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T.C. Memo. 2002-162
UNITED STATES TAX COURT
LUCIAN T. BALDWIN, III, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
LUCIAN T. BALDWIN, III AND TERESA M. BALDWIN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 18739-95, 24410-95.
Filed June 26, 2002.
Arnold A. Pagniucci, Paul D. Carman, Steven A. Miller,
Austin L. Hirsch, and Henry Pietrkowski, for petitioner Lucian T.
Baldwin III.
John J. Morrison, for petitioner Teresa M. Baldwin.
Marjory A. Gilbert, Catherine Thayer, and Claire McKenzie,
for respondent.
- 2 -
MEMORANDUM FINDINGS OF FACT AND OPINION
MARVEL, Judge:
In these consolidated cases, respondent
determined the following deficiencies, additions to tax, and
penalties in petitioners’ Federal income taxes:
Docket No. 24410-95
Lucian T. Baldwin III and Teresa M. Baldwin:
Year
Deficiency
1988
1989
$418,914
441,563
Additions to tax
Sec. 6653(a)(1) Sec. 6661
$20,946
—
Accuracyrelated penalty
Sec. 6662(a)
$104,729
---
--$88,313
Docket No. 18739-95
Lucian T. Baldwin III:
Year
Deficiency
Accuracyrelated penalty
Sec. 6662(a)
1990
1991
1992
$660,180
627,605
331,541
$132,036
125,521
66,308
All section references are to the Internal Revenue Code in
effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure.
Monetary amounts are
rounded to the nearest dollar.
After concessions,1 the issues for decision are:
1
Respondent has conceded that petitioner Teresa M. Baldwin
(Mrs. Baldwin) qualifies for relief from joint liability under
sec. 6015. Other assignments of error raised in the petitions
and not addressed in the stipulations of settled issues or on
brief are deemed conceded. See Rule 151(e)(4) and (5); Petzoldt
v. Commissioner, 92 T.C. 661, 683 (1989); Money v. Commissioner,
(continued...)
- 3 (1)
Whether Loma Farms, Inc. (LFI), an S corporation owned
by petitioner Lucian T. Baldwin III (petitioner) that purportedly
owned and managed a 5,000-acre lakefront lodge property known as
Granot Loma, operated a trade or business within the meaning of
section 162 or conducted an activity “not engaged in for profit”
within the meaning of section 183;
(2) whether the duty of consistency or the doctrine of
equitable estoppel applies to bar petitioner’s contention that
Baldwin Aircraft Corp. (BAC) was not a valid S corporation during
the years at issue;
(3) if the duty of consistency or the doctrine of equitable
estoppel applies to bar petitioner’s contention, whether BAC
operated a trade or business within the meaning of section 162,
or whether BAC conducted an activity “not engaged in for profit”
within the meaning of section 183;
(4) whether deductions for lodging and travel expenses
claimed by Baldwin Commodities Corp. (BCC), for 1990, 1991, and
1992, are allowable under sections 162 and 274; and
(5) whether petitioner is liable for the additions to tax
and penalties determined by respondent.
1
(...continued)
89 T.C. 46, 48 (1987).
- 4 FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts and supplemental stipulations of facts
are incorporated in this opinion by this reference.
Background
At the time the petitions in these cases were filed,
petitioners, who were married to each other during the years at
issue, were no longer married and resided separately in Winnetka,
Illinois.
Petitioner received his bachelor of science degree from
Santa Clara University.
He subsequently obtained a master of
business administration degree with emphasis in agribusiness.
Petitioner also attended law school for two semesters on a parttime basis.
Petitioners were married in 1978.
They have three children:
Christina, Jane, and Lucian, born in 1982, 1986, and 1987,
respectively.
In September of 1990, petitioners separated, and
in late 1990, a petition for divorce was filed.
In 1993,
following a hotly contested trial involving multiple issues
concerning the ownership of property, a judgment of dissolution
was entered, and petitioners’ divorce became final.
Petitioner’s Bond Trading Activities and Other Business Ventures
Petitioner has been a bond trader at the Chicago Board of
Trade since 1982.
From 1987 through 1989, petitioner traded as a
- 5 sole proprietor under the name of Baldwin Commodities (BC).
In
1990, petitioner incorporated the proprietorship and became sole
shareholder of BCC, an S corporation.
During the years at issue, petitioner was a very successful
trader in the bond pit at the Chicago Board of Trade.
Petitioner’s success was due, at least in part, to his financial
resources, reputation, and relationships with brokers and other
traders in the bond pit.
His financial resources enabled him to
trade with brokers representing institutional clients and other
traders with large volume orders.
In 1987, petitioner earned $19,160,059 from his bond trading
activity.
During the years at issue, the amount of time
petitioner spent in the bond pit decreased as a result of his
marital problems and the divorce litigation, as well as health
problems that followed a plane crash in November 1991.
Petitioner’s income from bond trading during the years at issue
was as follows:
Year
Income
1988
1989
1990
1991
1992
$7,254,066
4,570,760
5,269,504
4,134,403
3,045,776
During the years at issue, petitioner began to diversify his
business and investment interests and formed several new
companies.
For example, in December 1988, petitioner purchased
- 6 the Rookery Building on LaSalle Street in Chicago and formed two
real estate companies, Baldwin Development Corp. (BDC) and
Baldwin Asset Management Co. (BAMCo.), to restore and manage the
Rookery Building.
In May 1989, petitioner incorporated Baldwin
Financial Corp. (BFC).
BFC was registered with the Commodity
Futures Trading Commission as a commodity pool operator and a
commodity trading adviser.
In 1992, petitioner formed a New York
general partnership named MC Baldwin Financial to continue BFC’s
business as a commodity pool operator and commodity trading
adviser.
Granot Loma
During 1986 and 1987, petitioners looked sporadically for a
vacation home.
Petitioner first learned of the existence of
Granot Loma in 1987.
During a family vacation in 1987,
petitioners, accompanied by their children and Mrs. Baldwin’s
brother, Pat Matre, and his family, drove to see the property.
Granot Loma consisted of approximately 5,000 acres,
including 4 miles of Lake Superior shoreline.
There were two
complexes of buildings at Granot Loma, the large log cabin lodge
with its associated outbuildings and the old farm complex.
A
separate small log cabin which was the original depot for the
railroad spur that once serviced the property was also located on
the property.
- 7 The lodge complex was located on Lake Superior and consisted
of the large log cabin lodge, a garage, a child’s playhouse, a
separate building called the maid’s quarters, a carriage house,
and a guest house.
The lodge at Granot Loma had 22 bedrooms
arranged in 10 suites.
Because the lodge was sited on a small
peninsula, many of the lodge’s rooms faced Lake Superior.2
The old farm complex was located down the road from the
lodge complex and consisted of a farmhouse, a caretaker’s house,
a barn, a piggery, a manure house, a slaughterhouse, a creamery
which had been converted to a pool house prior to 1987, and a
pheasant/pigeon house.
The farmhouse and the caretaker’s house
were both habitable residences in 1987.
The garage, pool house,
and depot were the only other buildings in usable condition in
1987.
The remaining buildings were all in need of substantial
repairs, renovation, and cleaning.
The area around Granot Loma was essentially a wilderness
area.
The property was forested and contains mature stands of
hemlock, maple, pine, birch, cedar, spruce, and poplar.
Included
in its acreage was over a mile of frontage on the Little Garlic
2
The lodge was built in the 1920s by financier Lewis Kaufman
in the style of an Adirondack camp. Visitors during the 1920s
and 1930s included Governor Al Smith, actress Mary Pickford, and
the pianist and composer George Gershwin. The deal to build the
Empire State Building was finalized at Granot Loma. By 1987,
however, when petitioner purchased Granot Loma, the grand days of
Granot Loma were long over; no one had lived in the lodge for
decades.
- 8 River, considered to have some of the finest rainbow trout
fishing in the State of Michigan.
Since at least November 1992, Granot Loma’s frontage area
has been zoned for recreational structures, the farm area has
been zoned for rural residential, another area has been zoned for
resource production, and the remaining acreage has been zoned for
timber production.3
Petitioners’ Acquisition of Granot Loma
When petitioners’ family and the Matre family first visited
Granot Loma in 1987, the two families toured the property with
caretaker George Johnson.
During the tour, petitioner, Mrs.
Matre, and Mr. Johnson discussed numerous issues, including the
history and use of Granot Loma, other potential buyers of the
property, and potential business uses of the property, such as
for a corporate retreat.
Mr. Johnson also suggested selective
logging of the valuable maple trees that grew on the property, as
well as other ventures, such as a hunting club that could take
advantage of the property’s natural resources.
When petitioner first viewed the lodge, he thought the
property could be restored to its former grandeur.
Within a few
days of their first visit, petitioners decided to purchase Granot
Loma, and the transaction closed on October 1, 1987.
3
Petitioners
The record does not reflect the types of activities that
would have been allowed by local zoning laws as of the time of
purchase, or how they changed, if at all, through November 1992.
- 9 paid $4,380,000 for Granot Loma and took title to the property as
tenants by the entireties.4
Around the time of Granot Loma’s purchase, petitioner
discussed with Eugene Portman, an attorney who specialized in
real estate law, the creation of several corporate entities to
house several new businesses and investments petitioner was
acquiring in an attempt to diversify his assets.
Mr. Portman
handled Granot Loma’s closing and associated preclosing matters
for petitioner.
On April 14, 1988, Mr. Portman filed articles of
incorporation with the Illinois secretary of state for a company
that was later renamed Loma Farms, Inc. (LFI).
The articles
stated that the company was formed for the purpose of “engaging
in the business of * * * property manager and convention, hotel
and resort manager.”
Petitioner was LFI’s sole shareholder.
Petitioner’s Restoration of Granot Loma
Petitioner engaged Mr. Matre as his general contractor for
the restoration of Granot Loma.
In exchange for Mr. Matre’s
services, petitioner promised him 10 percent of any profit upon
the sale of Granot Loma and free use of the property when space
was available.
4
This amount includes $125,000 paid to George and Carmen
Johnson to purchase the depot property.
- 10 Because petitioner thought he might use Granot Loma as a
lodge or corporate retreat at some point, his plan for the
restoration included commercial amenities.
For example,
petitioner renovated and equipped the kitchen so that up to 150
guests could be accommodated.
Petitioner installed a commercial
bar system which dispensed metered shots of liquor and soda
through hoses from a basement storage area.
Furthermore,
heating, electrical, and other major systems were all built to
withstand and support commercial use.
In many other respects, however, Granot Loma’s restoration
also reflected petitioners’ intent to use it as a personal
residence for their immediate and extended family, their friends,
and other invited guests.
For example, although the renovation
of the kitchen included the installation of commercial grade
equipment and systems, the kitchen was designed so that it easily
could be used by petitioners and their family and friends when
they visited Granot Loma.
Petitioners’ renovation of the kitchen
included a greenhouse addition which was used as a family dining
area.
When Mrs. Baldwin decorated the lodge with help from an
interior decorator, she decorated the lodge to be her family
home.
Thus, the second floor of the lodge housed a nursery, a
children’s play area, a media room, a home office, and a master
bedroom for petitioners, along with several other bedrooms used
- 11 for petitioner’s children, Mr. Matre and his family, and other
regular guests.
Renovation of the lodge began in the spring of 1988 and was
substantially completed by the end of that year.
The lodge,
however, was not habitable until March 1989 when furniture was
first moved into the lodge.
During the renovation period,
petitioner and his family visited on a weekly or biweekly basis
so that petitioner could supervise the contractors and his family
could enjoy the property.
Until the lodge was habitable,
petitioner’s family and Mr. Matre’s family stayed in the
farmhouse.
The cost of capital improvements to Granot Loma from October
1, 1987, through December 31, 1992, totaled $2,504,794.
Petitioners’ Use of Granot Loma
Before acquiring Granot Loma, petitioners took vacations to
various locations around the world, including long trips on
holidays.
From the date they acquired Granot Loma through August
1990, petitioners spent almost every holiday at Granot Loma.
During the years at issue, petitioners and their family
personally used Granot Loma as follows:
Year
Days Used
1988
1989
1990
1991
1992
68
79
71
66
51
- 12 Granot Loma’s most frequent visitors were petitioners, their
children, and other family members.
Other visitors during the
years at issue included personal friends, business associates,
and pilots.
On several occasions, petitioners’ extended families
joined them at Granot Loma.
While at Granot Loma, petitioners and their guests
participated in recreational activities such as riding allterrain vehicles (ATVs), snowmobiling, skiing, hunting, boating,
and fishing.
Petitioners kept two small ATVs at Granot Loma for
their children to ride, and three to four full-size ATVs.
Petitioners also kept snowmobiles at Granot Loma.
When
petitioners first purchased Granot Loma, their children were
young; the children played, swam, rode on ATVs and snowmobiles,
and otherwise participated in normal childhood activities.
Petitioner participated in many activities with his children,
and, even on days when petitioner was out hunting or fishing, the
family ate meals together and played together in the evenings.
Petitioners’ children left toys, bicycles, and clothing at
Granot Loma when they returned to Winnetka.
Petitioners used the
master suite at Granot Loma as their bedroom and office until
they separated.
Mrs. Baldwin left her personal belongings in the
master bedroom when she returned to Winnetka.
After his
separation from Mrs. Baldwin in 1990, petitioner spent many
weekends and holidays with his children at Granot Loma.
- 13 Throughout the years at issue, petitioner insured Granot
Loma as his second residence.
Petitioner also insured all the
recreational vehicles at Granot Loma; i.e., boats, personal
watercraft, and snowmobiles, as his personal property.
Petitioner occasionally discussed investments or other
business matters while at Granot Loma.
Petitioner also
entertained family members and friends with whom he did business,
as well as employees, traders, brokers, and other business
associates, at such events as annual employee weekends and trader
weekends.
From time to time, petitioner investigated possible business
uses for Granot Loma.
For example, in 1989, petitioner decided
to plant Christmas trees on the property.5
Also, in 1989,
following a vicious winter storm, petitioner engaged a logging
company to remove some storm-damaged trees.
Sometime later,
petitioner hired a contractor to conduct a selective timber
harvesting program on a limited trial basis.
5
In approximately
The Marquette County Soil and Water Conservation District
was consulted to determine the optimum locations for planting the
trees. Petitioner rejected the Conservation District’s first
choice for siting the trees, as he wanted to keep that field
available for a runway. Petitioner ultimately decided to plant
the Christmas trees along the driveway, a site not recommended by
the Conservation District. In the year following their planting,
approximately one-half of the newly planted trees died because
their roots had not been clipped prior to planting. The burden
of digging up the dead trees and replanting was deemed to exceed
any expected benefit, so the Christmas tree operation was
abandoned. None of the Christmas trees planted at Granot Loma
ever generated any income.
- 14 1990, Granot Loma’s caretaker and his wife experimented with some
maple syrup equipment they found on the property to tap some of
the maple trees growing on the property and process the sap into
syrup.
They ceased the experiment, however, after the
caretaker’s wife received burns as a result of their activity.
In February 1989, petitioner hired Joseph Ketter as
caretaker and property manager for Granot Loma.
When Mr. Ketter
was hired, he was informed that petitioner intended to use Granot
Loma as a business retreat.
At some point after he was hired,
Mr. Ketter was instructed to issue an invoice in LFI’s name to
one of petitioner’s other corporations each time petitioners, a
member of their family, or one of their friends, business
associates, or guests visited Granot Loma.
For example, the
first invoice for $420, dated March 7, 1989, was addressed to BAC
and covered three nights for two pilots at a rate of $70 per
person per night.
Another invoice, dated August 9, 1989, for
$5,530 was addressed to BCC, reflecting the overnight stays of
petitioner’s employees during the 1989 employee weekend, at the
same rate.
One invoice for $123,285, dated April 23, 1990,6 was
addressed to BCC and retroactively billed BCC for visits by
petitioner, his family, and their guests during 1988, 1989, and
6
Petitioner’s accountant, Mr. DiMaggio, was first contacted
by a representative of the Internal Revenue Service regarding the
examination at issue in this case in April 1990.
- 15 the early part of 1990.
From March 1990 through the end of 1992,
LFI billed BCC for every night petitioner, a member of his
family, one of his business acquaintances, or one of his friends
stayed at Granot Loma.
LFI did not bill any of the guests directly; all invoices
were sent either to BCC, BDC, or BAC.
In fact, almost none of
the guests were even aware that LFI was charging anyone for their
stay.
Even Mrs. Baldwin was not aware of LFI’s invoicing system
until the divorce proceedings commenced.
No rooms at Granot Loma were ever held out to the public for
rent, and no rooms were ever rented to the public.7
No leases or
rental contracts for the rental of Granot Loma were executed by
LFI, any guest, or any of petitioner’s other companies.
Only
petitioner’s relatives, friends, business acquaintances, and
other invited guests used Granot Loma.
In fact, petitioners
decided not to operate Granot Loma as a commercial lodge because
they did not want to curtail their use of the facility or to open
it up for use by guests they had not invited personally.
When Mr. Ketter set the rental rates for Granot Loma, he did
not estimate an occupancy rate, project the frequency of use, or
7
In September 1989, Worth Brown, a resort manager, visited
Granot Loma for the purpose of determining whether Granot Loma
could be operated as a luxury resort. He concluded that it was
possible. Petitioners, however, decided not to commence a bed
and breakfast or other business open to the public because they
did not want to share the lodge with outsiders. Granot Loma was
never operated as a commercial lodge.
- 16 conduct any market studies.
The initial per-night rate of $70
per person purportedly covered lodging and meals and did not vary
by room.
Mr. Ketter increased the per-night rate to $125 per
person in August 1989, to $175 per person on January 1, 1991, and
to $200 per person on January 1, 1992.
Visitors to Granot Loma
enjoyed, for no additional charge, the Disney channel and other
entertainment channels, babysitters, shotgun shells, archery
targets and arrows, dry cleaning, and a variety of other items of
a personal nature.
All of LFI’s purported rental income came from BCC and other
companies owned or controlled by petitioner.
The income,
however, was insufficient to cover LFI’s alleged expenses.
LFI’s
cashflow deficits were funded through a shareholder’s loan
account, thus ensuring that Granot Loma had adequate cashflow to
cover expenses.
BCC paid some of LFI’s invoices by intercompany
account transfers; others were paid by reducing LFI’s
indebtedness to BCC.
In the summer of 1990, petitioners held an auction to sell
off furniture and rugs at the lodge that had not been used in the
restoration.
The auction raised a total of $309,386.
The net
proceeds were applied to reduce LFI’s debt to BCC.8
8
In a stipulation of settled issues, the parties agreed that
petitioner had additional capital gains of $261,889 arising from
the auction sale and that the auction sale proceeds were not
ordinary income to LFI.
- 17 Petitioner’s Attempt To Sell Granot Loma
In 1989, petitioner decided to sell Granot Loma.
His
decision to do so was influenced by his marital problems and a 1day trading loss of approximately $5 million.
In early 1990,
Gary Walker, an appraiser, valued the property in excess of $10
million.
On April 30, 1990, after discussions and negotiations
with several real estate brokers, petitioner listed Granot Loma
with a broker for an asking price of $12 million.
Although the
property generated considerable interest, no reasonable offers
were received.
Petitioner renewed the listing once and then
allowed it to expire during 1991.
On his financial statement dated May 31, 1992, petitioner
reported the value of his interest in LFI as $4,551,888.
During
the pendency of his divorce, petitioner obtained an appraisal of
Granot Loma that valued the fee simple interest in the property,
as of July 28, 1992, at $3,800,000.
That appraisal identified
petitioners as the owners of Granot Loma.
BAC
On May 20, 1988, petitioner purchased a Beechcraft King Air
200 (King Air) and formed BAC to own and operate the King Air.
Articles of incorporation for BAC were prepared and filed in
North Carolina the same day.
On August 24, 1988, BAC traded its
King Air for a Sabreliner jet (the Sabre). Petitioner hired
professional pilots to fly the Sabre.
- 18 BAC’s S Election
Mr. Portman recommended that BAC be owned by Mrs. Baldwin in
order to protect petitioner’s trading business from liability in
the event of an accident and informed petitioner’s accountant
that Mrs. Baldwin would own BAC.
Mr. Portman prepared BAC’s Form
2553, Election by a Small Business Corporation (Under section
1362 of the Internal Revenue Code), and sent the Form 2553 to
petitioner with instructions for Mrs. Baldwin to sign as sole
shareholder.
However, Mrs. Baldwin did not sign the form and did
not consent to BAC’s election to be treated as an S corporation.
Instead, Liz Matre signed Mrs. Baldwin’s name (as consenting
shareholder and as president of BAC) on the form.
Respondent
accepted the facially complete Form 2553 on May 31, 1988.
BAC’s 1988 and 1989 Forms 1120S, U.S. Income Tax Return for
an S Corporation, list Mrs. Baldwin as BAC’s sole shareholder.
BAC’s 1990, 1991, and 1992 Forms 1120S, which were filed after
petitioners’ divorce proceeding had commenced, list petitioner as
BAC’s sole shareholder.
BAC’s Transportation Activity
During the years at issue, petitioner regularly used the
Sabre to transport himself and his family, friends, and other
invited guests to Granot Loma.
In an effort to structure the
operation of BAC as a business, petitioner, beginning in
approximately May 1989, arranged for BAC to invoice one of his
- 19 other companies each time the Sabre was used.
From 1989 through
and including 1992, BAC billed one of petitioner’s companies for
each person transported, using a per capita rate established by
BAC’s president after consultation with petitioner.9
The per
capita rate used to prepare the invoices was increased in 1989,
1990, and 1991 in an effort to reduce BAC’s substantial operating
losses.
BAC claimed depreciation on the Sabre, which was titled in
BAC’s name, and on a Cessna, which was not titled in BAC’s
name.10
Petitioner acquired the Cessna ostensibly so that he
could obtain his pilot’s license and eventually fly the Sabre.
During the years at issue, BAC did not offer the Sabre for
charter by third parties, nor did it lease the Sabre to a third
party; BAC used the Sabre to provide transportation exclusively
to petitioners, their family, and invited guests.
9
After November 1990, BAC did not include passenger names
other than petitioner’s in the aircraft utilization reports and
trip recaps maintained by BAC. In addition, BAC did not maintain
any records regarding the nature of the trips taken on its
aircraft.
10
Record title to the Cessna was apparently held by a
separate corporation, Lucian Aircraft Co., which insured the
Cessna until 1991. Petitioner’s accountant testified that BAC
claimed depreciation on the Cessna because BAC should have owned
the Cessna. Certain records in evidence show that the Cessna was
rented on three occasions during 1990 by people who were or had
been employed as BAC’s pilots.
- 20 Tax Reporting
LFI
On a Schedule F, Farm Income and Expenses, attached to
petitioners’ 1987 Federal income tax return Form 1040,
petitioners represented that Granot Loma was a Christmas tree
farm and claimed a depreciation deduction of $163,781 with
respect to personal property with a book value of $1 million and
improvements with a book value of $2,255,000.
On LFI’s Forms 1120S for 1988 through 1992, LFI reported the
following income, expenses, and net operating losses:
1988
1989
1990
1991
1992
-0-
$16,290
$233,285
$154,373
$124,148
Income:
Lodging
Tree removal
8,135
Auction
Less:
305,567
Refunds
(1,414)
2,936
6,024
-0-
25,947
544,876
154,373
127,148
$284,437
144,996
89,153
80,192
33,908
30,771
12,758
Other income
Total income
3,000
Expenses:
Salaries & wages
Repairs
14,225
Bad debts
9,958
Rents
2,000
Taxes
Depreciation
307,422
Employee benefits
Other expenses
139,297
58,494
80,155
379,204
363,126
314,419
275,043
11,084
375,147
2,856
71,134
301,289
403,580
21,732
6,839
239,342
176,417
Total expenses
967,006
921,932
997,156
754,908
587,976
Net income or (loss)
(967,006)
(895,985)
(452,280)
(600,535)
(460,828)
BAC
On BAC’s Forms 1120S for 1988 through 1992, BAC reported the
following income, expenses, and net operating losses:
- 21 1988
1989
1990
1991
1992
$168,400
$179,406
$109,185
$221,563
$200,390
195,554
109,185
221,563
200,390
Salaries & wages
31,778
48,627
40,260
40,000
Repairs
87,433
12,345
16,208
18,310
17,826
18,694
4,561
3,166
3,612
86,502
322,667
194,240
116,583
108,057
Other expenses
269,890
169,331
374,463
424,697
316,743
Total expenses
364,010
646,656
638,099
603,124
486,238
Net income or (loss)
(195,610)
(451,102)
(528,914)
(381,561)
(285,848)
Income:
Rental income
Other income
Total income
16,148
168,400
Expenses:
Rents (Hangar)
7,618
Taxes
Depreciation
Employee benefits
4,408
108
Accountant’s Role
Throughout the years at issue, petitioner utilized the
services of Victor DiMaggio, a certified public accountant.
Mr.
DiMaggio provided consulting services to petitioner with respect
to LFI and BAC, prepared LFI’s, BAC’s, BCC’s, and petitioners’
tax returns, and helped LFI’s and BAC’s employees set up and
maintain the books and records for those companies.
Mr. DiMaggio
also advised petitioner individually regarding some tax matters.
Petitioner instructed his employees to contact Mr. DiMaggio
directly whenever they had any tax-related questions.
At some point before he prepared petitioner’s 1989 return,
Mr. DiMaggio warned petitioner that LFI and BAC may be activities
not engaged in for profit and that, therefore, the losses
attributable to those activities may be disallowed under section
183.
In addition, in the course of preparing BCC’s tax returns
for the years at issue, Mr. DiMaggio estimated that a substantial
portion of the amounts billed to BCC by LFI and BAC for 1990,
1991, and 1992 were attributable to petitioner’s personal use of
- 22 Granot Loma and the aircraft.
Specifically, Mr. DiMaggio
estimated that 90 percent of the amounts billed in 1990 and 75
percent in 1991 and 1992 by LFI and BAC were attributable to
petitioner’s personal use of Granot Loma and the aircraft.
The Audit and Notices of Deficiency
In April 1990, Mr. DiMaggio was first contacted about the
audit of petitioners’ returns.
In September 1990, Jean Witek,
the revenue agent assigned to audit petitioners’ returns, sent
the initial audit letter to petitioners.
In 1991, during the pendency of petitioners’ divorce case,
counsel for Mr. and Mrs. Baldwin argued in court about which
party owned BAC (the ownership dispute).
Mr. DiMaggio claimed
that Ms. Witek observed these arguments and subsequently referred
to the ownership dispute in conversations with him.11
The audit eventually was completed without any change to
BAC’s S corporation status.
During the appeals process, Mr.
DiMaggio never mentioned the ownership dispute, nor did he raise
any issues concerning the validity of BAC’s S election with any
of respondent’s Appeals officers or other agents.
The protest
documents filed by Mr. DiMaggio represented, indirectly, that BAC
was a valid S corporation; i.e., he maintained that petitioners
were entitled to deduct BAC’s passthrough losses.
11
According to Mr. DiMaggio, he and Ms. Witek agreed to
defer consideration of the ownership dispute until the end of the
audit. Unfortunately, Ms. Witek was unable to complete the audit
because of illness.
- 23 Respondent proposed numerous adjustments in the notices of
deficiency, most of which have been resolved.
For each year at
issue with respect to BAC, respondent disallowed all of BAC’s
expenses and recalculated BAC’s income accordingly, determined
that petitioner must include in his income BAC’s corrected S
corporation income, and allowed petitioner additional Schedule A
miscellaneous deductions in amounts equal to BAC’s corrected S
corporation income, presumably pursuant to section 183(b).12
For
1988, 1991, and 1992 with respect to LFI, respondent disallowed
petitioner’s deductions of LFI’s distributive net losses.
For
1989, respondent disallowed all of LFI’s deductions and
determined that petitioner must include in income LFI’s corrected
S corporation income but did not make any adjustment under
section 183(b) except with respect to Granot Loma’s real estate
taxes.
For 1990, respondent reclassified LFI’s net auction
proceeds as capital gain to petitioner, disallowed all of LFI’s
deductions, and determined that petitioner must include in income
LFI’s corrected S corporation income but did not make any
adjustment under section 183(b) except with respect to Granot
Loma’s real estate taxes.
12
By disallowing petitioner’s deductions of BAC’s losses,
respondent effectively allowed petitioner the adjustment required
by sec. 183(b).
- 24 OPINION
I.
LFI Issues
In a far-ranging and sometimes unfocused attack on LFI,
respondent, in his notices of deficiency, asserted numerous
grounds for disallowing LFI’s deductions and recalculating LFI’s
distributive net income for the years at issue:
(1) Petitioner
has not established the amounts in question were paid or incurred
in a trade or business; (2) Granot Loma was never transferred to
LFI by petitioners and, therefore, LFI is not entitled to
depreciate Granot Loma; (3) petitioner has not established that
he was at risk with respect to LFI; (4) petitioner has not
established that “the activity” was entered into for profit; (5)
petitioner has not established that “the transaction” had
economic substance; (6) petitioner has not established that the
claimed losses were incurred or were otherwise allowable; and (7)
petitioner has not established that “the amounts claimed as
payments were paid, and if paid, were for the purpose as stated.”
Although the parties devoted most of their arguments on
brief to the issue of whether LFI was a trade or business under
section 162 or an activity not engaged in for profit within the
meaning of section 183, the parties also addressed the other
grounds raised in the notices of deficiency as well as an
additional argument under section 280A that was not enumerated
in, or expressly raised by, the notices of deficiency.
Because
we believe that the issue regarding the proper tax treatment of
- 25 LFI’s income, deductions, and losses may be appropriately
resolved by applying sections 162 and 183, we direct our analysis
accordingly.
A.
Sections 162 and 183
Under section 162, a taxpayer may deduct the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on his trade or business.
A taxpayer is engaged in a
trade or business if the taxpayer is involved in the activity (1)
with continuity and regularity, and (2) with the primary purpose
of making a profit.
Commissioner v. Groetzinger, 480 U.S. 23, 35
(1987); Antonides v. Commissioner, 893 F.2d 656, 659 (4th Cir.
1990), affg. 91 T.C. 656 (1988).
Petitioner has the burden of proving that LFI was engaged in
a trade or business and that LFI is entitled to the deductions
claimed.13
Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S.
79 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435
(1934); Welch v. Helvering, 290 U.S. 111 (1933).
If petitioner
fails to establish LFI’s entitlement to the deductions under
13
The Internal Revenue Service Restructuring & Reform Act of
1998, Pub. L. 105-206, sec. 3001, 112 Stat. 726, added sec.
7491(a), which is applicable to court proceedings arising in
connection with examinations commencing after July 22, 1998.
Under sec. 7491, Congress requires the burden of proof to be
placed on the Commissioner, subject to certain limitations, where
a taxpayer introduces credible evidence with respect to factual
issues relevant to ascertaining the taxpayer’s liability for tax.
In the instant case, petitioners have not raised the application
of this provision. Further, the record indicates that the
Commissioner’s examinations commenced before July 22, 1998.
- 26 section 162,14 and fails to show error in respondent’s
determination that LFI was engaged in an activity not for profit,
then section 183 limits LFI’s deductions for expenses
attributable to the activity, as provided in section 183(b).
In order to establish that LFI engaged in an activity for
profit, petitioner must show he entertained an actual and honest
profit objective15 in engaging in the activity, even if that
objective was unreasonable or unrealistic.
Burger v.
Commissioner, 809 F.2d 355, 358 (7th Cir. 1987), affg. T.C. Memo.
1985-523; Surloff v. Commissioner, 81 T.C. 210, 233 (1983);
Dreicer v. Commissioner, 78 T.C. 642, 644-645 (1982), affd.
without opinion 702 F.2d 1205 (D.C. Cir. 1983); sec. 1.183-2(a),
Income Tax Regs.
Although section 183 applies at the corporate
level with respect to the activities of an S corporation, sec.
1.183-1(f), Income Tax Regs., we consider the intent of
petitioner, LFI’s sole shareholder, in deciding whether LFI had
the requisite profit objective, see Eppler v. Commissioner, 58
14
Sec. 183(c) provides that a taxpayer is engaged in an
activity not for profit if the activity is one other than “one
with respect to which deductions are allowable for the taxable
year under section 162 or under paragraph (1) or (2) of section
212.” Petitioner argues for the first time on brief that LFI is
entitled to deduct its expenses under sec. 212 if we conclude
that LFI did not operate a trade or business for profit under
sec. 162. Respondent objects to this argument as untimely raised
and prejudicial. We agree with respondent and decline to
consider petitioner’s argument under sec. 212. Estate of
Gillespie v. Commissioner, 75 T.C. 374 (1980).
15
Petitioner bears the burden of proving that he had the
requisite profit objective. Rule 142(a).
- 27 T.C. 691, 696-699 (1972), affd. without published opinion 486
F.2d 1406 (7th Cir. 1973); Butler v. Commissioner, 36 T.C. 1097
(1961).
In determining whether the requisite intention to make a
profit exists, greater weight is to be given to the objective
facts than to the taxpayer’s self-serving characterization of his
intent.
Dreicer v. Commissioner, supra at 645; sec. 1.183-2(a),
Income Tax Regs.
Section 1.183-2(b), Income Tax Regs., sets
forth a nonexclusive list of factors to be considered in
determining whether the taxpayer has the requisite profit
objective.
The factors are:
(1) The manner in which the
taxpayer carries on the activity; (2) the expertise of the
taxpayer or his advisers; (3) the time and effort expended by the
taxpayer in carrying on the activity; (4) the expectation that
assets used in the activity may appreciate in value; (5) the
success of the taxpayer in carrying on other similar or
dissimilar activities; (6) the taxpayer’s history of income or
loss with respect to the activity; (7) the amount of occasional
profits, if any, that are earned; (8) the financial status of the
taxpayer; and (9) elements of personal pleasure or recreation.
No single factor is determinative, and not all factors are
applicable in every case.
Burger v. Commissioner, supra at 358
n.4; Allen v. Commissioner, 72 T.C. 28, 34 (1979); sec. 1.1832(b), Income Tax Regs.
- 28 Respondent contends that petitioner used Granot Loma as a
residence, and that LFI did not own Granot Loma and did not
operate a trade or business or otherwise engage in any activity
for profit during the relevant years.
As we understand it,
petitioner’s argument is that, from the date petitioners
purchased Granot Loma, Granot Loma was a business asset that
petitioner and then LFI used in one or more business activities
for profit.
The activities that petitioner alleges he or LFI
conducted for profit at Granot Loma include a Christmas tree
farm, a timbering operation, a maple syrup operation, and a
rental activity.
Petitioner also alleges that petitioners and/or
LFI acquired Granot Loma with the intent of renovating and
operating it as a commercial property or selling it for a profit.
For the reasons set forth below, we agree with respondent.
From the time petitioner and his wife purchased Granot Loma
in 1987, petitioner was determined to claim that Granot Loma was
a business and began to deduct Granot Loma’s expenses, initially
for 1987 on a Schedule F, and then through LFI, an S corporation.
For 1988, petitioner, through LFI, claimed deductions for
depreciation of Granot Loma buildings and improvements (including
the lodge which was uninhabitable and in the process of being
renovated), other alleged operating expenses, and some of the
expenses incurred in renovating the lodge, claiming that Granot
Loma was an operating Christmas tree farm.
For 1990 through
- 29 1992, petitioner, through LFI, claimed that Granot Loma was used
exclusively for business, and continued to depreciate Granot Loma
buildings and improvements, to deduct all of Granot Loma’s
alleged operating expenses, and to report as lodging income
amounts paid or credited to LFI by petitioner’s other companies.
On his Federal income tax returns for 1988 through 1992,
petitioner deducted passthrough losses from LFI in the aggregate
amount of $3,376,634.
In support of LFI’s aggressive writeoff of Granot Loma,
petitioner asserts that LFI maintained extensive books and
records, experimented with and abandoned unprofitable activities,
and consulted with various experts regarding the renovation of
Granot Loma as a commercial facility.
Petitioner also contends
that he devoted considerable time and effort to the renovation
and operation of Granot Loma, that he regularly used Granot Loma
for business meetings throughout the years at issue, and that he
intended, among other things, to sell Granot Loma at a profit.
We first examine the activities in which LFI allegedly
engaged in order to ascertain whether any of those activities
were conducted with sufficient continuity and regularity to
satisfy the threshold test for a trade or business.
Petitioner
contends that Granot Loma was the site of an operating Christmas
tree farm, a timbering operation, a maple syrup operation, and a
rental activity.
In connection with the lodge, LFI also sold at
- 30 auction during 1990 various personal property that was not used
in the lodge renovation and claimed the auction proceeds as
business income.
Although there were isolated episodes in which LFI began to
explore possible money-making ventures, these activities never
materialized into a real business venture, either individually or
collectively.
For example, the Christmas tree operation, which
began with the planting of trees in 1989, was abandoned within a
year after the initial planting because over half of the trees
planted had died.
Similarly, the experiment with maple sugaring
was abandoned after LFI’s caretaker’s wife suffered burns during
the processing of the sap.
The timbering operation likewise
never got past the exploratory stage.
The auction was a one-time
sale of excess furnishings that were not used in the renovation
of the lodge and, under the circumstances, was the functional
equivalent of a garage sale, only on a larger scale.
“Carrying
on a trade or business” requires a showing of more than initial
research into or investigation of business potential.
Commissioner, 20 T.C. 511, 513 (1953).
Frank v.
None of the above-listed
activities, either individually or collectively, were conducted
with continuity or regularity and, hence, do not constitute a
trade or business for purposes of section 162.
v. Groetzinger, 480 U.S. at 35.
See Commissioner
- 31 The only activity allegedly conducted by LFI that warrants
detailed examination under sections 162 and 183 is the alleged
rental of the lodge.
Beginning in 1989 and continuing throughout
the remaining years at issue, LFI billed one of petitioner’s
other companies for every night spent at Granot Loma by
petitioners and their family, friends, and business
acquaintances.16
LFI arguably conducted this activity, variously
characterized by petitioner as a rental business or as the
operation of a corporate retreat or lodge, with sufficient
continuity and regularity from 1989 through at least 1992 that an
examination of whether the activity was conducted with the intent
to make a profit is appropriate.
In making the examination, we
apply the factors of section 1.183-2(b), Income Tax Regs.
The factors on which petitioner primarily relies in support
of his argument that petitioner’s and LFI’s use of Granot Loma
was an activity for profit are the manner in which petitioner and
LFI operated Granot Loma, the expertise of petitioner and his
advisers, the amount of time and effort petitioner devoted to
Granot Loma, and petitioner’s expectation that Granot Loma would
appreciate in value and ultimately be sold at an economic profit.
The factors on which respondent primarily relies in support
16
In 1990, after petitioner’s accountant raised concerns
about LFI’s ability to withstand scrutiny under sec. 183,
petitioner arranged for Granot Loma’s caretaker to bill for each
time petitioner, his family, and his guests stayed overnight at
Granot Loma during 1988, 1989, and the early part of 1990.
- 32 of his argument that petitioner’s and LFI’s use of Granot Loma
was not an activity for profit are the substantial history of
losses generated by the alleged business activity, the complete
lack of any profits from the activity over a 6-year period,
petitioner’s financial status during the years at issue, and the
personal pleasure and recreation derived by petitioners from
their use of Granot Loma.
The record in this case reveals that petitioners purchased
Granot Loma and renovated the lodge and other parts of the
property, in part, for possible commercial use in the future.
In
so doing, petitioner consulted with advisers regarding equipment
and systems to be installed in the lodge and around the property
to support commercial use.
The record also reveals, however,
that the renovation was designed to enable petitioner and his
family to use Granot Loma as their residence.
Whatever petitioner’s intention might have been regarding
the operation of Granot Loma as a commercial property at some
point in the future, the evidence convinces us that Granot Loma
was purchased primarily for use as petitioners’ residence and it
was used primarily as a residence; i.e., as petitioners’ vacation
home.
Like any other residence, Granot Loma was used by
petitioners for their own enjoyment and to entertain family,
friends, and business acquaintances.
Occasional entertainment of
petitioner’s business acquaintances, however, does not support a
- 33 conclusion that Granot Loma was used in an activity engaged in
for profit.
While it is certainly true that LFI maintained books and
records of its activities, the record is devoid of any credible
evidence that the books and records were used to make informed
business decisions regarding the operation of a business at
Granot Loma.
See Golanty v. Commissioner, 72 T.C. 411, 430
(1979) (holding that a taxpayer’s books and records should enable
the taxpayer to cut expenses, increase profits, and evaluate the
overall performance of the operation), affd. without published
opinion 647 F.2d 170 (9th Cir. 1981).
LFI did not engage in any
market studies or meaningful research regarding the likelihood of
operating Granot Loma as a commercial lodge for profit.
It did
not set the per capita charges billed to petitioner’s other
companies by analyzing what was necessary to turn a profit or
even by analyzing LFI’s total operating costs.
As best we can
ascertain from the record, LFI made no meaningful effort to
evaluate the cost efficiency of capital expenditures or to cut
the costs of “operating” the lodge.
Neither petitioner nor any of his principal advisers had any
material experience operating a hotel, motel, or other
commercially viable lodging establishment.
Some of petitioner’s
equipment and system suppliers had commercial experience but only
insofar as the design and use of such equipment and systems were
- 34 concerned.
The only person with resort management experience
whom petitioner apparently consulted visited Granot Loma once and
merely opined that the property might be used as a resort
property without any apparent analysis of the pertinent financial
data and without the benefit of any market study into the
feasibility of operating such a resort profitably.
Petitioner has conceded that Granot Loma was never operated
as a commercial resort and that only invited guests stayed there
during the years at issue.
In testimony at trial, that
concession was explained, at least in part, by the admission that
petitioners did not want to open Granot Loma to uninvited guests
because it would interfere with their use of the property.
The
evidence also suggests that, during the years at issue, LFI did
not have the licenses and permits to operate a commercial
facility required under Michigan State law, that Granot Loma was
not insured for business use, and that LFI did not file State
liquor tax returns or collect sales tax on its purported gross
receipts.
Although petitioner vociferously proclaimed throughout
the trial that LFI operated Granot Loma for profit and was a real
business, LFI did not take even the most minimal of steps under
Michigan State law to make its alleged rental activity function
like a real business.
Petitioner argues that LFI made changes in its operation of
Granot Loma to foster profitability.
The principal change he
- 35 cites was the annual increase in the per capita rate charged for
a visit to Granot Loma.
While it is true that LFI increased the
per capita rate on an annual basis from 1990 through 1992, the
increases were not supported by any meaningful economic analysis,
and the rate increases did not have a material impact on LFI’s
profitability.
Petitioner also argues that, when he purchased Granot Loma,
he intended to earn a profit from the property, at least in part,
by renovating and selling it as a commercial property.
Petitioners paid $4,380,000 for the property, invested
approximately $2,500,000 more in renovation costs, and expended
millions more in operating costs from 1987 through 1992.
Petitioner has not convinced us that he purchased Granot Loma
with any intention of selling it at a profit (as opposed to using
it as a residence), or that he seriously believed that any
appreciation in the fair market value of Granot Loma would be
sufficient to offset the cumulative losses and generate a profit.
Petitioner correctly points out that his and LFI’s intention
to make a profit from Granot Loma need not be reasonable, and he
argues that the considerable time he spent working on LFI’s
alleged business activities provides objective support for his
subjective statement of intent.
We reject this argument because,
like much of the evidence petitioner cites in support of his
arguments, the evidence of time spent by petitioner on LFI’s
- 36 alleged business activities is inadequate, ambiguous, and
unconvincing.
For example, although petitioner and his family
made several visits to Granot Loma during the renovation period,
petitioner kept no log or other records of the actual time he
spent on the renovation effort.
Moreover, even if we were
willing to accept petitioner’s undocumented claims of time spent
on the renovation effort, petitioner’s involvement with and
“supervision” of the renovation was completely consistent with
the desire of any homeowner to make informed decisions regarding
the nature and manner of the work to be done and to monitor the
renovation on his home.
The ambiguous nature of petitioner’s
testimony renders petitioner’s testimony unconvincing and not
credible.
Respondent presented a much more compelling picture of the
“reality” of Granot Loma.
In addition to the regular use of
Granot Loma by petitioner and his family, friends, and business
acquaintances, respondent introduced evidence showing the
following:
(1) Petitioner’s accountant “conservatively” concluded that
the vast majority of visits paid for by petitioner’s companies
were for petitioners’ personal use of Granot Loma;
(2) during the years at issue, petitioner was a man of
considerable financial means who earned millions of dollar each
- 37 year from his bond trading activities and who offset his earned
income with over $3,300,000 of LFI’s losses;
(3) petitioner insured Granot Loma as a second residence and
certain personal property at Granot Loma as his personal, and
insurable, property;
(4) LFI did not generate a profit from its alleged operation
of Granot Loma during any year at issue;
(5) petitioners never transferred Granot Loma’s legal title
to LFI; and
(6) petitioner and his family, friends, and business
acquaintances derived considerable personal pleasure from their
use of Granot Loma.
On balance, we conclude that petitioner has failed to prove
by a preponderance of evidence that LFI was engaged in the
conduct of a trade or business under section 162 or that any
activity allegedly conducted by LFI at Granot Loma was an
activity for profit.17
Consequently, we sustain respondent’s
determination that LFI was not engaged in an activity for profit.
B.
Respondent’s Determinations With Respect to LFI for
1989 and 1990
Section 183 disallows all expenses attributable to an
activity not engaged in for profit except as provided in section
183(b).
17
Section 183(b)(1) allows those deductions which are not
Even if we were to reach petitioner’s section 212
argument, we would still conclude on this record that LFI was not
engaged in an activity for profit.
- 38 dependent upon a profit motive, such as interest and taxes.
Section 183(b)(2) allows the deductions that would be allowable
only if the activity was engaged in for profit, but only to the
extent that gross income derived from the activity exceeds the
deductions permitted by section 183(b)(1).
For 1989 and 1990, respondent disallowed all of LFI’s
deductions, determined LFI’s corrected S corporation income, and
adjusted petitioner’s income accordingly.
In so doing,
respondent does not appear to have allowed petitioner any
adjustment for allowable deductions under section 183(b) except
with respect to Granot Loma’s real estate taxes.18
This approach
appears to be inconsistent with the approach taken by respondent
for 1991 and 1992, which effectively allowed petitioner to deduct
LFI’s expenses to the extent of LFI’s income.19
Respondent takes the position that LFI did not own Granot
Loma and, consequently, may not deduct depreciation attributable
to the property.
Respondent also contends that LFI’s other
expenses were not substantiated, that personal and capital
expenditures are not deductible, and that petitioner “failed to
allocate and prove which deductions, if any, are not for personal
18
For each of the years at issue, respondent increased
petitioner’s real estate tax deduction on Schedule A of
petitioner’s Federal income tax returns for the real estate taxes
attributable to Granot Loma, presumably because he determined
petitioner owned Granot Loma.
19
Respondent also disallowed petitioner’s deduction of LFI’s
loss for 1988. However, LFI did not report any income for 1988.
- 39 expenditures”.
Respondent, nevertheless, allows petitioner to
offset LFI’s income with LFI’s expenses for 1991 and 1992, but
not for 1989 or 1990.
Petitioner contends that, although legal title to Granot
Loma was never transferred to LFI, LFI owned a beneficial and
depreciable interest in the property and that LFI should be
allowed to deduct depreciation to the extent provided in section
183(b)(2).
Petitioner relies on several cases for the
proposition that command over property or enjoyment of its
economic benefits marks the real owner for Federal tax purposes.
See Speca v. Commissioner, 630 F.2d 554, 557 (7th Cir. 1980)
(quoting Anderson v. Commissioner, 164 F.2d 870, 873 (7th Cir.
1947)), affg. T.C. Memo. 1979-120; Hang v. Commissioner, 95 T.C.
74, 80 (1990).
Petitioner, however, has failed to convince us
that LFI owned any beneficial interest in Granot Loma.
The
record instead persuasively establishes that petitioners
personally controlled, used, and enjoyed Granot Loma throughout
the years at issue.
Regarding LFI’s other deductions, petitioner did not address
respondent’s argument that those deductions were unsubstantiated.
Ordinarily, a taxpayer is required to substantiate claimed
deductions.
See sec. 1.6001-1(a), Income Tax Regs.
In this
case, the parties did not stipulate that LFI incurred any
expenses and because petitioners introduced no evidence at trial
to prove the nature and amount of LFI’s expenses, we would
- 40 ordinarily hold that petitioner has failed to prove that LFI paid
or incurred any expenses in excess of those allowed by
respondent.
In this case, however, because the notices of
deficiency take what appear to us to be inconsistent positions
with respect to LFI’s expenses20 and, in our view, appear to
acknowledge petitioner’s entitlement to a deduction for a portion
of LFI’s expenses under section 183(b) for 1991 and 1992, we
shall require respondent to make adjustments for 1989 and 1990
under section 183(b) comparable to those made for 1991 and 1992.
C.
The Parties’ Other Arguments
We decline to address the parties’ other arguments regarding
LFI as our holdings under sections 162 and 183 adequately dispose
of the LFI issues raised by the parties.
II.
BAC Issues
In the notices of deficiency, respondent recalculated BAC’s
taxable income by disallowing all of BAC’s expenses and making
certain adjustments to income, increased petitioner’s income by
his distributable share of BAC’s corrected S corporation income,
and allowed petitioner additional miscellaneous Schedule A
deductions to the extent of petitioner’s distributable share of
BAC’s income for each of the years at issue.
20
For example, the notices of deficiency allege generally
that LFI’s losses and/or expenses were not substantiated but
allow petitioner an adjustment under sec. 183(b) for some of the
years at issue.
- 41 In an amendment to petition filed pursuant to a motion for
leave to amend petition that we granted, petitioner alleged that
he was not entitled to BAC’s passthrough losses, reasoning that
BAC did not have a valid S corporation election on file at any
time during the relevant taxable years, and asserted that we
lacked jurisdiction over respondent’s BAC adjustments because
respondent never issued a notice of deficiency to BAC as a C
corporation.
Respondent filed a notice of objection raising the
affirmative defenses of equitable estoppel and the duty of
consistency and an amendment to answer that clarified that he had
not placed the status of BAC as an electing corporation under
subchapter S at issue in the consolidated cases.
Section 1362(a) provides that small business corporations
may elect to be governed by the provisions of subchapter S and to
be taxed thereunder as passthrough entities.
For such an
election to be valid, all shareholders of the corporation, as of
the date the election is made, are required to consent to the
election.
Sec. 1362(a)(2); Wilson v. Commissioner, 560 F.2d 687,
689 (5th Cir. 1977), affg. T.C. Memo. 1975-92.
The parties agree
that Mrs. Baldwin did not sign the Form 2553.
The parties do not
agree, however, as to whether respondent may continue to treat
BAC as an S corporation for the years at issue.
duty of consistency to resolve the dispute.
We examine the
- 42 A.
The Duty of Consistency
The duty of consistency, sometimes referred to as quasiestoppel, is an equitable doctrine that Federal courts
historically have applied in appropriate cases to prevent unfair
Kielmar v. Commissioner, 884 F.2d 959, 965
tax gamesmanship.
(7th Cir. 1989), affg. Glass v. Commissioner, 87 T.C. 1087
(1986); Cluck v. Commissioner, 105 T.C. 324 (1995); LeFever v.
Commissioner, 103 T.C. 525 (1994), affd. 100 F.3d 778 (10th Cir.
1996).
The duty of consistency doctrine “is based on the theory
that the taxpayer owes the Commissioner the duty to be consistent
in the tax treatment of items and will not be permitted to
benefit from the taxpayer’s own prior error or omission.”
v. Commissioner, supra at 331.
Cluck
It prevents a taxpayer from
taking one position on one tax return and a contrary position on
a subsequent return after the limitations period has run for the
earlier year, if such contrary position would harm the
Commissioner.
Id.
This case is appealable to the Court of Appeals for the
Seventh Circuit.
In Kielmar v. Commissioner, supra at 965, the
Court of Appeals for the Seventh Circuit held that a taxpayer is
placed under a duty of consistency when there has been:
(1) A
representation or report by the taxpayer; (2) on which the
Commission has relied; and (3) an attempt by the taxpayer after
the period of limitations has run to change the previous
representation or to recharacterize the situation in such a way
- 43 as to harm the Commissioner.
Because the duty of consistency is
an affirmative defense, respondent bears the burden of proving
that it applies.
Rule 142(a).
From 1988 until approximately 1 month before trial,
petitioner consistently represented to respondent that BAC was an
S corporation.
Petitioner initially caused Form 2553, Election
by a Small Business Corporation, which indicated that Mrs.
Baldwin was BAC’s sole shareholder and that she had the authority
to elect S corporation status for BAC, to be filed on behalf of
BAC.
Petitioner also caused BAC to file Forms 1120S, U.S. Income
Tax Return for an S Corporation, and deducted BAC’s passthrough
losses on his Forms 1040, U.S. Individual Income Tax Return, for
the years at issue.
Petitioner did not inform respondent during
the audit that the validity of BAC’s S corporation election was
an issue.
Petitioner also represented, under oath, in formal
discovery proceedings in this case that BAC was an S corporation.
Petitioner now seeks to repudiate BAC’s S corporation status, in
an effort to deprive this Court of jurisdiction over the BAC
issues and respondent of the opportunity to obtain a ruling on
the BAC issues raised in this case.
Petitioner argues that the duty of consistency does not
apply because respondent has failed to prove that respondent
reasonably relied upon BAC’s S election when issuing the notices
- 44 of deficiency or that respondent suffered any harm as a result of
his reliance.
Petitioner also contends that the duty of
consistency does not apply because petitioner did not
intentionally misrepresent BAC’s S status or even know that BAC’s
S election was improper.
Petitioner’s argument that respondent could not have
reasonably relied upon BAC’s S corporation election when issuing
the notices of deficiency, because respondent knew or had reason
to know the S election was invalid, is based on the testimony of
his accountant, Mr. DiMaggio.
Mr. DiMaggio testified that the
auditing agent, Ms. Witek, became aware of a problem with BAC’s S
corporation election by watching petitioners’ divorce proceeding
in 1991.
Taking Mr. DiMaggio’s testimony in context, it appears that
the problem Mr. DiMaggio described in his testimony involved a
dispute between petitioners regarding the ownership of BAC, not
the validity of its S election.
Even if we were to believe Mr.
DiMaggio’s testimony that Ms. Witek somehow became aware of a
dispute between petitioners regarding the ownership of BAC, we
disagree with petitioner’s conclusion that such knowledge put
respondent on notice regarding a problem with BAC’s S election.
Although petitioners raised an issue regarding which one of them
owned BAC during the pendency of the divorce case, neither
petitioner raised or acknowledged any issue concerning the
- 45 validity of the S election or conceded that the S election was
invalid until approximately 1 month before trial.21
In fact,
petitioner continued to claim that BAC was an S corporation and
to deduct BAC’s losses on his tax returns in 1991 and later
years.22
Because the record contains no credible evidence that
respondent knew or had reason to know that BAC’s S election was
invalid until approximately 1 month before the trial in this
case, we reject petitioner’s reliance argument.
We also reject petitioner’s argument that respondent has not
shown he suffered any harm as a result of petitioner’s
representation.
Petitioner contends that even as a C
corporation, BAC would have no taxable income because BAC’s
deductions exceeded its income for the years at issue.
Petitioner’s argument ignores the fact that respondent disallowed
all of BAC’s deductions, vigorously litigating in a 2-week trial,
among other issues, whether BAC’s activities were engaged in for
profit, whether BAC’s deductions were ordinary and necessary
21
Under sec. 1362, once a valid S election has been made,
ownership of an S corporation may change without adversely
affecting the S election because new owners were not required to
consent to the prior S election. See sec. 1.1362-6(a)(2)(i),
Income Tax Regs.
22
We also note that Mr. DiMaggio’s testimony conflicted with
the objective facts in the record concerning petitioner’s divorce
case. Mr. DiMaggio testified that Ms. Witek learned about a
problem with BAC in 1991 while observing the divorce trial, yet
the trial in the divorce case did not occur until 1993.
- 46 business expenses, whether BAC’s deductions were substantiated,
and whether the claimed losses were passive losses under section
469.
If we were to accept petitioner’s concession and refuse to
apply the duty of consistency, respondent would be deprived of
the opportunity to evaluate BAC’s correct tax status or to
determine the proper tax effect of BAC’s activities for the years
at issue.
This is so, at least in part, because, if BAC were a C
corporation as petitioner contends, the limitations period for
assessing income tax deficiencies at the corporate level would
have expired.
The record reveals that respondent relied on
petitioner’s representations regarding BAC’s S status to his
detriment, and we so find.
Finally, we reject petitioner’s argument that, because he
was not aware of any problem with BAC’s S corporation election
prior to 1998, he did not have personal knowledge of BAC’s failed
S corporation election until after the audit was completed and
the period of limitations had run for the years at issue.
Although petitioner’s argument implies to the contrary, personal
knowledge is not an element of the duty of consistency.
v. Commissioner, 884 F.2d 959 (7th Cir. 1989).
Kielmar
The duty of
consistency may apply to a taxpayer who innocently misrepresents
a fact in a time-barred year and to one who misleads
intentionally.
Beltzer v. United States, 495 F.2d 211, 212 (8th
Cir. 1974); Unvert v. Commissioner, 72 T.C. 807, 816 (1979),
affd. 656 F.2d 483 (9th Cir. 1981).
- 47 Respondent has demonstrated that each of the elements of the
duty of consistency identified in Kielmar v. Commissioner, supra,
exists in this case.
First, petitioner consistently represented
BAC as an S corporation for Federal income tax purposes by filing
Forms 2553 and 1120S and by treating it as a passthrough entity
for tax purposes.
Second, respondent has relied upon these
representations to his detriment by auditing BAC as an S
corporation, making adjustments thereto, and adjusting the income
of BAC’s sole shareholder as if he were a shareholder in an S
corporation.
Third, petitioner has altered his previous
representation that BAC was a valid S corporation during each of
the years at issue in favor of the diametrically opposite
representation that BAC was never a valid S corporation.
This
alteration occurred after the period of limitations on assessment
with respect to BAC’s returns, if BAC were a C corporation, had
expired.
See sec. 6501.
On these facts, we hold that the duty of consistency applies
and that, therefore, petitioner is estopped from claiming that
BAC was not a valid S corporation for the years at issue.
B.
BAC Losses
Because BAC is treated as an S corporation for purposes of
this case, we must next address the substance of the parties’
arguments with respect to BAC.
Respondent contends that BAC did
not conduct a trade or business under section 162 or an activity
- 48 engaged in for profit under section 183 and that, therefore, he
properly disallowed BAC’s expenses and recomputed BAC’s income.
Petitioner asserts that BAC was operated as a trade or business
and that its profit motive is demonstrated by a variety of
factors, including BAC’s effect on the increased profitability of
petitioner’s related businesses.
1.
Activity Not Engaged in for Profit
We have already reviewed the relevant law governing our
analysis under sections 162 and 183 in connection with our
holding regarding petitioner’s deductions of LFI’s losses.
shall not repeat that discussion here.
We
We turn, instead, to our
analysis of whether BAC was a trade or business under section 162
or an activity not engaged in for profit under section 183.
In support of his argument that BAC engaged in its air
transportation activity for profit, petitioner contends that BAC
maintained adequate business records, periodically consulted with
and relied upon experts to operate the activity and to improve
its finances, and regularly increased the per-person fees charged
to its customers to improve its cashflow.
Respondent contends
that BAC was nothing more than a convenient and tax-favorable way
for petitioner and his family, friends, and business
acquaintances to travel to and from Granot Loma and other
vacation sites.
Respondent relies primarily upon BAC’s history
of substantial losses in each of the years at issue, petitioner’s
- 49 financial status and income during the years at issue, BAC’s and
petitioner’s failure to follow the advice of BAC’s president
regarding steps that should be taken to make BAC a profitable
venture, and the substantial personal use of BAC’s aircraft by
petitioner and his invited guests.
Our review of the record in this case confirms that BAC was
not an activity engaged in for profit but rather was an activity
established, structured, and operated primarily for the personal
use and benefit of petitioner.
We reach this conclusion by
applying the factors set forth in section 1.183-2(b), Income Tax
Regs., to the extent pertinent to our analysis, to the relevant
facts established by the record.
After petitioners purchased Granot Loma in 1987, petitioner
decided to purchase the first of two aircraft.
On May 20, 1988,
petitioner purchased a King Air and formed BAC to own and operate
the aircraft.
Sabre.
In August 1988, BAC traded in the King Air for the
Petitioner regularly used BAC’s Sabre to transport
himself and his family, friends, and business acquaintances to
Granot Loma.
In an effort to structure the operation and use of
the Sabre as a business, petitioner arranged for BAC to invoice
one of his other companies each time the Sabre was used.
At no
point during any of the years at issue did BAC offer the Sabre
for charter by third parties or take the steps necessary to
position the Sabre for use in a charter or leasing business.
- 50 Nevertheless, in 1993, petitioner’s accountant represented to
respondent that BAC operated as a charter service, and BAC made
similar representations concerning the nature of its business on
its tax returns.
Although BAC maintained extensive accounting records as well
as separate books of account and a separate checking account, BAC
did not consistently generate invoices to petitioner’s other
companies until May 1989.
After November 1990, BAC did not
include passenger names other than petitioner’s in the aircraft
utilization reports and trip recaps maintained by BAC.
BAC did
not maintain any records regarding the nature of the trips taken
on its aircraft; BAC simply contends that each trip was a
business trip because BAC charged a fee for everyone who used its
aircraft.
The record contains no credible evidence indicating that BAC
ever developed a business plan or that it engaged in any market
analysis before setting its per-passenger rates.
Although BAC
increased its per-passenger rates three times during the years at
issue, the rate increases were implemented without any market
studies in an effort “to successfully withstand any level of IRS
scrutiny”.
BAC did not take any additional steps to increase its
income or reduce its expenses despite advice from both
petitioner’s accountant and David Stubbs, BAC’s pilot and
- 51 president, in June and July 1989 that BAC’s continued losses
could have potentially “disastrous adverse tax effects.”23
The record in this case amply demonstrates that petitioner’s
use of BAC’s aircraft was primarily for personal purposes.
That
fact, combined with BAC’s history of substantial losses which
petitioner used to offset his considerable income from trading
during the years at issue, leads us to the conclusion that BAC
did not engage in its air transportation activity with the intent
of making a profit.
2.
Relationship Between BAC’s Activity and
Petitioner’s Related Businesses
Petitioner asserts that BAC’s profit motive is demonstrated
by the Sabre’s effect on the increased profitability of
petitioner’s related businesses.
Petitioner cites Campbell v.
Commissioner, 868 F.2d 833 (6th Cir. 1989), affg. in part and
23
In a memorandum dated July 7, 1989, to petitioner, Mr.
Stubbs outlined three options for turning BAC into a profit
center. The three options consisted of the manipulation of
company chargeback rates to ensure that BAC was profitable, the
operation of BAC as a charter service, and the implementation of
a timesharing plan with respect to the Sabre. BAC did not
implement any of the proposals. In another memorandum dated
Apr. 20, 1990, Mr. Stubbs expressed continuing concern over BAC’s
reliance on loans from petitioner and BCC to cover BAC’s expenses
and recommended a large increase in the rates charged to
petitioner’s other companies. Mr. Stubbs noted, however, that
FAA restrictions on passenger fees would force BAC to charge
lower fees to outsiders. In response, BAC increased its
intercompany charges from $1,200 per flight hour in 1989 to
$2,100 per flight hour in 1990 and to $2,500 per flight hour in
1991. These rate increases did not eliminate BAC’s losses.
BAC’s losses in 1988 ($195,610), 1989 ($451,102), 1990
($528,914), 1991 ($381,561), and 1992 ($285,848) exceeded $1.8
million in the aggregate.
- 52 revg. in part T.C. Memo. 1986-569, for the proposition that the
“entire economic relationship” of related companies must be
analyzed when making a determination regarding profit motivation.
Petitioner also relies upon several cases holding that the
taxpayer had a bona fide profit motive in what he contends are
similar situations.
See, e.g., Cornfeld v. Commissioner, 797
F.2d 1049 (D.C. Cir. 1986); Horner v. Commissioner, 35 T.C. 231
(1960); Kuhn v. Commissioner, T.C. Memo. 1992-460; Lee v.
Commissioner, T.C. Memo. 1986-294; Louismet v. Commissioner, T.C.
Memo. 1982-294.
The cases cited by petitioner are readily distinguishable
because none of the cases involved an alleged business activity
conducted primarily for the personal benefit of the owner.
For
example, in Campbell v. Commissioner, supra, the Court of Appeals
for the Sixth Circuit held that a taxpayer could deduct losses
from a partnership where the partnership’s only business purpose
was to lease an airplane to a corporation controlled by the
partners of the partnership.
The corporation’s employees and
officers engaged in extensive air travel in furtherance of the
corporation’s business and used the partnership’s airplane to
facilitate that travel.
Despite repeated losses in the
partnership, the Court of Appeals found a profit motive by
considering the overall increase in wealth of the partners
through the corporation, accomplished through the use of
- 53 transportation and communication efficiencies provided by the
partnership airplane.
In addition, the Court of Appeals found
that losses were due, in large part, to the dramatic rise in the
cost of fuel, inflation, and increased interest rates occurring
during the late 1970s and early 1980s.
The Court of Appeals
concluded that profits generated by the corporation through the
use of the partnership’s plane justified a conclusion that the
partnership venture was an activity engaged in for profit.
In contrast to the taxpayer in Campbell, petitioner has not
proven even an incidental benefit to his commodities trading
business or any other business resulting from BAC’s activities.
Petitioner testified that his unparalleled trading success was
due to his relationships with other traders and brokers in the
pit and that his discussions with traders and brokers on the
plane trips to and from Granot Loma enabled him to build close
personal relationships with the brokers and traders.
However,
the objective facts in the record demonstrate that after
petitioner purchased the King Air and organized BAC in 1988,
petitioner’s income from his commodities trading business
steadily decreased.
Also unlike the situation in Campbell, where the plane
leasing partnership was conducted solely to benefit another
business and was wholly dependent upon that business, BAC was
conducted almost exclusively to benefit petitioner personally.
A
- 54 corporation that is operated for the pleasure or recreation of
its shareholders is not engaged in a trade or business.
Intl.
Trading Co. v. Commissioner, 275 F.2d 578, 584 (7th Cir. 1960),
affg. T.C. Memo. 1958-104.
The extensive personal use of BAC’s aircraft by petitioner
and his family, friends, and business acquaintances, coupled with
petitioner’s failure to prove a legitimate economic connection
between his successful commodity trading business and BAC,
convinces us that BAC’s air transportation activity was not an
activity engaged in for profit.
3.
Conclusion
After considering the factors listed in section 1.183-2(b),
Income Tax Regs., we hold that BAC was not engaged in an activity
for profit.
We decline to address respondent’s other arguments
with respect to the BAC adjustments because our conclusion under
section 183 adequately disposes of respondent’s adjustments with
respect to BAC.24
24
Pursuant to sec. 183(b), respondent has allowed petitioner
additional miscellaneous itemized deductions for BAC’s expenses
in amounts equal to BAC’s corrected S corporation income in each
of the years in dispute (before application of the 2-percent
adjusted gross income limitation of sec. 67). Consequently, we
do not separately address the parties’ arguments regarding the
calculation of BAC’s depreciation deduction under sec. 280F or
the ownership of the Cessna that was depreciated by BAC.
- 55 III. BCC Issues
Respondent disallowed lodging and travel deductions in the
amounts of $9,658, $59,174, and $50,651 that BCC claimed on its
1990, 1991, and 1992 returns, respectively.
Respondent alleged
that the deductions were not allowed because they did not meet
the requirements of sections 162 and 274.
Petitioner did not address the BCC adjustments in either his
opening brief or his reply brief.
Consequently, we deem
petitioner to have conceded the adjustments to BCC’s lodging and
travel deductions.
See Petzoldt v. Commissioner, 92 T.C. 661,
683 (1989); Money v. Commissioner, 89 T.C. 46, 48 (1987).
IV.
Penalties and Additions to Tax
A.
Sec. 6661(a) Addition to Tax
For 1988, respondent determined petitioners are liable for
the substantial understatement addition to tax under section
6661.
Section 6661(a) imposes an addition to tax in an amount
equal to 25 percent of any underpayment attributable to such
substantial understatement.
A substantial understatement exists
when the amount of tax required to be shown on a taxpayer’s
return exceeds the amount shown on the return by the greater of
$5,000 or 10 percent of the amount of tax required to be shown on
the return.
282 (1987).
Sec. 6661; Schirmer v. Commissioner, 89 T.C. 277,
- 56 An understatement for purposes of section 6661 does not
include any item for which the taxpayer’s return position was
supported by substantial authority.
Tax Regs.
Sec. 1.6661-3(a)(1), Income
Substantial authority exists when the weight of
authorities supporting the treatment is substantial in comparison
to the weight of authorities supporting contrary positions.
1.6661-3(b)(1), Income Tax Regs.
Sec.
A position that is arguable but
fairly unlikely to prevail in court will not be considered as
supported by substantial authority.
Id.
A case having some
facts in common with the tax treatment at issue does not
constitute authority if the case is materially distinguishable on
its facts.
Sec. 1.6661-3(b)(3), Income Tax Regs.
Petitioner does not rely on any cases which, individually or
collectively, qualify as substantial authority for his reporting
position either with respect to the LFI adjustments or the BAC
adjustments.
Petitioner cites Campbell v. Commissioner, 868 F.2d
833 (6th Cir. 1989), revg. T.C. Memo. 1986-569, for the
proposition that the “entire economic relationship” of related
companies must be analyzed when making a determination regarding
profit motivation.
Petitioner also relies on several cases
holding that the taxpayer had a bona fide profit motive in what
he contends are similar situations.
See, e.g., Cornfeld v.
Commissioner, 797 F.2d 1049 (D.C. Cir. 1986); Horner v.
Commissioner, 35 T.C. 231 (1960); Kuhn v. Commissioner, T.C.
- 57 Memo. 1992-460; Lee v. Commissioner, T.C. Memo. 1986-294;
Louismet v. Commissioner, T.C. Memo. 1982-294.
We agree with
respondent that the cases are not substantial authority in favor
of petitioner’s position because they are all readily
distinguishable.
Sec. 1.6661-3(b)(3), Income Tax Regs.
Section 6661(c) authorizes respondent to waive part or all
of this addition to tax upon a showing by the taxpayer that he
had reasonable cause for the understatement and that he acted in
good faith.
Respondent’s failure to waive the addition to tax
under section 6661 is subject to review only for abuse of
discretion.
Mailman v. Commissioner, 91 T.C. 1079, 1082-1084
(1988); Parsons v. Commissioner, T.C. Memo. 2000-205.
Petitioner did not show that he ever requested a waiver
under section 6661(c) or that respondent ruled on such a waiver.
Even if petitioner had requested a waiver under section 6661(c),
as he seems to suggest, petitioner has not proven he is entitled
to relief under section 6661(c).
We hold that petitioner is liable for the addition to tax
under section 6661 for 1988 if the Rule 155 computation shows a
substantial understatement of income tax.
B.
Sec. 6653(a) Addition to Tax for Negligence and Sec.
6662(a) Accuracy-Related Penalty
For 1988, respondent also determined that petitioner is
liable for an addition to tax for negligence or intentional
disregard under section 6653(a)(1).
For 1989, respondent
- 58 determined that petitioner is liable for the accuracy-related
penalty under section 6662(a), alleging that all of the
underpayment for 1989 “is due to negligence or disregard of rules
or regulations and you have not established that such
underpayment of tax was due to reasonable cause.”
For each of
the years 1990 through 1992, respondent determined that
petitioner is liable for the accuracy-related penalty under
section 6662(a), alleging that all or part of petitioner’s
underpayment of tax for each of the years at issue “is
attributable to one or more of (1) negligence or disregard of
rules or regulations, (2) any substantial understatement of
income tax, or (3) any substantial valuation overstatement”.
As in effect for 1988, section 6653(a)(1) provides that, if
any part of an underpayment of tax is due to negligence or
disregard of rules or regulations, an amount equal to 5 percent
of the underpayment shall be added to the tax.
For purposes of
section 6653(a), negligence is defined as a “lack of due care or
failure to do what a reasonable and ordinarily prudent person
would do under the circumstances”, Neely v. Commissioner, 85 T.C.
934, 947 (1985), and includes “any failure to make a reasonable
attempt to comply with the provisions” of the Internal Revenue
Code (the Code), section 6653(a)(3).
As in effect for 1989, 1990, 1991, and 1992, section 6662(a)
imposes a 20-percent accuracy-related penalty on the portion of
- 59 an underpayment that, as pertinent here, is due to negligence or
intentional disregard of rules or regulations, section
6662(b)(1), a substantial understatement of income tax, section
6662(b)(2), or a substantial valuation misstatement, section
6662(b)(3).25
An underpayment is not attributable to negligence or
intentional disregard, substantial understatement of income tax,
or a valuation misstatement under section 6662 to the extent that
the taxpayer shows that he had reasonable cause for the
underpayment and that he acted in good faith with respect to such
underpayment.
Sec. 6664(c); secs. 1.6662-3(a), 1.6664-4(a),
Income Tax Regs.
To prove he had reasonable cause for an
underpayment, a taxpayer must show that he exercised ordinary
business care and prudence with respect to the disputed item.
United States v. Boyle, 469 U.S. 241 (1985); see also Neonatology
Associates, P.A. v. Commissioner, 115 T.C. 43, 98 (2000).
In
this case, petitioner bears the burden of proving that he is not
liable for the addition to tax under section 6653(a) and the
25
For purposes of sec. 6662(b)(1), negligence is defined to
include “any failure to make a reasonable attempt to comply with
the provisions of [the Code]”, and disregard is defined to
include “any careless, reckless, or intentional disregard.” Sec.
6662(c). For purposes of sec. 6662(b)(2), there is a substantial
understatement of income tax for any taxable year if the amount
of the understatement exceeds the greater of 10 percent of the
tax required to be shown on that year’s tax return or $5,000.
Sec. 6662(d)(1)(A). For purposes of sec. 6662(b)(3), a valuation
misstatement is as defined in sec. 6662(e).
- 60 penalties under section 6662.
Rule 142(a); Richardson v.
Commissioner, 125 F.3d 551 (7th Cir. 1997), affg. T.C. Memo.
1995-554; Accardo v. Commissioner, 942 F.2d 444, 453 (7th Cir.
1991), affg. 94 T.C. 96 (1990).
A taxpayer’s good faith, reasonable reliance on the advice
of an independent professional as to the tax treatment of an item
may establish that the taxpayer was not negligent under section
6653(a) and may satisfy the reasonable cause exception of section
6664(c).
United States v. Boyle, supra; sec. 1.6664-4(b), Income
Tax Regs.
Whether a taxpayer reasonably relied on an independent
and competent professional requires an examination of the facts
and circumstances of his case and applicable law.
1.6664-4(b)(1), Income Tax Regs.
See sec.
The taxpayer must prove: (1)
The adviser was a competent professional who had sufficient
expertise to justify the taxpayer’s reliance on him; (2) the
taxpayer provided necessary and accurate information to the
adviser; and (3) the taxpayer actually relied in good faith on
the adviser’s judgment.
Weis v. Commissioner, 94 T.C. 473, 487
(1990) (citing Pessin v. Commissioner, 59 T.C. 473, 489 (1972)).
In support of his determinations, respondent emphasizes
petitioner’s burden of proof as to the addition to tax and
penalties, lists numerous errors and purported errors on
petitioner’s returns, and asserts that petitioner, with the
assistance of Mr. DiMaggio, concocted an elaborate scheme to
disguise and deduct personal expenditures.
Petitioner contends
- 61 that his deductions were claimed in good faith and pursuant to
his reasonable reliance upon his professional tax adviser, Mr.
DiMaggio, and his lawyers.
Although petitioner places the blame for erroneous reporting
positions on both his accountant and his attorney, petitioner
directs most of the blame to his accountant, Mr. DiMaggio.
Petitioner claims, among other things, that it was Mr. DiMaggio
who decided to treat LFI and BAC as businesses under section 162,
who decided that LFI and BAC met the material participation
requirements of section 469, and who decided to treat BAC as an S
corporation for Federal tax purposes.
Petitioner also claims
that he reasonably relied upon his accountant for all decisions
regarding the proper tax treatment of LFI and BAC.
Mr. DiMaggio testified extensively at the trial in this
case.
Although Mr. DiMaggio admitted that he consulted with
petitioner concerning LFI and BAC, at no point during his
testimony did Mr. DiMaggio admit that he was responsible for the
reporting positions taken on petitioner’s returns with respect to
LFI and BAC.
Mr. DiMaggio’s testimony only reinforces the
impression left by the record as a whole that he did not have
accurate information regarding the use of Granot Loma and the
aircraft and that petitioner intended from the time he purchased
Granot Loma and the aircraft to claim they were business assets
used in a business activity.
For example, although Mr. DiMaggio
never visited Granot Loma during the years at issue, Mr. DiMaggio
- 62 testified that Granot Loma “operated no differently than a
Marriott or a Radisson”.
Mr. DiMaggio also testified that LFI
was operating as a business during 1988 because “people were
staying up there, overnight stays for business purposes.”
In
justifying the decision to depreciate Granot Loma, Mr. DiMaggio
testified that “the property was placed in service from a
business standpoint the minute Mr. Baldwin purchased it”, a
position petitioner consistently espoused throughout the trial
and briefing of this case.
Petitioner was obligated to prove that he gave all pertinent
information necessary to decide the proper tax treatment of
Granot Loma and the aircraft to Mr. DiMaggio.
Mr. DiMaggio’s
testimony leaves us with considerable doubt that petitioner gave
Mr. DiMaggio all of the information necessary to determine
whether and to what extent LFI and BAC were actually operating a
trade or business within the meaning of section 162 or whether
the activities conducted by the corporations were not engaged in
for profit within the meaning of section 183.
Having observed Mr. DiMaggio and petitioner at trial and
heard their testimony, we have no doubt that petitioner was an
important and demanding client of Mr. DiMaggio, that Mr. DiMaggio
wanted to keep petitioner happy, and that Mr. DiMaggio, without
having first received relevant and accurate information, either
concluded or accepted petitioner’s conclusion that LFI and BAC
were legitimate businesses.
Mr. DiMaggio’s apparent willingness
- 63 to treat LFI and BAC as businesses under section 162 and to
ignore his concerns regarding the possible application of section
183 without a healthy degree of skepticism and some meaningful
professional analysis falls short of proof establishing that
petitioner reasonably relied on the informed and studied advice
of a competent tax professional.
We also have considerable doubt whether petitioner acted in
good faith when he signed his tax returns for the years at issue.
Petitioner, an experienced businessman, knew or certainly should
have known that he and his family and invited guests used Granot
Loma and BAC’s aircraft primarily for personal relaxation and
entertainment.
Possessed of such knowledge, petitioner cannot
credibly claim that he signed his tax returns in good faith.
Under the circumstances, petitioner’s attempt to avoid liability
for the additions to tax and penalties by claiming he did not
know any better is ludicrous.
Because petitioner has failed to prove that he was not
negligent under sections 6653(a) and 6662 or that he is entitled
to relief under section 6664(c), we reject petitioner’s arguments
that he should be relieved of the section 6653 addition to tax
and the section 6662 penalties in these consolidated cases.
- 64 V.
Conclusion
We have carefully considered the remaining arguments of both
parties for results contrary to those expressed herein and, to
the extent not discussed above, find those arguments to be
irrelevant, moot, or without merit.
To reflect the foregoing and concessions by both parties,
Decisions will be entered
under Rule 155.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.