UNITED STATES TAX COURT
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T.C. Memo. 2013-11
UNITED STATES TAX COURT
E. BRUCE DIDONATO AND DENISE A. AGNESS DIDONATO, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 10801-09.
Filed January 14, 2013.
Robert John Alter, for petitioners.
Sze Wan Florence Char, Lydia A. Branche, and Marco Franco, for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: Respondent determined deficiencies in petitioners' 2003 and
2004 Federal income tax of $300,324 and $309,547, respectively, and accuracy-
SERVED JAN 14 2013
-2[*2] related penalties under section 6662(a) of $60,065 and $61,909,
respectively.' In an amended answer, respondent asserted a $69,278 increase to
the 2003 deficiency as well as a $13,856 increase to the corresponding accuracyrelated penalty. Both increases stem from a disallowed depreciation deduction for
2003 and recapture of excess depreciation deductions claimed for 1999 through
2002 for an undivided share in an aircraft that petitioner E. Bruce DiDonato
(DiDonato) owned through a limited liability company. In DiDonato v.
Commissioner, T.C. Memo. 2011-153, 101 T.C.M. (CCH) 1739 (2011), we held
through partial summary adjudication that petitioners were not entitled to a
$1,870,000 charitable contribution deduction for 2004 relating to the donation of a
land conservation easement to Mercer County, New Jersey (Mercer County),
because they did not obtain a contemporaneous written acknowledgment of the
contribution as required by section 170(f)(8).2
'Unless otherwise indicated, section references are to the applicable version
of the Internal Revenue Code (Code), and Rule references are to the Tax Court
Rules of Practice and Procedure. Some dollar amounts are rounded.
2More specifically, we held it was not possible for petitioners to obtain such
an acknowledgment in 2004 because the contribution was conditional until at least
December 2005, long after the 2004 year closed. See DiDonato v. Commissioner,
T.C. Memo. 2011-153, 101 T.C.M. (CCH) 1739, 1743 (2011).
-3-
1
[*3] Following petitioners' concession that they are not entitled to a dependency
exemption deduction for DiDonato's father for 2003 and 2004 (subject years), we
decide the following issues:3 (1) whether petitioners underreported by $52,397 the
2004 gross receipts of DiDonato's sole proprietorship optometry practice, Campus
Eye Group (CEG). We hold they did; (2) whethei. petitioners are entitled to
depreciation expense deductions of $29,058 for 2003 and $7,005 for 2004 for a
sport utility vehicle. We hold they are not; (3) wl3ether DiDonato's wholly owned
S corporation, Campus Eye Group, ASC, Inc. (ASC), is entitled to deduct amounts
claimed as employee achievement award expenses of $25,000 for 2003 and
$21,501 for 2004. We hold it is not; (4) whethe ASC may deduct expenses for
conferences and meetings of $69,663 for 2003 and $59,117 for 2004. We hold it
may not; (5) whether DiDonato's wholly owned S corporation, Campus Eye
Group ASC, Inc. (ASC), is entitled to deductions of $217,518 for 2003 and
$262,745 for 2004 for the lease of a fractional interest in an aircraft. We hold it
may not; (6) whether petitioners are entitled to deduct rental expenses of $549,203
for 2003 and $477,501 for 2004 relating to two residential properties DiDonato
owned. We hold they may to the extent stated herein; (7) whether petitioners are
3We also deem the parties to agree, as respondent determined in the notice
of deficiency, that petitioners are entitled to a $3,000 capital loss deduction and
additional deductions for self-employment taxes due for each of the subject years.
-4[*4] entitled to deduct losses of $694 for 2003 and $19,994 for 2004 they claim
were incurred in connection with a limited liability company's aircraft leasing
activity. We hold they may to the extent stated herein; (8) whether for 2003
petitioners must recapture excess depreciation claimed with respect to their aircraft
leasing activity for 1999 through 2002. We hold they must; and (9) whether
petitioners are liable for accuracy-related penalties for substantial understatements
of income tax. We hold they are.4
FINDINGS OF FACT
I.
Preliminaries
Some facts were stipulated and are so found. The stipulated facts and the
exhibits submitted therewith are incorporated herein by this reference. Petitioners,
husband and wife, resided in New Jersey when the petition was filed. They have
two children: R.D. (age seven in 2003) and D.D. (age five in 2003).5
4Because we conclude there was a substantial understatement of income tax
for each year at issue, we need not consider respondent's alternative positions that
petitioners are liable for accuracy-related penalties due to negligence or disregard
of rules or regulations or substantial valuation misstatement under sec. 6662(a)
and (b)(1) and (3). See sec. 1.6662-2(c), Income Tax Regs.
5The Court refers to minor children by their initials. See Rule 27(a)(3).
-5[*5] II.
Petitioners
A.
DiDonato
DiDonato completed his undergraduate stu ies at Widener University, and
he holds a doctorate in optometry from the Penns lvania College of Optometry
(now part of Salus University). He interned at the National Naval Medical Center
Hospital in Bethesda, Maryland. During the years at issue DiDonato was a
practicing optometrist, the owner and operator of an ambulatory surgical center, an
investor in stocks and bonds, and the owner of various commercial and residential
properties. He frequented many social clubs durisig the subject years, including
the Leash, the Philadelphia Club, and the Nassau Club.
B.
Ms. DiDonato
Petitioner Denise A. Agness DiDonato (Ms. DiDonato) attended St. John
Fisher College in Rochester, New York (Rochest r), and she graduated from the
Pennsylvania College of Optometry with a docto ate in optometry. During the
years at issue Ms. DiDonato was a staff optometrist with CEG who oversaw
billing and administration for that entity. Ms. DiDonato was also the corporate
-6[*6] secretary for ASC.6 At all relevant times, Ms. DiDonato had family who
resided in the greater Rochester area.
III.
The Prior Audit
.
,
DiDonato's (or petitioners') 1995 and 1996 Federal income tax returns,
neither of which is at issue here, were selected for examination in or about 1997
(prior audit). The Internal Revenue Service (IRS) audited those returns, and in
particular, investigated whether DiDonato was a qualifying real estate professional
entitled to deduct losses related to his rental real estate activities. The IRS
determined in the prior audit, the findings of which are not binding in the instant
case, that DiDonato was a qualifying real estate professional during 1995 and
1996. The record does not establish the extent to which (if at all) DiDonato's real
estate activities during the subject years paralleled his real estate activities in 1995
and 1996.
IV.
Overview of Petitioners' Activities Reported on the 2003 and 2004 Returns
Petitioners timely filed joint Federal income tax returns for 2003 (2003
return) and 2004 (2004 return). Each of the 2003 and 2004 returns reported items
6Although testimony elicited at trial indicated that Ms. DiDonato was
CEG's corporate secretary, we decline to conclude she was because CEG is not
organized as a corporation. Because Ms. DiDonato declined to appear at her own
trial. we do not have the benefit of her testimony on this point.
-7[*7] of income and expense from CEG, ASC, Equipment Leasing, L.L.C.
(Equipment Leasing), and Mallard Property Mana ement Group (Mallard).
V.
CEG and ASC
A.
CEG
CEG is a multidisciplinary eye care practice that DiDonato has owned and
operated since September 1981. CEG was organized as a sole proprietorship
during the subject years, though it was later organ zed as a limited liability
company of which DiDonato was the sole member. For each of the subject years
petitioners reported CEG's income and expenses n Schedule C, Profit or Loss
From Business.
During the years at issue CEG used the services of approximately 30
optometrists, 20 independent contractors, and 50 Åtaff employees.7 The
optometrists, independent contractors, and employees serviced patients in the
areas of neuroophthalmology, eye surgery, corned service, ocular implants,
optometry, and medical management of eye disease, in addition to other services.
7An optometrist is a doctor of optometry s ecializing in the examination and
diagnosis of eye diseases, visual conditions, and similar disorders. By contrast, an
ophthalmologist is a medical doctor specializing in eye and vision care trained to
(in addition to other skills) perform eye surgeries. While New Jersey recognizes
optometry as a profession, N.J. Stat. Ann. sec. 45:12-1 (West 2009), optometrists
are not necessarily permitted to practice medicinë and perform surgeries, see id.
sec. 45:12-9.7.
-8[*8] The optometrists who associated with CEG owned roughly 52 affiliated
offices that used CEG's offices to see patients.
B.
ASC
ASC is an ambulatory surgical center that DiDonato incorporated in 1990.
DiDonato is ASC's sole shareholder and president. Since its inception, ASC has
elected to be treated as a small business corporation (S corporation) for Federal
income tax purposes and filed for each year at issue Form 1120S, U.S. Income Tax
Return for an S Corporation. DiDonato did not receive from ASC a regular
biweekly salary, but he received from ASC a cash distribution at the end of each
year.8 Petitioners reported DiDonato's distributive share of income and loss from
ASC on Schedules E, Supplemental Income and Loss, attached to the 2003 and
2004 returns.
During the subject years, ASC had, in addition to its employees, between
five and seven consulting ophthalmologists staffed as independent contractors.
8Respondent does not assert, and we do not decide, whether the distributions
were compensation to DiDonato on which ASC owed employment taxes. Sm
eg, Joseph M. Gray Public Accountant, P.C. v. Commissioner, 119 T.C. 121,
129-130 (2002)(sole shareholder and president of an S corporation was a
corporate employee for whom the corporation was liable to pay employment taxes
under sec. 3121(d)(1)), aff'd, 93 Fed. Appx. 473 (3d Cir. 2004); see also David E.
Watson, P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), cert. denied, _U.S.
_, 133 S. Ct. 364 (2012).
[*9] Each ophthalmologist, a board certified medical doctor, was paid
approximately $100,000 annually, supposedly for services he or she performed as
a director of ASC.9 Each doctor allegedly handle varying aspects of ASC's
regulatory environment in exchange for the fee, purportedly for ensuring
accreditation under the Accreditation Associatioi for Ambulatory Health Care,
managing risk, giving testimony at depositions, a d overseeing the purchase of
new equipment and implantable devices. The re ord does not establish the extent
to which (if at all) the recipients actually performed these functions during the
subject years or at any other time.
The ophthalmologists performed patients' surgeries at ASC's facilities. The
ophthalmologists then billed their patients' third party payors (i.e., insurance
provider or Medicare) for services provided. At he same time, ASC billed the
same third-party payor for facility services such as operating room usage, the
labor, and implanted devices, in addition to othe charges.
90ne doctor who has the title of associate medical director received $48,000
per year for purportedly overseeing the purchas of new medical equipment and
implantable devices. Although we.may refer to ne or more of the
ophthalmologists as directors, we render no opinion as to whether he or she
actually provided nonmedical services to ASC.
- 10 [*10] C.
Relationship Between CEG and ASC
CEG's and ASC's businesses were sizable; in the aggregate they handled
roughly 30,000 patients during the subject years. ASC's patients came to it in one
of two ways.1° First, ASC's ophthalmologists received referrals through CEG.
Second, ASC's ophthalmologists performed surgeries for their patients at ASC's
facility.
Trial testimony made clear that the line of demarcation between CEG's and
ASC's practices was at times unclear. CEG and ASC mostly (if not entirely)
operated out of different suites within the same office complex. In that regard,
ASC paid to CEG for each subject year a facility fee for ASC's use of five office
1°DiDonato expressed concern at trial over whether ASC's relationship with
its medical directors (who doubled as surgeons) violated the Stark Act, 42 U.S.C.
sec. 1395nn, and/or the Anti-Kickback Act, 42 U.S.C. sec. 1320a-7b. In this
regard, DiDonato testified that during the years at issue he sought out the advice of
a law firm in Washington, D.C. (Washington), to review ASC's activities as they
related to the Stark Act and the Anti-Kickback Act. The Stark Act prohibits
medical providers and hospitals from presenting claims to Federal healthcare
programs where those claims are the result of referrals from physicians with whom
the medical provider has a financial relationship. See 42 U.S.C. sec. 1395nn(a)
(2006). The Anti-Kickback Act imposes criminal liability on anyone who, among
other prohibited acts, knowingly and willingly solicits or receives any
remuneration (including a kickback, bribe, or rebate) to induce an individual to
make referrals for services that may be covered by a Federal health care program.
See 42 U.S.C. sec. 1320a-7b(a) and (b). Because any potential violations of these
laws are not at issue in this civil tax case, we do not address them here. Nor do we
address whether the physician "director" fees of $100,000 each annually were for
services actually rendered.
- 11 [*11] suites. ASC claimed deductions for rents df $600,944 for 2003 and
$668,092 for 2004. In addition, CEG paid, on behalf of ASC, payroll and payroll
taxes of $204,650.13. Respondent allowed these payroll and payroll taxes as
offsets to CEG's 2004 gross receipts."
D.
DiDonato's Attempted Sale of ASC
During the subject years DiDonato investigated the possibility of a sale of a
majority of his shares of ASC stock to a venture icapital firm or a small cap
investor." In furtherance of such a stock sale, I)iDonato engaged Michael Witter
or his firm (among others) to f'md a suitable buyer. One potential buyer, a public
company, had in or around 2003 offered to purchase a 51% stake in ASC for $33
million. DiDonato opted to not sell his shares of ASC stock during the subject
years though at trial he testified that he intended to sell his shares of ASC stock for
$105 million in the summer of 2013.
"Respondent reflected his allowance for payroll and payroll taxes paid by
CEG for the benefit of ASC as an "adjusting entry" to CEG's gross receipts. The
record does not explain why respondent allowed this offset.
"We decide that DiDonato intended to structure the sale of ASC as a stock
sale and not an asset sale because, as he testified, he was offered $33 million for a
51% majority interest (i.e., stock interest) in AS;C. The record does not suggest
that DiDonato pursued the sale of ASC's assets at any time. We note that Barry
Concool (sometimes, Dr. Concool) was a business associate of DiDonato who was
involved, to an extent, in discussions regarding DiDonato's possible sale of ASC
to the public company.
- 12 [*12] VI.
A.
CEG's Controverted Income
Overview
Petitioners, relying on a trial balance printed at 2:20 p.m. on December 31,
2004 (2004 trial balance), reported gross receipts of $5,161,984 on CEG's 2004
Schedule C, Profit or Loss from Business.13 Respondent determined on audit of
the 2004 return that CEG's gross receipts for that year should be increased to
$5,214,381; i.e., an increase of $52,397. We summarize now the relevant facts
related to this adjustment.
B.
CEG's Purchase of Surgical Supplies for Itself and ASC
During the subject years, CEG purchased surgical supplies for its use and
that of ASC. From January 1, 2004, through 2:20 p.m. on December 31, 2004,
ASC "paid" $1,877,193 to CEG for the use of surgical supplies from January
through November 2004. At some point after 2:20 p.m. on December 31, 2004,
ASC "paid" $65,364.23 to CEG for the use of surgical supplies during December
2004. The $65,364.23 was not included in CEG's 2004 gross receipts. The record
is not clear whether amounts ASC paid for surgical supplies were actual transfers
of cash by check or otherwise or whether the payments were simply bookkeeping
entries adjusting intercompany obligations.
13CEG did not close for business until 5 p.m. on December 31, 2004.
[*13] C.
General Ledgers and Trial Balances
CEG and ASC at all relevant times employed a full-time in-house
accountant to keep the companies' books and rec!ords. During the years at issue,
CEG used proprietary software programs from which an individual could generate
general ledgers and trial balances and print hard copies thereof. CEG coded
accounts for "Contributed Capital--ASC" and "Contributed Capital" with account
Nos. 4500 and 4700, respectively. Both contributed capital accounts (i.e., account
nos. 4500 and 4700) refer to payments from ASC to CEG for ASC's use of
surgical supplies CEG purchased that were to be|included when calculating CEG's
gross receipts. Respondent determined that all amounts credited to account nos.
4500 and 4700 should be included in CEG's gross receipts. However, DiDonato
testified at trial that a portion of those amounts ( 54065,364.23)
was nontaxable
capital contributions.
D.
Conflicting Trial Balances
The parties have stipulated three CEG trial balances for the 2004 year: the
2004 trial balance, one dated August 21, 2006 (2006 trial balance), and the third
dated November 14, 2011 (2011 trial balance). As relevant here, the 2006 and
2011 trial balances each consistently included a credit (charge) to CEG's account
No. 4700 for $65,364.23 relating to ASC's payment to CEG for the use of surgical
- 14 [*14] supplies. The 2004 trial balance, on the other hand, omits entirely the
$65,364.23 capital contribution recorded under account No. 4700.
E.
Respondent's Determination of CEG's Gross Receipts
Respondent redetermined CEG's 2004 gross receipts on the basis of the
2006 or 2011 trial balance or both by making three adjustments. Using CEG's
patient fees as a starting point, respondent first increased CEG's gross receipts by
$1,877,193 to reflect payments from ASC for the purchase of surgical supplies
through 2:20 p.m. on December 31, 2004. Second, respondent increased CEG's
gross receipts by $65,364.23 to reflect payments from ASC for the purchase of
surgical supplies after 2:20 p.m. on December 31, 2004. Third, respondent
reduced CEG's gross receipts by $204,650.13 to reflect payroll and payroll taxes
CEG paid for the benefit of ASC. To summarize, respondent determined CEG's
2004 gross receipts as follows:
Patient fees
From ASC (surgical supplies)
From ASC (surgical supplies)
Adjusting entries (payroll and payroll taxes)1
Total
$3,476,473.98
1,877,193.00
65,364.23
(204,650.13)
5,214,381.08
iThe adjusting entries relate to CEG's payment of payroll and payroll taxes
for the benefit of ASC.
- 15 [*15] VII.
A.
CEG's Controverted Deductions
Overview
Petitioners claimed depreciation expense deductions of $29,058 and $7,005
for a GMC Yukon Denali (Denali) on CEG's respective 2003 and 2004 Schedules
C. Respondent disallowed each of these deductions because, according to him,
petitioners did not establish the vehicle was usedjin a trade or business.
B.
The Denali and CEG's Transportation Services
CEG and ASC, in addition to offering optömetric and surgical services, also
provided to patients transportation to and from the companies' facilities. During
the subject years, CEG employed between two and four full-time drivers and a few
part-time drivers and sometimes called upon staff or a limousine company to drive
patients as needed. CEG and ASC owned multiple vehicles to transport patients,
including two vans, one minivan, and the Denali (collectively, transport vehicles).
Each of the transport vehicles was kept at ASC's parking lot when not in use.
CEG at all relevant times maintained logs of its patients' appointments and
denoted in the log whether a patient was transported from CEG during a particular
visit by inserting a "T" on the comment line of the log. The logs do not indicate
which of CEG's vehicles was used to transport the patient, the patient's home
address, the pickup or dropoff location, or the distance the patient was driven.
- 16 [*16] VIII. ASC's Controverted Deductions
A.
Overview
Respondent disallowed various expenses ASC claimed as trade or business
expense deductions on its Forms 1120S, including: (1)"employee achievement"
awards paid to Mr. Witter and DiDonato Builders/Developers, Inc. (DiDonato
Builders), (2) expenses for conferences and meetings, and (3) lease payments to
Equipment Leasing.
B.
Employee Achievement Awards
1.
DiDonato Builders
ASC had a relationship with DiDonato Builders, a general contractor
business owned by DiDonato's cousin, Vincent DiDonato (Vincent). On each of
September 12 and October 10, 2003, DiDonato Builders invoiced ASC (and ASC
paid to Vincent) $12,500 for a "bonus per agreement". The parties have stipulated
that neither petitioners nor ASC has a written agreement purporting to entitle
DiDonato Builders to the $12,500 payments, and DiDonato testified at trial that
the agreement was oral.
ASC claimed a $44,385 total deduction for employee achievement awards
on its 2003 Form 1120S. Respondent disallowed $25,000 of the $44,385
deduction for employee achievement awards paid to Vincent.
- 17 [*17]
2.
Firearm Purchase
ASC claimed a $37,501 deduction for employee achievement awards on its
2004 Form 1120S. Respondent disallowed $21,501 of the $37,501 deduction for a
firearm DiDonato purchased in the United Kingdom for £11,250 ($21,501) on
February 10, 2004. DiDonato gave the firearm to Mr. Witter in connection with
investment advisory services related to the prospéctive sale of DiDonato's shares
of ASC stock. The parties stipulated that the only document petitioners provided
to substantiate ASC's entitlement to deduct the cost of the firearm was an
American Express statement indicating that ASC paid for the firearm.
C.
Conferences and Meetings
ASC claimed expenses of $69,663 for 2003 and $59,117 for 2004 for
conferences and meetings as other deductions on its Forms 1120S. More
specifically, ASC claimed a staff meeting expense deduction for each of the
following expenses for 2003:
Item
1
2
3
4
5
6
Date
1/10/03
1/27/03
1/27/03
2/28/03
3/1/03
3/11/03
Payee
Covert & Moore
Grand Island Lodge
MBNA Bank
Davis & Boring
Good Old Days
The Leash
Amount
$840.00
1,361.25
3,382.92
11,234.20
4,375.00
601.06
7
8
5/4/03
3/9/03
Musky
Amwell Valley Conservancy
657.50
2,500.00
- 18 [*18] 9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
3/20/03
3/31/03
5/4/03
4/24/03
5/23/03
5/23/03
7/17/03
6/12/03
8/6/03
8/6/03
8/11/03
9/30/03
9/30/03
10/2/03
10/10/03
10/16/03
10/22/03
12/14/03
12/14/03
12/27/03
12/21/03
Nassau Club
MBNA Bank
Muskyl
The Retail Company
Musky
Amwell Valley Conservancy
The Leash
The Leash
Philadelphia Club
The Leash
River's Edge Restaurant
The Leash
Nassau Club
DiDonato
Grand Island Lodge
The Leash
River's Edge Restaurant
Philadelphia Club
Atlantic Indian
River's Edge Restaurant
Davis & Boring
150.00
752.28
657.50
2,605.00
713.15
2,000.00
1,004.78
117.45
2,000.00
596.55
1,200.00
34.76
500.00
2,767.37
7,000.00
857.25
3,918.75
50.00
135.00
4,350.00
10,000.00
IWe note that items 7 and 11 are in the same amount, bear the same invoice
number, and bear the same check number.
ASC also claimed staff meeting expense deductions for 2004 as follows:
Item
Date
Payee
Amount
1
2
3
4
5
6
7
8
9
1/30/04
1/30/04
2/28/04
3/02/04
3/18/04
3/30/04
4/7/04
5/8/04
5/7/04
Philadelphia Club
Grand Island Lodge
American Express
Davis & Boring
The Leash
Musky
Musky
Musky
The Leash
$2,501.87
1,590.24
1,806.34
13,198.30
481.76
2,543.35
1,288.20
823.13
107.00
- 19 [*19] 10
11
12
13
14
15
16
17
18
19
20
21
22
23
6/24/04
7/2/04
7/12/04
7/13/04
7/23/04
9/15/04
9/20/04
10/4/04
10/7/04
10/19/04
11/6/04
11/8/04
11/19/04
11/22/04
The Leash
Amwell.Valley Conservancy
Nassau Club
.
The Leash
M&M
Philadelphia Club
Nassau Club
Nassau Club
Grand Island Lodge
Amwell Valley Conservancy
River's Edge Restaurant
Nassau Club
The Leash
Philadelphia Club
208.37
2,000.00
2,875.00
1,642.41
1,032.50
2,000.00
50.00
500.00
8,500.00
50.00
4,355.00
775.00
116.23
329.60
24
25
26
27
28
29
30
11/27/04
12/6/04
12/6/04
12/7/04
12/20/04
12/20/04
12/23/04
River's Edge Restaurant
Nassau Club
Atlantic Indian
Marsilio's
Philadelphia Club
Philadelphia Club
DiDonato
4,355.50
50.00
135.00
318.00
1,798.86
100.00
2,810.50
.
Respondent disallowed in full each of the deductions for conferences and
meetings. The parties have stipulated that the disallowed deductions relate to
"purported meals and entertainment expenses for.ASC's employees and staff."
The parties also have stipulated that ASC provided to respondent copies of
canceled checks and invoices from the establishments that provided the services
deducted as the only documents to substantiate tlie expenses. Finally, the parties
have stipulated ASC did not maintain logs recording the members of its staff who
were present at the events or the business purpose of the expense, if any.
- 20 [*20] D.
Lease Payments
1.
Equipment Leasing
Equipment Leasing, L.L.C. (Equipment Leasing), is a New Jersey limited
liability company that DiDonato formed in 1999 for purposes of holding a partial
ownership interest (aircraft share) in a Cessna Citation V Ultra aircraft (aircraft).
The aircraft is a jet with a crew of two pilots and can hold between seven and eight
passengers. DiDonato is Equipment Leasing's sole member, and petitioners
reported his share of Equipment Leasing's income and expenses for the subject
years on Schedules C attached to the 2003 and 2004 returns.
2.
ASC's Lease of the Aircraft
On August 3, 1999, Equipment Leasing entered into a purchase agreement
with Executive Jet Sales, Inc., d.b.a. Net Jets (Net Jets), for a 6.25% undivided
interest in the aircraft for $375,000. Equipment Leasing in turn leased the aircraft
share to ASC. Equipment Leasing did not engage in any business activity other
than leasing the aircraft share to ASC.
3.
ASC's Policy Regarding and Personal Use of the Aircraft
ASC had adopted a policy, which it did not follow, that the aircraft was to
be used for business purposes only. Under the terms of the policy, DiDonato had
to authorize any use of the aircraft, and any time DiDonato or Ms. DiDonato was
- 21 [*21] on the plane, use of the aircraft was require 1 to be authorized by one or more
of ASC's other executives. In practice, however, the aircraft was frequently used
by petitioners and their children for personal reasons, or in connection with the
sale of DiDonato's shares of ASC stock. As to thþ personal use of this aircraft,
one log for a flight in March 2003 (described mode fully below) stated petitioners'
video preferences as Barney and Thomas, ostensibly referring to the popular
children's characters, Barney the dinosaur and Thomas the train. The same flight
log also stated petitioners' in-flight meal selection as chicken finger dinner to
serve two children. We infer that the children reférred to on the flight log were
petitioners' children.
On one occasion in 2004 ASC used the air raft to transport one of its
doctors, Harmon Stein (Dr. Stein), to his home in East Hampton, New York (East
Hampton), on the Friday of the Labor Day holiday weekend, purportedly so Dr.
Stein could perform surgeries on the same day at ASC's office in New Jersey (Dr.
Stein had wanted to return to his home earlier that day). In this regard, petitioners
joined Dr. Stein on the outbound flight to East Hampton. The return flight, which
departed hours after the outbound flight landed, had petitioners as its sole
passengers. The lapse of time between when the utbound flight landed and the
return flight departed, coupled with petitioners' presence on the return flight,
- 22 [*22] suggests that the aircraft was used to transport petitioners to Dr. Stein's East
Hampton home. The record does not explain the business purpose, if any, for
petitioners' joining Dr. Stein on the outbound portion of this trip.
4.
The Cost for Using the Aircraft Share
Equipment Leasing paid an upfront fee of $375,000 for the aircraft share,
and it incurred a monthly management fee of an unspecified amount. In addition,
Equipment Leasing incurred an hourly rate of $1,400 to $1,500 per hour the
aircraft was in use (without a charge for deadhead time). DiDonato estimated the
all-in cost of the aircraft (i.e., inclusive of financing costs, the management fee,
and the hourly rate) to be approximately $4,000 per hour. While the cost for each
of petitioners' flights during the years at issue is not clear from the record, a oneway flight on this aircraft from New Jersey to Washington cost around $3,000.
5.
Petitioners'Travels
Petitioners traveled to the following destinations on the aircraft on the
following dates during 2003:
Tlig
Date
1
i
1
2
Thursday, 3/13/03
Tuesday, 3/18/03
Tuesday, 3/18/03
Friday, 4/4/03
2
Tuesday, 4/8/03
Origin
Destination
Miles
Passengers'
Trenton, NJ
Orlando, FL
Homestead, FL
Trenton, NJ
Orlando, FL
Homestead, FL
Trenton, NJ
Key West, FL
897
210
1,069
1,156
Petitioners & children
Key West, FL
Trenton, NJ
1,156
Petitioners, Mr. Witter & 1
unknown individual
Petitioners & children
Petitioners & children
Petitioners, Mr. Witter & 1
unknown individual
- 23 [*23] 3
Trenton, NJ
Washington, DC
168
Sunday, 4/27/03
Washington, DC
Trenton, NJ
168
Tuesday, 6/3/03
Trenton, NJ
Miami, FL
1,047
4
Tuesday, 6/10/03
Miami, FL
Trenton, NJ
1,047
5
Tuesday, 7/15/03
Trenton, NJ
New London, CT
162
5
Tuesday, 7/15/03
New London, CT
Trenton, NJ
162
6
Friday, 8/15/03
Trenton, NJ
Rochester, NY
246
6
Sunday, 8/l 7/03
Rochester, NY
Trenton, NJ
246
7
Thursday, 8/21/03
Trenton, NJ
Ukiah, CA
2,592
7
Tuesday, 8/26/03
Ukiah, CA
Trenton, NJ
2,592
8
Thursday, 9/18/03
Trenton, NJ
Wichita, KS
1,215
8
Thursday, 9/18/03
Wichita, KS
Las Vegas, NV
998
8
Sunday, 9/21/03
Las Vegas, NV
Trenton, NJ
2,200
9
Monday, 10/13/03
Trenton, NJ
245
9
Monday, 10/13/03
245
10
10
Tuesday, 11/4/03
Friday, 11/7/03
Charlottesville,
VA
Trenton, NJ
Jacksonville, IL
Charlottesville,
VA
Trenton, NJ
Jacksonville, IL
Trenton, NJ
818
818
3
Sunday, 4/27/032
·
Petitioners, Dr. Holt & 1
unknown individual
Petitioners, Dr. Holt & 1
unknown individual
DiDonato, Dr. Holt & another
individual to discuss the sale
of ASC
DiDonato, Dr. Holt & another
individual to discuss the sale
of ASC
DiDonato & 2 or 3 individuals
whose relationship to ASC is
not clear from the record
DiDonato & 4 individuals
whose relationship to ASC is
not clear from the record
Ms. DiDonato & 2 unknown
individuals
Ms. DiDonato & 2 unknown
individuals
DiDonato, Mr. Witter & 2
individuals whose
relationship to ASC is not
clear from the record
DiDonato, Mr. Witter & 2
individuals whose
relationship to ASC is not
clear from the record
DiDonato, Dr. Stein, 2 ASC
doctors & 1 individual whose
relationship to ASC is not
clear from the record
DiDonato, Dr. Stein, 2 ASC
doctors & 1 individual whose
relationship to ASC is not
clear from the record
DiDonato, Dr. Stein, 2 ASC
doctors & 1 individual whose
relationship to ASC is not
clear from the record
DiDonato & 4 unknown
individuals ;
DiDonato & 4'unknown
individuals
DiDonato & Mr. Witter
DiDonato & Mr. Witter
lOur statement of the identity of the passengers on each flight is derived primarily from the Net Jets flight
logs, as informed by DiDonato's testimony. Where we refer to a passenger as an "unknown individual", we do so
because the record does not specify the person's name or relationship to petitioners.
- 24 [*24] 2DiDonato testified that the purpose of this Sunday trip to Washington was to meet with DiDonato's lawyers
for an afternoon seminar on "health care issues." Leo Holt (Dr. Holt) is not an employee or staff member of ASC,
CEG, or DiDonato. The flight log for this flight, as well as for the return flight, states that a fourth individual was on
the aircraft, but that person.is not identified in the record.
PetitionerS traveled to the following deStinationS uSing the aircraft on the
following dateS in 2004:
T!rig
Date
12ay
Origin
Destination
Miles
701
701
895
895
1,061
1,208
246
246
168
Passengers'
1
1 ,
2
2
3
3
4
4
5
Tuesday, 2/17/04
Friday, 2/20/04
Friday, 2/27/04
Sunday, 2/29/04
Wednesday, 3/24/04
Sunday, 3/28/04
Wednesday, 4/7/04
Saturday, 4/10/04
Thursday, 4/8/04
Trenton, NJ
Atlanta, GA
Trenton, NJ
Columbus, MS
Trenton, NJ
Nassau, Bahamas
Trenton, NJ
Rochester, NY
Trenton, NJ
Atlanta, GA
Trenton, NJ
Columbus, MS
Trenton, NJ
Nassau, Bahamas
Trenton, NJ
Rochester, NY
Trenton, NJ
Washington, DC
5
Thursday, 4/8/04
Washington, DC
Trenton, NJ
168
6
Thursday, 5/20/04
Trenton, NJ
Washington, DC
168
6
Thursday, 5/20/04
Washington, DC
Trenton, NJ
168
7
7
8
Thursday, 5/27/04
Sunday, 5/30/04
Thursday, 8/12/04
Trenton, NJ
Key West, FL
Trenton, NJ
Key West, FL
Trenton, NJ
Saratoga Springs,
NY
1,206
1,156
198
8
Saturday, 8/14/04
Saratoga Springs,
NY
Trenton, NJ
198
9
9
10
Thursday, 8/26/04
Saturday, 8/28/04
Friday, 9/3/042
Trenton, NJ
Washington, DC
Washington, DC
168
168
143
10
Friday, 9/3/04
East Hampton,
NY
Trenton, NJ
East Hampton,
NY
Trenton, NJ
Petitioners
Petitioners
DiDonato & Mr. Witter
DiDonato & Mr. Witter
Petitioners & children
Petitioners & children
Ms. DiDonato & children
Ms. DiDonato & children
DiDonato & 1 unknown
individual
DiDonato & 1 unknown
individual
DiDonato & 4 individuals
whose relationship to
ASC is not clear from the
record
DiDonato & 4 individuals
whose relationship to
ASC is not clear from the
record
DiDonato & Mr. Witter
DiDonato & Mr. Witter
DiDonato & 2 individuals
whose relationship to
ASC is not clear from the
record
DiDonato & 2 individuals
whose relationship to
ASC is not clear from the
record
Petitioners & children
Petitioners & children
Petitioners & Dr. Stein
143
Petitioners
Trenton, NJ
- 25 [*25] I I Wednesday, 9/8/04
Trenton, NJ
Las Vegas, ÍNV
2,200
11
Saturday, 9/11/04
Las Vegas, NV
Trenton, NJ
2,200
12
12
Thursday, 10/7/04
Monday, 10/11/04
Trenton, NJ
Rochester, NY
Rochester, NY
Trenton, NJ
246
246
DiDonato, at least 2 ASC
doctors, and as many as 3
individuals whose
relationship to ASC is
not clear from the record
DiDonato, at least 2 ASC
doctors, and as many as 3
individuals whose
relationship to AsC is
not clear from the record
Ms. DiDonato & children
Ms. DiDonato & children
Our statement of the identity of the passengers on each flight is derived primarily from the Net Jets flight
logs, as informed by DiDonato's testimony.
2This trip occurred over the Labor Day holiday weekend.
6.
Flight Logs and Manifests
Net Jets provided to Equipment Leasing flight logs for the use of the aircraft
during the subject years. The parties have stipulated that the only written records
maintained by ASC, the lessee, to substantiate tlie business purpose for the use of
the aircraft during the subject years were Net Jets travel logs and invoices, and
copies of brochures and registration materials of various eye care conferences.
The travel logs specified the date, origin and destination of the flights, flight
distance, and flight and travel time and included a passenger manifest listing the
number and names of passengers on the flight, as well as any onflight services and
postflight transportation arrangements. However, some passenger manifests
- 26 [*26] included discrepancies between the number of passengers on the flight and
the listed names."
7.
Federal Income Tax Reporting of the Aircraft Share and
Respondent's Proposed Adjustments
a.
Equipment Leasing
Petitioners claimed accelerated depreciation expense deductions totaling
$278,950 on Equipment Leasing's 1999 through 2002 Schedules C. In addition,
petitioners reported losses from Equipment. Leasing for the years at issue as
follows:
Item
Gross receipts
Less:
Other expenses
Repairs and maintenance
Depreciation
Interest expense
Income (loss)
2003
2004
$217,518
$262,745
91,582
177,039
64,320
67,872
43,200
19,110
(694)
21,600
16,228
(19,994)
"For example, the travel log for the trip to Orlando, Florida (Orlando), from
March 13 through 18, 2003 (Orlando flight), stated that four passengers were on
the plane, yet the manifests listed petitioners as the only passengers on the flight.
At trial, following question from the Court on the point, DiDonato acknowledged
that his children were on the Orlando flight. As another example, the passenger
manifests for the trip to Rochester, New York (Rochester trip), stated that three
passengers were on the plane, yet Ms. DiDonato was the only passenger listed.
- 27 [*27] Respondent disallowed the loss deductions in full because, as he determined
in the notice of deficiency, petitioners had not established that such expenses were
incurred, paid, or ordinary and necessary business expenses of Equipment
Leasing. Alternatively, respondent determined th t the loss deductions were not
allowed because Equipment Leasing had not.esta lished that its leasing activity
was a bona fide business venture entered into for profit or that the substantiation
requirements of section 274 had been met.
b.
. ASC
.
ASC, the lessee of the aircraft share, claimèd equipment leasing expense
deductions on its Forms 1120S of $217,518 for 2Ô03 and $262,745 for 2004.
Under the alternative depreciation system of section 168(g), the aircraft share was
depreciable under the.straight-line method with a recovery period of 12 years.
Respondent disallowed ASC's claimed equipment leasing expense deductions in
their entirety and increased petitioners' distributi e share of income from ASC
accordingly.
IX.. The Personal Residence and Mallard's Real Estate Activities
A.
Overview
DiDonato's réal estate activities, with the xception of his ownership of his
personal residence and two office suites he owned through CEG, operated under
- 28 [*28] the Mallard trade name." DiDonato, individually or through Mallard,
owned various properties in New Jersey during the subject years. First, he owned
his personal residence at 273 Cold Soil Road (personal residence), approximately
89 acres in size. Second, he owned two other residential rental properties on Cold
Soil Road: 245 Cold Soil Road (245 Cold Soil property), and 265 Cold Soil Road
property (265 Cold Soil property).16 The acreage of the personal residence and the
245 and 265 Cold Soil properties, as DiDonato testified at trial, totals roughly 250
acres. The 245 and 265 Cold Soil properties are each adjacent to the personal
residence; and according to a map included with the record, the personal residence
was situated between the 245 and 265 Cold Soil properties. Third, he owned
seven suites in an office building in Hamilton, New Jersey (Hamilton), as well as
two additional commercial rental properties." During the subject years,
petitioners reported the income and expenses of nine real estate properties on
isThe record is not clear whether Mallard was a separate company or simply
a trade name through which DiDonato operated his rental real estate activities.
Nor does the record include documentary evidence indicating that Mallard owned
legal title to the properties in question. The parties stipulated, and we so find, that
petitioners used the Mallard trade name to manage many of DiDonato's rental
properties.
16The tOtal aCreage Of these properties is not clear from the record.
"Five of the suites operated under the Mallard trade name and two of the
suites were annarently owned hv CEG.
- 29 [*29] Schedules E attached to the 2003 and 2004 eturns;;namely, the 245 and 265
Cold Soil properties, fives suites in the Hamilton ffice building, and as explained
below, the two additional commercial rental properties. With the exception of the
245 and 265 Cold Soil properties and one of the office suites, DiDonato leased to
ASC the rental properties reported on Schedules E attached to the 2003 and 2004
returns.
B:
.
Mallard's Books and Records
Mallard maintained books and records for tl e subject years. The books and
records omitted rental income purportedly received for the 245 and 265 Cold Soil.
properties. At the same time, the books and records reported rental income from
each of the nine other properties Mallard-purporte ly managed. Notwithstanding
the fact that Mallard's books and records do not sh >w it received rental income
from the 245 and 265'Cold Soil properties, petitioners reported annual rental
income of $9,600 from each of the 245 and 265 Cold Soil properties. The parties
have stipulated petitionérs do not have copies of a y canceled checks showing
they received payments of rent for either the 245.C ld Soil property or the 265
Cold Soil property during either of the subject year .
- 30 [*30] C.
The Personal Residence
Beginning in August 1997 and continuing through at least December 2001,
DiDonato was granted several construction permits for his personal residence.
Specifically, DiDonato received permission to build a 28,948-square-foot singlefamily residence with 5 bedrooms, 11 bathrooms, 4 fireplaces, a 4-car garage, a
heated driveway and/or walkway, and an inground pool measuring 28 by 80 feet
as well as other improvements.18 DiDonato Builders was named on the permits as
the contractor for the personal residence. During the time of the examination of
the 2003 and 2004 returns, in or around early 2006, the personal residence had a
large, power-operated gate with security cameras and stone-lined driveway.
D.
245 and 265 Cold Soil Properties
1.
Overview
DiDonato, recognizing the opportunity to develop the lots adjacent to the
personal residence, acquired the 245 and 265 Cold Soil properties during the
early-to-mid-1990s. The record is not clear as to whether these properties are
titled in the name of DiDonato or in the name of Mallard. Petitioners conducted
'8The square footage of the personal residence was initially set at 16,652,
though permits included in the record proposed to increase it to 28,948 feet. We
understand a permit for installation of a snow-melting system at the personal
residence to mean a heated driveway and/or walkway.
- 31 [*31] "farming activities" on the 245 and 265 Cold Soil properties, allegedly
including the buying and selling of colts, pheasants, and cows.'' As DiDonato
testified at trial, the "farming activities" were carried on to maintain the farm
designation on the properties and "to save money on [his] property taxes." For the
most part, if not entirely, petitioners deducted the expenses related to their "farm"
operation as repair and maintenance expenses related to the 245 and 265 Cold Soil
properties. DiDonato paid the property taxes on the 245 and 265 Cold Soil
properties, and he included in the payments on those properties a portion of the
real estate taxes due on the personal residence not immediately clear from the
record.
2.
Sale of Development Rights
DiDonato sold property rights in the personal residence and the 265 Cold
Soil property during 1997 and 1998. In 1997 he sold to Lawrence Township for
$50,182 development rights on.a portion of the 265 Cold Soil.property by which
he agreed to preserve a portion of the property as farmland; i.e., to not develop the
property for residential purposes. In 1998 DiDonato sold to Mercer County for
19Ne refer to petitioners'"farming activitieá" as "allegedly" conducted
because petitioners did not report any farming income on the 2003 and 2004
returns. Nor is the record clear whether the alleged "farming activities" were
performed by DiDonato,
- 32 [*32] $822,003 development rights on portions of his personal residence and the
265 Cold Soil property by which he agreed to restrict his use of those properties.
We note that DiDonato also transferred to Mercer County, New Jersey,
development rights on the 245 Cold Soil property discussed more fully in our prior
opinion in this case. See DiDonato v. Commissioner, 101 T.C.M. (CCH) at 1739-
1741.
3.
Rental Agreements20
The evidence includes a rental agreement reciting that DiDonato leased to
his father for $800 per month "the dwelling" located at the 265 Cold Soil property
during the years at issue. Included in this rent were utilities at an average monthly
cost of $400. The 2003 and 2004 returns each responded "No" to a question on
Schedules E asking whether a member of petitioners' family used any properties
reported on that schedule for personal purposes for the greater of 14 days or 10%
of the total days rented at fair market value. DiDonato testified that he answered
the question this way because he did not consider his father a member of his
family.
20We render no opinion as to whether either rental agreement discussed in
this section was entered into at arm's length.
- 33 [*33] The evidence also includes a rental agreeñient reciting that DiDonato leased
to Matthew Richen, whose relationship to DiDoñato is not clear, for $800 per
month "the dwelling" located at the 245 Cold Soil property. Like the rental for the
265 Cold Soil property, the rent included utilities at an average monthly cost of
$400. During 2003 and 2004, when the dwelling houses of the 245 and 265 Cold
Soil properties were respectively leased to DiDonato's father and Mr. Richen,
DiDonato made major improvements to the land surrounding the dwelling houses.
4.
Improvements to the 265 Cold Soil Property
Respondent's revenue agent examined the 2003 and 2004 returns in March
2005. At or around that time, on two occasions, the revenue agent toured the
personal residence, the 245 Cold Soil property, and the 265 Cold Soil property.
The tours allowed the revenue agent to learn that the single-family residence
associated with the 265 Cold Soil property had not been substantially improved
despite DiDonato's contrary representation. Substantial improvements had been
made, however, to the barn and land of the 265 Cold Soil property, including the
building of ditches, swales, and bridges.
As will shown to be relevant, the revenue agent observed that the driveway
to the 265 Cold Soil property was not protected by;a gate and that the 245 Cold
Soil property had a dirt gravel road for a driveway with no structures placed
- 34 [*34] thereon. The 265 Cold Soil property contained a single-family residence, a
large barn, a small barnlike structure, several smaller structures, and a chicken
coop. The large barn had several horses in it and one of the other structures
contained machinery. The 245 Cold Soil property contained a single-family
residence, a barn, a chicken coop, and a structure that was being used as a hunting
lodge. There was a double line of trees running across the entire length of the
personal residence and the 245 and 265 Cold Soil properties.
5.
Purported Rental Expenses
Petitioners submitted thousands of pages of receipts, purchase orders, and
invoices, purporting to substantiate expenses Mallard allegedly incurred in respect
of DiDonato's rental properties. Some expenses were claimed to be exempt from
New Jersey sales tax because Mallard had completed a Form ST-7, Farmer's
Exemption Certificate." Other purchase orders explicitly referenced that the work
to be performed was to be completed at the personal residence; namely, electrical
N.J. Stat. Ann. sec. 54:32B-8.16 (West 2002) provides: "Receipts from
sales of tangible personal property and production and conservation services to a
farmer for use and consumption directly and primarily in the production, handling,
and preservation for sale of agricultural or horticultural commodities at the
farming enterprise of that farmer are exempt from the tax imposed under the 'Sales
- 35 [*35] work, installation of a security gate, the rental of dumpsters, and equipment
for the construction of a swale (i.e., a wetland)."
Included among the expenses claimed by petitioners as deductions for
repairs and maintenance of the 245 and 265 Cold Soil properties (or both) were
the following: $2,300 for a room at the Carlyle Hotel in New York, New York,
over the New Year's Day holiday; $374 to a toy store on December 15, 2003; a
barbecue grill; a scarecrow motion-activated sprinkler; a security system; a
lightning protection system; a farm gate; pool paint; dog food; fish food; toilet
paper; 44 poinsettias; 75 strands of garland; ice scrapers; a salt lick for "Lucky";
equine shampoo; alfalfa cubes; cracked corn; chicken feed; clover seed; 136 bales
of hay; hundreds of spruce, fir, and pine trees; flowers; grass seed; 42 live plant
stalks of corn; 110 live pumpkin plants; poultry wire; and 3 signs stating a
waterway was a "Private Streamway", in addition to many others. Suffice it to
say, some expenses were personal, others concerned the status of the 245 and 265
Cold Soil properties as farms, and many bore no apparent relationship to the rental
of the dwelling houses of the 245 and 265 Cold Soil properties.
"While the individual who delivered the dumpster and equipment for the
swale listed the address to which the work related as the personal residence,
DiDonato Builders referenced the property to which the expenses related as being
for DiDonato generally at "Cold Soil Road".
- 36 [*36]
6.
Expenses Reported on the 2003 and 2004 Returns
The parties stipulated Mallard's books and records included all of the
purported expenses of the 245 and 265 Cold Soil properties which petitioners
claimed as deductions on the 2003 and 2004 returns. Mallard's books and records
do not, however, show that Mallard received any rental income with respect to
either the 245 Cold Soil property or the 265 Cold Soil property.
Petitioners claimed the following income and expense items on Schedule E
of their 2003 Form 1040:
Item
245 Cold Soil Property
265 Cold Soil Property
Income
Rental income
Expenses
$9,600
$9,600
Advertising
Insurance
Legal
Mortgage interest
Repairs
Taxes
Utilities
Other
Depreciation
Net loss
148
3,703
6,689
93,199
95,944
5,590
2,898
17,158
18,886
234,615
-03,703
3,765
46,912
161,324
50,090
4,836
17,670
16,688
295,388
Petitioners claimed the following income and expense items on Schedule E
of their 2004 Form 1040:
- 37 [*37] Item
245 Cold Soil Property
Income
Rentalincome
Expenses
Advertising
Insurance
Legal
Mortgageinterest
Repairs
Taxes
Utilities
Other
Depreciation
Netloss
E.
265 Cold Soil Property
$9,600
$9,600
-04,237
. -082,171
105,200
5,853
3,414
20,698
26,641
238,614
50
6,024
5,357
45,945
48,925
51,081
3,056
7,176
61,683
219,697
Commercial Rental Properties
Respondent did not determine adjustments with respect to DiDonato's (or
Mallard's) commercial rental properties, though we summarize the related rental
activities for completeness and clarity.
DiDonato owned seven office suites in an office building in Hamilton,
referred to as A-1, A-2, A-3, A-4, A-5, B-1, and B-2 (collectively, Hamilton office
complex). CEG owned and occupied building A-1 (CEG office). CEG leased to
ASC buildings A-2, A-3, A-4, A-5, B-1, and B-2 (collectively, ASC offices).
DiDonato also occupied building A-5 for purposes of keeping a personal office,
conference room, and secretarial center. He also claims to have "managed" his real
estate out of building A-5. DiDonato never offered the ASC offices for rent to any
- 38 [*38] party other than ASC and did not advertise them for rent to any other party.
On Schedules E attached to the 2003 and 2004 returns, petitioners reported rents
from the ASC offices totaling $530,391 and $529,513, respectively. ASC claimed
corresponding deductions on its 2003 and 2004 Forms 1120S. DiDonato also
owned two additional rental properties which are not at issue in this proceeding.
X.
Tax Advice
A.
Overview
DiDonato has used the tax and accounting services of Amper, Politziner &
Mattia, LLP (Amper), since at least 1997 when the firm represented him in the
prior audit. Staff at Amper prepared the 2003 and 2004 returns. Paul Dougherty, a
certified public accountant and tax lawyer with 25 years' experience, supervised
the preparation of and reviewed the 2003 and 2004 returns. Mr. Dougherty also
provided petitioners with various tax advice for the years at issue. Petitioners
obtained from Amper separate written tax advice with respect to DiDonato's 1995
real estate activities and Equipment Leasing's ownership and operation of the
aircraft.
B.
Rental Real Estate Activities
On June 28, 1995, Amper provided to DiDonato an opinion letter (real
estate opinion) addressing various aspects of DiDonato's real estate activities. As
[*39] relevant here, the real estate opinion reflected a "will" comfort level that the
conservation easement contribution would yield aicharitable contribution deduction
on DiDonato's individual return." The real estate opinion, without specifying the
property to which the expenses related, opined that DiDonato "will" be able to
"depreciate the building and take all the related expenses." The real estate opinion
went on to state that the author of the letter had not fully researched the proper tax
treatment of rent-free occupancy of rental properties. The remainder of the
opinions reached in the real estate opinion are so general as to have no usefulness
for our discussion.
C.
Aircraft Advice and Reporting Positions
1.
Aircraft Letter
On June 16, 1999, Amper provided to DiDonato a letter (aircraft letter)
stating its recommendation on how to structure the ownership and operation of the
fractional share. The aircraft letter, less than two full pages in length, began by
recognizing DiDonato's intention to purchase thd aircraft share for "business and
personal purposes." After some general advice on owning the aircraft share
"In tax parlance there are a number of different "comfort levels" at which
an opinion letter can be issued. An opinion issued at the "will" level (as compared
with the "should" or "more likely than not" levels) is generally the highest level of
comfort. See Robert P. Rothman, "Tax Opinion Practice", 64 Tax Law. 301, 311-
319 (2011).
- 40 [*40] through Equipment Leasing, the aircraft letter advised DiDonato that
personal use of the aircraft by him or his employees would be considered a fringe
benefit includible in the gross income of the individual using the aircraft. The
letter further advised DiDonato that Equipment Leasing's operating and
management expenses may be limited due to personal use. Although the aircraft
opinion concluded the use of the aircraft would be deductible by ASC as a travel
expense, it did not address whether ASC's lease of the aircraft was an ordinary and
necessary business expense. DiDonato did not secure any additional written tax
advice on the aircraft share after 1999.
2.
DiDonato's Misstatements to Amper
Amper approved petitioners' claimed deductions for use of the aircraft share
because, as DiDonato explained to Mr. Dougherty or his staff, the aircraft was not
used for personal travel.24 Neither Mr. Dougherty nor his staff reviewed the flight
logs in connection with their preparation of the 2003 and 2004 returns. Mr.
Dougherty acknowledged at trial that had he known that petitioners' children were
on board the aircraft during the subject years, his firm would not have taken the
reporting position that the aircraft was not used for personal travel.
24DiDonato advised Mr. Dougherty that when he flew for personal reasons,
he flew commercial airliners. The record does not include any evidence showing
that DiDonato flew on a commercial airliner at any time during the subject years.
- 41 [*41] XI.
Notice of Deficiency, Petition, and Amended Answer
Respondent issued to petitioners a notice of deficiency proposing various
adjustments to the 2003 and 2004 returns. First, respondent determined petitioners
were not entitled to depreciation expense deductions for the Denali of $29,058 for
2003 and $7,005 for 2004. Second, respondent determined CEG's gross receipts
for 2004 were $5,214,381 and not $5,161,984 as reported on the 2004 return.
Third, respondent determined petitioners did not hold the 245 and 265 Cold Soil
properties as rental properties, that all expenses related thereto were nondeductible
personal expenses, and that petitioners' taxable income should be increased by
$549,203 for 2003 and $477,511 for 2004." Fourth, respondent determined
.
petitioners were not entitled to losses of $694 for 2003 and $19,994 for 2004
relating to Equipment Leasing's Aircraft share because petitioners had not
established that the aircraft leasing expenses were ordinary and necessary business
expenses or, in the alternative, that the aircraft leasing activity was a bona fide
business venture entered into for profit, or that the substantiation requirements of
25Respondent determined, in the alternative, that if the 245 and 265 Cold
Soil properties were rental properties, then repair expenses claimed as deductions
in the amounts of $257,268 for 2003 and $154,125 for 2004 were disallowed
because, according to respondent, petitioners did not establish that the expenses
were actually incurred or, if the expenses were actually incurred, then the expenses
were capital expenditures that were not currently deductible.
- 42 [*42] section 274(d) had been met. Fifth, respondent determined petitioners' share
of "Other Income" from ASC was increased by $312,181 for 2003 and $343,363
for 2004 because, respondent determined, ASC was not entitled to deductions for
(1) lease payments to Equipment Leasing for the aircraft share of $217,518 for
2003 and $262,745 for 2004, (2) employee achievement awards of $25,000 for
2003 and $21,501 for 2004, or (3) expenses for conferences and meetings of
$69,663 for 2003 and $59,117 for 2004.26 Sixth, respondent determined for 2003 a
favorable adjustment allowing an additional capital loss of $2,384, which is not at
issue. Seventh, respondent determined adjustments to petitioners' self-employment
tax and the corresponding self-employment tax deductions. Eighth, respondent
determined petitioners were entitled to additional itemized deductions for real
estate taxes of $55,680 for 2003 and $56,934 for 2004. Ninth, respondent
determined petitioners were not entitled to a charitable contribution deduction of
$1,870,000 for 2004 relating to a land conservation easement. Tenth, respondent
determined petitioners were not entitled to a dependency exemption deduction for
DiDonato's father. Petitioners petitioned the Court in response to the notice of
deficiency.
26The notice of deficiency determined that adjustments to "Other Income"
related to CEG and not ASC, but the parties have stipulated that the adjustments
related to ASC and not CEG.
- 43 [*43] Respondent amended his answer to assert increases to the 2003 deficiency
and accuracy-related penalty. Specifically, respondent alleged petitioners are not
entitled to an accelerated depreciation expense deduction for 2003 but that they
must use the straight-line depreciation method. Respondent further contends
petitioners must recapture for 2003 the excess depreciation claimed for 1999
through 2002.
OPINION
I.
Perception of Witnesses
During a three-day trial in New York, New York, we heard the testimony of
four fact witnesses; namely, DiDonato, Brian M. Cohen, Mr. Dougherty, and Carol
Domanski, respondent's revenue agent. Our charge as the trier of fact is, in part,.to
review the credibility of witnesses and the reliability of evidence for purposes of
finding disputed facts. In discharging that duty, we observe the truthfulness,
candor, and demeanor of each witness to evaluate his or her testimony. See Diaz v.
Commissioner, 58 T.C. 560, 564 (1972); Garavaglia v. Commissioner, T.C. Memo.
2011-228, 102 T.C.M. (CCH) 286, 296 (2011); HIE Holdings, Inc v.
Commissioner, T.C. Memo. 2009-130, 97 T.C.M. (CCH) 1672,1733 (2009). The
evidence is weighed, necessary inferences are drawn, and disputed facts are
resolved with a view toward ascertaining the truth.
- 44 [*44] It is fundamental to our system ofjurisprudence that the presiding judge is
"not a mere moderator, but is the governor of the trial for the purpose of assuring
its proper conduct and of determining questions of law." Quercia v. United States,
289 U.S. 466, 469 (1933); see Geders v. United States, 425 U.S. 80, 86-87 (1976);
Loque v. Dore, 103 F.3d 1040, 1045 (1st Cir. 1997); Warner v. Transam. Ins. Co.,
739 F.2d 1347, 1351 (8th Cir. 1984); United States v. Beaty, 722 F.2d 1090, 10921093 (3d Cir. 1983). We have discretion to participate in the trial process, see
United States v. Wilensky, 757 F.2d 594, 597 (3d Cir. 1985), and we may examine
a witness so as to unearth the truth, ensure the proper administration ofjustice, and
make certain that there is no misunderstanding of testimony, see Fed. R. Evid.
614(b); Beaty, 722 F.2d at 1093 (citing Riley v. Goodman, 315 F.2d 232, 234 (3d
Cir. 1963)); Nordmann v. Nat'l Hotel Co., 425 F.2d 1103, 1109 n.3 (5th Cir. 1970)
(citing Posey v. United States, 416 F.2d 545, 555 (5th Cir. 1969)). Of course, we
are careful to temper our participation in the conduct of a trial to maintain
impartiality, fairness, and justice. See Notes of the Advisory Committee on Fed. R.
Evid. 614(b); see also Beaty, 722 F.2d at 1093 (citing United States v. Green, 544
F.2d 138, 147 (3d Cir. 1976)); United States v. Nobel, 696 F.2d 231, 237 (3d Cir.
[*45] After observing DiDonato at trial, we believe he is sophisticated in many
subjects, including certain aspects of the Federal tax law, and we believe him to be
a manipulator of the facts and of the law. For example, DiDonato testified that his
father, for whom petitioners claimed a dependency exemption deduction and listed
their qualifying relationship as "parent," was not a!family member for purposes of
qualifying the 265 Cold Soil property as a rental property. He testified that his
taking private flights over weekends was necessary to ASC's business because he
had "immense responsibilities" that demanded he be at ASC's offices Monday
through Friday. Yet, when DiDonato testified about the time he purportedly
devoted to his rental real estate activities, he stated that ASC "pretty much runs
itself" and that his work there occupied "maybe" 5% of his time. DiDonato
testified to the effect that he believed that he was entitled to deduct as business
expenses the cost of the flights on which his children were present because, unlike
the Federal building in which the trial was held, where there was apparently a
daycare facility, "[w]e don't have daycare center[s] in the private sector."
DiDonato's testimony, especially with respect to his claimed business use of
the aircraft, was repeatedly vague, confusing, and!inconsistent. The Court, so as to
facilitate our decisionmaking process and ascertain petitioners' use of the aircraft,
questioned DiDonato on, among other items, the particulars of the Orlando trip. In
- 46 [*46] this regard, DiDonato's dialogue with the Court accentuates the unreliability
of his testimony. Whereas passage of time tends to fade memories, manipulation of
the facts can hardly be disguised as poor memory. The former is excusable; the
latter is not. The following dialogue, which we believe to illustrate the
unreliability of DiDonato's testimony, occurred at trial with respect to the Orlando
trip in March 2003:
The Court: So you say you went down and visited some
business associates, right?
DiDonato: Yeah, Dr. Barry Concool.
The Court: Okay. How long did that take?
DiDonato: Well, I don't remember. Let's see how many days
we were there.
The Court: It looks like you were there for five days.
DiDonato: Yes, we were there for five days.
The Court: So you visited him for one day. What did you do
the other four days.
DiDonato: Well, we didn't visit him for one day. We visited
him for most of that time. I would say three days of that time. He --
let me tell you who Dr. Barry Concool is.
The Court: That's all right. Let me ask you something. Where
did you spend the night?
DiDonato: I don't recall.
- 47 [*47] The Court: You don't know if you spent it in Orlando?
DiDonato: We may have spent the first night there. I don't
remember where we stayed.
The Court: So let me understand this trip. You flew to
Orlando, right?
DiDonato: Right.
The Court: You arrived before noon. Did you immediately
leave to go see your business associate?
DiDonato: Yes, we did. We probably saw him the next
morning, or we saw him that evening.
The Court: You saw him that evening in Fort Lauderdale?
DiDonato: Perhaps we did, yes. I didn't keep records of my
itinerary.
The Court: You just said you spent the night in Orlando.
DiDonato: I think we did.
The Court: So you arrived, you drove two hours down to Fort
Lauderdale, saw him for whatever you did for that evening, then you
drove back to Orlando that night?
DiDonato: No. Generally -- what time of the year was this?
March. It generally doesn't work that waý, With these small
business jets -The Court: How [sic] tell me how it worked in this instance.
DiDonato: In this instance, in this instance I don't remember
why we flew to Orlando. Probably it was weather-related. I
- 48 [*48] remember when we went out of -- we tried to get out of Fort
Lauderdale but they rescheduled us out of Homestead. So there are
thunderstorms there all the time, and they are always delaying us and
moving us, canceling us, or making us go to another city.
The Court: So are you saying you intended to go to Fort
Lauderdale but you in fact had to go to go Orlando?
DiDonato: That's probably what happened.
The Court: Well, when you say "probably", you either know or
you don't know.
DiDonato: I don't remember what happened.
The Court: All right.
DiDonato: But I do remember -The Court: If you don't know it's better -DiDonato: I do remember flying out of Homestead.
The Court: Listen to me.
DiDonato: Okay.
The Court: If you don't know, it's better to say "I don't know."
DiDonato: Okay.
The Court: Okay. So now you arrive in Orlando at around
noon and you drive down two hours to visit this associate and you say
you spent the night back in Orlando.
DiDonato: No, we never went back to Orlando.
- 49 [*49] The Court: Well, you said a few moment[s] ago that you spent
the night in Orlando?
DiDonato: On the front end.
The Court: That's what I'm talking about.
DiDonato: Right.
The Court: What do you mean on the front end?
DiDonato: On the arrival.
The Court: So you didn't go the first day?
DiDonato: My recollection is that we landed in Orlando, drove
to Fort Lauderdale. Then drove to Homestead, and flew home.
That's what the record shows.
The Court: Yes. I'm afraid I'm confused. Let's try it again.
You arrive a little before noon on Thursday, March 13th, is that about
right?
DiDonato: Correct.
The Court: Now what do you do after you arrive?
DiDonato: Probably got a rental car.
The Court: Okay, than what do you do?
DiDonato: My recollection is we stäyed there probably
because the weather was bad.
The Court: So you stayed in Orlando?
DiDonato: Right.
- 50 [*50] The Court: When did you go see the business associate?
DiDonato: Probably the next day.
The Court: Because a few moments ago you said you saw him
that day in the evening and now you are saying something different.
DiDonato: Well, I don't know.
The Court: Okay.
DiDonato: I don't know exactly.
The Court: If you don't know say "I don't know."
DiDonato: Yeah, I don't know what happened nine years ago.
The Court: Okay, so now you're saying you went there the
next day. So how long did you spend with him the next day?
DiDonato: Over the course of three or four days we -The Court: No, the next day how long did you spend?
The Witness: All day.
The Court: You spent from what, from 9 a.m. until 5:00 p.m.
with him?
DiDonato: Correct.
The Court: On Friday?
DiDonato: Correct.
The Court: Okay.
- 51 [*51] DiDonato: Because that was a business day with patient care,
we did patient care with him.
The Court: All right. So you spent the entire day with him.
DiDonato: Right.
The Court: You and your wife?
DiDonato: Correct.
The Court: Okay. Where did you spend that night?
DiDonato: Probably somewhere in Fort Lauderdale.
The Court: You don't know?
DiDonato: I don't remember the hotel.
The Court: Okay. Now the next day is Saturday.
DiDonato: Right.
The Court: What did you do on Saturday?
DiDonato: We spent Saturday and Sunday with him.
The Court: Doing what?
DiDonato: Everything that you would do on a weekend.
The Court: So it's personal stuff?
DiDonato: No, business stuff. We were -The Court: Well, you usually don't do business stuff on a
weekend.
- 52 [*52] DiDonato: I do.
The Court: Okay, so what did you do with him?
DiDonato: We were laying foundation. He was the contact
with TLC Laser Centers. I am bound by a confidentiality agreement
but if I'm allowed to discuss it here I will.
Petitioners' Counsel: You are.
DiDonato: Okay. We were -- he was our go- between TLC
Laser Centers, he was a contractor at TLC Laser Centers, and he was
putting together a deal for TLC Laser Centers to buy our LASIK and
Ambulatory Surgical Center, and he was going to receive a fee for
that service.
The Court: Okay. So you woke up Saturday morning in Fort
Lauderdale.
DiDonato: Right.
The Court: What time did you start with him?
DiDonato: Eight - nine.
The Court: And just the three of you?
DiDonato: And his entire staff.
The Court: And you worked the whole day?
DiDonato: I believe I was there all day.
The Court: When you say you believe, you either know or you
don't know.
ninnnntn. well. 1et's define all day. We had patient care in
- 53 [*53] the morning, then he did laser procedures in the afternoon. He
was probably done about three or 3:30, have you call it all day.
The Court: So he had procedures on a Saturday?
DiDonato: No, I'm still talking about Friday, sir.
The Court: Okay. Let's go to Saturday. Where were you on
Saturday.
DiDonato: Saturday, woke up late in the hotel, met Dr.
Concool for lunch probably and spent three or four hours -The Court: When you say "I met him for lunch probably", you
either did or you didn't.
DiDonato: I did.
The Court: You did meet him for lunch?
DiDonato: Right.
The Court: The three of you met for lunch?
DiDonato: Yes.
The Court: Okay. Then what happened?
DiDonato: Same thing on Sunday.
The Court: Well, what happened after lunch?
DiDonato: We went back to our hotel.
The Court: Which was where?
DiDonato: In Fort Lauderdale.
- 54 [*54] The Court: Okay. Now on Sunday what happens?
DiDonato: Same thing. We met him again.
The Court: You met him again at nine in the morning.
DiDonato: Yeah. What time did we come home? Did we
come home Sunday or Monday? Let's see.
The Court: Actually you came home on Tuesday.
DiDonato: Tuesday, okay.
The Court:. So you meet him again now on Sunday, right?
DiDonato: Right.
The Court: At nine in the morning?
DiDonato: Right.
The Court: Okay. And now what happens?
DiDonato: My recollection is that we were going to stay there
Sunday and then fly home on Monday, and I think we flew home on
Tuesday because we couldn't get out.
The Court: Okay, but let's stay with Sunday. You meet him at
nine in the morning and what happens?
DiDonato: What happened that Sunday?
The Court: Yes.
DiDonato: I don't recall.
The Court: All right.
- 55 [*55] DiDonato: But we spent the day with him.
The Court: Okay. You're sure you spent the day with him?
DiDonato: Yeah, I'm sure I spent the day with him. I spent the
whole weekend with him.
The Court: Okay. Now we have Monday, what did you do on
Monday?
DiDonato: I think our plan was to come home on Monday but
we couldn't get out.
The Court: So what did you do?
DiDonato: We had to go back and re-check into our hotel after
we checked out. Got on the plane, couldn't leave because of
thunderstorms, so we ended up getting -- we wanted to go home. We
went out to another airport and we had to wait until the next day.
That happens frequently.
The Court: Okay.
DiDonato: With these winds.
The Court: So where did you spend the night on Monday
night?
DiDonato: I don't know. I don't have where we stayed at Fort
Lauderdale?
The Court: Because you left at 8:30 in the morning from
Orlando. So you got up real early on Tuesday morning, didn't you?
*
*
*
*
*
*
*
*
The Court: So, if you spent that night in Fort Lauderdale and
you left at 8:30 in the morning and it's a two-hour drive.
- 56 [*56] DiDonato: According to this then we went back to Orlando.
Yeah, that's what we did.
The Court: When you say "according to this"?
DiDonato: Your Honor, I can't remember nine years ago.
The Court: Okay, I can understand that. I can't remember nine
years ago either, but the point is if you don't remember it's best to say
"I don't remember" rather than coming up with a story.
DiDonato: Well, no, I'm trying to be cooperative. I'm trying
to tell you what happened.
The Court: I don't want you to cooperate by making things up.
If you don't know say, "I don't know," and I'm satisfied with "I don't
know."
DiDonato: Okay.
The Court: So is it I don't know?
DiDonato: What was your question again?
The Court: The question is did you spend the night, Monday
night, March 17th in Fort Lauderdale and get up rather early -DiDonato: I don't know.
The Court: Okay, that's fine. So this flight leaves Orlando at
8:30 and goes to Homestead, why would that be so? It's a 48 minute
flight. Why would you do that?
DiDonato: I don't remember.
*
*
*
*
*
*
*
- 57 [*57] The Court: If you forward yourself a little bit in the
documents, you come across the meeting for Neurological Society
March 13th to 15th in Orlando. So you're saying you never attended
that meeting because you were down in Fort Lauderdale.
DiDonato: Well, you've got me confused now because these
documents are all out of order.
The Court: Well, take your time. See if we can understand
what happened. Take a look at the Net Jets' memo dated Tuesday,
March 18th. Do you see that?
DiDonato: Right.
The Court: Okay, now flip to the next page, and it looks like
there is a meeting in Orlando on March 13 through the 15th, and
you're saying you never went to that meeting because you were in
Fort Lauderdale.
DiDonato: No, I went to that meeting.
The Court: So you went to the meeting and you went to Fort
Lauderdale. That's a pretty good trip. I don't see how you could
spend all your time in Fort Lauderdale and still go to the meeting in
Orlando.
DiDonato: Well, obviously, your Honor, I had it mixed up.
The Court: All right. So your testimony was incorrect when
you said you went to Fort Lauderdale?
DiDonato: Well, they are out of order here. Let's see. Can I
have one minute please.
The Court: Surely.
DiDonato: Well, obviously I misspoke. I believe that I did go
- 58 [*58] down and meet with Dr. Concool and I did spend several days
with him, but it didn't encompass this weekend. I'm trying to recall
from nine years ago, but I obviously I made a mistake. I thought that
was the Dr. Concool trip because I had written here Dr. Concool,
that's my handwriting. But that threw me. I thought that was the trip
with Dr. Concool. But clearly now I'm looking at the date of the
neuro meeting, and that was the 13th, so what I was describing to you
was another trip. [Emphasis added.]
Setting aside for the moment that portions of DiDonato's testimony were
fabricated, as with the Orlando trip, his testimony was also internally inconsistent.
For example, DiDonato testified that he and his family flew into Orlando because
they wanted to take the drive to Fort Lauderdale, but he contradicted himself
moments later by testifying the Orlando arrival was "weather related". After we
heard him testify that he and his wife spent the duration of the Orlando trip in Fort
Lauderdale, our review of the record revealed that his wife incurred a $560 charge
for a Disney special activity in Lake Buena Vista, Florida, during the same
weekend." We assign very limited weight to DiDonato's testimony, and insofar as
we discounted any part of that testimony, we did so because we perceived him to
be untrustworthy when giving it.
In addition to our perception of DiDonato, we also draw certain adverse
inferences from Ms. DiDonato's decision not to testify. The Supreme Court noted
"The bank statement on which this charge appears is buried about 265
pages into Exhibit 29-J.
[*59] in United States v. Hale, 422 U.S. 171, 176 (1975): "In most circumstances
silence is so ambiguous that it is of little probative force." The Supreme Court
went on to note, however, that "[s]ilence gains more probative weight where it
persists in the face of accusation, since it is assumed in such circumstances that the
accused would be more likely than not to dispute an untrue accusation." Id.
Recently, in Loren-Maltese v. Commissioner, T.C. Memo. 2012-214, 104 T.C.M.
(CCH) 115, 116 (2012), we reflected a similar sentiment in that we observed:
"[P]eople have a natural tendency to defend their reputation, and that silence in the
face of accusations suggests that there might be some merit to the charges."
Ms. DiDonato allegedly supervised administrative matters for CEG, she was
ASC's corporate secretary, and she was a passenger on many of the flights at issue
in this case, sometimes with her children. We regard Ms. DiDonato's absence from
the trial of this case, especially given respondent's clear accusation that she used
the aircraft share for personal purposes, as giving rise to an inference that her
testimony would have been unfavorable to petitioners' position. Accord Wichita
Terminal Elevator Co. v. Commissioner, 6 T.C. 1158, 1165 (1946)("The rule is
well established that the failure of a party to introduce evidence within his
possession and which, if true, would be favorable to him, gives rise to the
- 60 [*60] presumption that if produced it would be unfavorable."), aff'd, 162 F.2d 513
(10th Cir. 1947).
As to petitioners' other witnesses, namely, Mr. Cohen and Mr. Dougherty,
we found their testimony to be credible but not fully informed. The record
supports that DiDonato was not forthcoming with his business associates (Mr.
Cohen) or his tax adviser (Mr. Dougherty). Thus, although we generally credit
these individuals' testimony, we appreciate fully that DiDonato failed to disclose
material facts to them, rendering unreliable some of their testimony. We need not
accept improbable, unreasonable, or unreliable testimony. See Barasso v.
Commissioner, T.C. Memo. 1978-432, 37 T.C.M. (CCH) 1783 (1978), aff'd sub
nom. De Cavalcante v. Commissioner, 620 F.2d 23 (3d Cir. 1980). Although we
found respondent's sole witness, Ms. Domanski, to be credible, her testimony was
of limited use to us in that she testified about DiDonato's rental activities only.
II.
Burden of Proof
The Commissioner's determinations in a notice of deficiency are generally
presumed correct, and taxpayers bear the burden of proving those determinations
erroneous. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933). The
Commissioner bears the burden of proof with respect to a new matter or increased
deficiency nieaded in the answer. Rule 142(a). Where a case involves unreported
- 61 [*61] income and is appealable to the U.S. Court of Appeals for the Third Circuit,
as this case is barring a contrary written stipulation, the Commissioner's
determination of unreported income is not presumptively correct until the
Commissioner produces foundational evidence linking the taxpayers to the taxgenerating activity. See Anastasato v. Commissioner, 794 F.2d 884, 887 (3d Cir.
1986) (citing Gerardo v. Commissioner, 552 F.2d 549, 554 (3d Cir. 1977), aff'g in
part, rev'g in part, and remanding T.C. Memo. 1975-341, 34 T.C.M. (CCH) 1480
(1975)), vacating and remanding T.C. Memo. 1985-101, 49 T.C.M. (CCH) 893
(1985). Whereas the burden of proof as to factual matters may shift to the
Commissioner under section 7491(a), we conclude it does not do so here because,
as discussed throughout this opinion, petitioners have not complied with the
substantiation requirements of section 274 or maintained all records required under
the internal revenue laws.28 See sec. 7491(a)(2)(A) and (B).
III.
CEG's Unreported Income
Petitioners, relying on the 2004 trial balance, reported CEG's gross receipts
for 2004 as $5,161,984. Respondent, pointing to the 2006 and 2011 trial balances,
determined that petitioners underreported CEG's 2004 gross receipts by $52,397.
2sPetitioners' brief is consistent in this result in that petitioners do not assert
that sec. 7491(a) applies in this case.
- 62 [*62] Petitioners maintain that they computed CEG's 2004 gross receipts on the
basis of the 2004 trial balance which, according to them, was a more accurate
reflection of CEG's gross receipts for 2004 than the 2006 or 2011 trial balance.
DiDonato testified at trial that the additional $65,354.23 with which CEG is
charged as gross receipts was really a nontaxable capital contribution from him to
CEG. We conclude that CEG's 2004 gross receipts were underreported by
$52,397.
Gross income is defined in section 61 to include "all income from whatever
source derived, including (but not limited to) * * * [g]ross income derived from
business". Sec. 61(a)(2). As a general rule, items of gross income must be
included in the gross income of a cash method taxpayer for the year in which the
taxpayer actually or constructively received the income. See sec. 451(a); sec.
1.451-1(a), Income Tax Regs. Income not actually reduced to a taxpayer's
possession is constructively received by a taxpayer in the year during which the
income is credited to an account, set apart, or otherwise made available so that the
taxpayer may draw upon it at any time. See sec. 1.451-2(a), Income Tax Regs.
Where taxpayers keep books and records that do not clearly reflect income,
the Commissioner is authorized under section 446(b) to reconstruct the taxpayers'
income usina a method of accountinst which. in the ooinion of the Commissioner.
[*63] clearly reflects income. Petzoldt v. Commissioner, 92 T.C. 661, 686-687
(1989). The Commissioner ordinarily regards an accounting method as clearly
reflecting income where the method the taxpayers chose reflects the consistent
application of generally.accepted accounting principles in accordance with
accepted conditions and practices of the taxpayers' trade or business. Sec. 1.4461(a)(2), Income Tax Regs. The Commissioner's income reconstruction need not be
exact, but must be reasonable in the light of the surrounding facts and
circumstances. Petzoldt v. Commissioner, 92 T.C. at 687. Once the Commissioner
offers sufficient evidence linking the taxpayers with the income-generating
activity, the burden of persuasion is on the taxpayers to prove the income
determinations erroneous. Rule 142(a).
Respondent meets his burden of production with the stipulated 2004, 2006,
and 2011 trial balances. The 2004, 2006, and 2011 trial balances each consistently
include in gross receipts the $1,877,193 ASC "paid" to CEG for surgical supplies
for January 1 through November 30, 2004. The 2004 trial balance, printed three
hours before CEG's business closed for the year, omits the $65,364.23 ASC "paid"
to CEG for surgical supplies in December 2004. Each of the 2006 and 2011 trial
balances, given to respondent after the 2004 return was audited, includes the
$65,364.23 in CEG's gross receipts. Given CEG's inconsistent treatment of
- 64 [*64] amounts received for surgical supplies across periods (i.e., December 2004 as
compared with the rest of the year) and its books and records (i.e., the 2004 trial
balance as compared with the 2006 and 2011 trial balances), we conclude that
respondent was justified in recreating CEG's gross receipts under section 1.4461(a)(2), Income Tax Regs. Thus, petitioners bear the burden of proving the
determinations in error, see Rule 142(a), including whether amounts deposited to
CEG were capital contributions, see Fin Hay Realty Co. v. United States, 398 F.2d
694, 699 (3d Cir. 1968).
Petitioners do not dispute that CEG received from ASC the $65,364.23 for
the use of surgical supplies. Instead, petitioners assert that the amount they
reported as CEG's gross receipts for 2004 was correct because, as they maintain,
the 2004 trial balance used to compute CEG's gross receipts was the most accurate
account of operations. We disagree. The 2004 trial balance is not a reliable
statement of CEG's operations because it was printed before CEG closed its
business for 2004. DiDonato confirmed this point when he testified that the
purpose of his working on January 1 of each year was to close out CEG's books for
the previous year. We agree with respondent it is likely that entries were made in
the three or so hours after the 2004 trial balance was printed that resulted in the
inconsistencies between the 2004 trial balance and the 2006 and 2011 trial
- 65 -
!
[*65] balances. Therefore, we reject petitioners' proposition that the 2004 trial
balance was less reliable than the 2006 or 2011 tri¼l balance.
Nor are we persuaded by DiDonato's testimôny that the $65,364.23 was a
nontaxable capital contribution from him to CEG. !Petitioners did not offer any
corroborating documentary evidence such as a canceled check, a check register, a
bank statement, or another similar document. See Grossman v. Commissioner,
T.C. Memo. 1994-231, 67 T.C.M. (CCH) 3001, 3dO3-3006 (1994) (rejecting
taxpayers' claim of capital contributions in the absence of documentary evidence).
Nor does the record establish that a capital contribution was necessary to the
continuation of CEG's business.. CEG was a mature optometry practice with
sufficient working capital from its eyecare practice and sale of surgical supplies to
ASC. Petitioners have not explained why CEG's financial needs were not met by
its existing capital base. Absent documentary evidence to show that a capital
contribution was made, and bearing in mind that such a contribution did not seem
necessary to keep CEG a going concern, we reject DiDonato's testimony.that the
$65,364.23 was a nontaxable capital contribution to CEG.
Respondent's computation of CEG's gross feceipts was reasonably based on
the surrounding facts. The 2004 trial balance included $1,877,193 paid from ASC
to CEG for the purchase of surgical supplies. Thei 2004 trial balance, however,
- 66 [*66] omitted $65,364.23 believed to have been paid from ASC to CEG for the
purchase of surgical supplies in December 2004. The revenue agent followed the
2006 and 2011 trial balances, which both included $65,364.23 for the purchase of
surgical supplies in December 2004. We conclude that respondent acted
reasonably when including in CEG's gross receipts for 2004 the $65,364.23 for
surgical supplies. The revenue agent, in an exercise of discretion, allowed CEG to
reduce its gross receipts by $204,650.13 for CEG's payment of payroll and payroll
taxes paid on behalf of ASC. Respondent did not challenge the related adjusting
entries in his pleadings, and we will defer to the decision to allow them as an offset
to gross receipts given the close relationship between CEG and ASC. Accordingly,
we hold CEG's 2004 gross receipts are increased by $52,397.
IV.
CEG's Deductions-The Denali
Respondent determined petitioners were not entitled to depreciation expense
deductions of $29,058 for 2003 and $7,005 for 2004 related to the Denali because,
as he contends on brief, petitioners did not comply with the substantiation
requirements of section 274(d). Petitioners rely on the testimony of DiDonato and
Mr. Cohen, as well as a sample CEG patient log, to prove their entitlement to the
claimed depreciation expense deductions. Petitioners, citing Cohan v.
Commissioner, 39 F.2d 540 (2d Cir. 1930), and Vanicek v. Commissioner, 85 T.C.
- 67 [*67] 731 (1985), ask the Court to estimate the allowable depreciation expense
deductions to the extent they have not proven the amounts to which they believe
they are entitled. We will sustain the disallowance of the depreciation deductions
for the Denali.
Section 162(a) allows a deduction for all ordinary and necessary expenses
paid or incurred during the taxable year in carrying on a trade or business. Section
6001, in turn, requires taxpayers to maintain records sufficient to substantiate the
amounts of the deductions claimed. See also sec. 1.6001-1(a), Income Tax Regs.
Certain expenses specified in section 274 are subject to heightened substantiation
requirements. Specifically, section 274(d)(4) provides that no deduction shall be
allowed under section 162 for listed property unless the taxpayers substantiate,
with adequate records, the following elements: (1) the amount of the expense; (2)
the mileage for each business use of the vehicle as well as the total mileage for all
purposes during the taxable period; (3) the date on which the property was used;
and (4) the business purpose of the property. See sec. 1.274-5T(b)(6), Temporary
Income Tax Regs., 50 Fed. Reg. 46016 (Nov. 6, 1985). Section 280F(d)(4) defines
the term "listed property" to mean, in addition to other property, any passenger
automobile or any other property used as a means of transportation. Without
adequate records, such as an account book, a diary, a log, a statement of expenses,
- 68 [*68] trip sheets, or a similar record, taxpayers still may substantiate mileage
expenses with sufficiently detailed written or oral statements and other collateral
evidence showing the expense was incurred. See sec. 1.274-5T(c)(2), (3)(i),
Temporary Income Tax Regs., 50 Fed. Reg. 46017, 46020 (Nov. 6, 1985).
Although we are satisfied CEG occasionally used the Denali during the
subject years for business purposes, we will not allow petitioners the depreciation
deductions to which they claim entitlement. The Denali is listed property because
CEG used it for transportation.29 See sec. 280(f)(d)(4)(A)(ii). Thus, the section
274(d) substantiation requirements apply. Sec. 274(d)(4). The patient logs
petitioners relied on to satisfy the substantiation requirements of section 274(d) are
not reliable. The logs do not indicate whether it was the Denali or another one of
the transport vehicles that was used to drive the particular patient. Nor do the logs
state the number of miles driven, the origin, the destination, or any other
information that would allow us to determine when, where, and for what purpose
the Denali was driven. That being so, we do not treat the patient logs as adequate
records within the meaning of section 274(d). See Royster v. Commissioner, T.C.
Memo. 2010-16, 99 T.C.M. (CCH) 1077, 1079 (2010) (nonspecific documentary
29The Denali, because it weighed more than 6,000 pounds, was not deemed
to be listed property as a passenger automobile under sec. 280F(d)(4). See sec.
280F(d)(5)(A).
- 69 [*69] evidence did not satisfy section 274(d) substantiation requirements); see also
Fleming v. Commissioner, T.C. Memo. 2010-60, 99 T.C.M. (CCH) 1239, 1241
(2010) (absence of business purpose on logs meant they were inadequate
substantiation under section 274(d)).
Nor does the testimony of DiDonato and Mr. Cohen qualify as sufficiently
detailed oral statements showing the expense was incurred. Neither DiDonato nor
Mr. Cohen made a specific showing as to the business purpose associated with the
use of the Denali, the total miles driven for business and personal uses, or the dates
on which the Denali was used. The record does not establish whether the Denali
was predominantly used for business or personal reasons. Moreover, DiDonato
testified that on at least one occasion he used the Denali to take his surgeons and
staff "down the shore" for what he testified was a personal trip. Given the absence
of specific testimony on the point, and bearing in mind that the Denali was used at
least once for personal travel, we decline to conclude that the Denali was
predominantly used for business purposes or that the substantiation requirements of
section 274(d) have been met. See Dyer v. Commissioner, T.C. Memo. 2012-224,
104 T.C.M. (CCH) 145, 151 (2012); Royster v. Commissioner, 99 T.C.M. (CCH) at
1079; Larson v. Commissioner, T.C. Memo. 2008-187, 96 T.C.M. (CCH) 73, 77
(2008). Whereas petitioners urge us to apply the Cohan rule to allow them
- 70 [*70] depreciation expense deductions for the Denali, we are precluded from doing
so because the section 274(d) substantiation requirements supersede the Cohan
rule. See Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff'd, 412 F.2d 201
(2d Cir. 1969); sec. 1.274-5T(a), Temporary Income Tax Regs., 50 Fed. Reg.
46014 (Nov. 6, 1985). Insofar as petitioners have not met the section 274(d)
substantiation requirements or established that the Denali was predominantly used
for business purposes, they may not claim a depreciation expense deduction for that
vehicle for either of the subject years. Sec. 274(d)(4). Accordingly, we hold
petitioners are not entitled to a depreciation expense deduction for the Denali of
$29,058 for 2003 or $7,005 for 2004.
V.
ASC's Deductions and Increase to DiDonato's Distributable Income
A.
Employee Achievement Expenses
1.
Overview
Respondent disallowed ASC's claimed employee achievement award
deductions of $25,000 for 2003 and $21,501 for 2004. The disallowed deduction
for 2003 stems from two payments of $12,500 to DiDonato Builders. The
disallowed deduction for 2004 is attributable to DiDonato's purchase of a $21,501
firearm for Mr. Witter in connection with DiDonato's possible sale of his ASC
- 71 [*71] shares of stock. We will sustain respondent's disallowance of these
employee achievement expenses.
2.
Guiding Principles
Sections 162 and 212 allow as a deduction all the ordinary and necessary
business expenses paid or incurred during the taxable year in carrying on a trade or
business or for the production or collection of income. See secs. 162(a), 212(1).
Among the potentially deductible expenses set forth in section 162 is a reasonable
allowance for salaries or other compensation for personal services actually
rendered. Sec. 162(a)(1). Personal, living, or family expenses are generally not
deductible. Sec. 262(a).
3.
Payments to DiDonato Builders
DiDonato testified that the payments from ASC to DiDonato Builders were
for final payment of construction and maintenance'work purportedly performed on
the Hamilton office complex by Vincent, his cousin. Respondent contends that,
other than DiDonato's self-serving testimony, the record does not support that the
services were performed for business purposes. We will sustain respondent's
determination as to the nondeductibility of payments to DiDonato Builders.
Taxpayers generally may not deduct the payment of another's expense. See
Deputy v. du Pont, 308 U.S. 488 (1940)! Ijietrick v. Commissioner, 881 F.2d 336
- 72 [*72] 6th Cir. 1989), aff'g T.C. Memo. 1988-180, 55 T.C.M. (CCH) 706 (1988).
The alleged bonuses paid to DiDonato Builders were purportedly for work done on
buildings owned by CEG, Mallard, or DiDonato and merely leased to ASC. The
record does not include a copy of any lease between ASC and CEG, Mallard, or
DiDonato, and we thus have no way to know whether it was the lessor (ASC) or the
lessee (CEG, Mallard, or petitioners) who was responsible for improvements to
leased buildings. Even if we assume that ASC was responsible for improving the
Hamilton office complex, which we do not, petitioners have not established that the
employee achievement payments to DiDonato Builders are deductible.
The test for the deductibility of compensation payments, such as bonuses to a
nonemployee, is whether the amounts are (1) reasonable in amount, and (2) paid for
services actually rendered to the payor in or before the year of payment.3° See
Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 (1930); sec. 1.162-7(a), Income
Tax Regs. Petitioners have not proven that either requirement for deductibility has
been met. First, petitioners offered no evidence, documentary or testimonial, as to
whether the amounts paid to DiDonato Builders for work on ASC's leased space
3°The record does not suggest that Vincent was an employee of ASC, and
consequently, we do not consider the applicability of sec. 274(j) or sec. 1.162-9,
- 73 [*73] were reasonable in amount when compared with the amount of compensation
paid to other builders for similar work.
Second, the record does not reveal whether the work DiDonato Builders
allegedly completed was for space leased to ASC or to another one of DiDonato's
businesses. Where a payment is made in the context of a family relationship, we
carefully scrutinize the facts to ensure there was a bona fide business relationship
and that the payment was not made on account of the familial relationship. See
Commissioner v. Culbertson, 337 U.S. 733, 746 (1949); Martens v. Commissioner,
T.C. Memo. 1990-42, 58 T.C.M. (CCH) 1288, 1292 (1990), aff'd without
published opinion, 934 F.2d 319 (4th Cir. 1991). The record does not establish that
DiDonato Builders rendered services to ASC in connection with the achievement
awards or whether the builder was under a preexisting duty to provide those
services. To the contrary, DiDonato only testified vaguely that DiDonato Builders
worked on roughly 14 properties during a 12-to-15-year period. Among the work
DiDonato Builders allegedly performed was fitting the interior of certain
unspecified rental properties not owned by ASC, performing maintenance on some
of DiDonato's rental properties which the record does not show ASC was obliged
- 74 -
[*74] to perform, and building out offices for DiDonato and ASC's surgeons."
This testimony does not fix whether the two $12,500 payments to DiDonato
Builders related to services rendered in 2003 or in another year.
Moreover, we find a notable inconsistency between the statement on the
invoices that the payments were a "bonus per agreement" and DiDonato's
testimony that the payments were an oral settlement for work performed. We find
it curious that DiDonato would accept as a final settlement release an invoice
referring to the payment as a "bonus". We also question the business purpose of
the payments, given that DiDonato Builders was the primary contractor for the
personal residence. On the basis of the foregoing, we hold petitioners may not
deduct employee achievement payments to DiDonato Builders totaling $25,000 for
2003.
4.
Firearm Purchase
Petitioners claimed a deduction of $21,501 on ASC's 2004 Form 1120S for a
firearm DiDonato gave to Mr. Witter in connection with Mr. Witter's efforts
regarding the possible sale of DiDonato's shares of ASC stock. Respondent
"DiDonato did not reveal in his testimony that DiDonato Builders was the
contractor named in multiple construction permits to improve the personal
residence. Nor did he explain the extent to which, if at all, payments to DiDonato
Builders for work completed on the personal residence overlapped with payments
for work completed at ASC's offices.
- 75 [*75] maintains the deduction is not allowable for two reasons. First, respondent
asserts that the cost of the firearm is not an ordinary and necessary business
expense of ASC because it was purchased in connection with the possible sale of
DiDonato's shares of ASC stock and so is a personal expense of DiDonato.
Second, respondent argues that even if we were to conclude that the cost of the
firearm was an ordinary and necessary expense of ASC, the amount of the
deduction is limited to $25 under section 274(b). We agree that the cost of the
firearm was not an ordinary and necessary expense of ASC and that the cost of the
firearm is not deductible.
An expense is ordinary if it is considered normal, usual, or customary in the
context of the particular business out of which it arose, see Du Pont, 308 U.S. at
495, and an expense is necessary if it is appropriate and helpful to the operation of
the taxpayer's trade or business, see Welch v. Helvering, 290 U.S. at 113. The cost
of a gift may be an ordinary and necessary business expense to the extent the gift is
related to the taxpayer's opportunity to generate business income. Bruns v.
Commissioner, T.C. Memo. 2009-168, 98 T.C.M. (CCH) 30, 35 (2009) (citing
Brown v. Commissioner, T.C. Memo. 1984-120, 47 T.C.M. (CCH) 1255 (1984)).
However, the amount of the deduction allowed for a gift is limited to $25 per donee
per year. Sec. 274(b)(1). Moreover, section 274(d) requires that the taxpayer
- 76 [*76] claiming the gift amount as a deduction substantiate with adequate records
(1) the cost of the gift, (2) the date and description of the gift, (3) the business
purpose of the gift, and (4) the business relationship of the person receiving the
gift. Sec. 1.274-5T(b)(5), Temporary Income Tax Regs., supra. Petitioners bear
the burden of proving the extent to which (if at all) the firearm gift contributed to
ASC's income. See Sutter v. Commissioner, 21 T.C. 170, 173-174 (1953).
Petitioners have not established that the firearm DiDonato gave to Mr. Witter
was an ordinary and necessary business expense of ASC or that it increased ASC's
future earnings potential. DiDonato testified to purchasing the firearm for Mr.
Witter in connection with investment advisory services related to the possible sale
of his shares of ASC stock. Expenses related to the sale of a shareholder's stock in
a corporation are not deductible at the corporate level. Accord Snyder Bros. Co. v.
Commissioner, T.C. Memo. 1980-275, 40 T.C.M. (CCH) 762, 772 (1980) (fees
paid by a corporation for the sale of a shareholder's stock were expenses paid for
the benefit of another and are nondeductible). Moreover, petitioners offered no
evidence as to any future income ASC expected to realize from the services of Mr.
Witter. Any goodwill that may have been realized from the gift of the firearm was
to the personal benefit of DiDonato and not ASC. In this regard, the firearm was a
personal gift born out of DiDonato's appreciation for services Mr. Witter provided
- 77 [*77] to him in connection with the possible sale of his shares of ASC stock." An
individual generally may not deduct his or her personal, living, or family expenses.
See sec. 262(a). In view of the foregoing, we hold ASC, and therefore petitioners,
may not deduct employee achievement exþenses of $21,501 for 2004."
B.
Conferences and Me'etings
!
.
Petitioners claimed on ASC's 2004 Form 11120S deductions for expenses for
conferences and meetings of $69,663 for 2003 and $59,177 for 2004. Respondent
disallowed the claimed deductions because, as he;states on brief, the expenses
relatéd almost exclusively to meals and entertainment expenses not properly
substantiated under section 274(d). Petitioners sought.to meet the substantiation
requirements of section 274(d) through DiDonato's testimony and documentary
evidence, including canceled checks:and invoices. We conclude petitioners may
"Respondent also asserts, and we agree, that the substantiation requirements
of sec. 274(d) have not been met with respect to the firearm. No evidence was
offered at trial, and certainly not adequate records or detailed testimony, showing
Mr. Witter's business relationship to ASC or that the gift of the firearm furthered a
legitimate business purpose of ASC. Whereas the business relationship between
Mr. Witter and DiDonato (in his capacity as ASC's shareholder) is apparent from
the record, the same cannot be said of Mr. Witter and ASC.
33Because we conclude the firearm purchake was not an ordinary and
necessary business expense of ASC, we need not decide whether sec. 274(b) limits
the amount of the deduction to $25.
- 78 [*78] not deduct the expenses for conferences and meetings as reported on ASC's
2003 and 2004 Forms 1120S.
Deductions are a matter of legislative grace, and taxpayers bear the burden of
proving their entitlement to the deductions claimed. Rule 142(a); INDOPCO, Inc.
v. Commissioner, 503 U.S. 79, 84 (1992). Section 274 imposes heightened
substantiation requirements with respect to deductions for meals and entertainment
expenses. No deduction is allowed for meals and entertainment expenses, unless
the taxpayer establishes with adequate records or other credible evidence: (1) the
amount of the expense; (2) the time and place of the entertainment; (3) the business
purpose of the expense; and (4) the business relationship of the taxpayer to the
persons entertained, including the name, title, or other designation sufficient to
establish the business relationship to the taxpayer. See sec. 274(d); sec. 1.274-
5T(b)(3), Temporary Income Tax Regs., 50 Fed. Reg. 46015 (Nov. 6, 1985).
Before a deduction is allowed for entertainment expenses, the taxpayer must
establish that the expenditure was (1) directly related to the active conduct of the
taxpayer's trade or business, or (2) associated with the active conduct of the trade
or business where the expenditure was incurred directly before or directly after a
substantial and bona fide business discussion. Sec. 274(a)(1)(A); see also sec.
1.274-2(a)(1), Income Tax Regs. An expenditure is for entertainment directly
- 79 [*79] related to the active conduct of a trade or business if, among other situations,
(1) the taxpayer had more than a general expectation of deriving some income or
other future benefit, (2) the entertainment occurred in a clear business setting in
furtherance of the taxpayer's trade or business, (3) the entertainment was for the
benefit of a nonemployee and in the nature of compensation for services rendered,
or (4) the expenditure was a portion of club dues allocable to certain facilities used
by the taxpayer to furnish food and beverages. jLee sec. 1.274-2(c), Income Tax
Regs.
An expenditure for entertainment is associated with the active conduct of the
taxpayer's trade or business where the taxpayer establishes a clear business purpose
in incurring the expense, such as to obtain new business or to encourage the
continuation of an existing business relationship. See sec. 1.274-2(d)(2), Income
Tax Regs. For a taxpayer to establish a substantial and bona fide business
discussion, the taxpayer must show that the taxpayer actively engaged in a business
meeting, negotiation discussion, or other bona fide business transaction, other than
entertainment, to obtain income or some other specific benefit. Sec. 1.2742(d)(3)(i)(a), Income Tax Regs. In addition, the taxpayer must prove the business
meeting, negotiation, discussion, or transaction was substantial in relation to the
entertainment. Id.
- 80 [*80] Petitioner introduced into evidence canceled checks and invoices from most
of the service providers to which the conference and meeting expenses relate.
While these records establish that DiDonato paid amounts to various social clubs
and proprietors, they are not adequate records under section 274(d) because they do
not establish the time and place of the entertainment, the business purpose of the
entertainment, or ASC's relationship to the person entertained. Petitioners'
attempts to buttress their documentary evidence with DiDonato's testimony does
not satisfy the strict requirements of section 274 because we find DiDonato's
testimony in isolation to be not credible. See sec. 1.274-5T(c)(2), (3), Temporary
Income Tax Regs., supra (the taxpayer must prove the business purpose of an
expense with "direct evidence" such as a written statement or the oral testimony of
the persons entertained).
As a preliminary matter, we note that DiDonato testified that CEG (and not
ASC) paid the conference and meeting expenses at issue." Even gratuitously
construing DiDonato's testimony as confusing ASC and CEG, we reject the
contention that he has satisfied the substantiation requirements of section 274.
DiDonato did not name each of the individuals present at any of the 29 or 30
"In response to the question "[A]re these expenses that were paid by CEG?"
- 81 [*81] conferences and meetings held in 2003 and 2004, respectively. He did not
call these individuals to testify as to their presence at the conferences and meetings,
their business relationship to ASC, or the business purpose of the conferences or
meetings they purportedly attended. Nor did he state the business relationship
between ASC and the persons entertained by, for example, giving the person's
name, title, or other affiliation to ASC. We thus decline to find his testimony
sufficiently detailed to satisfy the section 274 substantiation requirements. Accord
Tyson v. Commissioner, T.C. Memo. 2009-176, 98 T.C.M. (CCH) 66, 70 (2009)
(no meals and entertainment expense deductions where the business relationship
between the taxpayer and the person entertained was not accompanied with the
name, title, or other designation of the person entertained); Clooney v.
Commissioner, T.C. Memo. 1999-194, 77 T.C.M. (CCH) 2156, 2159 (1999)(credit
card statements and receipts alone do not establish a business purpose for the
expense); Hankenson v. Commissioner, T.C. Memo. 1984-200, 47 T.C.M. (CCH)
1567, 1569 (1984) (costs of lunch meetings that did not have a stated business
purpose were nondeductible personal expenses).
Moreover, DiDonato did not explain how the expenditures for conferences
and meetings related to ASC's trade or business. DiDonato did not establish that
ASC expected a future economic benefit as a result of any of the meetings, or that
- 82 [*82] any expense was incurred in a clear business setting. In addition, many
expenses at issue were incurred at social clubs such as the Leash, the Philadelphia
Club, and the Nassau Club, all of which bear strong personal elements. Multiple
notes on invoices from the Leash indicated that the invoices could not be paid from
business accounts, indicating to us further that these expenses were not for
business. Accordingly, we hold petitioners may not deduct conference and meeting
expenses of $69,663 for 2003 and $59,177 for 2004.
C.
Aircraft Leasing Expense
1.
Parties' Arguments
Respondent determined that ASC was not entitled to deduct lease payments
of $217,518 for 2003 and $262,745 for 2004 to Equipment Leasing for use of the
aircraft. Respondent asserts on brief that the aircraft lease was not an ordinary or
necessary business expense of ASC because petitioners used the aircraft mostly for
personal purposes that were unrelated to ASC's trade or business. Respondent,
relying on Harbor Med. Corp. v. Commissioner, T.C. Memo. 1979-291, 38 T.C.M.
(CCH) 1144 (1979), aff'd without published opinion, 676 F.2d 710 (9th Cir. 1982),
also argues it was unreasonable for ASC to lease the aircraft from Equipment
Leasing because, as respondent asserts, the cost of operating the aircraft was
"exponentially greater" than commercial air travel. Lastly, respondent maintains
- 83 [*83] that ASC may not deduct the cost of the aircraft lease even if petitioners
prove the aircraft was an ordinary and necessary business expense because, respondent contends, petitioners have not met the substantiation requirements of
section 274(d). Petitioners counter that they used the aircraft for legitimate
business purposes more than 50% of the time andithat their children's presence on
some of the flights does not limit their deduction. We conclude that petitioners
have failed to show the use of the aircraft was primarily related to petitioners'
business and that in any even they have not met the stringent substantiation
requirements under section 274(d) to support the reported expenses.
2.
Guiding Principles
Section 162 provides for a deduction of ordinary and necessary business
expenses including traveling expenses paid or incurred in carrying on any trade or
business. Sec. 162(a)(2). The Code recognizes traveling expenses as a type of
expense for which a deduction under section 162 may be allowed. Like all trade or
business expenses, traveling expenses are deductible only to the extent the
expenditures are reasonably necessary in, and directly attributable to, the taxpayers'
trade or business. Commissioner v. Flowers, 326 U.S. 465, 470 (1946); sec. 1.1622(a), Income Tax Regs. When taxpayers travel to a destination and engage in both
business and personal activities thereat, traveling expenses to and from the location
- 84 [*84] are deductible only if the trip is primarily related to the taxpayers' business.
Sec. 1.162-2(b)(1), Income Tax Regs. Whether a given trip is primarily related to
the taxpayers' business or personal pursuits depends upon the facts and
circumstances of each case. Sec. 1.162-2(b)(2), Income Tax Regs. As the trier of
fact, we draw inferences and conclusions from the totality of the record, see
Commissioner v. Scottish Am. Inv. Co., 323 U.S. 119, 122-123 (1944), and
whether traveling expenses are directly related to a trade or business is a primarily
a factual determination, see Commissioner v. Heininger, 320 U.S. 467, 475 (1943).
In deciding whether a trip is primarily personal, an important factor to consider is
the amount of time during the trip spent on personal activities as compared with the
amount of time spent on business activities. Sec. 1.162-2(b)(2), Income Tax Regs.
Petitioners bear the burden of proving that the expense of leasing an aircraft was
deductible.35 See Rule 142(a).
35The Secretary recently promulgated regulations providing that if a
corporate jet is used for both business and entertainment purposes, the corporation
must allocate the actual aircraft expenses person by person and flight by flight
between the two types of uses, under either an occupied-seat hours or occupiedseat miles method. See sec. 1.274-10, Income Tax Regs. (effective Aug. 1, 2012).
-85[*85]
3.. Analysis
.
Of the 10 trips taken in 2003, see supra pp. 22-23, at least 7 were completely
personal; namely, trips 1, 2, 4, 5, 6, 7, and 10.36 As to trip 1, petitioners' children
were on board; and although DiDonato provided inconsistent testimony as to
whether he stayed in Orlando or Fort Lauderdale, Ms. DiDonato's credit card
statements established that at least she was in or around Disney World. As to trips
2, 4, 5, 7, and 10, DiDonato testified at trial that each of these trips were for the
sale of his personal shares of ASC stock. As explained at section V.A.4 of this
opinion, expenses related to the sale of a shareholder's stock in a corporation are
not deductible by the corporation as a business expense of the corporation. See
Snyder Bros. Co. v. Commissioner, 40 T.C.M. (CCH) at 772; cf. sec. 1.280F6(d)(2), Income Tax Regs. (a qualified business use does not include use for which
a deduction is allowable under section 212; i.e., for the production or collection of
income or for the management, conservation, or maintenance of property held for
the production of income). As for trip 6, DiDonato testified that Ms. DiDonato
traveled to Rochester on a Friday and returned on a Sunday, purportedly to meet
36InsOfar as petitioners' children were present on a flight and the flight was
used in furtherance of the sale of DiDonato's shares of ASC stock, we count the
flights only once as being in connection with the sale of DiDonato's shares of
ASC stock.
- 86 [*86] with a supplier of eyecare products. We regard this trip as personal because
Ms. DiDonato traveled on a weekend, her children were present on board the flight,
and her family resided in the area.
The remaining trips taken in 2003, namely, trips 3, 8, and 9, had a business
purpose that was questionable at best. As to trip 3, we question the business
elements of that trip because we do not find credible DiDonato's testimony that he
flew to Washington on a Sunday primarily to attend a seminar at his law firm and
doubt there was a legitimate business purpose for the trip. As to trips 8 and 9,
purportedly for a conference at the Vision Expo in Las Vegas and to visit a
research facility, respectively, petitioners have failed to persuade us with credible
evidence that these trips were primarily motived by a business purpose. Thus, we
conclude that expenses reported and incurred in connection with the use of the
aircraft in 2003 were personal.
Of the 12 trips taken in 2004, see supra pp. 24-25, at least seven of those
trips were completely personal; namely, trips 2, 3, 4, 7, 8, 10, and 12. As to trips 2,
3, 4, 7, and 8, DiDonato testified at trial that each of these trips was for the sale of
his personal shares of ASC stock. As just explained, expenses related to the sale of
a shareholder's stock in a corporation are not deductible by the corporation as a
business expense of the corporation. See Snyder Bros. Co. v. Commissioner, 40
- 87 [*87] T.C.M. (CCH) at 772; cf. sec. 1.280F-6(d)(2), Income Tax Regs. (a qualified
business use does not include use for which a deduction is allowable under section
212; i.e., for the production or collection of income or for the management,
conservation, or maintenance of property held for the production of income). As to
trip 10, a trip to East Hampton, we conclude the trip was personal, seeing that
petitioners flew to East Hampton with Dr. Stein and flew back tö New Jersey
without the doctor after a lengthy layover. DiDonato did not explain why it was
necessary to ASC's business that he and his wife be present on the flight to East
Hampton, and he did not explain what he and his wife did during the layover they
had while in East Hampton. We thus conclude that trip 10 was for personal
purposes. As to trip 12, a flight Ms. DiDonato and her children took to Rochester,
we conclude this trip was personal for the same réasons stated above.
As to the other five trips taken in 2004, petitioners have not.shown a primary
business purpose existed. As to trip 1, from Trenton, New Jersey, to Atlanta,
Georgia, DiDonato testified that he and Ms. DiDónato took this trip to attend the
Southern Council of Optometry meeting. Petitioners offered no supporting details
to corroborate the business purpose of this trip, and we decline to accept
DiDonato's self-serving testimony on the issue. See Tokarski v. Commissioner, 87
T.C. 74, 77 (1986). As to trips 5, 6, and 9, DiDonato:testified that he flew to
- 88 [*88] Washington to meet with his lawyers and his congressman, but he failed to
show that these trips was made primarily to further a legitimate business purpose.
As to trip 9 specifically, we note that petitioners' children were on board this flight,
suggesting there were personal or recreational elements to this trip as well. Finally,
as to trip 11, another trip to a conference in Las Vegas, which we find inherently
suspect, petitioners have not persuaded us that it was primarily related to a
legitimate business purpose. For reasons explained, we conclude expenses
reported and incurred in connection with the use of the aircraft in 2004 were also
personal.
Even if we were to believe that one or more of the trips taken had a
legitimate business purpose, we agree with respondent that no deductions are
allowed because the heightened substantiation requirements of section 274(d) have
not been met. See Lysford v. Commissioner, T.C. Memo. 2012-41, 103 T.C.M.
(CCH) 1217, 1220-1221 (2012) (declining to credit the taxpayer with business use
of a personal aircraft where the taxpayer did not maintain written documentary
evidence of the business purpose of the flights, the names of persons visited, or a
description of the business actually or attempted to be conducted); Weekend
Warrior Trailers, Inc. v. Commissioner, T.C. Memo. 2011-105, 101 T.C.M. (CCH)
1506, 1521 (2011) (general testimony of individuals who flew on an airplane and
- 89 [*89] their alleged business relationship,.without specific testimony as to the
business purpose for each airplane use, did not satisfy the substantiation
requirements of section 274). See generally Sanford v. Commissioner, 50 T.C. at
827 (section 274(d) supersedes the Cohan rule); sec. 1.274-5T(a), Temporary
Income Tax Regs., supra.
D.
Effect of Disallowed Deductions
The disallowed deductions result in increases to ASC's income. Because
DiDonato was ASC's sole shareholder during the subject years, it follows that
petitioners must include in income 100% of the adjustments on Schedule E. See
sec. 1366.
VI.
Mallard's Expenses for the 245 and 265 Cold Soil Properties
A.
Overview
Respondent disallowed Schedule E rental real estate expenses relating to the
245 and 265 Cold Soil properties of $549,203 for 2003 and $477,511 for 2004. In
support of his position, respondent raises three related arguments. First, he asserts
petitioners (or Mallard) did not hold the 245 and 265 Cold Soil properties as rental
properties during the subject years. Second, he maintains all expenses claimed for
the 245 and 265 Cold Soil properties are nondeductible personal expenses. Third,
he avers petitioners were not engaged in the rental real estate or farming activities
- 90 [*90] for profit. Petitioners assert that expenses incurred in the ownership,
management, and rental of the 245 and 265 Cold Soil properties were deductible.
We agree with respondent that petitioners' deductions of the expenses are limited
as stated herein.
B.
Whether the 245 and 265 Cold Soil Properties Were Rental
Properties
Respondent asserts that all of the claimed expenses related to the 265 Cold
Soil property are nondeductible because, he contends, neither property was held as
a rental property for either of the subject years. With respect to the 265 Cold Soil
property, respondent cites section 280A(d) as standing for the proposition that the
property is deemed to have been used for personal purposes by virtue of his father's
residing there. As to the 245 Cold Soil property, respondent argues the property is
not a rental property because, as he sees it, petitioners failed to establish that they
received rent from the property. Petitioners argue that the 245 and 265 Cold Soil
properties were each rented at a fair rent and, with respect to the 265 Cold Soil
property, section 280A(d) does not disallow the claimed expense deductions for the
property. We agree with respondent that expense deductions claimed with respect
to the 265 Cold Soil property are disallowed under section 280A(d), and we hold
that petitioners may deduct only the expenses, i.e., real estate taxes, specified
- 91 [*91] herein. We disagree with respondent that the 245 Cold Soil property was not
held as a rental property for the subject years, though we conclude that deductible
"losses" related to the 245 Cold Soil property are limited by section 183(b).
Section 280A disallows otherwise allowable deductions with respect to a
dwelling unit used as a taxpayer's residence. Section 280A(d)(1) provides that a
taxpayer is considered to have used a dwelling unit as a residence where the
property is used for personal purposes for a number of days which exceeds the
greater of 14 days or 10% of the number of days during which the property is
rented at a fair rent. Section 280A(d)(1) specifies that a dwelling unit may not be
treated as rented at fair rental value for any day fór which the property is used for
personal purposes. In general, a taxpayer is generally deemed to have used a
dwelling unit for personal purposes if, during any part of a day, a member of the
taxpayer's family (as defined in section 267(ó)(4))uses the unit for personal
purposes. Sec. 280A(d)(2). A member of the taxpayer's family includes, among
other enumerated relationships, the taxpayer's ancestors. Sec. 267(c)(4).
Notwithstanding the general rule that a family member's use of a dwelling
unit is imputed to the taxpayer, a taxpayer is not treated as using the property for
personal purposes for any period where the dwelling unit is rented to the family
member for use as the family member's personal residence at a fair rent. Sec.
- 92 [*92] 280(d)(3)(A). DiDonato's father rented the dwelling at the 265 Cold Soil
property during the entire period of the subject years. Therefore, under section
280A(d), DiDonato is deemed to have used the dwelling unit on that property for
personal purposes under section 280A(d), and so his rental expenses may not be
deducted unless the dwelling was rented at a fair rent.
The determination of whether a dwelling unit is rented at a fair rent is made
in the light of the facts and circumstances that existed when the rental agreement
was entered into. See sec. 280A(d)(2)(C); sec. 1.280A-1(e)(3)(iii), Proposed
Income Tax Regs., 48 Fed. Reg. 33320 (July 21, 1983). Although the term "fair
rent" is not defined in the Code or the regulations under section 280A, the
legislative history makes clear that the fairness component be determined on the
basis of comparable rents in the area. See H.R. Rept. No. 97-404, at 8 (1981); see
also Senate Explanation to Pub. L. 97-119, 27 Cong. Rec. S15487 (daily ed. Dec.
16, 1981). Petitioners bear the burden of proving the fair rental value of the
dwelling unit. See Rule 142(a); Crotty v. Commissioner, T.C. Memo. 1990-261,
59 T.C.M. (CCH) 691, 695-696 (1990); Smith v. Commissioner, T.C. Memo. 1985446, 50 T.C.M. (CCH) 904, 905 (1985); Bindseil v. Commissioner, T.C. Memo.
1983-411, 46 T.C.M. (CCH) 764, 765 (1983).
- 93 -
[*93] Petitioners offered no evidence at trial as to the fair rental value of the 265
Cold Soil property other than DiDonato's testimony that the amount of rent to be
charged was set by his tax attorney and, in DiDonato's view, the rent was fair by
virtue of his belief that the property was in "deplorable shape". DiDonato's
testimony alone is unpersuasive. The record does not include the methodology, if
any, the tax attorney used to determine the fair rental value. Because petitioners
did not call this individual to testify on their behalf, we do not have the benefit of
his reasoning. Nor does the record include evidence as to the fair rental value of
comparable homes in the area surrounding the 265 Cold Soil property. We decline
to accept DiDonato's uncorroborated and self-serving testimony that monthly rent
of $400 for a single-family residence in New Jersey was fair rental value. See
Gerdau Macsteel, Inc. v. Commissioner, 139 T.C.
, __(slip op. at 143) (2012);
see also Tokarski v. Commissioner, 87 T.C. at 77; Barasso v. Commissioner, T.C.
Memo. 1978-432. In the absence of reliable evidence that the 265.Cold Soil
property was rented at fair rental value, we conclude that it was not. See Epstein v.
Commissioner, T.C. Memo. 1994-34, 67 T.C.M. (CCH) 2046, 2051 (1994) (the
failure of a party to introduce evidence as to the fair rental value of a dwelling unit
creates a presumption that the evidence would be unfavorable to that party's
position); Roy v. Commissioner, T.C. Memo. 1998-125, 75 T.C.M. (CCH) 2081,
- 94 [*94] 2083 n.3 (1998)(taxpayers could not prevail in the absence of evidence on
the fair rental value of that portion of a dwelling unit rented); Bindseil v.
Commissioner, 46 T.C.M. (CCH) at 765 (taxpayer not able to prevail in the
absence of expert evidence to support his claim of fair rental value). As far as
Mallard's books and records suggest, DiDonato's father paid no rent at all. This
documentary evidence (or lack thereof) is consistent with testimony of
respondent's revenue agent, who testified that rent was not received by Mallard or
petitioners.
We are mindful of section 1.280A-1(e)(6), Proposed Income Tax Regs., 48
Fed. Reg. 33320 (July 21, 1983), which states that a taxpayer shall not be deemed
to have used a dwelling unit for personal purposes on any day on which the
principal purpose of the unit's use was to perform repair or maintenance work on
the dwelling unit. Still, our conclusion is unchanged. The record abounds with
evidence showing that most (if not all) of the repairs and maintenance to the 265
Cold Soil property related to work on two barns, several smaller structures, a
chicken coop, grounds, and other like alterations. While DiDonato testified about
general improvements to the dwelling house on the 265 Cold Soil property, he did
not offer specific testimony about whether the work performed qualified as repairs
and maintenance on the dwelling unit. Indeed, a pretrial request respondent made
- 95 [*95] to the Township of Lawrence pursuant to New Jersey's Open Public Records
Act, N.J.S.A. sec. 47:lA-1, et seq., and requesting information as to work
performed on the 265 Cold Soil property, revealed that construction permits for the
dwelling house of that property had not been issued until late 2009. The lack of
evidence on fair rental value of the 265 Cold Soil property, coupled with the
testimony of respondent's revenue agent that the dwelling unit at the 265 Cold Soil
property had not undergone significant repairs or maintenance, leads us to conclude
that the 265 Cold Soil property was used for DiDonato's personal purposes under
section 1.280A-1(e)(6), Proposed Income Tax Regs., supra.
As to the 245 Cold Soil property, respondent argues the property is not a
rental property because, he posits, petitioners failed to establish that they received
rent from the property. We are not persuaded. Included in the record is a rental
agreement reciting that DiDonato leased to Mr. Richen for $800 per month the
dwelling house located at the 245 Cold Soil property. The record does not include
evidence suggesting that Mr. Richen was a member of DiDonato's family within
the meaning of section 267(c)(4). We thus find that section 280A does not require
the disallowance of any of the expenses petitioners claimed with respect to the 245
Cold Soil property.
- 96 [*96] Pursuant to section 280A(d)(2)(A), petitioners are deemed to have used the
dwelling at the 265 Cold Soil property for personal purposes during the subject
years, because the record does not establish that the 265 Cold Soil property was
rented at fair rental value at any point during the subject years. Therefore, none of
the claimed deductions are allowable under section 280A(c)(3) and (e)(1), except
deductions allowable without regard to their connection with DiDonato's rental
real estate activities; specifically, property taxes of $50,090 for 2003 and $51,081
for 2004 are the only claimed expenses for which deductions are allowed. See sec.
164(a)(1). Insofar as the 265 Cold Soil property was not a qualified residence to
petitioners under section 163(h)(4)(A)(i) they are not entitled to mortgage interest
deductions with respect to that property. See Epstein v. Commissioner, 67 T.C.M.
(CCH) at 2049 n.4.
C.
Whether Petitioners' Real Estate Activities Were Entered Into for
Profit
1.
Overview
Respondent claims that petitioners may not deduct expenses relating to the
245 and 265 Cold Soil properties because petitioners did not hold either property
with the primary purpose of making a profit. Petitioners are deemed to have used
the 265 Cold Soil property for personal purposes throughout the subject years, and
- 97 [*97] we therefore need not decide whether section 183 applies for that property.
See sec. 280A(f)(3) (where section 280A(a) applies with respect to the use of a
dwelling unit for any year, section 183 generally does not apply to that unit for that
year); sec. 1.183-1(g), Proposed Income Tax Regs., 37 Fed. Reg. 13679 (July 13,
1972). After considering the claimed deductions relating to the 245 Cold Soil
property in the light of section 183, we agree with respondent and conclude that
petitioners' activities with respect to that property were not engaged in for profit.
Sections 162 and 212 allow a deduction for all the ordinary and necessary
business expenses paid or incurred during the taxable year in carrying on a trade or
business or for the production or collection of income. See secs. 162(a), 212(1).
Section 183 generally limits deductions for an activity not engaged in for profit to
the amount of the activity's gross income. Sec. 183(b). Section 183(c) defines an
activity not engaged in for profit as "any activity 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."
2.
Whether Petitioners' Real Estate Activities Should Be
Aggregated or Examined in Isolation
Petitioners contend on brief that the Court should consider DiDonato's real
estate activities in the aggregate when evaluating his section 183 profit motive
- 98 [*98] because petitioners purportedly elected to aggregate his rental real estate
activities as one activity under section 469(c)(7)(A)." We decline to do so for two
reasons. The first reason is lack of conforming proof. The record does not include
a copy of petitioners' (or DiDonato's) Federal income tax return showing a proper
election was made under section 469 to aggregate the real estate activities as a
single activity. See sec. 1.469-9(g)(3), Income Tax Regs. (requiring an election to
be made on a statement accompanying the taxpayer's original tax return). In the
absence of reliable documentary evidence establishing that such an election was
properly made, we decline to conclude it was.
The second reason is a blend of law and fact. The regulations promulgated
under section 183 specify that, as an initial matter, in determining whether section
183 applies for a particular activity of the taxpayer, a determination must be made
as to the scope of the activity. Sec. 1.183-1(d)(1), Income Tax Regs. The activity
to be considered under section 183 may encompass a single undertaking by the
taxpayer or the activity may comprise several undertakings by the taxpayer. Id.
For purposes of section 183, each undertaking may be its own activity or several
"Petitioners claim on brief, as they stated at trial, that DiDonato elected to
aggregate his rental real estate activities under sec. 465. We are unaware of any
election available under sec. 465 allowing a taxpayer to aggregate his or her rental
real estate activities. We understand petitioners to refer to the election available
under sec. 469(c)(7)(A).
- 99
[*99] undertakings may be treated as a one activity. Id. .In ascertaining whether
the taxpayer's multiple undertakings constitute a single activity,or separate
activities, all the facts and circumstances of the case are taken into account. Id. In
general, the most important facts and circumstances to be evaluated in deciding the
scope of the activity are the degree of organizational and economic
interrelationship of the various undertakings, the similarity of the undertakings, and
the extent to which the overall business purpose is or may be served by carrying on
the various undertakings separately or together. Id. Where it is determined that the
taxpayer's multiple undertakings are separate activities, deductions and income
attributable to each activity must be treated separately and cannot be aggregated in
determining whether an activity is subject to section 183 or when applying the
section 183 loss limitation for that activity. Id.
Significantly, regulations interpreting section 183 provide an example of a
taxpayer who engages in farming on land purchased or·held primarily for profit
from appreciation. See sec. 1.183-1(d)(1), Income Tax Regs. In such an instance,
the farming and the holding of the land will ordinarily be considered a single
activity only if the farming activity reduces the net cost of carrying the land for its
appreciation in value. Id2 Thus, the farming and the holding of land will be
considered a single activity only if the income derived from the farming activity
- 100 [*100] exceeds the deductions attributable to the farming activity that are not
directly attributable to holding the land. Id.
Applying these general principles in this case, we will treat petitioners' real
estate undertaking with respect to the 245 Cold Soil property as a separate activity
for purposes of section 183. As we find, the facts and circumstances of this case
lead us to conclude that the undertaking involving the 245 Cold Soil property was
not sufficiently interrelated to petitioners' other rental real estate undertakings so as
to constitute a single activity. DiDonato's rental real estate activity in respect of
the 245 Cold Soil property was limited to renting to Mr. Richen the dwelling house
on that property. The rental real estate activity with respect to the 265 Cold Soil
property was also limited to renting to DiDonato's father the dwelling house on
that property. The undertaking as to the 245 Cold Soil property was not related to
the undertaking as to the 265 Cold Soil property. To the contrary, DiDonato
specifically rejected offers from developers to purchase the properties. Moreover,
since 1997, DiDonato had sold property rights related to the personal residence and
the 245 and 265 Cold Soil properties without any apparent regard for the possible
development of these properties in a subdivision. Nor do DiDonato's commercial
rental real estate activities bear any apparent relationship to his undertakings at the
A C
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042
- 101 [*101] DiDonato's profit objective with respect to the 245 Cold Soil property
independent of his other rental real estate undertakings.
3.
Guiding Principles
The test for deciding whether an activity is engaged in for profit is whether
the taxpayers entered into the activity with an "'actual and honest objective of
making a profit.'" See Elliott v. Commissioner, 84 T.C. 227, 236 (1985), aff'd
without published opinion, 782 F.2d 1027 (3d Cir. 1986); Purdey v. Commissioner,
T.C. Memo. 1989-657, 58 T.C.M. (CCH) 947, 950 (1989) (quoting Dreicer v.
Commissioner 78 T.C. 642, 645 (1982), aff'd without published opinion, 702 F.2d
1204 (D.C. Cir. 1983)), aff'd without published opinion, 922 F.2d 833 (3d Cir.
1990). In this context, the term "profit" focuses on economic profit independent of
tax savings. Seaman v. Commissioner, 84 T.C. 564, 588 (1985); Fox v.
Commissioner, 80 T.C. 972, 1006 (1983), aff'd without published opinion sub
nom. Rosenblatt v. Commissioner, 734 F.2d 7 (3d Cir. 1984). A reasonable
expectation of profit is not needed, but the facts and circumstances must indicate
the taxpayers entered into or continued the activity with the objective of making a
profit. Sec. 1.183-2(a), Income Tax Regs. In determining whether an activity is
engaged in for profit, we lend greater weight to objective facts than to a taxpayer's
statements of his or her intent. Id.
- 102 [*102] Regulations interpreting section 183 include a nonexclusive list of objective
factors to be evaluated in determining whether an activity is engaged in for profit.
The factors to be considered are: (1) the manner in which the taxpayers carry on the
activity; (2) the expertise of the taxpayers or their advisors; (3) the time and effort
expended by the taxpayers in carrying on the activity; (4) the expectation that
assets used in the activity may appreciate in value; (5) the success of the taxpayers
in carrying on other similar or dissimilar activities; (6) the taxpayers' history of
income or loss with respect to the activity; (7) the amount of occasional profits, if
any, which are earned; (8) the financial status of the taxpayers; and (9) whether
elements of personal pleasure or recreation are involved. Sec. 1.183-2(b), Income
Tax Regs. No single factor is outcome determinative, and we may look to factors
not specifically enumerated. Id.
a. .
Petitioners' Conduct of Their Activity
The fact that taxpayers carry on their activity in a businesslike manner may
indicate the existence of a profit objective. Sec. 1.183-2(b)(1), Income Tax Regs.
In deciding whether a taxpayer conducted an activity in a businesslike manner, we
consider whether complete and accurate books and records were kept, whether the
activity was conducted in a manner substantially similar to other comparable forprofit activities, and whether changes were made in an attempt to earn a profit. Id.
- 103 [*103] Although petitioners maintained books and records for Mallard and engaged
Amper to prepare the 2003 and 2004 returns, we are not persuaded they conducted
their real estate activity as to the 245 Cold Soil property in a businesslike manner.
Respondent's revenue agent testified credibly that petitioners' representative told
her during the audit that rental income from the 245 Cold Soil property was never
received (or collected) from the tenants. We credit this testimony in the light of the
fact that Mallard's books failed to report rental income from the 245 Cold Soil
property. We further credit the revenue agent's testimony given that Mallard's
books and records showed that petitioners (or Mallard) received rental income in
respect of DiDonato's seven other rental properties, The record does not include
copies of canceled checks or bank account statements showing that rental income
was received for the 245 Cold Soil property, further leading us to conclude that
petitioners were not concerned with receiving the rental income of the 245 Cold
Soil property.
Moreover, we are unpersuaded that petitioners ever meaningfully changed
any aspects of their rental activity of the 245 Cold Soil property with the primary
objective of making a profit. The annual expenses petitioners claimed for the 245
Cold Soil property, net of depreciation, exceeded the annual income earned from
- 104 [*104] that property by $215,729 for 2003 and $211,973 for 2004.38 Simply for
petitioners to break even during the subject years, a tenant residing in the 245 Cold
Soil property would have to have paid monthly rent of roughly $18,777 for 2003
and $18,464 for 2004, significantly greater than the $400 per month charged to Mr.
Richen (or his successor).39 No explanation was provided at trial as to the grossly
disproportionate charge of income to expense or how (if at all) petitioners intended
to ultimately profit from the 245 Cold Soil property. This factor disfavors a finding
that a profit objective existed.
b.
Petitioners' Expertise in the Rental Real Estate Activity
We next consider the level of expertise of petitioners or their advisers with
respect to the rental of the 245 Cold Soil property. Extensive study of accepted
business practices within a given activity or a willingness to consult with experts
therein may connote the existence of a profit objective. Sec. 1.183-2(b)(2), Income
Tax Regs. Where taxpayers have made such preparation or procured such expert
advice but do not carry on the activity in accordance with such practices, a lack of
38Calculated as total Schedule E expenses for the 245 Cold Soil property
($244,215 for 2003 and $248,214 for 2004), less depreciation expense ($18,886
for 2003 and $26,641 for 2004), less rental income ($9,600 for 2003 and 2004).
39Calculated as total Schedule E expenses for the 245 Cold Soil property,
net of depreciation ($225,329 for 2003 and $221,573 for 2004) divided by 12
- 105 [*105] intent to derive profit may be indicated unless it appears that the taxpayers
are aiming to develop a new or superior technique which may result in profits from
the activity. Id.
Although we agree with petitioners that DiDonato possessed the requisite
expertise in real estate management to indicate a profit objective, we are unwilling
to find that the rental real estate activity at the 245 Cold Soil property showed a
bona fide profit objective. DiDonato incurred expenses for the 245 Cold Soil
property, net of depreciation expense, of almost $450,000 for the subject years on
an investment that yielded him a mere $19,200 of rental income for the same years.
Finally, we question DiDonato's motivation for substantially improving the
grounds of the 245 Cold Soil property. As DiDonato testified on direct
examination, he did not incur these expenses to make his rental real estate activity
more profitable but "to maintain the reduced farmland/agricultural property tax
assessment." We treat this testimony as direct evidence of his desire to obtain
favorable tax treatment and not to make profitable the 245 Cold Soil property rental
real estate activity. This factor weighs against finding a profit objective.
c.
The Time and Efforts Expended by Petitioners
The taxpayers' dedication of much time and effort to carrying on an activity
may indicate a profit objective. Sec. 1.183-2(b)(3), Income Tax Regs. Although
- 106 [*106] DiDonato claimed at trial to have devoted between 60% and 70% of his
time to his real estate activities, we decline to credit this testimony for a few
reasons. First, DiDonato rented the 245 and 265 Cold Soil properties and nine
commercial rental buildings only to ASC, his father, Mr. Richen, or another
individual throughout the subject years. Second, DiDonato's testimony concerning
the amount of time he spent managing his rental properties was inconsistent. In
this regard, DiDonato contradicted his testimony about the amount of time devoted
to his rental real estate activities when he testified to "immense responsibilities" at
ASC and that he "tr[ies] to be there Monday through Friday." DiDonato went on to
contradict himself by later testifying that ASC "pretty much runs itself" and that he
spends "maybe five percent" of his time at ASC and that he spends the rest of his
time (i.e., roughly 95% of his time) managing real estate. We do not credit
DiDonato's conflicted testimony in the absence of documentary evidence to
support the amount of time he claims to have spent managing his rental real estate
activity. The record does not include a logbook, a diary, a planner, or other reliable
evidence from which we might deduce the hours he actually spent on his rental real
estate activity. In view of the fact that most of DiDonato's rental real estate
activities occurred between related entities or parties, we conclude he did not
-107[*107] expend as much time and effort on his rental real estate activities as he
claims to have done. This factor weighs against the finding of a profit objective.
d.
Expectation of the 245 Cold Soil Property's
Appreciation in Value
For purposes of section 183, the term "profit" encompasses appreciation in
the value of assets, such as land, used in the activity. Sec. 1.183-2(b)(4), Income
Tax Regs. Even if no profit is derived from the current operation of the activity,
the taxpayers may intend that an overall profit will result when appreciation in the
value of the asset used in the activity is realized because income from the activity
together with the appreciation of the asset will exceed expenses of operation. Id.
Petitioners presented no specific evidence regarding the likelihood of any
appreciation in value of the 245 Cold Soil property or how DiDonato intended to
recoup losses related to that property. DiDonato sold development rights to Mercer
County with respect to the 245 Cold Soil property, see DiDonato v. Commissioner,
101 T.C.M. (CCH) at 1739-1741, he declined offers from real estate developers to
sell the property, and he erected barns, chicken coops, and fences on the land. The
weight of this evidence suggests to us that DiDonato did not hold the 245 Cold Soil
property for appreciation but for personal reasons lacking a profit objective. This
factor disfavors our finding a profit objective.
- 108 [*108]
e.
Petitioners' Success in Carrying On Similar Activities
We next examine petitioners' success in carrying on other similar activities.
The taxpayers' success in similar activities may indicate the taxpayers had a profit
objective even though the current activity is not presently profitable. Sec. 1.1832(b)(5), Income Tax Regs. DiDonato had previously worked with rental real estate
properties, but he has not shown the profitability or success of his endeavors with
reliable evidence. DiDonato testified that he first got involved with rental
properties at the age of 18 and that since that time he has purchased, sold, owned,
managed, or mortgaged at least 75 commercial and residential rental properties in
Mercer County. Petitioners did not offer any evidence to corroborate DiDonato's
testimony, and we decline to accept it given the fact that the 2003 and 2004 returns
reported the extent of his rental real estate activities as pertaining to only nine
rental properties. As far as the record is concerned, DiDonato appears to be a
successful optometrist who has limited experience in the rental real estate market
by virtue of his leasing rental properties to entities he owned and operated. We
question DiDonato's claim to have had success in his rental real estate activities
given that the only reliable history in that respect concerns his renting each of nine
rental properties to ASC, his father, or Mr. Richen (or another individual). This
factor is neutral at best.
- 109 -
[*109]
f.
Petitioners' History of Income and Loss
We next examine petitioners' history of incóme and loss with respect to the
rental real estate activity. A series of substantial losses may indicate the taxpayer
did not conduct the activity for profit. Golanty v.e Commissioner, 72 T.C. 411, 427
(1979), aff'd without published opinion, 647 F.2d 170 (9th Cir. 1981); sec. 1.1832(b)(6), Income Tax Regs. Losses during the initial stage of an activity do not
necessarily indicate, however, that the activity was not conducted for profit.
Engdahl v. Commissioner, 72 T.C. 659, 669 (1980); sec. 1.183-2(b)(6), Income
Tax Regs.
Petitioners reported sizable losses with respect to the 245 Cold Soil property
for each of the subject years. They offered no evidence that the rental activity for
the 245 Cold Soil property became profitable in later years or that they sold the
property for a gain. At the same time, DiDonato rebuffed inquiries from real estate
developers about the sale of the 245 Cold Soil property. This factor weighs against
the finding of a profit objective.
g.
The Amount of Occasional Profits
The amount of profits earned in relation to the amount of losses incurred, the
amount of the investment, and the value of the assets in use may indicate a profit
objective. Sec. 1.183-2(b)(7), Income Tax Regs. The opportunity to earn
- 110 [*110] substantial profits in a highly speculative venture may be sufficient to
indicate that the activity is engaged in for profit even though only losses are
produced. Id. In determining whether the taxpayers entered into the activity for
profit, a small chance of making a large profit may indicate the requisite profit 042
objective. Id.
Petitioners presented no evidence that their investment in the 245 Cold Soil
property might create a windfall profit to them apart from tax savings. Although
real estate developers may have sought out the 245 Cold Soil property, among
others, DiDonato was then unwilling to discuss the sale of that property. The
record does not include evidence to suggest petitioners might earn a profit from the
sale of the 245 Cold Soil property. In the absence of such information, we
conclude it does not exist or it would not be favorable to petitioners' position.
Accord Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. at 1165 ("The rule
is well established that the failure of a party to introduce evidence within his
possession and which, if true, would be favorable to him, gives rise to the
presumption that if produced it would be unfavorable."). This factor does not favor
a finding of a profit objective.
-111[*111]
h.
Petitioners' Financial Status
The fact that taxpayers do not have considerable income from sources other
than the activity may indicate the activity is engaged in for profit. See sec. 1.1832(b)(8), Income Tax Regs. Substantial income from other sources may indicate a
lack of a profit objective, however, particularly if there are personal or recreational
elements in the activity. Id.
Petitioners reported sizable total income for each of the subject years; they
reported receiving $237,196 for 2003 and $222,279 for 2004. Because petitioners
aggregated their rental income and expenses on Schedules E, they were able to
claim losses from their activity at the 245 Cold Soil property to offset rental income
that they (or Mallard) received from ASC for the commercial rental properties.
Indeed, the losses from the 245 and 265 Cold Soil properties, net of depreciation,
would have enabled petitioners to offset all rental income they (or Mallard)
received from ASC. The considerable tax savings petitioners claimed from
structuring their investment in the 245 Cold Soil property to offset gains from other
rental real estate activities undercuts the claim that petitioners engaged in the
activity with an intent to profit without regard for tax savings.* See Seaman v.
*Petitioners' farming activity, as it related to the personal residence and the
245 and 265 Cold Soil properties, also enabled them to reduce their local property
(continued...)
- 112 [*112] Commissioner, 84 T.C. at 588; see, e.g., Smith v. Commissioner, T.C.
Memo. 2007-154, 93 T.C.M. (CCH) 1371, 1376 (2007) (using losses to offset
income weighs in favor of finding the taxpayer was not engaged in an activity for
profit); Kahla v. Commissioner, T.C. Memo. 2000-127, 79 T.C.M. (CCH) 1846,
1852 (2000), aff'd without published opinion, 273 F.3d 1096 (5th Cir. 2001). This
factor weighs against the finding of a profit objective.
i.
Elements of Personal Pleasure
The existence of elements of personal pleasure or recreation relating to the
activity may indicate the absence of a profit objective. Sec. 1 .183-2(b)(9), Income
Tax Regs. An activity will not be treated as not engaged in for profit simply
because the taxpayers have purposes or motivations other than making a profit. Id.
The record does not suggest that petitioners derived any satisfaction from the rental
*(...continued)
taxes by hundreds ofthousands of dollars. On this point DiDonato testified that
his failure to secure farm and agricultural designation of these properties for
assessment purposes would result in the "county government * * * confiscating his
property." He went on to explain that "two-hundred [sic] fifty acres assessed at
market value, I'd have a tax bill of $750,000 a year plus rollback taxes. You can't
do it. Nobody in New Jersey has acreage more than five acres without getting a
farm assessment. To get a farm assessment, you have to sell agricultural products.
Everybody in New Jersey sells agricultural products." We reject the suggestion
that manipulating local property tax law creates an actual and honest profit
objective for Federal income tax purposes.
- 113 [*113] of the 245 Cold Soil property apart from the Federal income tax and local
property tax savings they expected to realize therefrom. We view this factor as
neutral.
j.
Summary
On balance, one factor weighs in favor of a profit objective, one factor is
neutral, and eight weigh against a finding of a profit objective. We conclude
petitioners's rental real estate activity with respect to the 245 Cold Soil property
was not entered into with an actual or honest objective of making a profit. Thus,
petitioners may not deduct expenses for the 245 Cold Soil property under section
162(a) or 212. Petitioners are, however, entitled to deductions under section
183(b) with respect to the 245 Cold Soil property as follows. First, petitioners are
allowed deductions for expenses that are deductible without regard to whether the
rental real estate activity was engaged in for profit; specifically, real estate taxes of
$5,590 for 2003 and $5,853 for 2004. See secs. 164(a)(1), 183(b)(1); Brannen v.
Commissioner, 78 T.C. 471, 499-500 (1982), aff'd, 722 F.2d 695 (11th Cir. 1984).
Second, petitioners are allowed deductions for expenses that would be deductible if
the rental real estate activity was engaged in for profit, but only to the extent of
gross receipts from the activity; namely $9,600 for each of the subject years. See
sec. 183(b)(2). Because the 245 Cold Soil property was not a qualified residence
-114[*114] of petitioners under section 163(h)(4)(A)(i), they are not entitled to
mortgage interest deductions over and above that already allowed under section
183(b)(2). See Epstein v. Commissioner, 67 T.C.M. (CCH) at 2049 n.4.
VII. Equipment Leasing's Losses and Recapture of Excess Depreciation
A.
Overview
Petitioners claimed loss deductions that flowed through from Equipment
Leasing's aircraft leasing activity of $694 for 2003 and $19,964 for 2004.
Petitioners took the reporting position on their 1999 through 2003 returns that the
aircraft was prèdominantly used in a qualified business use. Consistent with that
position, petitioners claimed accelerated depreciation expense deductions totaling
$278,950 on Schedules C attached to.the 1999 through 2002 returns. Petitioners
also took the position that the aircraft was predominantly used in a qualified
business use during 2003. Consistent therewith, they claimed accelerated
depreciation expense deductions of $43,200 and $21,600 on Equipment Leasing's
Schedules C attached to their 2003 and 2004 returns, respectively. On brief,
petitioners assert that they are entitled to an accelerated depreciation expense
deduction for each of the years 1999 through 2004 because the aircraft share was
used in a qualified business use more than 50% of the time.
- 115 [*115] Respondent challenges petitioners' entitlement to loss deductions from
Equipment Leasing's aircraft leasing activity.for 2003 and 2004, and he alleges
through an amended answer that petitioners must recapture in 2003 excess
depreciation claimed for 1999 through 2002. We agree with respondent on both
points.
B.
Burden of Proof
Petitioners generally bear the burden of proving their entitlement to the
aircraft leasini, activity loss deductions claimed for 2003 and 2004.. See Rule
142(a). Respondent concedes on brief that he must prove that petitioners must
recapture for 2003 excess depreciation claimed for 1999 through 2002. See id.
C.
Loss Deductions Claimed for 2003 and 2004
·.
Respondent disallowed loss deductions of $694 for 2003 and $19,964 for
2004 with respect to Equipment Leasing's aircraft leasing activity. Respondent
concedes on brief that petitioners are entitled to claim items of income and expense
as reported on the Schedules C for Equipment Leasing attached to the 2003 and
2004 returns, but respondent maintains that petitioners must depreciate the aircraft
using the alternative depreciation system of section 168(g) and recapture in 2003
excess depreciation claimed on their.1999 through 2002 Federal income tax
returns. On the basis of respondent's concession, Equipment Leasing's net profit
-116[*116] or loss for the subject years shall be calculated as reported on the 2003 and
2004 returns, except as modified immediately below.
D.
Recapture of Excess Depreciation
Respondent alleges in his amended answer that petitioners did not use the
aircraft share in a qualified business use during 2003 for two reasons. First, he
asserts that the aircraft share was not predominantly used in a qualified business
use under section 280F because Equipment Leasing and ASC were related parties.
See sec. 280F(d)(6)(C)(i). Second, he contends that less than 25% of the total use
of the aircraft share consisted of a qualified business use that was not between
related parties. See id. Respondent argues that because the aircraft share was not
used in a qualified business use during 2003, petitioners are not entitled to claim an
accelerated depreciation expense deduction for 2003 but must use the straight-line
depreciati
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