’s Schedule C, the Conrads

13 It is unclear where on the Form 1120S FMC deducted the $222,207 of

compensation paid to Dr. Conrad for his management services. Line 7 of its Form

1120S, Compensation of officers, is blank. As mentioned supra, FMC deducted

$761,576 on line 19, Other deductions. FMC’s Form 1120S includes a TY 2008 Other

Deductions Schedule that provides an itemization of these other deductions. Among

the expenses making up the other deductions is “Professional Services” of $264,570.

This is the only specific deduction claimed on FMC’s return that is large enough to

include the $222,207 of compensation paid to Dr. Conrad, whether on the TY 2008

Other Deductions Schedule or anywhere else on FMC’s 2008 Form 1120S (aside from

depreciation). It follows that if FMC deducted the $222,207 paid to Dr. Conrad, it likely

did so on line 19, Other deductions.

[*15] claimed a total mortgage interest deduction of $380,562 in 2008

despite having paid only $328,010.

On their 2008 Schedule E the Conrads deducted $644,816 for

their 51.25% share of FMC’s ordinary business loss of $1,258,079. This

$644,816 includes the Conrads’ proportional share of FMC’s claimed

depreciation deductions for the yacht and the airplane and of FMC’s

claimed deductions for storage, maintenance, and upkeep expenses

related to the yacht and the airplane and for Dr. Conrad’s flying

lessons. 14 The Conrads did not claim any deductions on their 2008

Schedule E related to the renting of a portion of their condominium to

FMC.

2009 returns

FMC’s 2009 tax return

For tax year 2009 FMC filed Form 1120S claiming $290,340 of

depreciation deductions for all its assets. The parties have stipulated

that FMC claimed a $281,347 depreciation deduction for both the yacht

and the airplane. The stipulation does not state how much of the

$281,347 was for the yacht versus the airplane, nor can we determine

from the record how much of the $281,347 deduction was for the yacht

versus the airplane. As for 2008, however, we need not determine how

much of this $281,347 relates to the yacht versus the airplane because

we hold that for 2009 FMC is not entitled to deduct depreciation for

either asset. See infra OPINION, Part II.A and II.C.

FMC’s 2009 Form 1120S also deducted $400,091 on line 19, Other

deductions. An attached statement gave an itemization of the “Other

deductions.” One such line item was a $21,893 deduction for “marine

expense.” Unlike the 2008 Form 1120S, it has no line item for “aviation

expense.” Although the word “marine” might suggest the category

“marine expense” would not include expenses for an airplane, paragraph

24 of the Supplemental Stipulation states that the $21,893 deduction for

“marine expense” relates to the expenses for both the yacht and the

airplane. We need not determine how much of the $21,893 deduction

was claimed to be related to the yacht versus the airplane because

(1) the IRS does not dispute that the storage, maintenance, and upkeep

14 For 2008 the Conrads’ proportional share of FMC’s depreciation deductions

for its yacht and its airplane (as claimed) equals $491,662. For 2008 the Conrads’

proportional share of FMC’s nondepreciation deductions for its yacht and its airplane

(as claimed) equals $131,689.

[*16] expenses of $21,893 for the yacht and airplane were incurred and

(2) we hold that the entire $21,893 for the storage, maintenance, and

upkeep of FMC’s yacht and airplane is deductible. 15 See infra OPINION,

Part II.B and II.D.

On its 2009 Form 1120S FMC did not deduct any interest

expense. However, the parties stipulated that in 2009 “$7,582 [of]

interest [was] paid relating to the yacht.” This stipulation establishes

two facts: first, that interest of $7,582 was actually paid, and second,

that the interest was related to the yacht. The stipulation alone does not

reveal who paid the interest and who was the borrower in the

corresponding loan transaction (if different). Mrs. Conrad reported this

interest expense on her 2009 Schedule C.

However, in its opening brief the IRS’s proposed finding of fact

paragraph 8 states that Dr. Conrad purchased the yacht “in his capacity

as President of [FMC],” which, if true, means that FMC was the owner

of the yacht. Dr. Conrad did not respond to this proposed fact in his brief,

and we conclude that he thus admitted it is true. See Rule 151(e)(3). The

IRS’s proposed findings of fact paragraphs 13 and 14 state, respectively,

that (1) the yacht was used only in 2003 and (2) the yacht was never

used by FMC or the Conrads thereafter. Dr. Conrad did not respond to

paragraph 13 and expressly stated that paragraph 14 is correct.

Therefore, we conclude that Dr. Conrad agrees that neither he nor his

wife used the yacht during 2009. See Rule 151(e)(3). Finally, the IRS’s

proposed finding of fact paragraph 52 states that the yacht interest is

unrelated to Mrs. Conrad’s accounting sole proprietorship. Dr. Conrad

admitted in his brief that this is correct. We therefore conclude that Mrs.

Conrad did not use the yacht in her accounting business during 2009.

As we discuss more fully infra OPINION, Part IV, FMC was the

borrower on the loan related to its yacht. We need not determine who

paid the interest during 2009 because, for reasons discussed infra

OPINION, Part IV, the identity of the payor does not affect our holdings

in this case.

15 Neither the stipulations nor the record explains why the storage,

maintenance, and upkeep expenses for the yacht and the airplane were $235,041 less

in 2009 than in 2008. This could relate, at least in part, to Dr. Conrad’s inability to fly

the airplane for 15 months during the second half of 2008 and 2009 (while he recovered

from his heart attacks). In any event, we hold that the amounts paid or incurred by

FMC for these expenses are not at issue because the IRS has waived any argument

relating to the proper amounts of these expenses or whether they were paid or incurred

by FMC in the relevant years.

[*17] FMC also deducted $104,333 on line 11 of its 2009 Form 1120S as

“Rents.” This deduction is for its payment of $104,333 for rent to the

Conrads for its use of portions of the Conrads’ condominium and the

house during 2009.

Overall, FMC claimed an “ordinary business loss” deduction of

$544,327 for 2009 on line 21 of its Form 1120S. This amount included

the $281,347 of depreciation deductions for both the yacht and the

airplane and the $21,893 deduction for the storage, maintenance, and

upkeep of the yacht and the airplane.

The Conrads’ 2009 tax return

For 2009 the Conrads filed a joint return. They did not report any

wages or salaries on their Form 1040 or deduct unreimbursed employee

business expenses on their Schedule A for Dr. Conrad’s role as president

of FMC or for Mrs. Conrad’s accounting services to FMC. The Conrads

reported income of $288,000 on Dr. Conrad’s 2009 Schedule C ostensibly

for his services as president of FMC and $81,267 on Mrs. Conrad’s 2009

Schedule C for her accounting services to FMC as an independent

contractor. Therefore, the Conrads reported on their return a combined

total of $369,267 of income for their professional services to FMC. The

Conrads did not report any rental income on their 2009 Schedule E even

though FMC reported a $104,333 deduction for rent paid to the Conrads

on its 2009 Form 1120S. In his posttrial brief, Dr. Conrad argues that,

contrary to their return, the $369,267 consists of $104,333 of rents from

FMC and $264,934 of compensation for professional services. Dr.

Conrad’s brief does not assert how much of the $264,934 is attributable

to his management services versus Mrs. Conrad’s accounting services.

Whether the Conrads reported the $104,333 of rental income paid by

FMC on their Form 1040 is a disputed issue in this case, which we

discuss more fully infra OPINION, Part III.B.1. We hold that the

Conrads did report the $104,333 of rental income but that they did so on

Dr. Conrad’s Schedule C as part of the $288,000 ostensibly reported as

compensation for services.

On their 2009 Schedule A the Conrads deducted $81,889 for home

mortgage interest and $21,038 for real estate taxes.

On Dr. Conrad’s 2009 Schedule C the Conrads deducted $288,000

for the “business use of home.” The Form 8829 attached to Dr. Conrad’s

Schedule C divides the $288,000 deduction into the following categories:

(1) $40,944 of mortgage interest; (2) $21,038 of real estate taxes;

[*18] (3) $1,763 of insurance expenses; (4) $3,755 of utilities expenses;

(5) $30,906 of other expenses; (6) $56,319 of an operating-expense

carryforward from 2008; and (7) $133,275 of depreciation and excess

casualty loss expenses (consisting of $72,724 of depreciation for 2009

and $60,551 of depreciation and excess casualty loss expenses carried

forward from 2008). Items (1), (2), (3), (4), and (5) were expressly

computed on the Schedule C by using 50% to determine the portions of

the expenses allocable to nonpersonal use. Adding the mortgage interest

deductions claimed on both their Schedule A and Dr. Conrad’s Schedule

C, the Conrads claimed a total mortgage interest deduction of $122,833

for 2009 despite having paid only $81,889.

On Mrs. Conrad’s 2009 Schedule C the Conrads claimed

deductions for the following: (1) $7,582 of interest expenses related to

FMC’s yacht, (2) $48,542 of condominium fees for the condominium, and

(3) $43,200 of rent for the house.

The $48,542 of condominium fees for the condominium was

reported on Mrs. Conrad’s Schedule C on the line for “[o]ffice expense.”

The parties have stipulated that the actual amount the Conrads paid for

condominium fees was only $24,271.

The $43,200 of rent for the house was reported on Mrs. Conrad’s

Schedule C on the line for “[r]ent or lease” of “[v]ehicles, machinery, and

equipment.”

On their 2009 Schedule E the Conrads claimed a $278,989

deduction for their 51.25% share of FMC’s ordinary business loss of

$544,327. This $278,989 includes the Conrads’ proportional shares of

FMC’s reported depreciation deductions for the yacht and the airplane

and of FMC’s reported deductions for storage, maintenance, and upkeep

expenses related to FMC’s yacht and airplane. 16 As for 2008, the

Conrads did not deduct any expenses on their 2009 Schedule E related

to the renting of portions of their residences to FMC.

16 For 2009 the Conrads’ proportional share of FMC’s depreciation deductions

for its yacht and its airplane (as claimed) equals $144,202. For 2009 the Conrads’

proportional share of FMC’s nondepreciation deductions for its yacht and its airplane

(as claimed) equals $11,221.

[*19] III.

Notice of deficiency and determination of accuracy-related

penalties under section 6662(a)

Audit and penalty approval form

In 2011 the Conrads’ 2008 and 2009 returns were audited by

Revenue Agent Milton Finney. On April 12, 2011, Finney prepared a

Civil Penalty Approval Form that covered both years at issue. The first

page of the form had the standard preprinted heading “Reason(s) for

Assertion of Penalty(s) IRM 4.10.6.7(1).” Underneath was a blank box in

which Finney wrote two reasons for asserting a penalty. First, he wrote

that “[t]axpayers failed to exercise ordinary and necessary care in the

preparation of the return.” Second, he wrote that “[t]he understatement

of the tax is greater than $5,000.00.” These reasons did not include

citations of Code provisions.

On the second page of the Civil Penalty Approval Form is a table

titled “Penalties Requiring Group Manager Approval.” This table has

several preprinted columns, of which those labeled “IRC,” “Penalty,” and

“Assert Penalty” are relevant for this case. The “Assert Penalty” column

asks the examining agent to mark either the “Yes” or the “No” box for

various components of the accuracy-related penalties, which are

identified by preprinted descriptions of each component in the “Penalty”

column and by preprinted Code provisions in the “IRC” column. Finney

marked the “Yes” box in the “Assert Penalty” column only for the

component identified as “Substantial Understatement” in the “Penalty”

column and “6662(d)” in the “IRC” column. Finney marked the “No” box

in the “Assert Penalty” column for all other components, including the

one identified as “Negligence” in the “Penalty” column and “6662(c)” in

the “IRC” column.

On July 18, 2011, Janelle Marlow, Finney’s supervisor, signed

this Civil Penalty Approval Form. For reasons discussed infra

OPINION, Part V.B, we conclude that Finney determined that the

Conrads were liable for only the section 6662(a) penalty as to a

substantial understatement of income tax, but not as to negligence. We

also conclude that Marlow approved only the section 6662(a) penalty as

to a substantial understatement of income tax, but not as to negligence.

Marlow credibly testified that she sent the Conrads an “initial

report” with the Civil Penalty Approval Form attached. This initial

report is not in the record, and the record does not allow us to determine

the date that the initial report was sent to the Conrads. Because the

[*20] initial report was attached to the Civil Penalty Approval Form,

and because that form bears the date July 18, 2011 (i.e., the date of

Marlow’s signature on the form), we conclude that the initial report was

sent to the Conrads on or after July 18, 2011.

On January 8, 2013, the IRS issued a notice of deficiency to the

Conrads. It was signed by Alan Redstone, who is referred to in the notice

of deficiency as an “Appeals Team Manager.” The notice of deficiency

named Marion S. Tate as the “Person to Contact.” It did not provide any

additional information on Redstone and Tate. We now describe the

adjustments to income made in the notice of deficiency and the accuracyrelated penalties determined by the notice of deficiency.

Notice of deficiency

2008

For 2008 the notice of deficiency made two adjustments to FMC’s

income. First, it disallowed the $959,265 deduction claimed on FMC’s

Form 1120S for the combined depreciation of both FMC’s yacht and its

airplane. The disallowance of the depreciation deductions was explained

as follows:

[I]t has been determined your present Accounting

Method (of deducting Depreciation) does not clearly reflect

expenses in accordance with IRC [section] 446 . . . . A

change of Accounting Method is imposed pursuant to IRC

[section] 446 . . . . In the “New Accounting Method” you will

not be allowed to deduct Depreciation. Therefore

Depreciation is increased $959,265.00 for your 200812 . . . .

Second, the notice of deficiency disallowed the $256,934 deduction

claimed on FMC’s Form 1120S for the total storage, maintenance, and

upkeep expenses of both FMC’s yacht and its airplane, as well as the

expenses of Dr. Conrad’s flying lessons. The disallowance of the

nondepreciation deductions was explained as follows:

[I]t has been determined your present Accounting

Method (of deducting Other Deductions) does not clearly

reflect expenses in accordance with IRC [section] 446 . . . .

A change of Accounting Method is imposed pursuant to IRC

[section] 446 . . . . In the “New Accounting Method” you will

[*21] not be allowed to deduct Other Deductions. Therefore

Other Deductions is increased $256,934.00 for your 200812

....

The total amount of deductions disallowed from FMC’s Form 1120S is

$1,216,199. This is the sum of $959,265 and $256,934. The notice of

deficiency reduced the Conrads’ $644,816 deduction claimed on their

Schedule E for their 51.25% proportional share of FMC’s losses by

$623,350, i.e., 51.25% of $1,216,199.

Next, the notice of deficiency disallowed the entire $222,207

deduction for the business use of the condominium claimed on Dr.

Conrad’s Schedule C. The notice of deficiency explained that “you [Dr.

Conrad] failed to establish that the office was used exclusively on a

regular basis as your principal place of business.” Instead, the notice of

deficiency determined that the Conrads were entitled to an $18,443

deduction on their Schedule E. 17 The notice of deficiency did not disallow

the Conrads’ $216,556 of mortgage interest claimed as an itemized

deduction on their 2008 Schedule A. Neither did it adjust the $144,000

of rental income from FMC that the Conrads claimed on their

Schedule E.

The notice of deficiency determined that the Conrads were liable

for a section 6662(a) accuracy-related penalty of $26,850 because their

underpayment for 2008 was due to (1) a substantial understatement of

income tax, (2) a substantial valuation misstatement, or (3) negligence.

As explained infra OPINION, p. 79, we conclude that the IRS has

abandoned any argument that the Conrads are liable for a penalty due

to a substantial valuation misstatement. Although the notice of

deficiency bore the names of two employees of Appeals (i.e., Redstone

and Tate), the employees likely assumed, like IRS counsel in this

litigation, that the Civil Penalty Approval Form evinced Finney’s

determination to assert a penalty for both a substantial understatement

of income tax and negligence. For reasons discussed infra OPINION,

Part V.B.1 and V.B.2, we conclude that Finney determined that the

17 In its opening brief the IRS proposed in finding of fact 47 that the notice of

deficiency allowed the Conrads a Schedule E deduction “because [the Conrads]

reported rental income from [FMC] . . . for [FMC’s] use of their home for business.” The

IRS did not explain in the notice of deficiency or further explain in its briefs how it

calculated $18,443 as the correct allowable deductions in 2008 or which expenses it

included in this calculation.

[*22] Conrads were liable for a penalty due only to a substantial

understatement of income tax.

2009

For 2009 the notice of deficiency made two adjustments to FMC’s

income. First, it disallowed the $281,347 deduction claimed on FMC’s

Form 1120S for the combined depreciation of both FMC’s yacht and its

airplane. The disallowance of the depreciation deductions was explained

as follows:

[I]t has been determined your present Accounting

Method (of deducting Depreciation) does not clearly reflect

expenses in accordance with IRC [section] 446 . . . . A

change of Accounting Method is imposed pursuant to IRC

[section] 446 . . . . In the “New Accounting Method” you will

not be allowed to deduct Depreciation. Therefore

Depreciation is increased . . . $281,347.00 for your 200912.

Second, the notice of deficiency disallowed the $21,893 deduction

claimed on FMC’s Form 1120S for the combined storage, maintenance,

and upkeep expenses of both FMC’s yacht and its airplane. The

disallowance of the nondepreciation deductions was explained as

follows:

[I]t has been determined your present Accounting

Method (of deducting Other Deductions) does not clearly

reflect expenses in accordance with IRC [section] 446 . . . .

A change of Accounting Method is imposed pursuant to IRC

[section] 446 . . . . In the “New Accounting Method” you will

not be allowed to deduct Other Deductions. Therefore

Other Deductions is increased . . . $21,893.00 for your

200912.

The total amount of deductions disallowed on FMC’s Form 1120S is

$303,240. This is the sum of $281,347 and $21,893. The notice of

deficiency reduced the Conrads’ $278,989 deduction claimed on their

Schedule E for their 51.25% proportional share of FMC’s losses by

$155,422, i.e., 51.25% of $303,240.

Next, the notice of deficiency made four adjustments to the

Conrads’ income that were unrelated to the passthrough of FMC’s

income and deductions. First, the notice of deficiency disallowed the

entire $288,000 deduction claimed on Dr. Conrad’s Schedule C. Instead,

[*23] it determined that the Conrads were entitled to a $3,885 businessuse-of-home deduction on Mrs. Conrad’s Schedule C. 18 Second, it

disallowed the $43,200 deduction for rental payments for the house

claimed on Mrs. Conrad’s Schedule C. Third, it disallowed the $48,542

deduction for condominium fees claimed on Mrs. Conrad’s Schedule C.

Fourth, it disallowed the $7,582 deduction for interest expenses related

to FMC’s yacht claimed on Mrs. Conrad’s Schedule C.

The notice of deficiency determined that the Conrads were liable

for an accuracy-related penalty of $14,626 under section 6662(a) because

the Conrads’ underpayment for 2009 was due to (1) a substantial

understatement of income tax, (2) a substantial valuation misstatement,

or (3) negligence. As explained infra OPINION, p. 79, we conclude that

the IRS has abandoned any argument that the Conrads are liable for a

penalty due to a substantial valuation misstatement. The notice of

deficiency bore the names of two employees of Appeals (i.e., Redstone

and Tate). However, the employees likely assumed, like IRS counsel in

this litigation, that the Civil Penalty Approval Form evinced Finney’s

determination to assert a penalty for both a substantial understatement

of income tax and negligence. For reasons discussed infra OPINION,

Part V.B.1 and V.B.2, we conclude that Finney determined that the

Conrads were liable for a penalty due only to a substantial

understatement of income tax.

The Conrads timely filed their Petition with this Court on April

5, 2013, seeking redetermination of the deficiencies and penalties

determined in the January 8, 2013, notice of deficiency. The parties have

stipulated that the Conrads were residents of Panama when they filed

their Petition. The IRS filed an Answer. The Answer did not further

clarify the reasons for the disallowances of deductions FMC claimed on

its 2008 and 2009 Forms 1120S or the disallowances of deductions the

Conrads claimed on their 2008 and 2009 Forms 1040. The Answer did

not state that IRS counsel had made an independent determination to

assert the negligence component of the accuracy-related penalty.

18 As with its adjustment for deductions for 2008, the notice of deficiency failed

to explain how it calculated $3,885 as the correct allowable deduction on Mrs. Conrad’s

Schedule C or which expenses were included in this calculation. And the IRS did not

attempt to give such an explanation in its briefs.

[*24] IV.

Trial proceedings

The Court set a trial date of May 2, 2016. The order setting this

case for trial required the parties to file pretrial memoranda, which,

among other things, were to identify what issues were extant in the case.

The IRS’s Pretrial Memorandum, which was filed on April 18,

2016, stated that the only issue in the case was the deductibility of the

expenses related to the condominium and the house: “Petitioners and

respondent’s counsel have resolved all issues except for the disallowance

of petitioners’ Business Use of Home deduction for both years at issue.”

When the Court was convened on the day of trial, Dr. Conrad and IRS

counsel lodged the Stipulation of Facts, the subject matter of which was

limited to the condominium and house expenses. Dr. Conrad and IRS

counsel advised the Court that they had thought they would be able to

settle all other issues in the case before trial. However, they explained

that they realized shortly before the start of trial they could not agree

on the terms of the settlement. 19

After this discussion of the failure of the parties’ settlement

negotiations, Dr. Conrad asked the Court if “we’re just going to stop

today?” The Court explained that the day had been appointed for trial

and that the trial should proceed.

Dr. Conrad began testifying on direct about the issue of the

expenses of the condominium and the house. After Dr. Conrad had

finished testifying with respect to that issue and began testifying about

the issues related to the yacht and the airplane, it became apparent that

Dr. Conrad was unprepared for trial on these latter issues. The Court

began to inquire of IRS counsel what the IRS’s positions were on the

issues related to the yacht and the airplane. IRS counsel explained that

the yacht and airplane expenses had both been “disallowed in the notice

of deficiency.” The Court asked IRS counsel whether the Conrads had

the burden of proof with respect to the expenses. IRS counsel said, “Yes.”

The Court asked whether that meant Dr. Conrad had to prove “in this

trial his entitlement to the plane and yacht expenses”? IRS counsel

responded: “Yes. And the business purpose for both a plane and yacht in

the corporation [FMC].” The Court asked whether “one aspect of the

deduction is that he [Dr. Conrad] has to prove that the corporation

incurred the expense?” IRS counsel stated: “Yes. Incurred the expenses,

19 Dr. Conrad and IRS counsel explained that no written settlement had ever

been executed.

[*25] and then the other aspect is whether or not there was a real

business purpose for having an airplane and a yacht.”

When the Court turned to Dr. Conrad, it asked: “So Dr. Conrad,

you understand that Ms. Bacon [IRS counsel] says you need to address

these other issues, too, in order to prevail”? Dr. Conrad responded: “Yes,

sir. But I apologize for not being prepared, because I thought we had

that all taken care of.” The Court then asked Dr. Conrad: “If you were

to litigate these issues . . . would you need documents that you don’t

have here today?” Dr. Conrad responded: “I’ve got four large boxes that

I can’t even carry, lift, that have all these records in them . . . .” Dr.

Conrad then asked for a continuance of the trial, so as to allow him

additional time to, among other things, present the documents to IRS

counsel for the purpose of engaging in further settlement negotiations.

The Court, over the objection of the IRS, granted the continuance. The

Court did not order additional pretrial memoranda from the parties in

advance of the continued trial. Thus, when the continuation of trial

came, the IRS had not filed a new pretrial memorandum in the case

addressing the yacht and airplane issues.

At the start of the continued trial, the parties lodged the

Supplemental Stipulation regarding both the depreciation and

nondepreciation deductions related to FMC’s airplane and yacht.

Paragraph 17 of the Supplemental Stipulation stated that for 2008 FMC

had deducted $959,265 of depreciation related to the yacht and the

airplane. Paragraph 18 of the Supplemental Stipulation stated that for

2008 FMC had deducted $256,934 of nondepreciation expenses related

to the yacht and the airplane. Paragraph 23 of the Supplemental

Stipulation stated that for 2009 FMC had deducted $281,347 of

depreciation related to the yacht and the airplane. Paragraph 24 of the

Supplemental Stipulation stated that for 2009 FMC had deducted

$21,893 of nondepreciation expenses related to the yacht and the

airplane.

When the trial resumed, the parties did not make opening

statements. Dr. Conrad testified on direct about the airplane, yacht, and

residence expenses; he was then subject to examination by IRS counsel.

During the testimony, the Court periodically asked IRS counsel about

its position regarding the airplane and yacht deductions. As to the

nondepreciation expenses related to the airplane, IRS counsel explained

that the deductions were challenged because the airplane “was never

used for business.” The Court then asked: “Would you be contesting that

the expenses were incurred?” IRS counsel responded:

[*26]

No. No, the expenses were incurred. The Appeals

officers looked through the documents and disallowed it

just on the legal basis of the ordinary and necessary

business assets, no depreciation, no ordinary and

necessary but they were incurred.

The record is unclear as to whether IRS counsel’s reference to “Appeals”

meant IRS review (1) before the January 8, 2013, notice of deficiency or

(2) between May 2, 2016, and the continued trial on September 13, 2016.

The Court also inquired as to the IRS’s challenge to the

deductibility of expenses related to the yacht. After discussing

depreciation, IRS counsel addressed the nondepreciation expenses:

The disallowance of the expenses [is] that they’re

not—owning a yacht to visit 25 customers for 30 days is not

an ordinary and necessary business expenses [sic], nor is

the upkeep of that yacht for years to come in the

Government’s opinion.

IRS counsel also explained that the nondepreciation expenses were not

deductible because of the section 274(a)(1)(B) limitations on deducting

the expenses of an entertainment facility.

At the conclusion of the continued trial, the Court ordered the

parties to file briefs. We extensively discuss the IRS’s brief regarding

the nondepreciation deductions related to the yacht infra OPINION,

Part II.B. Our conclusions about these portions of the IRS’s brief are

that the brief (1) contends that the yacht is an entertainment facility,

(2) relies on the factual allegation that the yacht was used for personal

and entertainment purposes during the 2003 trip, (3) relies on the

uncontested fact that during the years at issue, the yacht was in storage,

and (4) does not directly argue that FMC failed to pay or incur the

nondepreciation expenses claimed as deductions for the yacht. As

discussed infra OPINION, Part II.B, we hold that the IRS has waived

any argument that the nondepreciation expenses for the yacht were not

paid or incurred by FMC.

OPINION

Before we discuss the merits of this case, one procedural matter

requires our attention. At trial, Mrs. Conrad did not appear, nor was

there any appearance on her behalf. Dr. Conrad did make an

appearance. The IRS made an oral motion to dismiss the case for lack of

[*27] prosecution as to Mrs. Conrad, and this motion was taken under

advisement to be acted upon at the time the merits of the case were

decided. As Dr. Conrad had no authority to represent his wife, and there

was no other appearance by her or on her behalf, the motion to dismiss

will be granted, and a decision will be entered against Mrs. Conrad for

deficiencies and penalties in the same amounts as those ultimately

determined against Dr. Conrad.

It is unnecessary to determine who has the burden of proof

regarding deficiencies.

The taxpayer generally bears the burden of proof (and therefore

must prove the relevant facts by the preponderance of the evidence),

except when the conditions of section 7491(a) are satisfied. See Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); Bronstein v.

Commissioner, 138 T.C. 382, 384 (2012). Some of our findings of fact

relate to the deficiency amounts, while others relate to penalty

liabilities. Our findings of fact regarding the deficiency amounts are

based on the preponderance of the evidence. Thus, it is unnecessary to

determine which party (i.e., the Conrads or the IRS) has the burden of

proof as to the deficiency amounts. See Estate of Bongard v.

Commissioner, 124 T.C. 95, 111 (2005).

We discuss the burden of proof regarding the Conrads’ liabilities

for the penalties separately. See infra OPINION, Part V.A.

II.

FMC cannot deduct depreciation for its yacht and its airplane but

can deduct expenses for storage, maintenance, and upkeep of both

and for the costs of Dr. Conrad’s flying lessons.

On its 2008 Form 1120S, FMC claimed $959,265 of depreciation

deductions for both its yacht and its airplane and $256,934 of deductions

for storage, maintenance, and upkeep expenses for both its yacht and its

airplane. 20 The $256,934 of nondepreciation deductions also includes

expenses paid for Dr. Conrad’s flying lessons. The notice of deficiency

disallowed all these deductions, resulting in a total disallowance of

$1,216,199. We disallow the depreciation deductions claimed for 2008

20 As the Conrads were 51.25% owners of FMC, their share of these claimed

deductions was $623,350, which was incorporated into the $644,816 total deduction

claimed on their Schedule E for their share of FMC’s reported net loss. An

S corporation such as FMC is not subject to federal income tax, see § 1363(a), but its

taxable income is computed, see § 1363(b)(1), and its income and deductions are passed

through to its shareholders pro rata, see § 1366(a)(1).

[*28] for both the yacht and the airplane. See infra OPINION, Part II.A

and II.C. We allow the deductions claimed for 2008 for the storage,

maintenance, and upkeep expenses for the yacht and the airplane (and

flying-lesson expenses). See infra OPINION, Part II.B and II.D.

On its 2009 Form 1120S, FMC claimed $281,347 of depreciation

deductions for both its yacht and its airplane and $21,893 of deductions

for storage, maintenance, and upkeep expenses for both its yacht and its

airplane. 21 The notice of deficiency disallowed all these deductions,

resulting in a total disallowance of $303,240. We disallow the

depreciation deductions claimed for 2009 for the yacht and the airplane.

See infra OPINION, Part II.A and II.C. We allow the deductions claimed

for 2009 for the storage, maintenance, and upkeep expenses for both the

yacht and the airplane. See infra OPINION, Part II.B and II.D.

We sustain the disallowance of depreciation deductions

FMC claimed for its yacht.

Although FMC claimed depreciation deductions related to its

yacht, Dr. Conrad stated in his answering brief that “[t]he depreciation

[for the yacht] is not important to me and can be denied or withdrawn.”

We consider this a waiver of the claim to the depreciation deductions.

See Rule 151(e)(5); Amazon.com, Inc. & Subs. v. Commissioner, 148 T.C.

108, 220 (2017) (concluding that an argument not made by a party in its

brief is waived), aff’d, 934 F.3d 976 (9th Cir. 2019). We therefore sustain

the determination in the notice of deficiency that FMC is not entitled to

depreciation deductions claimed with respect to its yacht for 2008 and

2009.

The expenses for the storage, maintenance, and upkeep of

FMC’s yacht are deductible.

We next address the deductions for storage, maintenance, and

upkeep expenses FMC claimed related to its yacht. Section 162(a)

generally allows a deduction for ordinary and necessary expenses paid

or incurred in carrying on a trade or business.

Section 212(2) also allows a deduction to individuals for “ordinary

and necessary expenses paid or incurred . . . for the management,

conservation, or maintenance of property held for the production of

21 As the Conrads were 51.25% owners of FMC, their share of these claimed

deductions was $155,422, which was incorporated into the $278,989 total deduction

claimed on their Schedule E for their share of FMC’s reported net loss.

[*29] income.” This provision was enacted after Higgins v.

Commissioner, 312 U.S. 212, 218 (1941), held that under the predecessor

of section 162 (section 23(a) of the Revenue Act of 1932, ch. 49, 47 Stat.

169, 179), an individual without a business could not deduct the

expenses of managing, conserving, and maintaining property held for

the production of income. The predecessor to section 212(2) (i.e., section

23(a)(2) of the Internal Revenue Code of 1939, as amended by the

Revenue Act of 1942, ch. 619, § 121(a), 56 Stat. 798, 819) was enacted to

allow such an individual to deduct such expenses. United States v.

Gilmore, 372 U.S. 39, 45 (1963); see also Brown v. United States, 526

F.2d 135, 138 (6th Cir. 1975) (“The purpose of the provisions now

contained in Section 212 was to create a parity of treatment between

such nonbusiness expenses and similar business expenses which had

long been deductible.”). Because section 212(2) provides a deduction only

for individuals, it cannot serve as authority for a corporation to deduct

the expenses of managing, conserving, and maintaining property held

for the production of income. However, a corporation is not precluded

from deducting such expenses under the authority of other Code

provisions. Indeed, Bittker and Eustice’s treatise on corporate tax

explains that a corporation can deduct, under section 162(a), the

expenses of managing, conserving, and maintaining property held for

the production of income:

Section 212 is restricted to individuals, however,

presumably on the theory that § 162(a) covers the same

ground for corporations that §§ 162(a) and 212 in

combination cover for other taxpayers.25 Thus, if a

corporation engaged in manufacturing holds some

securities as an incidental investment, the cost of a safedeposit box, investment advice, bookkeeping, and so forth

incurred with respect to the securities would be deductible

under § 162(a) as a trade or business expense, even though

an individual proprietor holding such securities would

have to resort to § 212 as authority for deducting such

expenses.

25During

the 1942 hearings on § 212, a taxpayer representative

recommended enlargement of § 212 to include corporations. See

Hearings on Revenue Act of 1942 Before the Senate Finance Comm.,

77th Cong., 2d Sess. 1733 (1942). The recommendation was not

adopted, probably because it was thought to be unnecessary. At any

rate, it has been generally assumed since 1942 that a corporation can

deduct under § 162(a) any expenses that could be deducted under § 212

by an individual proprietor or partnership. See generally Bittker &

[*30] Lokken, Federal Taxation of Income, Estate and Gifts ¶ 20.5.1

(Warren, Gorham & Lamont, 3d ed. 1999) . . . .

Boris I. Bittker & James S. Eustice, Federal Income Taxation of

Corporations and Shareholders ¶ 5.03, at *2 (2020), Westlaw FTXCORP.

A corporation’s deduction of the expenses of managing,

conserving, and maintaining an asset is not unlimited. A corporation

may deduct these expenses under section 162(a) if the acquisition and

ownership of the asset is primarily associated with profit-motivated

purposes and if the personal use of the property by shareholders,

officers, or other individuals in control of corporate affairs is distinctly

secondary and incidental. 22 Int’l Artists, Ltd. v. Commissioner, 55 T.C.

94, 104 (1970). But “if the acquisition and maintenance is primarily

motivated by personal considerations, the deductions must be

disallowed.” 23 Id. And if “substantial business and personal motives

22 An example of a yacht’s expenses’ being deductible under section 162(a) is

Tr. Prop. No. 4 v. Commissioner, 21 B.T.A. 627 (1930). A corporation bought a yacht

for $6,000 in 1915. Id. at 628. The yacht was used to take out the corporation’s

customers. Id. The president of the corporation owned his own boat that he used for

his personal purposes. Id. During 1923, the corporate yacht was temporarily inactive

because it was being repaired in dry dock. Id. The Board of Tax Appeals held that the

cost of the repairs was deductible because the yacht had been acquired and used to

entertain the company’s customers and because it had not been used by the

corporation’s president strictly for personal purposes. Id. at 628–29.

23 An example of a yacht’s expenses’ being disallowed as a deduction under

section 162(a) is Savarona Ship Corp. v. Commissioner, 1 T.C.M. (CCH) 89 (1942).

Philadelphia socialite Emily R. Cadwalader was the president and major shareholder

of a corporation that commissioned the construction of a yacht for $2.1 million. Id.

at 89–90. In July 1931 the yacht was completed. Id. at 90. During the month of October

1931 Cadwalader chartered the yacht herself. Id. For two weeks in January 1932 she

again chartered the yacht herself. Id. at 91. From January to March 1932 a friend of

hers charted the yacht. Id. at 90–91. For part of April 1932 Cadwalader chartered the

yacht herself. Id. at 91. In 1933 a German production company chartered the yacht for

a short time to make a film. Id.

For 1937, the year at issue, the yacht was unused, but the corporation still

incurred costs to maintain it. Id. The Board of Tax Appeals held that the maintenance

expenses were nondeductible. Id. The Board found that the yacht had been bought

primarily for the use of Cadwalader. Id. at 92. The Board reasoned that the mere fact

that the yacht was unused during the year at issue did not “show an abandonment of

the yacht for pleasure purposes.” Id.

[*31] exist,” then “allocation becomes necessary.” 24 Id. at 105 (emphasis

added).

FMC is an S corporation. In general, S corporations are not

subject to income tax. § 1363(a). Instead, an S corporation’s income is

passed through to its shareholders. § 1366(a)(1). This is done in two

ways. First, a shareholder must include in income the shareholder’s pro

rata share of the S corporation’s “separately stated items of income or

loss,” defined by section 1366(a)(1)(A) as “items of income [or] loss . . .

the separate treatment of which could affect the liability for tax of any

shareholder.” See also Treas. Reg. § 1.1366-1(a)(2). Second, the

shareholder must include in income the shareholder’s pro rata share of

the S corporation’s “nonseparately stated income or loss,” defined by

section 1366(a)(2) as “gross income minus the deductions . . . determined

by excluding all items described in [section 1366(a)(1)(A)].” See also

Treas. Reg. § 1.1366-1(a)(3).

Deductions under section 162(a) (i.e., business expenses) are

included in the computation of an S corporation’s nonseparately stated

income (or loss). See Treas. Reg. § 1.1366-1(a)(2) (section 162(a) is not

enumerated in the list of separately stated items); see also Dunn v.

Commissioner, T.C. Memo. 2010-198, 2010 Tax Ct. Memo LEXIS 234, at

*25 n.11 (stating that deductions under section 162(a) are aggregated

with the S corporation’s other items of income, deductions, losses, and

credits). Deductions under section 167(a) (i.e., depreciation deductions)

are also included in the computation of an S corporation’s nonseparately

stated income (or loss). See Treas. Reg. § 1.1366-1(a)(2) (section 167(a)

is not enumerated in the list of separately stated items); see also Broz v.

Commissioner, 137 T.C. 25, 30 (2011) (depreciation deduction factored

24 An example of a yacht’s expenses’ being allocated between deductible section

162(a) business expenses and nondeductible personal expenses is Hal E. Roach Studios

v. Commissioner, 20 B.T.A. 917 (1930). In that case a corporation that produced films

bought a yacht in 1922 to be used in the production of films at sea. Id. at 918. Shortly

after the purchase, the corporation stopped producing sea films. Id. As a result the

yacht was used very little for film production. Id. For much of 1922 the yacht was

attached to its moorings. Id. Occasionally the yacht was used for personal purposes of

Hal E. Roach, Id., whose name suggests that he was the owner of the corporation.

The Board of Tax Appeals found that the corporation acquired the yacht “solely

for business purposes,” that the yacht “was not used more than a dozen times for

picture production,” and that “had the boat not been used at all for pleasure[,] much of

the expense of maintenance would have been incurred nevertheless.” Id. at 919. The

Board held that one-half of the expense of maintaining the yacht in 1922 was an

ordinary and necessary expense of the corporation. Id. The other half of the expense

was held to be nondeductible. Id.

[*32] into the computation of the S corporation’s income, which was

passed through to the shareholder; the dispute was over the amount of

depreciation).

Deductions under section 212 are separately stated items of

income or loss. See Treas. Reg. § 1.1366-1(a)(2)(vi) (“[S]eparately stated

items of the S corporation include . . . the additional itemized deductions

for individuals provided in part VII of subchapter B (section 212 and

following) of the Internal Revenue Code.”); see also Dunn, 2010 Tax Ct.

Memo LEXIS 234, at *25 n.11 (“[I]temized deductions under sec. 212 . . .

must be separately stated rather than aggregated with the

S corporation’s other items of income, deductions, losses, and credits.”);

1 Richard D. Blau et al., S Corporations: Federal Taxation § 7.57 (2021)

(stating that deductions under section 212 are among items that are

required to be separately stated); James S. Eustice, Joel D. Kuntz &

John A. Bogdanski, Federal Income Taxation of S Corporations

¶ 7.05[5][a] (Nov. 2021) (“[Treas. Reg. § 1.1366-1(a)(2)(vi) reveals],

however, that items that would be deductible at the corporate level

under Section 212 pass through to the shareholders, who may deduct

them, even though the corporation technically does not get to do so.”).

They are not deductible in computing the S corporation’s nonseparately

stated income or loss. See § 1363(b)(2) (disallowing to an S corporation

deductions referred to in section 703(a)(2)); § 703(a)(2)(E) (providing

that among the deductions disallowed to a partnership are those in

sections 211–223); see also Treas. Reg. § 1.1366-1(a)(3) (defining the

nonseparately stated income or loss of the S corporation as excluding

“any item requiring separate computation under” Treasury Regulation

§ 1.1366-1(a)(2)); Treas. Reg. § 1.1366-1(a)(2)(vi) (providing that

separately stated items of an S corporation include the deductions in

sections 212–223).

Section 274 disallows deductions otherwise permitted under

section 162(a), section 167(a), or section 212. There are two provisions of

section 274 we will discuss here: section 274(a)(1)(B) and section 274(d).

Section 274(a)(1)(B) disallows deductions for the expenses of a facility

used in connection with entertainment. Section 274(d) imposes rules

known as “strict substantiation” requirements that allow certain types

of deductions only if the taxpayer supplies contemporaneous

substantiation of certain informational elements supporting the

deductions. See Falsetti v. Commissioner, 85 T.C. 332, 358 (1985). The

types of deductions covered by the version of section 274(d) in effect

during 2008 and 2009 included (1) deductions for traveling expenses,

(2) deductions with respect to a facility used in connection with

[*33] entertainment, (3) deductions for gifts, and (4) deductions with

respect to “listed property” (defined by section 280F(d)(4)(A)(ii) to

include any property used as a means of transportation). 25 The

requirement (in section 274(d)) that deductions with respect to a facility

used in connection with entertainment be strictly substantiated is a

moot requirement after 1978. This is because such deductions are

disallowed by section 274(a)(1)(B) after the provision’s amendment in

1978. 26 See Revenue Act of 1978, Pub. L. No. 95-600, § 361, 92 Stat. 2763,

2847 (amending § 274(a)(1)(B)).

FMC reported the nondepreciation deductions for its yacht under

section 162(a). (The deductions were reported on Part III, line 1 of the

2008 and 2009 Schedules K–1, Shareholder’s Share of Income,

Deductions, Credits, etc., 27 sent to FMC’s shareholders, which reported

the shareholders’ pro rata shares of FMC’s nonseparately stated income

or loss. Recall that section 162(a) deductions, but not section 212

deductions, are included in the computation of nonseparately stated

income or loss. Treas. Reg. § 1.1366-1(a)(2).) In litigation Dr. Conrad

defends the deductions by making the following points: the 71-day yacht

trip in 2003 was an activity by which the Conrads entertained and met

with WOMF’s clients; for several years after the trip FMC tried and

failed to sell the yacht; and because the yacht was not sold until after

the years at issue, FMC had to incur expenses of storing, maintaining,

and keeping up the yacht during the years at issue.

The IRS contends that the nondepreciation expenses of the yacht

are not deductible under section 162(a) because FMC did not intend to

25 In 2017 Congress amended section 274(d). Under the current version, section

274(d) no longer applies to deductions with respect to a facility used in connection with

entertainment. See Tax Cuts and Jobs Act of 2017 (TCJA), Pub. L. No. 115-97,

§ 3304(a), 131 Stat. 2054, 2124.

26 When both section 274(a)(1)(B) and section 274(d) were enacted in 1962,

section 274(a)(1)(B) did not completely disallow deductions for facilities used in

connection with entertainment. See Revenue Act of 1962, Pub. L. No. 87-834, § 4(a), 76

Stat. 960, 974–76. However, section 274(a)(1)(B) was amended in 1978 to disallow

these deductions.

27 For each taxable year, an S corporation sends Schedule K–1 to each of its

shareholders. The Schedule K–1 reports (1) the shareholder’s pro rata share of the

S corporation’s nonseparately stated income or loss and (2) the shareholder’s pro rata

share of the S corporation’s separately stated items of income or loss.

[*34] use the yacht in its business after 2003. We reject the IRS’s

contention for reasons we explain in the paragraph below. 28

FMC bought the yacht in 2003 so that Dr. Conrad could solicit

customers to promote FMC’s business, and he did so on a 71-day trip in

2003. After the trip, FMC held the yacht for sale but was unable to sell

it immediately. No further use was made of the yacht, either business

or personal. FMC had to incur storage, maintenance, and upkeep

expenses during the years at issue (2008 and 2009) because it could not

sell the yacht. During the years at issue the yacht remained FMC’s

business asset. It was not used by the Conrads for personal purposes.

Therefore, FMC can deduct the storage, maintenance, and upkeep

expenses for the yacht under section 162(a). See Int’l Artists, Ltd., 55

T.C. at 104; Tr. Prop. No. 4, 21 B.T.A. at 628–29.

We suppose that alternatively, one might view FMC’s expenses of

maintaining, storing, and keeping up its yacht as corresponding to the

deduction provided by section 212(2) for the “ordinary and necessary

expenses paid or incurred during the taxable year [here 2008 and 2009]

. . . for the management, conservation, or maintenance of property held

for the production of income.” § 212(2). As an itemized deduction,

though, a section 212 deduction is generally less favorable for taxpayers

than an above-the-line deduction such as a section 162(a) deduction. See

Guill v. Commissioner, 112 T.C. 325, 328 (1999) (stating that a

deduction under section 212 for legal costs unrelated to a trade or

business, and therefore not deductible under section 162(a), is an

itemized deduction). 29 Usually, it is up to the IRS to make arguments

that the taxpayer should be subject to greater tax than the taxpayer

reported. Here, the IRS has not argued that the yacht expenses must be

deducted under section 212(2). We therefore need not consider such a

theory. See Feigh v. Commissioner, 152 T.C. 267, 277 (2019) (“Our job is

to consider the issues advanced by the parties, not to craft alternative

arguments never raised.”).

The IRS also argues that even if the expenses of the yacht would

be deductible under section 162, the deductions are nonetheless

disallowed under section 274 because the yacht is used in connection

with entertainment. Specifically, the IRS argues that the yacht should

28 The IRS also contends that the yacht is a facility used for entertainment, a

contention we evaluate later.

29 We discuss the differences between above-the-line deductions and itemized

deductions in more detail infra OPINION, pp. 45–46.

[*35] be considered a facility used in connection with entertainment

because the Conrads have failed to meet the strict substantiation

requirements of section 274. To understand the IRS’s argument, 30 we

must delve into the history of section 274(a)(1)(B).

The current version of section 274(a)(1)(B)—applicable for the

years at issue—disallows deductions for the expenses of a facility used

in connection with entertainment, amusement, or recreation. A prior

version of section 274(a)(1)(B)—applicable only for expenses incurred

before January 1, 1979—disallowed deductions for the expenses of a

facility used in connection with entertainment unless the facility was

used primarily to further the taxpayer’s business and the expenses were

directly related to the active conduct of the business. See § 274(a)(1)(B)

(1964) (before amendment by the Revenue Act of 1978, § 361, 92 Stat. at

2847). A regulation related to the prior version of section 274(d),

Treasury Regulation § 1.274-5T(c)(6)(iii), imposed a strict

substantiation requirement for a taxpayer seeking to prove that a

facility was used primarily to further the taxpayer’s business. This strict

substantiation requirement is applicable only for expenses incurred

before January 1, 1979. The IRS argues that the Conrads failed to

substantiate that the yacht was primarily used in FMC’s business.

Although the IRS words the argument in a way that obviously tracks

the regulation, the IRS does not directly cite the regulation.

The IRS’s arguments regarding the primary use of the yacht are

irrelevant under current law. It no longer matters whether a facility is

used primarily in furtherance of a taxpayer’s trade or business or

whether a taxpayer has strictly substantiated that a facility is so used.

Under the current version of section 274 the relevant question is

whether FMC’s yacht was used in connection with entertainment. See

30 The IRS’s arguments against the deductibility of the nondepreciation yacht

expenses are confused because the IRS cites pre-1979 law. The IRS’s argument that

the yacht is a facility used in connection with entertainment is made in its opening

brief in the paragraph spanning pages 29 and 30 and in the second full paragraph on

page 33. The IRS’s reasoning that the yacht was not used primarily in furtherance of

FMC’s trade or business is stated in two full paragraphs on page 30, in the paragraph

spanning pages 30 and 31, and in the full paragraph on page 31. The IRS’s support for

its reasoning (i.e., that the Conrads have failed to meet strict substantiation

requirements regarding the fact that the yacht was primarily used to further FMC’s

business) is given in the full paragraph on page 34 and in the paragraph spanning

pages 34 and 35. The IRS’s argument that the yacht expenses are not encompassed by

section 162(a), because FMC did not intend to use the yacht in its business after 2003,

is made in the paragraph spanning pages 35 and 36 and in the first full paragraph on

page 36.

[*36] § 274(a)(1)(B). Treasury Regulation § 1.274-2(e)(2) provides that

property owned by a taxpayer is considered to constitute a facility used

in connection with entertainment if it is “used during the taxable year

for, or in connection with, entertainment.” See also Harrigan Lumber

Co. v. Commissioner, 88 T.C. 1562, 1565 n.7 (1987) (stating that the

provisions in Treasury Regulation § 1.274-2(e)(2), (3), and (4) govern

expenditures paid or incurred after December 31, 1978), aff’d without

published opinion, 851 F.2d 362 (11th Cir. 1988). Treasury Regulation

§ 1.274-2(b)(1)(i) provides that the term “entertainment” means any

activity that is generally considered to constitute entertainment,

amusement, or recreation. Thus, FMC’s yacht is a facility used in

connection with entertainment if it was used during 2008 and 2009 for,

or in connection with, an activity generally considered to be

entertainment, amusement, or recreation.

During the 2003 trip the yacht was used in connection with

entertainment. 31 But during 2008 and 2009 the yacht was docked and

unused. Therefore, it was not “used during the taxable year [2008, 2009]

for, or in connection with, entertainment.” Treas. Reg. § 1.274-2(e)(2).

For these years the yacht was not a facility used in connection with

entertainment. See id. Accordingly, section 274(a)(1)(B) does not

disallow FMC’s deductions for the yacht’s storage, maintenance, and

upkeep expenses.

The IRS does not rely on the strict substantiation requirements

of section 274(d) other than for the assertion (irrelevant, as we have

explained) that the Conrads did not strictly substantiate that the yacht

was used primarily for the furtherance of FMC’s business. For example,

the IRS does not argue that the nondepreciation expenses of the yacht

must be strictly substantiated under the rules for listed property. See

§ 274(d)(4). We therefore do not consider whether the yacht expense

31 The regulations provide that whether an activity is generally considered to

constitute entertainment, amusement, or recreation is determined by an “objective

test.” Treas. Reg. § 1.274-2(b)(1)(ii). However, the regulations also state that “in

applying this test the taxpayer’s trade or business shall be considered.” Id. In

explaining how a taxpayer’s trade or business should be considered, the regulations

give as an example a manufacturer of dresses that puts on a fashion show to introduce

its products to a group of store buyers. Id. The regulations state that the show would

not generally constitute entertainment. Id. However, the regulations state that a

fashion show conducted by an appliance distributor for the “wives” of the distributor’s

retailers would generally be considered entertainment. Id. Under these examples,

FMC’s yacht cruise in 2003 would be an entertainment activity even though a yacht

operated by a cruise line would not be. FMC is not in the business of entertainment,

but a cruise line is in the business of entertainment.

[*37] deductions meet the strict substantiation requirements of section

274(d). See Feigh, 152 T.C. at 277.

One common issue that arises in determining whether an expense

is deductible under section 162(a) is whether it was paid or incurred

during the year at issue. See Commissioner v. Lincoln Sav. & Loan

Ass’n, 403 U.S. 345, 352 (1971) (stating that an item’s having been paid

or incurred during the taxable year is one of five elements required for

deducting an expense under section 162(a)). In this case, however, the

IRS has not argued that FMC did not pay or incur the expenses of

maintaining, keeping up, and storing the yacht during 2008 and 2009. 32

We have addressed all arguments made by the IRS. Therefore, we

do not sustain the IRS’s disallowance of deductions for the storage,

maintenance, and upkeep expenses incurred by FMC for its yacht

during the years at issue.

32 The notice of deficiency disallowed the nondepreciation yacht deductions but

gave only the obscure explanation that the disallowance was the result of the IRS’s

changing FMC’s “accounting method.” A change in method of accounting involves the

proper timing for a deduction. Treas. Reg. § 1.446-1(e)(2)(ii)(b) (“[A] change in method

of accounting does not include adjustment of any item of income or deduction that does

not involve the proper time for inclusion of the item of income or the taking of a

deduction.”). FMC reported that it used the accrual method of accounting to prepare

its Forms 1120S. Under that method of accounting, the taxpayer claims deductions for

the year the corresponding liability is incurred. Treas. Reg. § 1.461-1(a)(2). By contrast,

under the cash method of accounting, the taxpayer claims deductions for the year that

the corresponding amount is paid. Treas. Reg. § 1.461-1(a)(1). It is unclear from the

notice of deficiency whether the IRS intended to change FMC’s method of accounting

to the cash method of accounting (or to some other method of accounting). In any event,

the IRS’s change to an accounting method is different from an argument that an item

was never paid or incurred.

The IRS’s Answer gave no further explanation as to why it disagreed with the

nondepreciation yacht deductions. On May 5, 2016, the IRS stated in court that it was

challenging that the yacht expenses were “incurred.” On that same day, the Court

continued the case and told the Conrads to give FMC’s records regarding the

nondepreciation yacht deductions and other issues to the IRS. At the continued trial

date and after the Conrads were supposed to have given the IRS records related to the

yacht, the IRS explained again the nature of its arguments regarding the yacht

deductions. The IRS argued that the yacht was a facility used in connection with

entertainment, but it did not identify a challenge to whether the expenses were

actually paid or incurred. The IRS’s Pretrial Memorandum did not make such a

challenge either. Nor did the IRS raise in its briefs the question of whether the yacht

expenses were paid or incurred. Under the circumstances, the IRS did not preserve

any argument that the nondepreciation yacht expenses were not paid or incurred. See

Amazon.com, Inc., 148 T.C. at 220.

[*38] C.

FMC cannot deduct depreciation for its airplane.

We next address the deductions for depreciation of FMC’s

airplane. Section 167(a) allows a deduction for depreciation of property

if the property is either (1) used in a trade or business or (2) held for the

production of income. Treasury Regulation § 1.167(a)-10(b) provides

that a depreciation deduction under section 167(a) is available only for

the tax year in which the property was placed in service and later years.

Section 179(a) allows a taxpayer to affirmatively elect to deduct the

entire cost of certain property for the year in which the property is

placed in service. The election must be made on the taxpayer’s return.

§ 79(c).

FMC’s 2008 and 2009 returns claimed depreciation deductions for

its airplane and did not elect to deduct for either year the entire cost of

the airplane under section 179. Nevertheless, the IRS’s challenge to the

depreciation deductions for FMC’s airplane is that the airplane was

never placed in service within the meaning of “[s]ection 179(a).” Both

sections 167 and 179 require that the property be placed into service as

a condition for deductions. See § 179(a) (providing that a depreciation

deduction “shall be allowed as a deduction for the taxable year in which

the section 179 property is placed in service”); Treas. Reg. § 1.167(a)10(b) (“The period for depreciation of an asset shall begin when the asset

is placed in service . . . .”); Treas. Reg. § 1.167(a)-11(e)(1)(i) (defining

when property is placed in service for purpose of Treasury Regulation

§ 1.167(a)-10(b)); Baca v. Commissioner, T.C. Memo. 2019-78, at *25

(determining whether an asset was placed in service for purpose of

section 179 by reference to the definition of placed in service in Treasury

Regulation § 1.167(a)-11(e)(1)(i)). Therefore, we are willing to consider

the proposition that section 167 depreciation deductions for FMC’s

airplane should be denied on placed-in-service grounds even though the

IRS contests the depreciation deductions as if FMC sought a section 179

deduction.

Regulations provide that property is considered “first placed in

service” when it is “first placed in a condition or state of readiness and

availability for a specifically assigned function, whether in a trade or

business [or] in the production of income . . . .” Treas. Reg. § 1.167(a)11(e)(1)(i).

It is the “taxpayer . . . who gets to determine what an asset’s

‘specifically assigned function’ is.” Brown v. Commissioner, T.C. Memo.

2013-275, at *35 (first citing Consumers Power Co. v. Commissioner, 89

[*39] T.C. 710 (1987); and then citing Valley Nat. Fuels v.

Commissioner, T.C. Memo. 1991-341, 1991 Tax. Ct. Memo. LEXIS 390,

aff’d without published opinion, 990 F.2d 1266 (9th Cir. 1993)). FMC’s

specifically assigned function for the airplane was for Dr. Conrad to

personally fly the airplane in order to travel cross-country for client

meetings and business trips. Dr. Conrad credibly testified that the

purpose of buying the airplane was for him to pilot the airplane himself.

He credibly testified that hiring licensed pilots to fly FMC’s airplane

would have been not only cost prohibitive but also logistically

challenging because of the lack of available pilots who were certified to

fly this particular type of airplane.

Because Dr. Conrad never completed his certification and was

thus never licensed to fly FMC’s airplane, the airplane was never “in a

condition or state of readiness and availability for [its] specifically

assigned function” in either 2008 or 2009. See Treas. Reg. § 1.167(a)11(e)(1)(i). 33

Our conclusion is not affected by the fact that FMC leased the

airplane on a few occasions to third parties while waiting for Dr. Conrad

to finish earning his license to pilot the airplane. In Cooper v.

Commissioner, 88 T.C. 84, 113–14 (1987), and Waddell v. Commissioner,

86 T.C. 848, 898 (1986), aff’d, 841 F.2d 264 (9th Cir. 1988), we held that

the assets in question were placed in service as soon as they were

available to be leased because the taxpayers’ specifically assigned

functions were to lease the assets to third parties. These assets,

however, are distinguishable from the FMC airplane because FMC’s

specifically assigned function for its airplane was to allow Dr. Conrad to

33 We reached a similar conclusion that the lack of certified pilots precludes an

airplane from being available for its specifically assigned function (of being flown) in

Douglas v. Commissioner, T.C. Memo. 2011-214, 2011 WL 3849550. In that case, the

taxpayers’ wholly owned S corporation bought an airplane for use in its trucking

business. Id. at *1. The S corporation’s specifically assigned function for the airplane,

we held, was to allow the S corporation to fly truck drivers on short notice so that they

could replace other drivers who were unable to finish their deliveries. Id. at *2. We

concluded that the S corporation had never placed the airplane in service because none

of its employees had been licensed to fly the airplane. Id. The record also failed to show

that it would have been possible for the S corporation to hire outside pilots. Id. Because

the airplane could not be flown by employees or non-employees, the airplane was never

capable of being used in the S corporation’s business and was therefore not placed in

service. Id.; see also Siskiyou Commc’ns, Inc. v. Commissioner, T.C. Memo. 1990-429,

1990 Tax Ct. Memo LEXIS 446, at *15 (concluding that the taxpayer’s new phone

system was not placed in service until the taxpayer’s employees were trained to operate

the system).

[*40] personally fly the airplane for cross-country business trips. Since

this was the intended use of the airplane, Dr. Conrad would need to

establish that an asset that is not available for its original intended

function can nonetheless be placed in service by being available for an

alternative function (in the Conrads’ case, leasing the airplane to third

parties). The regulations seem unexpressive as to whether a function

other than the originally intended function can qualify as a specifically

assigned function. Treas. Reg. § 1.167(a)-11(e)(1)(i) (“Property is first

placed in service when first placed in a condition or state of readiness

and availability for a specifically assigned function . . . .”). Caselaw

suggests that only the taxpayer’s original intended function can be the

specifically assigned function. See Brown, T.C. Memo. 2013-275, at *37

(“An asset must instead be available for its intended use on a regular,

ongoing basis before we can find it ‘placed in service’ in the tax year in

question.” (emphasis omitted); the taxpayer’s plane had not been placed

in service, even though it had been used for a few trips, because the

specifically assigned function contemplated physical modifications

completed after the year at issue); Doherty v. Commissioner, T.C. Memo.

1992-573, 1992 WL 237243, at *5 (“Alternate use is not sufficient for an

asset to be placed in service.” (citing Consumers Power Co., 89 T.C. 710)).

Even if a specifically assigned function can be a function other than that

originally intended by the property owner, leasing of the airplane by

FMC should not qualify as a specifically assigned function because there

is no indication that renting the airplane out was as useful to FMC as

using the airplane itself (piloted by Dr. Conrad). 34 There is no evidence

of how much rental income FMC earned from leasing the airplane. FMC

reported total income of $626,587 and $253,947 on its Forms 1120S for

2008 and 2009, respectively. The table below shows how these amounts

were broken out on the returns:

34 We reached a similar conclusion in Valley Nat. Fuels, 1991 Tax Ct. Memo

LEXIS 390, at *26. In that case, the taxpayer attempted to place an ethanol distillation

plant in service during 1983. Id. at *13. The plant’s specifically assigned function was

to produce “198.2+ proof” fuel. Id. at *14. We concluded that the plant was not placed

in service for its specifically assigned function during 1983. Id. The taxpayer argued

that the plant was placed in service during 1983 because in that year the plant

produced lower-grade fuel that the taxpayer was able to sell to third parties. Id.

at *14–15. We rejected the taxpayer’s argument in part because the taxpayer failed to

show that the lower-grade fuel “was actually sold commercially in . . . a market, or that

such a market existed.” Id. at *16; see also Olsen v. Commissioner, T.C. Memo. 2021-41,

at *40 (concluding that the leasing of the taxpayer’s asset did not qualify as placing

the asset in service in part because the taxpayer “was not engaged in a leasing business

and his venture was certainly not ‘profit-motivated’”), aff’d on other grounds, 52 F.4th

889 (10th Cir. 2022).

[*41]

Description

2008

2009

Income/Loss from passthrough

entities

−$48,759

−$37,634

Fund management income

641,829

290,329

Other income

33,517

1,252

Total income

$626,587

$253,947

Assuming arguendo that the descriptions and amounts above are

accurate, the most that FMC could have earned from renting the

airplane was $33,517 in 2008 and $1,252 in 2009, the amounts reported

as “Other income” for the respective years. (The assumption that the

amounts reported as “Other income” were composed entirely of rents

from the airplane is a very generous hypothetical given that no

supporting evidence such as rental agreements, invoices, testimony, etc.

has been produced to corroborate the airplane’s rental.) Such revenue

still would not have covered the cost of expenses incurred from owning

the airplane. In 2008 FMC incurred $178,917 of expenses related to the

airplane, well more than “Other income” earned of $33,517. And while

for 2009 the record does not indicate how much of the $21,893 of storage,

maintenance, and upkeep for the yacht and the airplane was incurred

just for the airplane, we find it unlikely that it was less than $1,252. The

rental of the airplane was at most an effort to reduce the cost of storage,

maintenance, and upkeep expenses, not an economically profitable use.

See Doherty v. Commissioner, 1992 WL 237243, at *4. We hold,

therefore, that FMC’s leasing of the airplane did not place the airplane

in service for a specifically assigned function.

Because the airplane was not placed in service, FMC cannot

deduct depreciation under section 167(a) with respect to the airplane.

See Treas. Reg. § 1.167(a)-10(b). We therefore sustain the determination

in the notice of deficiency that FMC is not entitled to depreciation

deductions with respect to its airplane for 2008 and 2009.

FMC can deduct expenses for the storage, maintenance, and

upkeep of its airplane, as well as the cost of Dr. Conrad’s

flying lessons.

We next address whether FMC can deduct its costs for the

storage, maintenance, and upkeep of its airplane, as well as the costs for

Dr. Conrad’s flying lessons. Section 162(a) allows taxpayers to deduct

[*42] ordinary and necessary expenses paid or incurred in carrying on a

trade or business. Section 262(a) prevents a taxpayer from deducting

otherwise deductible expenses if the expenses are “personal, living, or

family expenses.”

Section 274(d)(4) requires the taxpayer to comply with strict

substantiation requirements for any deductions related to listed

property. An airplane qualifies as listed property. See § 280F(d)(4)(A)(ii)

(providing that listed property includes “any . . . property used as a

means of transportation”); Treas. Reg. § 1.280F-6(b)(2)(i) (defining

“means of transportation” to include airplanes). The IRS did not argue

at trial or in its briefs that FMC failed to comply with section 274(d) as

to the airplane. Moreover, the IRS conceded that the airplane expenses

were actually incurred. See § 274(d) (“No deduction or credit shall be

allowed . . . (4) with respect to any listed property . . . unless the taxpayer

substantiates by adequate records or by sufficient evidence . . . the

amount of such expense . . . .”). Thus, we need not and do not consider

whether FMC failed to satisfy the strict substantiation requirements of

section 274(d) for the airplane’s nondepreciation expenses. See Feigh,

152 T.C. at 277.

FMC claimed the nondepreciation deductions as section 162(a)

deductions. (The deductions were reported on Part III, line 1 of the 2008

and 2009 Schedules K–1 sent to FMC’s shareholders, which reported the

shareholders’ pro rata shares of FMC’s nonseparately stated income or

loss. Recall that section 162(a) deductions are included in the

computation of nonseparately stated income or loss. Treas. Reg.

§ 1.1366-1(a)(2).) In litigation Dr. Conrad likewise contends that the

storage, maintenance, and upkeep expenses, as well as the cost of his

flying lessons, were ordinary and necessary in carrying on FMC’s trade

or business. Dr. Conrad specifically argues that FMC needed the

airplane because WOMF had clients in 22 states and he was physically

unable to drive these distances to meet with WOMF’s clients. Dr. Conrad

also argues that FMC needed him to earn his license to fly the plane

himself because it was both prohibitively expensive and logistically

unfeasible for FMC to hire certified pilots to fly the airplane.

The IRS’s argument against the deductibility of the storage,

maintenance, and upkeep expenses and the cost of Dr. Conrad’s flying

lessons is that the only use made of the airplane was training for Dr.

Conrad to earn his license to fly the airplane, and this was a personal

use. The IRS argues that since the airplane was used only for Dr.

Conrad’s (allegedly personal) flying lessons, the expenses incurred for

[*43] storing, maintaining, and keeping the airplane were not ordinary

and necessary in carrying on FMC’s trade or business.

However, FMC bought the airplane so that Dr. Conrad could use

it for corporate travel. FMC allowed Dr. Conrad to fly the airplane for

training purposes and incurred the nondepreciation expenses for the

airplane (including expenses for Dr. Conrad’s flying lessons) so that he

could earn his license to pilot the airplane himself while he performed

tasks on behalf of FMC. Although Dr. Conrad failed to ever become

licensed to fly the airplane, that does not change the fact that the

expenses (including for Dr. Conrad’s flying lessons) were incurred solely

for FMC’s business purposes. Furthermore, Dr. Conrad piloted the

airplane only for this training purpose; he did not use the airplane for

his personal activities. Thus, these expenses were not personal expenses

of the Conrads but were instead business expenses of FMC. See Int’l

Artists, Ltd., 55 T.C. at 104; Tr. Prop. No. 4, 21 B.T.A. at 628–29.

An expense is deductible under section 162(a) only if it is paid or

incurred during the year at issue. See Commissioner v. Lincoln Sav. &

Loan Ass’n, 403 U.S. at 352. During trial, in response to the Court’s

question as to whether the IRS contested that the expenses were

incurred, counsel for the IRS responded: “The expenses were incurred.

The Appeals Officers looked through the documents and disallowed it

just on the legal basis of the ordinary and necessary business assets.”

The IRS’s statement is tantamount to a stipulation that whether the

storage, maintenance, and upkeep expenses and cost of flying lessons

were paid or incurred is not at issue. See Rule 91(e) (stating that a

stipulation is binding); Church of Scientology of Cal. v. Commissioner,

83 T.C. 381, 524 (1984) (concluding that the IRS’s “concession in open

court . . . was the equivalent of a [binding] stipulation”), aff’d, 823 F.2d

1310 (9th Cir. 1987).

We hold that the nondepreciation expenses for FMC’s airplane

were not personal expenses of the Conrads but were instead ordinary

and necessary business expenses of FMC that are deductible under

section 162(a). Therefore, we do not sustain the IRS’s determination that

deductions for these expenses should be disallowed. 35

35 Even though FMC cannot deduct depreciation for the airplane under section

167, this does not compel the disallowance of FMC’s nondepreciation deductions for

the airplane. Section 162 does not require the taxpayer to place an asset in service for

a specifically assigned function before a taxpayer may deduct an expense. So long as

[*44] E.

A summary of the allowed deductions related to the yacht

and airplane for 2008 and 2009.

The tables below summarize the allowable deductions by FMC

and the Conrads related to the yacht and the airplane for 2008 and 2009.

2008

Expenses

FMC’s

deductions

The

Conrads’

deductions 36

Airplane and yacht

depreciation expenses

-0-

Airplane and yacht nondepreciation expenses

$256,934 37

$131,689

2009

III.

Expenses

FMC’s

deductions

The

Conrads’

deductions

Airplane and yacht

depreciation expenses

-0-

Airplane and yacht nondepreciation expenses

$21,893

$11,221

For both 2008 and 2009 the Conrads can deduct portions of the

expenses related to their residences.

The next issue we will address is whether the Conrads can claim

deductions related to their personal residences for both 2008 and 2009.

Several Code provisions are relevant to our discussion. Two of the

the nondepreciation expenses for the airplane are ordinary and necessary to FMC’s

business (and we conclude that they are), FMC can deduct these expenses. See Noyce

v. Commissioner, 97 T.C. 670, 689–90 (1991).

36 For both 2008 and 2009 51.25% of FMC’s deductions flow through to the

Conrads. See supra FINDINGS OF FACT, Part I.

37 The $256,934 consists of $178,917 of nondepreciation expenses related to

FMC’s airplane and $78,017 of nondepreciation expenses related to FMC’s yacht.

[*45] relevant provisions are section 162(a) and section 212(2), which

we have already discussed at length supra.

Section 163(a) allows a deduction for “all interest paid or accrued

within the taxable year on indebtedness.” However, section 163(h)(1)

provides that noncorporate taxpayers cannot deduct any “personal

interest.” Section 163(h)(2) carves out several different types of interest

from the definition of personal interest. Section 163(h)(2)(C) provides

that “any interest which is taken into account under section 469 in

computing income or loss from a passive activity” is not personal interest

under section 163(h)(1). A passive activity generally includes a

taxpayer’s rental activity. § 469(c)(2), (7). Section 163(h)(2)(D) provides

that “any qualified residence interest” is not personal interest under

section 163(h)(1). “Qualified residence interest” includes “acquisition

indebtedness with respect to any qualified residence of the taxpayer.”

§ 163(h)(3)(A). A “qualified residence” includes “the principal residence

. . . of the taxpayer.” § 163(h)(4)(A)(i)(I).

Section 164(a)(1) allows a deduction for “State and local . . . real

property taxes” paid by the taxpayer. Section 262(a) prevents a taxpayer

from deducting otherwise deductible expenses if the expenses are

“personal, living, or family expenses.”

Importantly for our analysis, the Code does not treat all the

above-mentioned deductions in the same way. Instead, the Code

classifies deductions into two broad categories. The first category is

known as above-the-line deductions because they are subtracted from

gross income to calculate a taxpayer’s adjusted gross income (AGI). See

§ 1 (defining gross income); § 62(a) (defining AGI as gross income minus

certain deductions); Knight v. Commissioner, 552 U.S. 181, 184 (2008)

(explaining that the deductions in the computation of AGI are referred

to as above-the-line deductions). The taxpayer’s AGI represents “the

line.” Any other allowable deductions are then subtracted from AGI to

calculate the taxpayer’s taxable income. This second group of deductions

is referred to as itemized or “below-the-line” deductions because the

deductions are subtracted from the taxpayer’s AGI. § 63(d) (defining

below-the-line deductions as all deductions except deductions in the

[*46] computation of AGI, i.e., all deductions except above-the-line

deductions). 38

As between a below-the-line deduction and an above-the-line

deduction, a taxpayer normally prefers the latter for three reasons.

First, an above-the-line deduction is fully deductible regardless of the

taxpayer’s AGI, while certain below-the-line deductions are limited to

the total amount of these certain deductions that exceeds a percentage

of AGI. See, e.g., § 67(a) (miscellaneous itemized deductions); 39 § 68(a)

(itemized deductions of high-income taxpayers); § 213(a) (medicalexpense deductions). Second, an above-the-line deduction reduces AGI,

which, in turn, allows the taxpayer to claim more of the below-the-line

deductions that are limited to the total amount of deductions that exceed

a percentage of AGI. See William L. Rudkin Testamentary Tr. v.

Commissioner, 124 T.C. 304, 307 (2005) (below-the-line deductions do

not affect AGI), aff’d, 467 F.3d 149 (2d Cir. 2006), aff’d sub nom. Knight

v. Commissioner, 552 U.S. 181 (2008). Third, above-the-line deductions

can be claimed even if the taxpayer takes the standard deduction. § 63(a)

and (b). By contrast, the taxpayer must choose between claiming the

standard deduction or claiming below-the-line deductions.

Section 62(a) defines the deductions that are above-the-line

deductions. Two types of above-the-line deductions are a section 162(a)

deduction (i.e., ordinary-and-necessary business expenses of selfemployed taxpayers) and a section 212 deduction attributable to the

production of rents. See § 62(a)(1), (4). A section 163(a) deduction for

interest expenses is not an above-the-line deduction under section 62(a)

and is therefore an itemized deduction. § 63(d). However, an interest

expense attributable to a business is an above-the-line deduction under

section 162(a). See McNutt-Boyce Co. v. Commissioner, 38 T.C. 462, 464

(1962), aff’d per curiam, 324 F.2d 957 (5th Cir. 1963); Standing v.

Commissioner, 28 T.C. 789, 795 (1957), aff’d, 259 F.2d 450 (4th Cir.

1958). And an interest expense attributable to the production of rents is

an above-the-line deduction under section 212(2). See Charles H.

Ungerman, Jr. Revocable Tr. v. Commissioner, 89 T.C. 1131, 1136

38 For taxpayers who claim the standard deduction, taxable income is equal to

AGI (i.e., gross income minus above-the-line deductions) minus the standard

deduction. § 63(b).

39 Under the TCJA, taxpayers may not deduct any miscellaneous itemized

deductions for tax years 2018 through 2025. § 67(g). This provision is inapplicable here

because we are dealing with tax years 2008 and 2009.

[*47] (1987); Koshland v. Commissioner, 19 T.C. 860, 862–63 (1953),

aff’d per curiam, 216 F.2d 751 (9th Cir. 1954).

Real property taxes “directly attributable to a trade or business

or to property from which rents or royalties are derived” are above-theline deductions. Temp. Treas. Reg. § 1.62-1T(d). Real property taxes

attributable to a taxpayer’s personal use are below-the-line deductions.

§§ 62, 63(d).

Section 280A disallows otherwise deductible expenses related to

a taxpayer’s residence. The relevant portions of section 280A are

reproduced below:

Sec. 280A.—Disallowance of certain expenses in connection

with business use of home, rental of vacation homes, etc.

(a) General rule.—Except as otherwise provided in

this section, in the case of a taxpayer who is an individual

or an S corporation, no deduction otherwise allowable

under this chapter shall be allowed with respect to use of a

dwelling unit which is used by the taxpayer during the

taxable year as a residence.

(b) Exception for interest, taxes, casualty losses,

etc.—Subsection (a) shall not apply to any deduction

allowable to the taxpayer without regard to its connection

with his trade or business (or with his income-producing

activity).

limitation on deductions for such use.—

(1) Certain business use.—Subsection (a)

shall not apply to any item to the extent such item is

allocable to a portion of the dwelling unit which is

exclusively used on a regular basis—

(A) as the principal place of business for

any trade or business of the taxpayer,

....

(3) Rental use.—Subsection (a) shall not apply

to any item which is attributable to the rental of the

dwelling unit or portion thereof . . . .

....

(5) Limitation on deductions.—In the case of

a use described in paragraph (1) . . . and in the case

of a use described in paragraph (3) where the

dwelling unit is used by the taxpayer during the

[*48]

taxable year as a residence, the deductions allowed

under this chapter for the taxable year by reason of

being attributed to such use [i.e., the non-personal

use described in paragraph (1) or paragraph (3)]

shall not exceed the excess of—

(A) the gross income derived from such

use for the taxable year, over

(B) the sum of—

(i) the deductions allocable to

such use which are allowable under

this chapter for the taxable year

whether or not such unit (or portion

thereof) was so used, and

(ii) the deductions allocable to

the trade or business (or rental

activity) in which such use occurs (but

which are not allocable to such use) for

such taxable year.

Any amount not allowable as a deduction under this

chapter by reason of the preceding sentence shall be

taken into account as a deduction (allocable to such

use) under this chapter for the succeeding taxable

year. Any amount taken into account for any taxable

year under the preceding sentence shall be subject

to the limitation of the 1st sentence of this

paragraph whether or not the dwelling unit is used

as a residence during such taxable year.

(6) Treatment of rental to employer.—

Paragraphs (1) and (3) shall not apply to any item

which is attributable to the rental of the dwelling

unit (or any portion thereof) by the taxpayer to his

employer during any period in which the taxpayer

uses the dwelling unit (or portion) in performing

services as an employee of the employer.

(d) Use as residence.—

(1) In general.—For purposes of this section,

a taxpayer uses a dwelling unit during the taxable

year as a residence if he uses such unit (or portion

thereof) for personal purposes for a number of days

which exceeds the greater of—

(A) 14 days, or

[*49]

(B) 10 percent of the number of days

during such year for which such unit is rented

at a fair rental.

For purposes of subparagraph (B), a unit shall not

be treated as rented at a fair rental for any day for

which it is used for personal purposes.

(2) Personal use of unit.—For purposes of this

section, the taxpayer shall be deemed to have used a

dwelling unit for personal purposes for a day if, for

any part of such day, the unit is used—

(A) for personal purposes by the

taxpayer or any other person who has an

interest in such unit, or by any member of the

family . . . of the taxpayer or such other

person;

....

(e) Expenses attributable to rental.—

(1) In general.—In any case where a taxpayer

who is an individual or an S corporation uses a

dwelling unit for personal purposes on any day

during the taxable year (whether or not he is treated

under this section as using such unit as a residence),

the amount deductible under this chapter with

respect to expenses attributable to the rental of the

unit (or portion thereof) for the taxable year shall

not exceed an amount which bears the same

relationship to such expenses as the number of days

during each year that the unit (or portion thereof) is

rented at a fair rental bears to the total number of

days during such year that the unit (or portion

thereof) is used.

(2) Exception for deductions otherwise

allowable.—This subsection shall not apply with

respect to deductions which would be allowable

under this chapter for the taxable year whether or

not such unit (or portion thereof) was rented.

(f) Definitions and special rules.—

(1) Dwelling unit defined.—For purposes of

this section—

(A) In general.—The term “dwelling

unit

includes

house,

apartment,

condominium, mobile home, boat, or similar

[*50]

property, and all structures or other property

appurtenant to such dwelling unit.

The Treasury Department has published proposed regulations

under section 280A. 45 Fed. Reg. 52,399, 52,403, 52,405 (Aug. 7, 1980);

48 Fed. Reg. 33,320, 33,325 (July 21, 1983). The relevant provisions of

these proposed regulations are reproduced below:

§ 1.280A-2 Deductibility of expenses attributable to

business use of a dwelling unit used as a residence.

....

(i) Limitation on deductions.

....

(2) Gross income derived from use of unit.

....

(iii) Exclusion of certain amounts. For

purposes of section 280A(c)(5)(A) and this

section, gross income derived from use of a

unit means gross income from the business

activity in the unit reduced by expenditures

required for the activity but not allocable to

use of the unit itself, such as expenditures for

supplies and compensation paid to other

persons. . . .

....

(5) Order of deductions. Business deductions

with respect to the business use of a dwelling unit

are allowable in the following order and only to the

following extent:

(i) The allocable portions of amounts

allowable as deductions for the taxable year

under chapter 1 of the Code with respect to

the dwelling unit without regard to any use of

the unit in trade or business, e.g., mortgage

interest and real estate taxes, are allowable

as business deductions to the extent of the

gross income derived from use of the unit.

(ii) Amounts otherwise allowable as

deductions for the taxable year under chapter

1 of the Code by reason of the business use of

the dwelling unit (other than those which

would result in an adjustment to the basis of

property) are allowable to the extent the gross

[*51]

income derived from use of the unit exceeds

the deductions allowed or allowable under

subdivision (i) of this subparagraph.

(iii) Amounts otherwise allowable as

deductions for the taxable year under chapter

1 of the Code by reason of the business use of

the dwelling unit which would result in an

adjustment to the basis of property are

allowable to the extent the gross income

derived from use of the unit exceeds the

deductions allowed or allowable under

subdivisions (i) and (ii) of this subparagraph.

§ 1.280A-3 Deductibility of expenses attributable to the

rental of a dwelling unit used as a residence.

.....

(d) Limitation on deductions if taxpayer has used

dwelling unit as a residence.

....

(2) Gross rental income. For purposes of

section 280A and this section gross rental income

from a unit equals the gross receipts from rental of

the unit reduced by expenditures to obtain tenants

for the unit, such as realtors’ fees and advertising

expense. . . .

(3) Order of deductions. Deductions with

respect to the rental use of a dwelling unit are

allowable in the following order and only to the

following extent:

(i) The allocable portions of amounts

otherwise allowable as deductions for the

taxable year under chapter 1 of the Code with

respect to the dwelling unit without regard to

the rental use of the unit, e.g., mortgage

interest and real estate taxes, are deductible

as rental expenses to the extent of the gross

rental income from the unit.

(ii) The allocable portions of amounts

otherwise allowable as deductions for the

taxable year under chapter 1 of the Code by

reason of the rental use of the dwelling unit

(other than those which would result in an

adjustment to the basis of property) are

[*52]

allowable to the extent the gross rental

income exceeds the deductions allowed or

allowable under subdivision (i) of this

subparagraph.

(iii) The allocable portions of amounts

otherwise allowable as deductions for the

taxable year under chapter 1 of the Code by

reason of the rental use of the dwelling unit

which would result in an adjustment to the

basis of property are allowable to the extent

the gross rental income exceeds the

deductions allowed or allowable under

subdivisions (i) and (ii) of this subparagraph.

Proposed regulations “carry no more weight than a position

advanced on brief by [the IRS].” F.W. Woolworth Co. v. Commissioner,

54 T.C. 1233, 1265–66 (1970). However, as will be discussed in more

detail infra OPINION, Part III.A.5 and III.B.2.d, we will use the

proposed regulations’ method for calculating the Conrads’ allowable

deductions under section 280A because the IRS argues that the

regulations should be used for applying section 280A and because Dr.

Conrad did not argue at trial or in his brief that the regulations’ method

should not be used to determine the Conrads’ income from their

condominium and house.

Taxpayers report their current-year deductions for business-useof-home expenses, and any business-use-of-home deductions suspended

and carried forward on account of section 280A(c)(5), on the Form 8829.

Dr. Conrad’s 2008 and 2009 Forms 8829 are reproduced below. These

forms will be referred to when discussing how the Conrads reported the

residence expenses for 2008 and 2009.

[*53]

[*54]

[*55] Taxpayers calculate their current-year deductions for expenses

related to the renting of their personal residences and any carryforward

of such expenses from prior years on a worksheet attached to the IRS’s

instructions to Schedule E. Taxpayers do not attach this worksheet to

their filed returns. A copy of this blank worksheet is reproduced below:

I.R.S. Pub. 527, Residential Real Property (Including Rental of Vacation

Homes) 26 (2008).

Section 1401 imposes a tax “on self-employment income . . . for

[the] taxable year.” § 1401(a). “In the case of a husband and wife filing a

joint return . . . the [self-employment tax] shall not be computed on the

[*56] aggregate income but shall be the sum of the taxes computed . . .

on the separate self-employment income of each spouse.” § 6017; see also

Treas. Reg. § 1.6017-1(b)(1) (“In the case of a husband and wife filing a

joint return . . . the tax on self-employment income is computed on the

separate self-employment income of each spouse, and not on the

aggregate of the two amounts.”). Both spouses, as joint-return filers, are

jointly liable for both self-employment taxes. § 6017. Section 1402(b)

defines “self-employment income” as “the net earnings from selfemployment derived by an individual,” which, in turn, is defined by

section 1402(a) as “the gross income derived by an individual from any

trade or business carried on by such individual, less the deductions

allowed by this subtitle which are attributable to such trade or

business.” Section 1402(c)(2) defines a “trade or business” as not

including income earned by the taxpayer for “the performance of service

by an individual as an employee.” Self-employment income thus

includes an independent contractor’s personal-services income. Treas.

Reg. § 1.1402(a)-1(a)(1). However, section 1402(a) provides that “net

earnings from self-employment” do not include income earned by

taxpayers through “rentals from real estate . . . unless such rentals are

received in the course of a trade or business as a real estate dealer.”

§ 1402(a)(1).

2008

The table below shows the parties’ positions on the 2008

deductions related to the condominium and our conclusions as to these

deductions. Column 2 states the position the Conrads took on their 2008

tax return. Column 3 states the IRS’s position in its notice of deficiency,

while column 4 states the IRS’s primary position in litigation. Column 5

states the IRS’s alternative position in litigation. Finally, column 6

states our holding on the deductions for 2008.

[*57]

The

Conrads’

2008 return

Notice of

deficiency

The IRS’s

alternative

litigating

position

$222,207

The Court’s

conclusions

$222,207

The IRS’s

primary

litigating

position

$222,207

Gross income from professional services under Prop. Treas. Reg. § 1.280A-2(i)(2)

Total expenditures not allocable to business use of condo. Under Prop. Treas. Reg. §

1.280A-2(i)(2)(iii)

Gross income derived from business use of condo. Under Prop. Treas. Reg. § 1.280A2(i)(2)(iii)

Deductions under Prop. Treas. Reg. § 1.280A-2(i)(5)(i)

Amount allowable

Limit on further deductions

Deductions under Prop. Treas. Reg. § 1.280A-2(i)(5)(ii)

Amount allowable

Limit on further deductions

Deductions under Prop. Treas. Reg. § 1.280A-2(i)(5)(iii)

Amount allowable

Disallowed Prop. Treas. Reg. § 1.280A-2(i)(5)(ii) deductions (carryover to 2009)

Disallowed Prop. Treas. Reg. § 1.280A-2(i)(5)(iii) deductions (carryover to 2009)

$222,207

222,207

164,006

58,201

114,520

58,201

387,391

56,319

387,391

222,207

Gross income from rental use under Prop. Treas. Reg. § 1.280A-3(d)(2)

Reduction for expenditures not allocable to rental use of condo. Under Prop. Treas. Reg. §

1.280A-3(d)(2)

Gross income from rental use under Prop. Treas. Reg. § 1.280A-3(d)(2) after reduction

Deductions under Prop. Treas. Reg. § 1.280A-3(d)(3)(i)

Amount allowable

Limit on further deductions

Deductions under Prop. Treas. Reg. § 1.280A-3(d)(3)(ii)

Amount allowable

Limit on further deductions

Deductions under Prop. Treas. Reg. § 1.280A-3(d)(3)(iii)

Amount allowable

Disallowed Prop. Treas. Reg. § 1.280A-3(d)(3)(ii) deductions (carryover to 2009)

Disallowed Prop. Treas. Reg. § 1.280A-3(d)(3)(iii) deductions (carryover to 2009)

$144,000

144,000

18,443

125,557

144,000

164,005

144,000

164,005

144,000

114,520

387,391

114,520

387,391

Schedule A – mortgage interest

$216,556

$328,010

$184,010

The top 13 rows of the table correspond to the method used in

Proposed Treasury Regulation § 1.280A-2 for applying section 280A to a

dwelling unit partly used as an office and partly used as the taxpayer’s

residence. See id. para. (i). The next 13 rows of the table correspond to

the method used in Proposed Treasury Regulation § 1.280A-3 for

applying section 280A to a dwelling unit partly used for rental activity

and partly used as the taxpayer’s residence. See id. para. (d).

Section 280A(a) disallows all deductions “with respect to use of a

dwelling unit which is used by the taxpayer during the taxable year as

a residence.” The Conrads’ condominium is a dwelling unit. See

§ 280A(f)(1)(A) (providing that a condominium is considered a dwelling

unit). The condominium is the Conrads’ residence for 2008 because “the

number of days during” which the Conrads used the condominium for

personal purposes was 366, which is greater than the greater of (1) 14

days or (2) 10% of the days the condominium was rented at fair market

value (with any day of personal use not counting as a day the

$222,207

[*58] condominium was rented at fair market value). See § 280A(d)(1).

Therefore, under section 280A(a), no deductions are allowed with

respect to any use of the Conrads’ condominium for both the personal

and rental portions, unless the deductions fall under exceptions

provided in section 280A. Section 280A(c)(1) exempts from section

280A(a) those expenses allocable to the portion of the dwelling unit used

for the taxpayer’s business (under certain conditions). Section 280A(c)(3)

exempts from section 280A(a) those expenses attributable to renting out

the dwelling unit. Both types of exempted expenses are subject to the

deductibility limit of section 280A(c)(5).

The Conrads’ 2008 tax return

The Conrads filed Form 8829 on which Dr. Conrad claimed

condominium deductions purportedly related to his professional

services. The format of the Form 8829 reflects the interpretation of the

section 280A(c)(5) limitation by Proposed Treasury Regulation

§ 1.280A-2 with respect to residences used for the taxpayer’s business.

The Conrads also reported the $144,000 of rental income they received

from FMC on their Schedule E. However, they did not report any

deductions related to their condominium on their Schedule E. That is,

they did not report that the expenses of the condominium were allocable

to the rental use of the condominium. In litigation Dr. Conrad does not

suggest that the expenses of the condominium were allocable to the

rental of the condominium to FMC. As we have explained, Dr. Conrad

instead argues solely that these deductions were allocable to his

professional services performed for FMC.

For 2008 line 13 of Dr. Conrad’s Form 8829 reported a deduction

of $164,006 of mortgage interest purportedly related to Dr. Conrad’s

professional services. Mortgage interest is deductible whether or not the

residence is used in Dr. Conrad’s sole proprietorship. See §§ 163(a),

(h)(2)(D), 280A(b). The deduction for mortgage interest that is allocable

to a taxpayer’s business activities corresponds to the first category of

Proposed Treasury Regulation § 1.280A-2(i)(5), which is Proposed

Treasury Regulation § 1.280A-2(i)(5)(i). The deduction is shown in the

table above in the row titled “Deductions under Prop. Treas. Reg.

§ 1.280A-2(i)(5)(i).”

Line 24 of Dr. Conrad’s Form 8829 reported a $114,520 operatingexpense carryforward from 2007. The Form 8829 did not claim

deductions for any operating expenses paid during 2008. Form 8829 is

designed such that line 24 corresponds to the second expense category

[*59] of Proposed Treasury Regulation § 1.280A-2(i)(5), which is

Proposed Treasury Regulation § 1.280A-2(i)(5)(ii). The $114,520

carryforward is listed in the table above in the row titled “Deductions

under Prop. Treas. Reg. § 1.280A-2(i)(5)(ii).”

Finally, Dr. Conrad’s Form 8829 on line 29 reported $72,724 of

depreciation for 2008 and on line 30 reported $314,667 of depreciationand-excess-casualty-loss carryforwards from the Conrads’ 2007 return.

Lines 29 and 30 correspond to the third category of expenses governed

by Proposed Treasury Regulation § 1.280A-2(i)(5), which is Proposed

Treasury Regulation § 1.280A-2(i)(5)(iii). The amounts reported on these

two lines total $387,391 and are shown in the table above in the row

titled “Deductions under Prop. Treas. Reg. § 1.280A-2(i)(5)(iii).”

In accordance with the ordering rules from Proposed Treasury

Regulation § 1.280A-2(i)(5) (which the Form 8829 incorporates), the

Conrads first deducted all their Proposed Treasury Regulation § 1.280A2(i)(5)(i) expenses ($164,006) against Dr. Conrad’s gross income from

professional services ($222,207). After doing so, the Conrads were left

with $58,201 of income that could be offset with other deductions. The

$58,201 was reported on line 15 of Dr. Conrad’s Form 8829. The Conrads

then used $58,201 of Dr. Conrad’s Proposed Treasury Regulation

§ 1.280A-2(i)(5)(ii) expenses to offset Dr. Conrad’s remaining income.

The Conrads carried forward $56,319 of Proposed Treasury Regulation

§ 1.280A-2(i)(5)(ii) expenses for use in future years. The $56,319 was

reported on line 42 of the Form 8829. In addition, the Conrads also

carried forward the $387,391 of Proposed Treasury Regulation § 1.280A2(i)(5)(iii) expenses for use in future years. The $387,391 was reported

on line 43 of the Form 8829.

The notice of deficiency

The notice of deficiency reflected the IRS’s position that the

condominium was not exclusively used as Dr. Conrad’s principal place

of business and that therefore all the expenses related to the

condominium were not exempted from the disallowance of section

280A(a) by section 280A(c)(1)(A). The notice of deficiency also implicitly

disallowed the two types of carryforwards from 2007 reported by the

Conrads on Dr. Conrad’s Form 8829 because it did not incorporate an

adjustment for their claimed carryforwards even though Dr. Conrad

reported professional-services income during 2008. See § 280A(c)(5)

(flush language).

[*60] The notice of deficiency did not disallow the $216,556 mortgage

interest deduction the Conrads claimed as an itemized deduction on

their Schedule A.

The notice of deficiency allowed the Conrads an $18,443

deduction on their Schedule E. The notice of deficiency stated that the

$18,443 deduction was the “amount . . . for ordinary and necessary

business purposes and that this amount qualifies under the provisions

of the . . . Code.” However, the notice of deficiency did not further explain

what specific expenses the deduction corresponded to or whether the

deduction related to the renting of the Conrads’ condominium to FMC.

The IRS’s primary litigating position

On brief the IRS explains the $18,443 allowance made by the

notice of deficiency as follows:

This $18,443.00 was [the IRS’s] allowance for [the

Conrads’] Business Use of Home deduction. The $18,443.00

was permitted as a Schedule E deduction because [the

Conrads] reported rental income from [FMC] to themselves

for the company’s use of their home for business in the

amount of $144,000.00 on their Schedule E for the 2008 tax

year.

Having thus acknowledged that the notice of deficiency allowed the

deduction, the IRS’s brief makes the following statement:

One hundred percent of [the Conrads’] mortgage

interest deduction for both years at issue rightfully belongs

on [the Conrads’] Schedule A for the 2008 and 2009 tax

years. [The Conrads] have not proven their Business Use

of Home deductions taken are permissible, and as such the

mortgage interest deduction should only appear on their

Schedule A for both [2008 and 2009].

We interpret this statement to be a disavowal of the allowance of the

$18,443 deduction as a Schedule E deduction by the notice of deficiency.

Therefore, the IRS’s primary position, which is stated in its posttrial

briefs, is that 100% of the mortgage interest, which is $328,010, is

allowable as a Schedule A deduction (i.e., as an itemized deduction),

rather than as a Schedule E deduction (i.e., as a rental-expense

deduction).

[*61]

The IRS’s alternative litigating position

Column 5 of the table illustrates the IRS’s alternative position,

which is that the deductions allocable to the rental use of the

condominium are allowable only to the extent of the section 280A(c)(5)

limitation and that the limitation is the amount of rent received by the

Conrads from FMC. In the IRS’s (alternative) view, this limitation

works as follows: “In this case, the [Conrads’] Business Use of Home

deduction would be limited to the rents they received - $144,000.00 for

2008 . . . .” This sentence reflects the view that the gross income in the

section 280A(c)(5) limitation is the rents received, not Dr. Conrad’s

professional-services income. This sentence also reflects the view that

section 280A(c)(5) should be applied in accordance with the

interpretation of that provision found in Proposed Treasury Regulation

§ 1.280A-3(d)(3)(i). Under that interpretation the mortgage interest and

taxes allocable to rental use are deductible as rental expenses only to

the extent of gross rental income. I.R.S. Publication 527, supra,

at 23–27, adopts a different approach, under which the mortgage

interest and taxes allocable to rental use are deductible as rental

expenses even in amounts exceeding gross rental income.

The Court’s conclusion

We conclude that the nonpersonal portion of the condominium

was rented by FMC from the Conrads, and FMC in turn permitted Dr.

Conrad and other workers to use that portion of the condominium.

Therefore, as column 6 in the table above shows, we agree with the IRS’s

alternative position. We disagree with the Conrads’ reporting position

that the nonpersonal portion of the condominium was used by Dr.

Conrad’s sole proprietorship, and we therefore reject the Conrads’

reporting position. The expenses of the Conrads with respect to that

portion of the condominium were thus rental expenses of the Conrads

rather than business expenses of Dr. Conrad’s sole proprietorship. See

§ 280A(c)(3). We will therefore apply the ordering rules provided in

Proposed Treasury Regulation § 1.280A-3(d)(3) rather than those in

Proposed Treasury Regulation § 1.280A-2(i)(5) to determine the

Conrads’ deductions for 2008.

Dr. Conrad does not contend that Proposed Treasury Regulation

§ 1.280A-3(d)(3) should not be used to calculate the section 280A(c)(5)

limitation, he does not argue that I.R.S. Publication 527, supra,

at 23–27, should be used to calculate the section 280A(c)(5) limitation,

and he does not argue that the Conrads should be allowed to deduct

[*62] mortgage interest as a rental expense in excess of the rent they

received from FMC. We will not make these arguments on his behalf.

See Feigh, 152 T.C. at 277.

In our application of the section 280A(c)(5) limit for 2008, we

include the $114,520 operating-expense carryforward reported by the

Conrads on their 2008 return. The IRS’s critique of the Conrads’

computations used in their tax reporting, i.e., that the nonpersonal

portion of the condominium was rented to FMC rather than used by Dr.

Conrad’s sole proprietorship, a critique with which we agree, suggests

that the $114,520 operating-expense deductions carried forward from

2007 are not overstated. The Conrads likely used Dr. Conrad’s 2007

professional-services income as their section 280A(c)(5) limit rather

than the 2007 rents received from FMC. The 2007 professional-services

income was likely greater than the 2007 rents received (as it was in

2008). In our computation of the section 280A(c)(5) limit for 2008, we

include the $314,667 carryforward of depreciation and excess casualty

loss expenses from 2007 for similar reasons. We also include the

$328,010 in deductible mortgage interest the Conrads paid during 2008

($164,005 of which was allocable to rental use). We also include $72,724

of depreciation for 2008 reported on Dr. Conrad’s Form 8829. The IRS

does not challenge the accuracy of this amount. It argues only that the

nonpersonal part of the condominium was used to rent to FMC

(alternative position) and that the condominium was not used in Dr.

Conrad’s sole proprietorship (primary position).

For 2008 the Conrads paid $328,010 of mortgage interest. On Dr.

Conrad’s Form 8829 the Conrads divided the expenses related to the

condominium and the house evenly between the portions of the

residences used by FMC and the portions used by them personally. The

IRS has not argued that we should adjust this allocation method.

Therefore, we will accept the Conrads’ method and will divide the

mortgage interest related to the condominium equally between their

personal and rental activities. See Feigh, 152 T.C. at 277.

Half of the Conrads’ mortgage interest, $164,005, is attributable

to rental use. This half is deductible as an above-the-line rental expense

only to the extent of the $144,000 of rental income FMC paid to the

Conrads because of the limit imposed by Proposed Treasury Regulation

§ 1.280A-3(d)(3)(i). The excess, $20,005, is allowable as a Schedule A

deduction. See §§ 163(a), (h)(2)(D), 280A(b); Coffman v. Commissioner,

T.C. Memo. 2000-7, slip op. at 11 (concluding that when the grossincome limitation of section 280A(c)(5) prevents the taxpayers from

[*63] deducting a portion of their mortgage interest as a business

deduction, the portion of the mortgage interest disallowed as a business

deduction is an itemized deduction for the year at issue). In addition,

the other half of the $328,010 of mortgage interest, which is attributable

to the Conrads’ personal use of the condominium, is allowable as a

Schedule A deduction. See §§ 163(a), (h)(2)(D), 280A(b).

Therefore, we hold that for 2008 $144,000 of mortgage interest is

deductible as an above-the-line rental-expense deduction. See

§§ 62(a)(4), 212(2), 280A(c)(3). Also, another $184,010 of mortgage

interest is an itemized deduction (consisting of (1) the $164,005 of

mortgage interest attributable to the personal portion of the

condominium and (2) the $20,005 of the mortgage interest attributable

to the rental portion of the condominium but that cannot be deducted as

a rental expense for 2008 because of section 280A(c)(5) and Proposed

Treasury Regulation § 1.280A-3(d)(3)(i)). 40 See §§ 163(a), (h)(2)(D),

280A(b).

As discussed supra OPINION, Part III.A.1, the Conrads deducted

$58,201 of operating-expense carryforwards on Dr. Conrad’s Form 8829

for 2008. The Conrads also carried forward an additional $56,319 of

operating-expense deductions into 2009. After the allowance of their

deduction for mortgage interest allocable to their rental activity, the

Conrads may not deduct any additional residence expenses against their

rental income. See § 280A(c)(5); Prop. Treas. Reg. § 1.280A-3(d)(3)(ii).

Therefore, we conclude that the Conrads must carry forward the

$114,520 of operating expenses (which is the sum of $58,201 and

$56,319) to 2009.

As discussed supra OPINION, Part III.A.1, the Conrads claimed

a current-year depreciation deduction of $72,724 on Dr. Conrad’s Form

8829 for the condominium and a $314,667 depreciation-and-excess

casualty-loss carryforward from 2007. The Conrads did not deduct

either of these amounts on Dr. Conrad’s Form 8829 but instead carried

forward the deductions to 2009. We agree with the Conrads that the

carryforwards are appropriate. Thus, the Conrads must carry forward

40 The notice of deficiency did not disallow the $216,556 mortgage interest

expense the Conrads claimed as an itemized deduction (i.e., a Schedule A deduction).

Furthermore, the IRS’s opening brief contends that all of the Conrads’ $328,010 of

mortgage interest should be claimed on their Schedule A. Thus, we conclude that the

IRS does not dispute that the mortgage interest on the condominium is “qualified

residence interest.” See § 163(h)(3)(A); Feigh, 152 T.C. at 277. Qualified residence

interest is exempt from section 280A(a) by section 280A(b).

[*64] $387,391 of depreciation and excess casualty loss expenses (which

is the sum of $72,724 and $314,667) to 2009.

Having determined the allowable deductions under section

280A(c)(3) and (5) ($144,000), our final step is to determine whether any

other provision in section 280A further limits the Conrads’ deductions.

During 2008 and 2009 the Conrads’ extended family used the portions

of the condominium rented to FMC for personal purposes while visiting

the Conrads. This personal use is attributed to the Conrads. See

§ 280A(d)(2)(A) (attributing personal use of the residence by the

taxpayer’s family to the taxpayer). Because we conclude that the

Conrads used their residences for rental activity instead of as a home

office in Dr. Conrad’s business, the Conrads’ personal use of the rented

portions of the condominium does not result in the disallowance of any

of the Conrads’ deductions for 2008. The Code provides that taxpayers

cannot deduct any residence expenses as business expenses when the

taxpayers also use the business portion of the residence for personal

activities. See § 280A(c)(1); H.R. Rep. No. 94-658, at 161 (1975), as

reprinted in 1976-3 C.B. (Vol. 2) 695, 853 (“The use of a portion of a

dwelling unit for both personal purposes and for the carrying on of a

trade or business does not meet [the section 280A(c)(1)] exclusive use

test.”); S. Rep. No. 94-938, at 148 (1976), as reprinted in 1976-3 C.B.

(Vol. 3) 49, 186 (same); Perry v. Commissioner, T.C. Memo. 1996-194,

slip op. at 14–15 (“The use of a portion of a dwelling unit for both

personal and business purposes does not meet the exclusive use

requirement of section 280A(c)(1).”). However, no such exclusivity

restriction relates to section 280A(c)(3). See § 280A(c)(1)(A) (“Subsection

(a) shall not apply to any item to the extent such item is allocable to a

portion of the dwelling unit which is exclusively used on a regular basis

as the principal place of business for any trade or business of the

taxpayer . . . .”); § 280A(c)(3) (“Subsection (a) shall not apply to any item

which is attributable to the rental of the dwelling unit or portion thereof

. . . .”); Francisco v. Commissioner, 119 T.C. 317, 323 (2002) (“We can

reasonably assume Congress intentionally chose different words in

closely related statutory provisions to produce a different meaning.”),

aff’d, 370 F.3d 1228 (D.C. Cir. 2004). Therefore, the Conrads’ personal

use of the rented portion of the condominium does not prevent them from

deducting any of their expenses.

A taxpayer who has expenses attributable to renting out a

residence may find the deductions attributable to such expenses limited

by section 280A(e)(1). The IRS does not suggest that this provision limits

the deductions for the expenses attributable to the Conrads’ rental of

[*65] the condominium to FMC. We therefore need not address this

potential argument. See Feigh, 152 T.C. at 277.

Section 280A(c)(6) bars deductions otherwise allowed under

section 280A(c)(3) when (1) an employee rents part or all of the

employee’s personal residence to his or her employer (provided the

rental expenses relate to part or all of the personal residence rented to

the employer) and (2) the employee performs services for the employer

within the personal residence. The IRS cited section 280A(c)(6) in its

Pre-trial Memorandum as support for disallowing the deductions

related to the condominium; however, the IRS then failed to assert any

argument under section 280A(c)(6) in its briefs. The IRS has thus

abandoned any argument regarding section 280A(c)(6). See

Amazon.com, Inc., 148 T.C. at 220. Therefore, we hold that section

280A(c)(6) does not bar any of the Conrads’ deductions for 2008. 41

In sum, we hold that for 2008 the Conrads may deduct

(1) $144,000 of mortgage interest as an above-the-line rental-expense

deduction and (2) $184,010 of mortgage interest as an itemized

deduction. There is a carryforward of (1) $114,520 of operating expenses

and (2) $387,391 of depreciation and excess casualty loss expenses to

2009. 42

Although the text of section 280A(c)(6) refers to “employees” and

“employers,” parts of the legislative history claim that section 280A(c)(6) was intended

to also apply to independent contractors such as the Conrads. See H.R. Rep. No. 99426, at 134 (1985), as reprinted in 1986-3 C.B. (Vol. 2) 1, 134 (stating that for section

280A(c)(6), “an individual who is an independent contractor is treated as an employee,

and the party for whom such individual is performing services is treated as an

employer”); S. Rep. No. 99-313, at 84 (1986), as reprinted in 1986-3 C.B. (Vol. 3) 1, 84

(same). Because we conclude that the IRS has waived any argument under section

280A(c)(6), we need not decide whether the legislative history is enough to overcome

the plain language in section 280A(c)(6) that the provision applies to “employees.”

42 The Conrads did not report that the activities of Dr. Conrad’s sole

proprietorship resulted in any self-employment income. That is because Dr. Conrad’s

Schedule C reported that his $222,207 of professional-services income was offset by

$222,207 of residence expenses purportedly related to the use of the condominium for

his professional-services sole proprietorship. Because in our view these expenses

related not to his sole proprietorship but to rental use, the Conrads underreported Dr.

Conrad’s self-employment income by $222,207 by improperly deducting $222,207

against his professional-services income.

[*66] B.

2009

The table below shows the parties’ positions on the 2009

deductions and our conclusions as to these deductions. Column 2 states

the position the Conrads took on their 2009 tax return. Column 3 states

the IRS’s position in its notice of deficiency. Column 4 states the IRS’s

primary position in litigation, while column 5 states the IRS’s

alternative position in litigation. Finally, column 6 states our holding on

the deductions for 2009.

Notice of

deficiency

Dr. Conrad’s professional services

Gross income from professional services under Prop. Treas. Reg. § 1.280A-2(i)(2)

Total expenditures not allocable to business use of residences under Prop. Treas. Reg. § 1.280A-2(i)(2)(iii)

Gross income derived from business use of residences under Prop. Treas. Reg. § 1.280A-2(i)(2)(iii).

Dr. Conrad’s deductions under Prop. Treas. Reg. § 1.280A-2(i)(5)(i)

Amount allowable

Limit on further deductions

Dr. Conrad’s deductions under Prop. Treas. Reg. § 1.280A-2(i)(5)(ii)

Amount allowable

Limit on further deductions

Dr. Conrad’s deductions under Prop. Treas. Reg. § 1.280A-2(i)(5)(iii)

Amount allowable

Dr. Conrad’s disallowed Prop. Treas. Reg. § 1.280A-2(i)(5)(ii) deductions (carryover to 2010)

Dr. Conrad’s disallowed Prop. Treas. Reg. § 1.280A-2(i)(5)(iii) deductions (carryover to 2010)

The

Conrads’

2009

return

The IRS’s

primary

litigating

position

$288,000

288,000

61,982

226,018

92,743

133,275

460,115

133,275

326,840

$288,000

288,000

$288,000

288,000

$288,000

288,000

$183,667

183,667

Mrs. Conrad’s accounting services

Gross income from accounting services under Prop. Treas. Reg. § 1.280A-2(i)(2)

Total expenditures not allocable to business use of residences under Prop. Treas. Reg. § 1.280A-2(i)(2)(iii)

Gross income derived from business use of residences under Prop. Treas. Reg. § 1.280A-2(i)(2)(iii)

Mrs. Conrad’s deductions under Prop. Treas. Reg. § 1.280A-2(i)(5)(i)

Amount allowable

Limit on further deductions

Mrs. Conrad’s deductions under Prop. Treas. Reg. § 1.280A-2(i)(5)(ii)

Amount allowable

Limit on further deductions

Mrs. Conrad’s deductions under Prop. Treas. Reg. § 1.280A-2(i)(5)(iii)

Amount allowable

Mrs. Conrad’s disallowed Prop. Treas. Reg. § 1.280A-2(i)(5)(ii) deductions (carryover to 2010)

Mrs. Conrad’s disallowed Prop. Treas. Reg. § 1.280A-2(i)(5)(iii) deductions (carryover to 2010)

$81,267

81,267

91,742

$81,267

81,267

3,885

77,382

$81,267

81,267

3,885

77,382

$81,267

81,267

3,885

77,382

$81,267

81,267

$104,333

104,333

$104,333

104,333

61,983

42,350

70,160

38,465

27,810

$104,333

104,333

61,983

42,350

184,680

42,350

460,115

142,330

460,115

$102,927

$123,965

$61,983

Gross income from rental use under Prop. Treas. Reg. § 1.280A-3(d)(2) before reductions

Reduction for expenditures not allocable to rental use of condo under Prop. Treas. Reg. § 1.280A-3(d)(2)

Gross income from rental use under Prop. Treas. Reg. § 1.280A-3(d)(2) after reduction

Deductions under Prop. Treas. Reg. § 1.280A-3(d)(3)(i)

Amount allowable

Limit on further deductions

Deductions under Prop. Treas. Reg. § 1.280A-3(d)(3)(ii)

Amount allowable

Limit on further deductions

Deductions under Prop. Treas. Reg. § 1.280A-3(d)(3)(iii)

Amount allowable

Disallowed Prop. Treas. Reg. § 1.280A-3(d)(3)(ii) deductions (carryover to 2010)

Disallowed Prop. Treas. Reg. § 1.280A-3(d)(3)(iii) deductions (carryover to 2010)

Schedule A – mortgage interest plus real estate taxes

The IRS’s

alternative

litigating

position

The

Court’s

conclusions

[*67] The top 28 rows of the table for 2009 correspond to the method

used in Proposed Treasury Regulation § 1.280A-2 for applying section

280A to a dwelling unit partly used as an office and partly used as the

taxpayer’s residence. See id. para. (i). The next 13 rows of the table

correspond to the method used in Proposed Treasury Regulation

§ 1.280A-3 for applying section 280A to a dwelling unit partly used for

rental activity and partly used as the taxpayer’s residence. See id.

para. (d).

One major difference between the 2008 and 2009 tables is that

the 2009 table includes a second section corresponding to Proposed

Treasury Regulation § 1.280A-2. This is because the Conrads deducted

some of the residence expenses on Mrs. Conrad’s 2009 Schedule C. The

Conrads did not report these deductions as business-use-of-home

expenses. (They reported the deductions directly on Mrs. Conrad’s

Schedule C rather than indirectly through Form 8829.) The Schedule C

for Mrs. Conrad reported deductions of $48,542 of condominium fees (the

actual condominium fees paid by the Conrads were only $24,271) and

$43,200 for rent for the house. The notice of deficiency determined that

the $48,542 and $43,200 deductions should be disallowed because the

corresponding expenses do not meet the requirements of section

162(a). 43 Because we believe that these expenses are attributable to the

rental use of the residence (in reduced amounts, $12,136 of

condominium fees and $21,600 of rent expense for the house) and are

therefore deductible under section 212(2), we reject the IRS’s argument

that the deductions should be disallowed for their failure to meet the

requirements of section 162(a). However, the IRS’s argument that

section 280A limits the expenses of the condominium and the house

should also be considered. The $12,136 of condominium fees allocable to

the rental portion of the condominium and the $21,600 of rent expense

allocable to the rental portion of the house are the expenses of the

Conrads’ residences under section 280A(a). Therefore, we will analyze

the deductions for condominium fees for the condominium and rent for

43 Mrs. Conrad reported the deduction for condominium fees for the

condominium as an “office expense” and the deduction for rent for the house as “[r]ent

or lease” of “[v]ehicles, machinery, and equipment.” The IRS did not realize that these

two expenses were residence expenses until Dr. Conrad’s testimony at trial. It is

therefore understandable why the notice of deficiency did not disallow Mrs. Conrad’s

Schedule C deductions for condominium fees for the condominium and rent for the

house under section 280A.

[*68] the house under section 280A in order to determine whether the

Conrads can deduct these expenses. 44

The Conrads’ 2009 rental income from FMC

The first numerical row of the table is for Dr. Conrad’s gross

income for professional services. Dr. Conrad’s Schedule C, the notice of

deficiency, and the IRS’s primary and alternative litigating positions all

embrace the view that Dr. Conrad earned $288,000 of professionalservices income during 2009. However, Dr. Conrad testified at trial that

the $104,333 of rent from FMC was reported as part of the $288,000

reported as professional-services income on his Schedule C. This

testimony was credible. We consequently find that the $288,000

reported as compensation for Dr. Conrad’s professional services was

actually composed of (1) $104,333 of rental payments from FMC and

(2) $183,667 (i.e., $288,000 minus $104,333) of compensation from FMC

for Dr. Conrad’s professional services.

Dr. Conrad’s income earned as president of FMC ($183,667) and

Mrs. Conrad’s income earned for accounting services to FMC ($81,267)

are both subject to self-employment tax. The Conrads’ rental income

from FMC, however, is not subject to self-employment tax because the

Conrads are not “real estate dealers.” See § 1402(a). Therefore, the

Conrads overreported Dr. Conrad’s self-employment income by

reporting that the $104,333 of rents received was income of his sole

proprietorship. The parties’ Rule 155 computations will determine how

much self-employment tax the Conrads owe. When making these

calculations, the parties should exclude the $104,333 of rental income

from Dr. Conrad’s self-employment income.

Residence deductions

We now turn to the residence deductions the Conrads claimed for

2009. Section 280A(a) disallows all deductions “with respect to use of a

dwelling unit which is used by the taxpayer during the taxable year as

a residence.” The condominium and the house are dwelling units. See

44 The IRS did not argue that the calculation of the allowable deductions under

section 280A should be done property by property, i.e., once for only the condominium

and once for only the house. This would require the Court to determine the rental

income and expenses attributable to each of the properties. We wi

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