# Petition for Writ of Certiorari — Cannon v. Commissioner

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Petition for Writ of Certiorari
- **Published:** January 1, 1992
- **Citation:** 505 U.S. 1220

## Text

=

6 6 5 Suprane Court, U.S

; FILED
NO. |
en tH?
In the SPiGE QF THE CLERK

Supreme Court of the United States

OCTOBER TERM 1991

CHARLA GATES CANNON,

Petitioner,

versus

COMMISSIONER OF INTERNAL REVENUE,

Respondent.

PETITION FOR A WRIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS
FOR THE TENTH CIRCUIT

TOWNER SHIELDS LEEPER
JOHN LEEPER

Attorneys for Petitioner
LEEPER & LEEPER

661 Mesa Hills Drive

El Paso, Texas 79912

(915) 581-8748

A B Letter Service, Inc., 327 Chartres St., New Orleans, La. (504) 581-5555

i

QUESTIONS PRESENTED

The litigants in this income tax case tried and briefed
the case in the issues of whether the stipulated expenses
were deductible as business expenses or for the production
of income. The Tax Court disallowed the expenses on the
ground they were hobby losses. The Tenth Circuit affirm-
ed. The questions presented are:

Was it reversible error to sua sponte construe the hob-
by loss provisions in pari materia with those involving
business expenses?

Should the case be remanded to the Tax Court to af-
ford petitioner the opportunity to offer evidence on the
hobby loss issue?

il
TABLE OF CONTENTS

Question Presented

Table of Contents

Table of Authorities

Citations to Opinion Below
Jurisdiction

Statement of the Case

Reasons Why the Writ should be granted
Conclusions and Prayer

APPENDIX:

A. STATUTES INVOLVED

B. DECISION OF THE TAX COURT
C. OPINION OF THE TAX COURT

D. OPINION OF THE TENTH CIRCUIT

E. DENIAL OF PETITION FOR REHEARING

Page

9

A-49

F. SENATE COMMITTEE REPORT ON SECTION

183

A-51

ill

TABLE OF AUTHORITIES

CASES

Ah Pah Redwood Co. v Commissioner (9th Cir 1957)
276 U.S. 145, 6 AFTR 7358

Baird v Commissioner (3d Cir 1970) 438 F2d 490, 26
AFTR 2d 70-5799

Bingham’s Trust v Commissioner (Sup Ct 1945) 325
U.S. 33 AFTR 842

Clark v Commissioner 266 F2d 698. 3AFTR 2d 1333
(9th Cir 1959)

Clifford v United States

Edison Securities Corporation (4th Cir) 78 F2d 85.
16 AFTR 307

Hormel v Helvering (Sup Ct 1941) 312 U.S. 552. 25
AFTR 1198

Kornhauser v United States (Sup Ct 1928) 276 U.S.
145, 6 AFTR 7358

Little v Commissioner (1st Cir 1960) 273 F2d 746, 5
AFTR 2d 492

Tex-Pen Oil Co. v Commissioner 83 F2d 518 17
AFTR 518 (3rd Cir 1936)

Commissioner v Transport Manufacturing and
Equipment Co., (8th Cir 1973) 478 F2d 731. 31
AFTR 2d 73-1247

PAGE

6

6,5

6

~)

6

]

IN THE
SUPREME COURT OF THE UNITED STATES
OCTOBER TERM 1991

CHARLA GATES CANNON,

Petitioner

versus

COMMISSIONER OF INTERNAL REVENUE,
Respondert.

PETITION FOR A WRIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS
FOR THE TENTH CIRCUIT

Petitioner Charla Gates Cannon respectfully pray a
Writ of Certiorari issue to review the Judgment of the
Tenth Circuit Court of Appeals entered into this pro-
ceeding on November 15, 1991 and the denial of a Petition
for Rehearing on January 13, 1992.

CITATIONS TO OPINIONS BELOW

The United States Tax Court entered its opinion
reported in Tax Court Memo 1990-148. The Tenth Circuit
Court of Appeals entered its opinion which has not
reported to date.

JURISDICTION

Petitioner appeals from the judgment of the Tenth
Circuit decided November 15, 1991. Petitioner’s petition
for rehearing was denied on January 13, 1992. Jurisdiction
of this Court is invoked under 28 U.S.C. 1254 and 2101 and

Supreme Court Rule 10.

STATEMENT OF THE CASE

This case involves a taxpayer’s treatment of losses
incurred in connection with a Mexican geld and silver min-
ing venture. In 1973, the taxpayer, Charla Cannon, joined
a limited partnership (‘‘Vemco’’) that was formed ‘‘to
engage in the business of land development, exploration,
mining and ore processing both in the United States and
foreign countries.’’ The Taxpayer provided Vemco with the
funds necessary to conduct its business operations.

Vemco decided to invest in the Mexican venture at
issue in this case in reliance upon the findings of an ex-
perienced miner who explored the sites and an engineer
who analyzed and reported on the mining properties.
Because Mexican law prohibits non-Mexican nationals or
corporations from acquiring a majority interest in Mexican
mining concessions, Compania Minera San Jose de Man-
zanillas, S.A. (‘‘Manzanillas’’), a Mexican corporation, held
the mining concessions, and Vemco became a forty-nine
percent shareholder in that corporation. In 1978, however,
Vemco discovered that the president of Manzanillas had
been embezzling, and the mining concessions were transfer-
red to Memco, a different Mexican corporation. Although
the taxpayer, through Vemco, expended over $800,000 for
exploration and development of the mines, Memco never
operated at a profit. Vemco did not report any income from
mining for the years involved in this lawsuit, nor did it
receive any dividends.

The taxpayer deducted her distributive share of the
partnership losses claimed by Vemco on her federal income
tax returns for 1976, 1977, 1978, and 1979. The Commis-
sioner of Internal Revenue disallowed these deductions on

I EE_ OO

3

the grounds that the tazpayer did not establish that these |
amounts constituted ordinary and necessary business ex- |
penses or were for an activity entered into for profit or for |
the production of income.

The Tax Court agreed with the Commissioner’s deci-
sion to disallow the deductions, but found the expenditures
to be nondeductible under section 183 of the Internal
Revenue Code. Because the Tax Court decided the case on
the basis of a section that neither party raised explicitly,
the taxpayer filed a motion for reconsideration, which was
denied. The taxpayer appealed to the Tenth Circuit which
affirmed holding:

‘Here, the taxpayer contends that the Tax Court er-
roneously decided this case on the basis of a theory and
Code provision (lack of profit motive and section 183) that
neither party considered or raised. thereby surprising and
prejudicing the taxpayer. According to the taxpayer, only
three Code sections were at issue: sections 162, 212, 616.
We disagree. Section 183 is interrelated to sections 162 and
212, profit motive being the common underlying theme. In-
deed, as discussed infra, these provisions even reference
each other. Accordingly, we find that the taxpayer in this
case was adequately put on notice, was not prejudiced, and
should not have been surprised.’’ The Tenth Circuit affirm-
ed and further refused to remand the case to the Tax Court
for consideration and consolidation with subsequent years
involving the same issue pending in Docket Number
4389-91.

REASONS WHY THE WRIT SHOULD BE GRANTED
I

The Tenth Circuit's Statutory construction theory

4

that the sections of the Internal Revenue Code here in-
volved are ‘“‘naturally”’ interrelated, conflicts with the
decisions of other Circuits.

Without congressional or judicial authority the
Tenth Circuit has erroneously manufactured a ‘‘natural”’
implication that the interpretation of two sections of the
I.R.C., Section 162 defining business expenses, and Section
212 involving expenses for the production of income, are
naturally to be construed by considering the elements of
the profit motive. Consideration of the origin and purpose
of three statutes reveals the Tenth Circuit’s error in
statutory construction.

Section 162 was enacted in 1918 as Section 214
allowing as deductions ‘“‘all the ordinary and necessary
business expenses paid or incurred during the taxable year
in carrying on any trade or business’’ and interpreted by
this Court in Kornhauser v. U.S. (Sup Ct 1928) 276 U.S.
145, 6 AFTR 7358 allowing a deduction for attorney fees
between partners. Section 212 was added to the Code in the
Revenue Act of 1942 as section 23(a)(2) to allow deductions
for non-business expenses incurred for the production of in-
come and interpreted by this Court in Bingham’s Trust v
Comm (Sup Ct 1945) 325 U.S. 365, 33 AFTR 842 allowing
a deduction for attorney’s fees to a trust carrying on no
business. This Court held the two statutes, 162 and 212 are
to be construed with reference to each other. The ap-
plicability of these statutes was litigated and briefed by the
parties in the instant case.

However, the Tax Court, with affirmance by the
Tenth Circuit, sua sponte held Section 183 of the Internal
Revenue Code was decisive. Section 183 was enacted in
1969 to disallow hobby losses in excess of gross income.
The accompanying Senate Report to H.R. 13270, lst

5

Section 103 is set forth in Appendix E the pertinent part
of which follows:

‘The committee is concerned, however, that re-
quiring a taxpayer to have reasonable expectation” of
profit may cause losses to be disallowed in situation
where an activity is being carried on as a business
rather than as a hobby. Accordingly, the committee
has modified the house bill to provide that in deter-
mining whether losses from an activity are to be allow-
ed, the focus is to be on whether the activity is engag-
ed in for profit rather than whether it is carried on
with a reasonable expectation of profit. This will pre-
vent the rule from being applicable to situations where
many would consider that it is not reasonable to ex-
pect an activity to result in a profit even though the
evidence available indicates that the activity actually
is engage in for profit. For example, it might be argued
that there was not a “reasonable”’ expectation of pro-
fit in the case of a bona fide inventor or a person who
invests in a wildcat oil well. A similar argument might
be made in a case of a poor person engaged in what ap-
pears to be an inefficient farming operation. The com-
mittee does not believe that this Provision should ap-
ply to these situations on that the House intended it
to so apply, if the activity is engaged in for profit.

Consequently, as passed, Section 183(c) expressly ex-
cluded items deductable as business expenses under Sec-
tion 162 or for the production of income under Section 212.
The statute provides: “For purposes of this section, the
term ‘‘activity not engaged in for profit’’ means any activi-
ty 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.” No changes were made
in sections 162 or 212. Thus the Tenth Circuits holding that
three sections are entwined was patently erroneous.
Neither Section 162 or 212 refer to or are limited by Section

6

183; the latter’s applicability kicks in, if at all, only if the
former sections are not applicable. This case was litigated
under one theory and erroneously decided and affirmed
under an entirely different issue.

Other circuit courts have uniformly rejected the
Tenth Circuit’s approach. The Eight Circuit in Comm v
Transport Manufacturing and Equipment Co (8th Cir 1973)
478 F2d 731, 31 AFTR 2d 73-1247 approved the Tax
Court’s refusal to consider an issue not raised at trial,
stating, ‘“The Commissioner should notify the taxpayer of
the particular Code section, regulation or theory involved
in a case to avoid prejudice to the taxpayer.’’ The Third Cir-
cuit in Baird v. Comm (8rd Cir 1970) 438 F2d 490, 26
AFTR2d 70-5799 held: ‘‘Although the Commissioner may
suggest additional theories of liability during the hearing,
it is impermissible for the Tax Court to decide the case on
an issue other than that explicity tendered without
reasonable notice to the taxpayer’ (Emphasis Added). In
like manner the Ninth Circuit in Ah Pah Redwood Co v
Commissioner (9th Cir 1957) 251 F2d 163, 1 AFTR2d 456
reversed and remanded the case where neither of the par-
ties had addressed the issue although the Tax Court had.
In Edison Securities Corporation the 4th Circuit in an opi-
nion reported at 78 F2d 85, 16 AF'TR 307, expressed the
proper judicial stardard when the trial court sue sponte
raised the theory on which the case was decided, stating:

‘In the pending case, however, the new matter
was not introduced by the parties but by the Board
itself, and the subsequent course of the proceedings
should have been shaped with this circumstance in
mind. A sharp issue was raised as to a point upon
which the parties had theretofore agreed, and
although some evidence bearing on the subject had
been put in the record in connection with the other
transactions, it was obviously inadequate for the pur-

7

pose now under discussion, for the Board itself said
that it was difficult to tell from the available facts
what had taken place. In this emergency, the Board
might well have ordered a rehearing upon its own mo-
tion, and in any event, should have granted the Com-
missioner’s motion to that end.”’

Furthermore, allocation of the burden of proof with
regard to the new theory would be necessary as neither par-
ty has ever raised the issue except the Tax Court itself.
Clark v Commissioner, 266 F2d 698, 3 AFTR 2d 1333 (9th
Cir. 1959); Tex-Penn Oil Co. v Commissioner, 83 F2d 518,
17 AFTR 518 (3rd Cir. 1936) (‘In view of these changes of
front, we submit that any presumption of correctness
which originally attached to the Commissioner’s formal
determination has now disappeared completely’’).

The Tenth Circuit has thus created a confusing
precedent, likely to generate further confusion among the
other Circuits. It is a precedent directly at odds with the
prior appellate decisions.

II

The decision below affirming the Tax Court’s decision
rather than remanding the proceeding conclusively
denied petitioner her day in court, a fundamental
injustice.

In its opinion the Tenth Circuit expressly
acknowledged that Section 183 was not considered by the
litigants. Rather than outright reversing the Tax Court the
tenth Circuit applied Section 183 and the nine factors listed
thereunder in Treasury Regulation 1.183-2(b) concluding
that were it considering the issue de novo it might well
have reached a different conclusion, however, the Tax

8

Court’s finding of fact was not clearly erroneous. All of this
without petitioner presenting evience of the Section 183
factors.

If the Supreme Court cencludes this case should not
be reversed, it is well resolved under its own standards that
the case should be remanded to afford petitioner the oppor-
tunity to present evidence directed towards Section 183. In
Hormel v Helvering (Sup Ct 1941) 312 U.S. 552, 25 AFTR
1198, the issue related to the definition of income. Subse-
quent to the trial court proceeding the Supreme held such
trust income was taxable in Clifford v. U.S. However, the
Supreme Court remanded Hormel to the trial court to allow
the taxpayers to present evidence on the issue, stating,
‘Under these circumstances we do not feel that petitioner
should be foreclosed from all opportunity to offer evidence
before the Board on this issue, however remote may be his
chance to take his case out of the Clifford rule.”

This principle of jurisprudence was well expressed by
the Phird Circuit in Baird v Commissioner (3d Cir 1970)
438 F2d 490, 26 AFTR2d 70-5799 and in the First Circuit
in Little v Commissioner (lst Cir 1960) 273 F2d 746,
5AFTR2d 492. In Baird the Court remanded for considera-
tion of the new issue. In Little the Court held that remand-
ing would be appropriate to allow the taxpayer to introduce
evidence on the new theory advanced by the government,
however, in oral argument appellant’s attorney conceded
no additional evidence was available. In the instant case
appellant has ample evidence to respond to the Regulations
nine factors, she simply seeks the opportunity to do so.

In view of the conflict of the decision below with the
past decisions of this Court, the Supreme Court may wish
to consider summary reversal.

9
CONCLUSIONS AND PRAYER
Because of the importance and broad application of
these issues in Federal tax cases, the petitioner prays that

this Court grant a Petition of Certiorari to the United
States Supreme Court.

Respectfully submitted,

TOWNER SHIELDS LEEPER

A-l
APPENDIX A

SEC. 162. TRADE OR BUSINESS EXPENSES.

(a) In General.—There shall be allowed as a deduction
all the ordinary and necessary expenses paid or incurred
during the taxable year in carrying on any trade or
business, * * *

* * * * *

SEC. 183 [as added by Sec. 213(a), Tax Reform Act
of 1969, Pub. L. No. 91-172, 83 Stat. 487].
ACTIVITIES NOT ENGAGED IN FOR
PROFIT.

(a) General Rule.—In the case of an activity engaged
in by an individual or an electing small business corpora-
tion (as defined in section 1371(b)), if such activity is not
engaged in for profit, no deduction attributable to such ac-
tivity shall be allowed under this chapter except as provid-
ed in this section.

(b) Deductions Allowable.—In the case of an activity
not engaged in for profit to which subsectior. (a) applies,
there shall be allowed—

(1) the deductions which would be allowable
under this chapter for the taxable year without regard
to whether or not such activity is engaged in for profit,
and

(2) a deduction equal to the amount of the deduc-
tions which would be allowable under this chapter for
the taxable year only to the extent that the gross in-
come derived from such activity for the taxable year
exceeds the deductions allowable by reason of
paragraph (1).

A-2

(c) Activity Not Engaged in for Profit Defined.—For
purposes of this section, the term “‘activity not engaged in
for profit’’ means 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.

(d) Presumption.—If the gross income derived from
an activity for 2 or more of the taxable years in the period
of 5 consecutive taxable years which ends with the taxable
year exceeds the deductions attributable to such activity
(determined without regard to whether or not such activity
is engaged in for profit), then, unless the Secretary or his
delegate establishes to the contrary, such activity shall be
presumed for purposes of this chapter for such taxable year
to be an activity engaged in for profit. In the case of an ac-
tivity which consists in major part of the breeding, train-
ing, showing, or racing of horses, the preceding sentence
shall be applied by substituting the perior of 7 consecutive
taxable years for the period of 5 consecutive taxable years.

* * * * x

SEC. 212 EXPENSES FOR PRODUCTION OF
INCOME.

In the case of an individual, there shall be allowed as
a deduction all the ordinary and necessary expenses paid or
incurred during the taxable year—

(1) for the production or collection of income;

(2) for the management, conservation, or
maintenance of property held for the production of in-
come; or

(3) in connection with the determination, collec-
tion, or refund of any tax.

A-3
APPENDIX B

COPY
UNITED STATES TAX COURT
CHARLA GATES CANNON, )
)
Petitioner, )
)
) Docket No.
) 2261-85
COMMISSIONER OF IN- )
TERNAL REVENUE, )
)
Respondent. )
DECISION
Pursuant to the opinion of the Court filed March 20,
1990, and incorporating herein the facts recited in the
respondent’s computation as the findings of the Court, it is
ORDERED and DECIDED: That there are deficien-
cies in income taxes due from the petitioner for the taxable
years 1978 and 1979 in the amounts of $120,334.60 and
$101,980.00, respectively.

(Signed) W.M. DRENNEN
Judge

Entered: JUL 10 1990

A-4
COPY

UNITED STATES TAX COURT
CHARLA GATES CANNON, )
)
Petitioner, )
)
) Docket No.
) 9671-82
COMMISSIONER OF IN- )
TERNAL REVENUE, )
)
)

Respondent.
DECISION

Pursuant to the opinion of the Court filed March 20,
1990, and incorporating herein the facts recited in the
respondent’s computation as the findings of the Court, it is

ORDERED and DECIDED: That there are deficien-
cies in income taxes due from the petitioner for the taxable

years 1976 and 1977 in the amounts of $155,221.20 and
$244,581.83, respectively.

(Signed) W.M. DRENNEN

Judge

Entered: JUL 10 1990

A-5
APPENDIX C
T. C. Memo. 1990-148
UNITED STATES TAX COURT
CHARLA GATES CANNON, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE,

Respondent

DOCKET NOS. 9671-82, 2261-85.
Filed March 20, 1990.

Towner Leeper, for the petitioner.

John F. Eiman, for the respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

DRENNEN, Judge:! In two separate notices of defi-
ciency, respondent determined deficiencies in petitioner’s
income tax for the taxable years and in the amounts shown
below:

Year Amount
1976 $156,531
1977 245,576
1978 123,155
1979 106,628

1 This case was assigned and deemed submitted to J udge Drennen by
order dated June 6, 1989.

A-6

Petitioner filed two petitions, one for the years 1976
and 1977 (docket No. 2671-84) and one for the years 1978
and 1979 (docket No. 2261-85). The issues in both dockets
were similar so the cases were consolidated for trial, briefs,
and opinion.

The parties filed stipulations of facts and the facts
stipulated therein are so found.

After concessions by petitioner, the remaining basic
issue is whether petitioner is entitled to deduct amounts of
money she allegedly paid, through Vemco, a limited part-
nership in which she was a limited partner, in connection
with a gold and silver mining venture in Durango, Mexico,
during each of the years at issue. More specifically, the
issues are:

(1) Whether the mining venture was an activity not
engaged in for profit by and through Vemco within the
meaning of section 183(a);2

(2) Whether the funds advanced to two Mexican cor-
porations, by and through Vemco, were nondeductible
shareholder contributions to the Mexican corporations or
were deductible expenses of a joint venture between Vemco
and the Mexican Corporations;

2 All Rule references are to the Tax Court Rules of practice and Pro-
cedure. All section references are to the Internal Revenue Code of 1954,
as amended and in effect for the years at issue.

A-7

(3) Whether amounts paid by Vemco to persons other
than the Mexican corporations in connection with the ex-
ploration, development, and operations of the mining con-
cessions constituted nondeductible capital contributions to
the Mexican corporations;

(4) Whether the expenditures, if not capital contribu-
tions, were paid in connection with mining development
(section 616 IRC) or mining exploration (section 617);

(5) Whether all of the aforementioned expenditures
were ordinary and necessary;

(6) Whether petitioner has substantiated all of the
amounts and the nature of the aforementioned expen-
ditures; and

(7) Whether the application of section 482 reduces
Vemco’s (and petitioner’s distributive share of) claimed in-
ventory loss to zero for the taxable year 1976.

FINDINGS OF FACT

Petitioner, Charla Cannon, was a widow who lived in
Denver, Colorado. She had a large annual income, primarily
from various trusts established by her family, and from her
deceased husband's estate, and various other benefits pro-
vided under bonus and pension plans by her deceased hus-
band’s former employer, Beatrice Foods Co. She had no
education or experience in mining or engineering, except
what she might have gleaned from her father, who was a
mining engineer. She was 67 years of age at the time of trial
in 1986. She received a junior college education at Benn-
ington College in New York. She was engaged in several

A-8

businesses prior to becoming involved in Vemco, including
Cannon Aeronautical Center, raising sheep in Wyoming, a
health spa for women, and selling helicopters in Colorado.

In 1973 petitioner became involved with a limited
partnership, Vemco, in which she was a 54 percent limited
partner. Vemco was a Texas limited partnership formed by
Ramon Perez Madrid. The limited partnership was
reconstructed under the same name in 1975. The limited
partnership then consisted of Hersey W. Young, Jr. and
Harold B. Young, general partners, and Charla G. Cannon,
H. R. Chrisman, M.D., and Carl W. Weaver, limited
partners.

The limited partnership agreement executed in 1975
set forth the purpose for Vemco which was ‘“‘to engage in
the business of land development, exploration, mining and
ore processing both in the United States and foreign coun-
tries.’’ This limited partnership agreement was amended
again as of January 1, 1978. It recited that subsequent to
the establishment of the partnership it needed additional
funds to conduct its business operations, and Cannon had
provided those funds; also that Cannon was willing to ‘‘pro-
vide further contributions to the partnership as requested
by the general partner’’ provided the agreement was ex-
ecuted. It stated further that because of the agreement of
Cannon to contribute additional capital to the partnership
while the other partners were not contributing a significant
additional capital or services, it was agreed that the alloca-
tion of profits of the partnership, as well as the proceeds in
the event of sale or disposition of the partnership assets,
should be allocated as follows:

Name Percentage
Charla G. Cannon 45%
Hersey W. Young, Jr. 30%

H. R. Chrisman, M.D. 9%

A-9

Carl W. Weaver 8%
Harold B. Young 8%

It was also agreed that the annual expenses and
losses of the partnership would continue to be allocated to
Cannon insofar as her capital account permitted. All of the
expenses of the mining ventures, which were paid by peti-
tioner through Vernco, were allocated to petitioner during
the years here involved. Hersey W. Young, Jr. was
designated to be the sole general partner with Harold
Young, Cannon, Weaver, and Chrisman being limited part-
ners. Harold B. Young resigned as a general partner.

In about 1970 Madrid acquired all the mining conces-
sions for three mining claims, Ampl. de San Jose, San Jose,
and Tres de Mayo, which were located in Sierra Madre Oc-
cidental Mountain range in the State of Durango, near the
village of Manzanillas, in the Republic of Mexico. Madrid
started working these claims prior to 1973.

The three San Jose mines were located in very moun-
tainous country, near Durango, Mexico, at an elevation of
6,000 to 6,500 feet above sea level. The terrain is rough and
the hillsides are very steep and roads are on a contour.
Manzanillas is the nearest village. A very primitive road
connecting Manzanillas and Topia, extending about 35
kilometers in length, was in place in 1973. The mines had
been opened and worked by hand through shafts and tun-
nels. Gold and silver were found in veins extending
underground.

Carl Weaver, an experienced miner and a limited
partner in Vemco, entered into an agreement with Madrid
in 1973 whereby Weaver paid Madrid $300 per month for
the right to conduct exploration activities for a limited
time at the site of the Madrid mining concessions. In
return, Madrid obligated himself to transfer the mining
concessions to a Mexican mining corporation at Weaver's
request. After spending approximately 30 days at the

A-10

mining site, Weaver prepared and submitted a report on
the San Jose mining properties to Hersey Young, Vemco’s
general partner and a long time business associate of peti-
tioner. In his report, Weaver estimated that the mine had
been in operation since 1913 and that the ore in the mine
(gold and other metals) was obvious, being exposed in the
face of the mine. Weaver estimated that with proper
development the mines had a potential production of 50
tons per day, although the small, very primitive mill on the
property could not mill more than three tons in 24 hours.
Weaver recommended the on-site installation of a larger
capacity mill because the cost of freight to transport ore to
the nearest smelter was about $100 per ton. Weaver also
reported that the per ton ore values of various ore samples
taken from the Taonita vein (located approximately one-
haif mile south of the San Jose mine) averaged between 0.7
and 1.0 ounces of gold and 9.0 ounces of silver.

Vemco’s decision to invest in the mining concessions
was based on Weaver’s findings and on the findings of an
engineer, Henry P. Ehrlinger (deceased at the time of the
trial), whom Young retained to analyze and report on the
mining properties. Ehrlinger was a professor of mining and
engineering at the University of Texas at El Paso with
much experience in mining activities in Mexico.

Ebrlinger visited the mine and subsequently sent
Ralph Wilcox, Jr., then a graduate geology student at the
University of Texas at E] Paso, to the location of the min-
ing claims. Wilcox prepared a report, dated April 1975,
which included the assay results of the ore samples taken
from the areas in which Manzanillas Corporation held min-
ing concessions. In his discussion of Taonita, Wilcox
revealed the following assay results of certain ore samples:

ee

A-11
Ounces of Ounces of
Description Gold Per Ton Silver Per Ton
Channel sample 0.04 0.76
Channel sample 0.28 6.04
Quartz vein 0.04 0.60

The report also included a discussion of the Tres de
Mayo mine and contained the following assay results of
three channel samples taken at or near the mine:

Ounces of Ounces of

Description Gold Per Ton Silver Per Ton
N 1 Entrance,

first level 0.34 3.16
N 2 Second level,

rear 0.04 0.58
N 3 Third level,

rear 0.96 13.18

Wilcox’s report also included the following com-
ments regarding the mill located below Manzanillas: ‘At
current crushing capability, the mill can process about one
ton per day with about 60% recovery of precious metals.
The crusher is old and failing.”’

Ehrlinger prepared a mining report, dated May 1975,
which included Wilcox’s findings. Ehrlinger’s report con-
tained profit projections based on 50 tons of ore mined dai-
ly and a respective gold and silver ore grade of 0.70 and 9.0
troy ounces per ton of ore mined. Total monthly expenses
were projected at $99,011.68. Of these monthly expenses
only one, income taxes of $18,117.68, varied with changes
in profitability. All other expenses, fixed or variable, were
unaffected by changes in the precious metal ore grade per
ton of ore mined. Ehrlinger’s report projected a monthly

A-12

ore mining operationg rate of 1,200 tons and a ‘“‘net
calculated monthly profit’? of $50,172.32 if properly
exploited.

Ehrlinger’s report also contained a copy of the El
Paso Chemical Laboratories report addressed to Ehrlinger.
The El Paso Chemical Laboratories report contained the
assay results of 12 ore samples, partially reproduced below:

RESULTS

Gold Silver
Sample Designation oz/ton oz/ton
N-1l RW-T-14 0.04 0.60
N-1l RW-N-1 0.34 3.16
N-1l RW-M-19 0.01 0.33
N-1 RW-T-10 0.03 0.49
N-1 RW-T-15 0.04 0.60
N-1l RW-T-21 0.28 6.04
N-1l RW-F-1 0.03 0.63
N-1 RW-M-24 0.01 0.33
N-l RW-N-3 0.96 13.18
N-1 RW-N-2 0.04 0.58
N-1l RW-T-8 0.04 0.46
N-1l RW-T-13 0.04 0.76

Ehrlinger’s report further included various mineral
descriptions, prepared by Wilcox, of the 12 ore samples, in-
cluding the location from which they were extracted, most
of which were from either Tres de Mayo or Taonita.

Petitioner read both Weaver’s and Ehrlinger’s
reports. Petitioner had known Weaver for some time and
had confidence in his metallurgical knowledge. She read his

ee

A-13

report on the San Jose mining properties and agreed to
make an investment therein. After petitioner read Ehrl-
inger’s report, which predicted a net profit of $50,172.32
per month if the mines were properly developed with an
adequate mill, she was willing to invest more in the project.

Vemco also became interested in the mining conces-
sions as a potential investment. Vemco entered into an
agreement with Madrid that Madrid would put his mining
interests into a corporation or partnership and that Vemco
would put up the money to cover the costs of defining and
developing the mines, which would be repaid first out of the
profits from the mine with the balance of the profits being
divided equally between them.

After petitioner learned from her Mexican legal
counsel that Mexican law prohibits non-Mexican nationals
or corporations from acquiring a majority interest in Mex-
ican mining concessions, the interested individuals decided
that a corporate ownership was the legal mechanism which
would best facilitate indirect ownership of the mining con-
cessions. Madrid later transferred his mining concessions
to a Mexican corporation, known as Compania Minera San
Jose de Manzanillas, S.A. (Manzanillas). Subsequent to the
transfer Vemco became a 49 percent shareholder in Man-
zanillas. The remaining 51 percent was issued to Mexican
nationais. However, because of further Mexican law re-
quirements, the stock representing Vemco’s 49 percent was
issued in the name of petitioner, and Hersey W. Young, Jr.,
for the benefit and on behalf of Vemco.

Madrid was president of Manzanillas until 1978.
Madrid supervised the mining and milling activities of
Manzanillas at the site of the mining claims. He testified
that during the time he worked the claims all the extraction
was done by hand. Madrid sold in his own name and in the

A-14

name of Manzanillas gold and silver extracted from the
claims. During 1974-1978, Madrid deposited at least
$47,288 of total sale proceeds either into his personal or
Manzanillas’ bank accounts. After this embezzlement was
discovered, Young ‘“‘fired’’ Madrid in 1978. Subsequently,
Young successfully brought suit against Madrid to recover
these amounts.

In 1976 and 1977, Vemco, acting through Young,
contracted with third parties for the construction of roads
and tunnels on the sites of the mining concessions and paid
for the work with its own funds. It also contracted with
Juan Sanchez to explore, repair and prepare the mining
property of the Manzanillas’ company. These contract ex-
penditures were claimed by Vemco as _ exploration-
development expenses, and totalled $165,827 in 1976,
$335,584 in 1977, $180,000 in 1978, and $125,460 in 1979.

In 1978 Memco S.A. de C.V. (Memco), was formed
and the owner of Mexican mining concessions adjacent to
the Madrid concessions, Raul Olguin Lopez (Lopez), subse-
quently transferred his mineral interests to Memco. Lopez
was the president of Memco. Vemco was granted an option
to acquire 49 percent of Memco’s stock (Class B) in ex-
change for an agreement to explore the mining claim. The
remaining 51 percent of Memco’s stock (Class A stock) was
subscribed for by Mexican nationals. On the same date
Vemco contracted with Sanchez for exploration of the min-
ing claim at a cost not to exceed $180,000. Memco was to
reimburse Vemco for the cost of exploring the mine with
the profits earned from Memco’s operations. Memco never
operated at a profit.

There was never any core drilling on any of the above
mentioned mining claims. A rather basic procedure was
used to extract and separate the gold from the mines.

A-15

Activity at the mines was curtailed, to some extent, after
it was discovered in 1978 that Madrid had been selling the
ore for his own account.

Romelia Carpenter has been nvolved in the actual
preparation of Vemco’s tax returns since 1978. Carpenter
has also prepared various financial schedules of Vemco’s
accounting data relating back to 1973. At trial, Carpenter
testified that, when available, she used source documents
in preparing the financial schedules. But in certain situa-
tions, payments made under contract did not flow through
Vemco’s regular checking account. In those situations,
Carpenter used the contract itself as a source document

and relied upon oral verification that payment thereunder
had been made.

Vemco did not report any income from mining on any
of its tax returns for the years here involved. Neither Man-
zanillas nor Memco has ever paid a dividend to Vemco.

The parties have stipulated that Vemco paid or in-
curred certain expenses in the years 1976, 1977, 1978, and
1979, which produced the losses claimed by Vemco in its
tax returns for those years. Petitioner, by virtue of the
limited partnership agreement, claimed these losses as
Schedule E partnership losses. In his notices of deficiency,
respondent determined the extent to which the amounts
claimed by petitioner, through Vemco, should be disallow-
ed. Those amounts disallowed by respondent totalled
$187,173.96 for 1976, $354,608.29 for 1977, $214,078.00 for
1978, and $152,415.00 for 1979. The principal amounts
disallowed by respondent were deductions claimed for each
of those years for ‘exploration development”’ expenses
which totalled $165,827.35 for 1976, $335,584.16 for 1977,
$180,000.00 for 1978, and $125,460.00 for 1979. Vemco
deducted these expenses on its tax returns for 1976

A-16

through 1979, labelling the 1976-1979 amounts as
‘‘development’”’ expenses. Vemco also deducted additional
expenses such as travel, vehicle, rent, etc. in the total
amounts of $25,124.99 for 1976, $20,865.46 for 1977,
$36,308.00 for 1978, and $28,889.00 for 1979. Of those
amounts, $21,346.61 for 1976, $19,024.40 for 1977,
$2,230.00 for 1978, and 1,934.00 for 1979, were included as
part of the total amounts disallowed by respondent.

In his notices of deficiency, respondent set forth the
following alternative grounds upon which he based his
aforementioned determinations. Respondent does not
agree that the amounts were expended for the purposes
designated nor does respondent agree to the characteriza-
tion of the amounts. Respondent also contends that the
amounts claimed as deductions by Vemco represent
amounts paid or incurred in connection with an activity not
engaged in for profit. Alternatively, respondent argues
that the amounts claimed as deductions by Vemco con-
stituted nondeductible capital contributions to either Man-
zanillas or Memco inasmuch as the amounts were paid by
Vemco, their shareholder, on the corporations’ behalf for
corporate expenses.

Inventory Issue

Cannon Aeronautical, Inc. (‘‘Aero’’), of which peti-
tioner was majority owner, was liquidated in 1975, and cer-
tain of its assets (copper wire and airplane parts) were
distributed by Aero, as debtor, to petitioner, as creditor, in
partial satisfaction of a loan. Petitioner then transferred
these assets to Vemco and received a credit to her capital
account of $54,850, which was the book value of the assets
on Aero’s books at the time they were distributed to Vem-
co. The principal asset distributed was 275,000 feet of
20-strand copper wire recorded by Aero at a cost of

A-17

$41,250. It had been purchased by Aero in 1970 and was
obsolete at the time of the transfer to Vemco and had only
scrap value. All of the assets transferred were entered on
Vemco’s books at the cost reflected on Aero’s books. In
1976 Vemco sold certain miscellaneous parts and supplies
for $1,500. In 1976 it wrote down the value on the books of
the remainder of these assets by a total of $42,250, $33,000
of which was attributable to the copper wire. On its returns
for 1976 Vemco claimed cost of goods sold for these assets
in the amount of $42,500, including the $1,500 worth that
were sold. Of the $42,500, cost of goods sold claimed,
$40,750 was attributable to the assets which were not sold
in 1976. Respondent disallowed $40,750 of this claimed
cost of goods sold expense. Respondent also determined
that a $12,600 date of acquisition fair market value should
be allocated to the inventory assets.

OPINION

The parties have stipulated that Vemco paid or in-
curred certain expenses claimed as deductions on its tax
returns for the years in question. The expenses claimed as
deductions by Vemco generally fall into three broad
categories: (1) amounts Vemco contributed directly to the
two Mexican corporations, Manzanillas and Memeo, who,
in turn, allegedly paid out the contributions in connection
with the exploration and development of their respective
mining concessions; (2) amounts Vemco paid directly to
third parties under contract in connection with the explora-
tion and development of the Mexican mining concessions;
and (3) amounts Vemco paid to others for the purchase of
equipment and in the form of salaries, professional fees and
overhead expenses as these amounts relate to the mining
activities of the Mexican corporations.

Petitioner contends that all of the amounts she paid

A-18

out in connection with the mining activities are deductible
under either section 162, 165, 212, 616, or 617. At trial,
respondent reiterated the alternative bases, as set forth in
his notices of deficiency, supra, upon which he determined
the extent to which petitioner's claimed deductions should
be disallowed.

First, the record does not support a finding that
either petitioner or Vemco were directly engaged in the
business of mining gold and silver in Mexico. So none of the
expenses claimed by petitioners are deductible under sec-
tion 162, which requires that they be paid or incurred in
carrying on a trade or business. For the same reason none
of those expenses are deductible by petitioner under sec-
tion 165 as losses. If those expenses are deductible at all
they must be deductible under section 212(1) as ordinary
and necessary expenses paid or incurred for the production
or collection of income, or under section 616 as mining
development expenses or section 617 as mining exploration
expenses.

A basic requirement under all of the above provisions
is a showing that the activity giving rise to the expenditure
was engaged in by petitioner with the objective of making
a profit. Horn v. Commissioner, 90 T.C. 908, 933 (1988);
Patin v Commissioner, 88 T.C. 1086, 1116 (1987). Similarly,
a deduction under section 617 depends upon a showing that
the mining activities constituted a trade or business or
were undertaken and carried on for the production of in-
come. Patin v. Commissioner, supra at 1117, which, in turn,
also depends upon a showing of a bona fide profit objective.

Furthermore, section 183(a) provides the general rule
that if an individual engages in an activity, and “‘if such ac-
tivity is not engaged in for profit, no deduction attributable
to such activity shall be allowed under this chapter except

ae

A-i9

as provided in this section.’ Section 183(b) provides for the
following exceptions to section 183(a) nondeductibility: (1)
Deductions which would be allowable without regard to
whether such activity is engaged in for profit shall be allow-
ed, section 1.183-1(b)(1), Income Tax Regs.; and (2) deduc-
tions which would be allowable only if such activity is
engaged in for profit shall be allowed “but only to the ex-
tent that the gross income derived from such activity for
the taxable year exceeds the deductions allowable by
reason of paragraph (1)."’ Section 183(b\(2). Section 183(c)
defines an activity not engaged in for profit as follows:

(c) ACTIVITY NOT ENGAGED IN FOR PRO-
FIT DEFINED.—For purposes of this section, the term
“activity not engaged in for profit’’ means 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.

Where a partnership is involved, whether an activity
is engaged in for profit is determined at the partnership
level and not at the partner level. Brannen v. Commis-
stoner, 78 T.C. 471, 505 (1982), affd. 722 F.2d 695 (11th Cir.
1984); Siegel v. Commissioner, 78 T.C. 659, 698 (1982). If a
partnership activity is not engaged in for profit by the part-
nership, all partners are denied deductions affected by sec-
tion 183. See Flowers v. Commissioner, 80 T.C. 914, 932
(1983); see also Brannen v. Commissioner, supra at 505.

The determination that an activity is engaged in for
profit is one of fact to be resolved on the basis of all the
facts and circumstances. Flowers v. Commissioner, supra
at 931-932. A reasonable expectation of profit is not re-
quired as long as there is a bona fide objective to realize a
profit. Golanty v. Commissioner, 72 T.C. 411, 425-426
(1979), affd. without published opinion 647 F.2d 170 (9th
Cir. 1981). Profit means economic profit, independent of

A-20

tax savings. Landry v. Commissioner, 86 T.C. 1284, 1303
(1986).

In determining the partnership intent, we have often
focused on the actions taken by the promoters and general
partners, including their intent, knowledge, conduct, exper-
tise, and all other factors they relied upon in making deci-
sions for the partnership. Surloff v. Commissioner, 81 T.C.
210, 233 (1983); Finoli v. Commissioner, 86 T.C. 697, 722
(1986); Brannen v. Commissioner, supra. However, this
does not mean that our inquiry is confined solely to the ac-
tivities of the partnership, ‘‘for those parties possessing
resources sufficient to acquire and exploit investment pro-
perty are not always blessed with corresponding exper-
tise.’ Flowers v. Commissioner, supra at 932. The scope of
the relevant inquiry therefore permeates the entire profit
objective issue must still be assessed from the perspective
of the partnership. Flowers v. Commissioner, supra at 932.
Petitioner bears the burden of proving the required profit
objective. Welch v. Helvering, 290 U.S. 111, 115 (1933);
Rule 142(a).

Section 1.183-2(b), Income Tax Regs., sets forth
several relevant factors which are to be considered in deter-
mining whether an activity is engged in for profit. Among
them are: (1) The manner in which the taxpayer carried on
the activity; (2) the expertise of the taxpayer or his ad-
visors; (3) the time and effort expended by the taxpayer in
carrying on the activity; (4) the expectation that assets us-
ed in the activity may appreciate in value; (5) the success
of the taxpayer in carrying on other similar or dissimilar ac-
tivities; (6) the taxpayer’s history of income or loss with
respect to the activity; (7) the amount of occasional profit,
if any, which is earned; (8) the financial status of tne tax-
payer; and (9) whether elements of personal pleasure or

A-2]

recreation are involved.

Objective facts are accorded greater weight than are
mere statements of intent. Engdahl v. Commissioner, 72
T.C. 659, 666 (1979). No one factor is determinative of the
taxpayer's objective to make a profit. Section 1.183-2(b),
Income Tax Regs. However, a record of substantial losses
over many years and the unlikelihood of achieving a pro-
fitable operation are important factors bearing on the tax-
payer's true objective. Bessenyey v. Commissioner, 45 TC.
261, 274 (1965), affd. 379 F.2d 252 (2d Cir. 1967). As we
stted in Bessenyey v. Commissioner, supra at 274:

the presence of losses in the formative years of a
business, * * * is not inconsistent with an intention to
achieve a later profitable level of operation, bearing in
mind, however, that the goal must be to realize a profit
on the entire operation, which presupposes not only
future net earnings but also sufficient net earning to
recoup the losses which have meanwhile been sustained
in the intervening years.

After a review of the record before us, we are convinc-
ed that Vemco did not enter into the mining activity with
the objective to make a profit. Nor does it appear, for the
reasons stated below, that the mining activity was poten-
tially profitable because it is unlikely that it could ‘recoup
the losses which have meanwhile been sustained in the in-
tervening years.’ Bessenyey v. Commissioner. supra at
274.

Vemco’s decision to enter into the mining activity
was ostensibly based on the $50,172.32 net calculated mon-
thly profit projection contained in Ehrlinger’s report.
These profit projections assumed. inter alia, that an ore
grade of 0.70 troy ounces of gold and 9.0 troy ounces of
silver could be realized per ton of ore mined. However, the

A-22

quality of ore grades used in these profit projections were
inconsistent with the data that was available at the time
the projections were made. The El Paso Chemical
Laboratories report contained the results of the 12 ore
samples. The results of these 12 samples indicated an
average of 0.155 ounce of gold and 2.263 ounces of silver
per ton of ore. Moreover, the results of the six samples con-
tained in Wilcox’s report indicated per ton averages of 0.12
ounces of gold and 2.467 ounces of silver and 0.447 ounces
of gold and 5.64 ounces of silver for Taonita and Tres de
Mayo, respectively. Use of the samples’ highest average
ore grade values in Erhlinger’s profit formula, all other
values remaining constant including the assumed opera-
tiong rate of 50 tons per day, results in a projected cash
flow from the mining operations which falls short of even
achieving/attaining the break-even point, much less a
profit.

The record also contains information concerning the
mining activities for a period of 11 years, 1973-1983.
Neither of the Mexican corporations ever paid a dividend to
Vemco. Vemco reported losses in each and every of the 11
years for a total loss in the amount of $2,205,045.10. A
record of such losses over so many years is persuasive
evidence that Vemco did not possess the requisite objective
of making a profit. Sec. 1.183-2(b)(6), Income Tax Regs.;
Golanty v. Commissioner, supra at 427.

The record also reveals that petitioner received a
substantial annual income from sources unrelated to the
mining activity. Petitioner’s ability to provide Vemco with
continuous capital infusions was no doubt due to her
substantial annual income. But for the existence of peti-
tioner’s substantial annual income, neither petitioner nor
Vemco could have sustained the perennial losses generated
by the mining activity. See section 1.183-2(b)(8), Income

A-23
Tax Regs.

Where a taxpayer procures, but fails to follow, the
advice of experts, a lack of an objective to derive profit may
be indicated unless it appears that the taxpayer is attemp-
ting to develop a different yet profitable technique. Section
1.183-2(b)(2), Income Tax Regs.

In their various reports, Weaver and Ehrlinger
recommended that, in light of several factors including
high transportation costs, a mill be installed at or near the
site of the mine for a profitable and a more efficient opera-
tion overall. In fact, Ehrlinger’s report contained only one
profit projection which was based on an assumed operating
rate of 50 tons per day. Ehrlinger’s report also included
blueprints and estimated costs for a 50 ton capacity mill.
This report, in which profits were forecasted, contained the
only detailed projection of income, expenses and profits
found in the record before us.

Young testified that four tons per day was the max-
imum capacity of the mill that was actually employed in
the mining operations and we find nothing in the record to
indicate that a larger capacity mill was installed. It is ap-
parent that Vemco’s failure to implement Weaver’s and
Ehrlinger’s recommendations for a larger capacity mill,
which was the sole basis upon which we find profits were
projected, severely hampered any chances of transforming
the mining activity into a profitable operation.

Vemco maintained books and records. However, bas-
ed on the record before us, including the testimony of
Carpenter, it is clear that Vemco maintained incomplete
books and records inasmuch as Carpenter was unable to
verify many of Vemco’s claimed payments by tracing them
back to a source document. See section 1.183-2(b)(1),

A-24

Income Tax Regs.

We find it noteworthy that Young’s testimony
revealed that he has never operated a profitable mine.
However, Weaver testified that, in the past, he operated
profitable mines located in Utah and Colorado, but not in
Mexico. See section 1.183-2(b)(5), income Tax Regs.

Weaver aiso testified that he was in charge of the
day-to-day operations at the mining claims from 1973 until
1976 when, although the record is unclear on this point, it
appears that Young became in charge of operations. We are
mindful of the testimony of both Weaver and Young that
they contributed time and effort to the mining operations.
See section 1.183-2(b)(3), Income Tax Regs.

However, we find that, based on the facts shown by
the record in this case, neither Vemco nor petitioner could
have had a bona fide objective or reasonable prospect of
making a profit out of the mining venture. Very little
marketable gold or silver was mined or recovered over 4
period of at least five years (1972-1978), and yet few or no
steps were taken to increase the production. Money may
have been spent to improve the transportation of the ore
from the mine to the market but little was done to bring ore
to the surface for transportation. And very little was spent
to increase or improve the crushing, separation and clean-
ing process had the ore been mined. Under the cir-
cumstances we cannot find that petitioner or Vemco enter-
tained an actual and honest objective of realizing a profit
from the mining activities within the meaning of section
183(a). Based on the record we are at a loss to understand
just what the objective of petitioner and Vemco was in
throwing good money after bad into this project. We har-
bor a suspicion, however, that had petitioner not had a
sizeable outside income and possibly no interest in spend-

op Sa at

A-25

ing her income in any other way, she would have taken a
good hard look at the venture and would have been less
willing to continue putting money into it just to keep it
alive.

We recognize that gold mining is a risky business
and also that if it is successful it will pay off well, and that
some people are willing to take the risk for the anticipated
reward. But where, as here, efforts had been made to mine
this property for years, according to the evidence, without
sufficient production to report any income from mining, it
would be a pipe dream to expect to make a profit without
some change in circumstances, and there is no evidence
that changes were made that would materially increase
production.

On balance we find that neither Vemco nor petitioner
entertained an actual and honest objective of realizing a
profit from this mining venture for the years involved
within the meaning of section 183(a).

Moreover, to the extent that certain deductions
claimed by petitioner, through Vemco, are not precluded by
application of section 183, we nonetheless find that they
are disallowed by virtue of their being the expenses of
another taxpayer.

It is a well-established principle of Federal tax law
that a shareholder is precluded from deducting the ex-
penses of a corporation of which it is a shareholder because
the corporation and its shareholders are recognized as
separate taxable entities. Deputy v. du Pont, 308 U.S. 488
(1940). Although it is true that Vemco’s activities went
beyond the passive holding of stock in the Mexican cor-
poration this, in itself, does not form a sufficient basis upon
which we should disregard the corporate existence of the

A-26

Mexican corporations. Rink v. Commissioner, 51 T.C. 746,
752 (1969). The record before us reveals that the Mexican
corporations had substance, that their existence was not a
mere matter of form, and that they maintained a mean-
ingful corporation/shareholder relationship with Vemco.
Moreover, we have reviewed the character of the expenses
which petitioner, through Vemco, claimed as deductions
and find them to be those properly attributable to the Mex-
ican corporations.

But petitioner contends, for the first time in her re-
ply brief, that the corporate entity should be disregarded
inasmuch as the substance of the relationship between the
Mexican corporations and Vemco was that of a joint ven-
ture. A joint venture is treated and taxable as a partner-
ship for tax purposes under section 761(a) and 7701(a)(2).
See also section 1.761-1(a), Income Tax Regs.

In support of her joint venture contention, petitioner
relies heavily upon Commissioner v. Bollinger, 485 U.S.
340 (1988). Generally, a corporation is regarded as a
separate taxable entity even if it has only one shareholder
who exercises total control over its affairs. Moline Proper-
ties v. Commissioner, 319 U.S. 436 (1943). But where a cor-
poration is acting as the agent of its shareholder, the
separate entities of corporation and shareholder may be
disregarded for Federal tax purposes because the law at-
tributes tax consequences of property held by a genuine
agent to the principal. Commissioner v. Bollinger, supra.
The three-part test to be used in determining whether a cor-
poration is a true agent of its shareholder is (1) whether the
fact that the corporation is acting as an agent with respect
to a particular asset is set forth in a written agreement at
the time the asset is acquired; (2) whether the corporation
functions as agent and not as principal with respect to the
asset for all purposes; and (3) whether the corporation is

A-27

held out as the agent and not as the principal in dealings
with third parties relating to the asset. See George v. Com-
missioner, 844 F.2d 225, 228-229 (5th Cir. 1988), affg. a
Memorandum Opinion of this Court.

After a review of the record before us, we find that
petitioner has failed to satisfy each part of the three-part
Bollinger test. Therefore, Vemco’s relationship vis-a-vis
each of the Mexican corporations was not one of prin-
cipal/agent. Thus, the amounts are not deductible by peti-
tioner, through Vemco, because as a shareholder Vemco is
not entitled to pay and claim a deduction for expenditures
properly attributable to the Mexican corporations. See
Koree v. Commissioner, 40 T.C. 961, 965-966 (1963). In-
stead, we agree with respondeant’s position that petitioner
‘is no doubt entitled [to] additional basis in her allocable
share of the corporate stock attributable to the payment
of’’ amounts that ‘‘*** were related to corporate business
and deductible by the corporation ***”’

In view of the foregoing, we find it unnecessary to
address the remaining issues raised by the parties, save the
inventory issue discussed below, because they are rendered
moot.

Inventory Issue
Whether the application of section 482 reduces Vem-

co’s (and petitioner’s distributive share of) claimed inven-
tory loss to zero for the taxable year 1976.

Section 482 allows respondent to allocate between
any two or more controlled organizations. trades, or
businesses, gross income, deductions, credits, or
allowances if respondent determines that such allocation is
necessary in order to prevent evasion of taxes or clearly to

A-28

reflect the income of any such organizations, trades, or
businesses.

‘“‘Controlled”’ is defined in sweeping terms so as to in-
clude any type of control, direct or indirect, whether legally
enforceable, and however exercisable or exercised. Section
1.482-1(a)(3), Income Tax Regs. It is the reality of the con-
trol which is decisive, not its form or the mode of its
exercise.

Petitioner owned a majority interest in both Cannon
Aero and Vemco. Petitioner exerted financial control over
each organization. Based on the record before us, it is abun-
dantly clear that petitioner controlled both Cannon Aero
and Vemco within the meaning of section 482.

In his notice of deficiency, respondent determined
that a $12,600 date of acquisition fair market vaiue should
be allocated to the inventory assets. Petitioner has the
burden of proving that respondent’s determination is er-
roneous. Welch v. Helvering, supra; Rule 142(a). Therefore,
in order to prevail petitioner must prove that either the
date of acquisition fair market value of the inventory
assets was more than $12,600 to justify a writedown in
1976 or that respondent’s determination under section 482
was unreasonable, arbitrary, or capricious. Ach v. Commis-
sioner, 42 T.C. 114, 126 (1964), affd. 358 F.2d 342 (6th Cir.
1966), cert. denied 385 U.S. 899 (1966).

Petitoner has conceded that the inventory became
obsolete prior to the time petitioner transferred the inven-
tory to Vemco. There is nothing in the record before us in-
dicating that the inventory was worth more than $12,600
at the beginning of the year 1976. The inventory loss was
properly disallowed inasmuch as any allowable loss that
might have been claimed was properly that of Cannon Aero

a

A-29

and not that of Vemco. Petitioner has clearly failed to carry
her burden of proof, and therefore, respondent’s
disallowance of petitioner’s claimed cost of goods sold in
the amount of $42,250 must be sustained.

Decision will be entered

for the respondent.

A30

Internal Revenue Service Department of the Treasury
Regional Commissioner

Date: 9 FEB 1982 Tax Year Ended and Deficiency:
12-31-76 $136,531.00
12-31-77 $245,576.00

Mrs. Charla Gates Cannon
420 South Marion Parkway, #2002
Denver, Colorado, 80209
Person to Contact
Ronald J. Dombroyski
Certified Mail #367801
Contact Telephone Number
713/226-4604

Dear Mrs. Cannon:

We have determined that there is deficiency (in-
crease) in your income tax as shown above. This letter is a
NOTICE OF DEFICIENCY sent to you as required by
law. The enclosed statement shows how we figured the
deficiency.

If you want to contest this determination in court
before making any payment, you have 90 days from the
above mailing date of this letter (150 days if addressed to
you outside of the United States) to file a petition with the
United States Tax Court for a redetermination of the
amount of your tax. The petition should be filed with the
United States Tax Court, 400 Second Street NW.,
Washington, DC 20217 and the copy of this letter should
be attached to the petition. The time in which you must file
a petition with the Court (90 or 150 days as the case may
be) is fixed by law and the Court cannot consider your case
if your petition is filed late. If this letter is addressed to

A-31

both a husband and wife, and both want to petition the Tax
Court, both must sign the petition or each must file a
separate, signed petition. You can get a copy of the rules
for filing a petition by writing to the Clerk of the United
States Tax Court, at the address shown in this paragraph

If you decide not to file a petition with the Tax Court,
we would appreciate it if you would sign and return the
enclosed waiver form. This will permit us to charge your ac-
count quickly and will limit the accumulation of interest.
The enclosed addressed envelope is for your convenience. If
you decide not to sign and return the waiver and you do not
timely petitiion the Tax Court, the law requires us to bill
you after 90 days from the above mailing date of this letter
(150 days if this letter is addressed to you outside the
United States).

If you have any questions, please contact the person
whose name and telephone number are shown above.

Sincerely yours.

Roscoe L. Egger, Jr.
Commissioner

By /s/_ Vincent A. Imbornone
Vincent A. Imbornone
Associate Chief, Appeals Office

Houston Letter 894(RO)(Rev.8)

Enclosures:

Copy of this letter
Statement

Waiver

Envelope

Room 8031, 515 Rusk Ave., Houston, Texas 77002

A-32
COPY

UNITED STATES TAX COURT

CHARLA GATES CANNON,

Petitioner,

9671-82
COMMISSIONER OF IN-

)
)
)
)
) Docket No.
)
)
TERNAL REVENUE, )
)
)

Respondent.
DECISION

Pursuant to the opinion of the Court filed March 20,
1990, and incorporating herein the facts recited in the
respondent's computation as the findings of the Court, it is

ORDERED and DECIDED: That there are deficien-
cies in income taxes due from the petitioner fer the taxable
years 1976 and 1977 in the amounts of $155,221.20 and
$244,581.83, respectively.

(Signed) W.M. DRENNEN

Judge

Entered: JUL 10 1990

A-33
COPY

UNITED STATES TAX COURT

CHARLA GATES CANNON,

Petitioner,

2261-85
COMMISSIONER OF IN-

)
)
)
)
) Docket No.
)
)
TERNAL REVENUE, )
)
)

Respondent.
DECISION

Pursuant to the opinion of the Court filed March 20,
1990, and incorporating herein the facts recited in the
respondent's computation as the findings of the Court, it is

ORDERED and DECIDED: That there are deficien-
cies in income taxes due from the petitioner for the taxable
years 1978 and 1979 in the amounts of $120,334.60 and
$101,980.00, respectively.

(Signed) W.M. DRENNEN

Judge

Entered: JUL 10 1990

A-34
APPENDIX D

PUBLISH

UNITED STATES COURT OF APPEALS

TENTH CIRCUIT

FILED
NOV 15 1991

CHARLA GATES CANNON,
Petitioner-Appellant,

Docket No.
90-9017

Vv.

)
)
)
)
)
)
)
COMMISSIONER OF IN-
TERNAL REVENUE, )
)
)

Respondent-Appellee.

Appeal from the United States Tax Court
No. 9671-82

Towner Leeper of Leeper & Leeper, E] Paso, Texas (Arthur
Bosworth of Denver, Colorado with him on the brief) for
Petitioner-Appellant.

Sally J. Schornstheimer of the United States Department
of Justice, Tax Division, Washington, D.C. (Gary R. Allen,

a ii i iia a alls ta

A-35

Richard Farber, and Shirley D. Peterson with her on the
brief) for Respondent-Appellee.

Before MOORE and EBEL, Circuit J udges, and ANDER-
SON, District Judge*.

EBEL, Circuit Judge.

This case concerns a taxpayer who became involved
in an unprofitable mining venture and deducted her
distributive share of certain partnership losses on her in-
come tax returns. The Commissioner of Internal Revenue
disallowed these deductions, and the Tax Court upheld the
Commissioner’s determinations. The taxpayer appeals,
raising two issues. First, did the Tax Court correctly
resolve the case on a theory not considered by either party,
namely, section 183 losses? Second, did the Tax Court cor-
rectly conclude that the limited partnership did not incur
the expenses at issue with the requisite profit motive? We
conclude that the Tax Court’s reliance on section 183 was
proper and that the court’s findings regarding partnership
motives were not clearly erroneous. Accordingly, we
affirm.

I. BACKGROUND

The facts in this case are fully set forth in the Tax
Court's opinion. See Cannon v. Commissioner, 59 T.C.M.
(CCH) 164 (1990). For purposes of this appeal, they may be
summarized as follows:

* The Honorable Aldon J. Anderson, District Judge, United States
District Court for the District of Utah, sitting by designation.

A-36

This case involves a taxpayer's treatment of losses
incurred in connection with a Mexican gold and silver min-
ing venture. In 1973, the taxpayer, Charla Cannon, joined
a limited partnership (‘‘Vemco”’) that was formed ‘‘to
engage in the business of land development, exploration,
mining and ore processing both in the United States and
foreign countries.”’ Jd. at 165 (citation omitted). The tax-
payer, who had a large annual income from trusts and her
deceased husband’s estate and employment benefits, pro-
vided Vemco with the funds necessary to conduct its
business operations. In return, she was to receive a higher
percentage than her partners of the profits or the proceeds
in the event of a sale or disposition of the partnership
assets. In addition, the annual expenses and losses of the
partnership were allocated to the taxpayer insofar as her
capital account permitted.

Vemco decided to invest in the Mexican venture at
issue in this case in reliance upon the findings of an ex-
perienced miner who explored the sites and an engineer
who analyzed-and reported on the mining properties.
Because Mexican law prohibits non-Mexican nationals or
corporations from acquiring a majority interest in Mexican
mining concessions, Compania Minera San Jose de Man-
zanillas, S.A. (‘‘Manzanillas’’), a Mexican corporation, held
the mining concessions, and Vemco became a forty-nine
percent shareholder in that corporation.! In 1978,
however, Vemco discovered that the president of Man-
zanillas had been embezzling, and the mining concessions
were transferred to Memco, a different Mexican corpora-
tion. Although the taxpayer, through Vemco, expended
over $800,000 for exploration and development of the
mines, Memco never operated at a profit. Vemco did not

1 The taxpayer claimed that Vemco was in a joint venture with this
Mexican corporation, but the Tax Court rejected this argument. 59
T.C.M. at 171.

A-37

report any income from mining for the years involved in
this lawsuit, nor did it receive any dividends.

The taxpayer deducted her distributiv_ share of the
partnership losses claimed by Vemco on her federal income
tax returns for 1976, 1977, 1978, and 1979. The Commis-
sioner of internal Revenue (‘‘Commissioner’’) disallowed
these deductions on the grounds that the taxpayer did not
establish that these amounts constituted ordinary and
necessary business expenses or were for an activity entered
into for profit or for the production of income. Alternative-
ly, the Commissioner asserted that these amounts were
nondeductible capital contributions to the Mexican cor-
poration that the parties formed to hold title to the mines.

The Tax Court agreed with the Commissioner's deci-
sion to disallow the deductions, but found the expenditures
to be nondeductible under section 183 of the Internal
Revenue Code. Because the Tax Court decided the case on
the basis of a section that neither party raised explicitly,
the taxpayer filed a motion for reconsideration, which was
denied. The taxpayer appeals. This court has jurisdiction
to review the Tax Court’s decision pursuant to 26 U.S.C. §
7482(a).

We first discuss whether the Tax Court erred in
resolving this case on the basis of section 183. We then
discuss whether the expenses at issue were incurred with
the requisite profit motive.

II. DISCUSSION

A. The Propriety of Resolving the Case Under Sec-
tion 183

In Commissioner v. Transport Manufacturing &

A-38

Equipment Co., 478 F.2d 731, 735 (8th Cir. 1973), the
Eighth Circuit stated that the Commissioner should notify
the taxpayer of the particular Code section, regulation, or
theory involved in a case to avoid prejudice to the tax-
payer. The court reasoned that “‘[t]he taxpayer works at an
extreme disadvantage in trying to invalidate deficiency
assessments if he does not specifically know why the Com-
missioner is challenging the taxpayer.’’ Id. (footnote omit-
ted). The court recognized, however, that prejudice does
not always result: “Of course, if a certain Code section,
regulation or theory has not been specifically raised in the
notice of deficiency, in the pleadings, or at trial and if there
is an absence of surprise on the taxpayer’s part, the tax-
payer has no reason to complain.”’ Jd. n.8 (citation omitted).

Here, the taxpayer contends that the Tax Court er-
roneously decided this case on the basis of a theory and
Code provision (lack of profit motive and section 183) that
neither party considered or raised, thereby surprising and
prejudicing the taxpayer. According to the taxpayer, only
three Code sections were at issue: sections 162, 212, and
616.2 We disagree. Section 183 is interrelated to sections
162 and 212, profit motive being the common underlying
theme. Indeed, as discussed infra, these provisions even
reference each other. Accordingly, we find that the tax-

2 Section 162 allows for the deduction of “‘all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any
trade or business .. . .”’ I.R.C. § 162(a).

Section 212 allows for the deduction of ‘all the ordinary and
necessary expenses paid or incurred during the taxable year — (1) for the
production or collection of income; [or] (2) for the management, conserva-
tion, or maintenance of property held for the production of income. . .
” LR.C, § 212.

Section 616 allows for the deduction of development expenditures
for mines and other naturai deposits ‘if paid or incurred after the ex-
istence of ores or minerals in commercially marketable quantities has
been disclosed.” I.R.C. § 616(a).

A-39

payer in this case was adequately put on notice, was not
prejudiced, and should not have been surprised.

The taxpayer asserts that neither party ever con-
sidered the Tax Court’s position that a profit motive was
not present. Yet, the evidence reveals that profit motive
was indeed a critical issue in this case and that the Com-
missioner was unwilling to concede the presence of a profit
motive. For example, the statutory notices of deficiency
that the Commissioner issued to the Taxpayer expressly
stated that she had not established that she entered into
the transaction in pursuit of economic profit and that this
lack of profit motive was one of the bases for the
disallowance of the claimed partnership deductions.
Record, vol. I, doc. 3, Deficiency Notice, Explanation of
Adjustments, Exhibit A. In addition, the Commissioner’s
opening statement explicitly noted that the taxpayer had
to prove a profit motive. Record, vol. II, Transcript, Nov.
19, 1986, at 26. Indeed, the taxpayer attempted to do this,
see infra Part II.B, and acknowledged that “‘[t]o obtain a
deduction under Section 162 for a trade or business ex-
pense or under Section 212 for an expenditure for the pro-
duction of income requires a profit motive.’’ Brief for Ap-
pellant at 37.3

In determining whether the mining activity met the
requirements of sections 162 or 212, the court naturally ap-
plied section 183. Section 183 is often used in analyzing
‘for profit’’ issues, both in the context of hobby losses and
in the context of trade or business expenses. Numerous
courts have used the regulations accompanying section 183
to determine profit motive under other sections. See, e.g.,
independent Elec. Supply, Inc. v. Commissioner, 781 F.2d

3 Thomas v. Commissioner, 792 F.2d 1256, 1259 (4th Cir. 1986),
establishes that section 616 also requires a profit motive.

A-40

724, 726-27 (9th Cir. 1986) (‘‘the courts have relied on the
section 183 factors in conducting the profit motive analysis
under section 162’’); Brannen v. Commissioner, 722 F.2d
695, 704-06 (11th Cir. 1984) (applying factors listed in sec-
tion 183 regulations to determine whether taxpayer’s ac-
tivities were engaged in for profit under section 162);
Faulconer v. Commissioner, 748 F.2d 890, 893 (4th Cir.
1984) (referring to section 183 to determine whether a tax-
payer was entitled to deductions under sections 162 or 212,
noting that the profit motive is the same under all three
statutory sections, and concluding that ‘‘[t]he regulations
under section 183, therefore, explicate the profit-motive re-
quirements of sections 162 and 212’’); Carter v. Commis-
sioner, 645 F.2d 784, 786 (9th Cir. 1981) (‘‘[section] 183(c)
must be reed in conjnunction with [section] 162’’) (footnote
omitted); Dreicer v. Commissioner, 665 F.2d 1292, 1294
(D.C. Cir. 1981) (‘a taxpayer claiming a deduction under
Sections 162 or 212 for an expense, or under Section 165 for
a loss, must be prepared to demonstrate an associated pro-
fit motive in order to avoid the ban of Section 183’’) (foot-
note omitted). Thus, the Tax Court’s application of section
183 was routine and predictable, not extraordinary.

In fact, the regulations accompanying section 212,
on which the taxpayer relied, expressly refer to section 183.
They specify that the inquiry as to profit motive under sec-
tion 212 is determined by reference to section 183 and the
accompanying regulations: ‘‘For provisions relating to ac-
tivities not engaged in for profit applicable to taxable years
beginning after December 31, 1969, see section 183 and the
regulations thereunder.’’ Treas. Reg. § 1.212-1(c). Section
183 similarly references sections 162 and 212 when it
defines ‘‘activity not engaged in for profit’’ as ‘‘any activi-
ty other than one with respect to which deductions are
allowable . . . under section 162 or under paragraph (1) or

A-41
(2) of section 212.’’ I.R.C. § 183(c).

In summary, the tax Court did not err in resolving
this case on the basis of Internal Revenue Code section 183.
Given the importance of profit motive, the Tax court’s
reliance on section 183 was both predictable and
nonprejudicial.

B. Applying Section 183

Having determined that it was proper to utilize sec-
tion 183 in this case, we next address whether the Tax
Court correctly applied the factors enumerated in the
Treasury Regulations accompanying that section.

Whether Vemco and the taxpayer were in pursuit of
economic profit is a question of fact. The applicable stand-
ard of review is a stringent one: a finding of fact should not
be disturbed unless it is clearly erroneous. Fed. R. Civ. P.
§2(a). “‘A finding is ‘clearly erroneous’ when although there
is evidence to support it, the reviewing court on the entire
evidence is left with a definite and firm conviction that a
mistake has been committed.’’ United States v. United
States Gypsum Co., 333 U.S. 364, 395 (1948).

The taxpayer makes a persuasive argument that
might well have convinced us if we were examining the
record de novo. However, as the Supreme Court stated in
Anderson v. Bessemer City, 470 U.S. 564 (1985):

This [clearly erroneous] standard plaintly does not en-
title a reviewing court to reverse the finding of the
trier of fact simply because it is convinced that it
would have decided the case differently. . . . If the
district court’s account of the evidence is plausible in
light of the record viewed in its entirety, the court of
appeals may not reverse it even though convinced that

A-42

had it been sitting as the trier of fact, it would have
weighed the evidence differently.

Id. at 573-74. Given the Tax Court’s ‘“‘plausible’’ account of
the evidence, we cannot say as a reviewing court that its
decision was clearly erroneous. After a thorough examina-
tion of the facts and circumstances of this case, we
therefore affirm the Tax Court’s determination that neither
the taxpayer nor Vemco possessed the requisite profit
motive.

The Tax Court appropriately delineated the proper
procedures to follow in determining whether an activity is
engaged in for profit. Where a partnership is involved, as
it is in this case, the dominant economic motive of the part-
nership, not that of the individual investors, is deter-
minative. Polakof v. Commissioner, 820 F.2d 321, 323 (9th
Cir. 1987), cert. denied, 484 U.S. 1025 (1988); Tallal v. Com-
missioner, 778 F.2d 275, 276 (5th Cir. 1985); Brannen, 722
F.2d at 703-04.

The taxpayer bears the burden of proving the re-
quired profit objective. Tax Ct. R. 142(a); Welch v. Helver-
ing, 290 U.S. 111, 115 (1933). The test is whether profit was
the dominant or primary objective of the venture. See, e.g.,
Polakof, 820 F.2d at 323-24 (‘dominant economic motive.”’
“primary purpose’’); Thomas v. Commissioner, 792 F.2d
1256, 1259 (4th Cir. 1986) (‘‘primary objective’’); Snyder v.
United States, 674 F.2d 1359, 1364 (10th Cir. 1982)
(“primarily motivated’’); Eastman v. United States, 635
F.2d 833, 837 (Ct. Cl. 1980) (‘primary purpose, ”’ “‘over-
riding profit motivation’’).

The regulations under section 183 set forth nine
nonexclusive factors to be considered in determining
whether a taxpayer’s activities are engaged in with the ob-

A-43

jective of realizing a profit: (1) the extent to which the tax-
payer carries on the activity in a businesslike manner; (2)
the taxpayer’s expertise or his reliance on the advice of ex-
perts; (3) the time and effort the taxpayer expends in carry-
ing on the activity; (4) the expectation that assets used in
the activity may appreciate in value; (5) the taxpayer’s suc-
cess in similar activities; (6) the taxpayer’s history of in-
come or loss in the activity; (7) the amount of occasional
profits, if any; (8) the taxpayer’s financial status; and (9)
the elements of personal pleasure or recreation. Treas. Reg.
§ 1.183-2(b).

The Treasury Regulations provide insight regarding
how to apply these objective factors to determine subjec-
tive intent. The ultimate inquiry entails examining the
facts and circumstances of each case:

No one factor is determinative in making this deter-
mination. In Addition, it is not intended that only the
factors described in this paragraph are to be taken in-
to account in making the determination, or that a
.-. determination is to be made on the basis that the
~~ number of factors (whether or not listed in this
paragraph) indicating a lack of profit objective ex-
ceeds the number of factors indicating a profit objec-

tive, or vice versa.

Id.

The Tax Court applied the relevant factors and con-
cluded that the partnership was not motivated by profit on
the following bases: (1) the $50,172.32 projected net month-
ly profit that lured the taxpayer and Vemco into this min-
ing activity, predicted in the expert’s report, was un-
attainable as it was erroneously based upon projected ore
grades that were contrary to actual test results. (2) Vemco
failed to increase the milling capacity of the mines as

A-44

recommended in the same expert report.4 (3) Vemco con-
tinued to fund projects relating to the mines even though
they had an unbroken record of substantial losses
($2,205,045.10), they were unlikely to recoup those losses,
and the Mexican corporations never paid a dividend to
Vemco. (4) Despite these losses, Vemco took few steps to
increase production. (5) The taxpayer received substantial
income from other sources, which enabled her to provide
large amounts of capital.° (6) Vemco maintained in-
complete books and records.

In support of the taxpayer’s position, the Tax Court
acknowledged that some of the limited partners con-
tributed time and effort to the mining operations® and that
one limited partner had operated profitable mines in the
past.’ We add several other factors to this short list, name-
ly the taxpayer’s repeated statements regarding profit
motive during the proceedings below, the taxpayer's
reliance upon expert advice, and the lack of an alternative
non-profit-making explanation for the venture.

The taxpayer stated during the proceedings before

4 Treas. Reg. § 1.183-2(b)(2) provides: ‘Where a taxpayer . . . procures
... expert advice, but does not carry on the activity in accordance with
such practices, a lack of intent to derive profit may be indicated unless
it appears that the taxpayer is attempting to develop new or superior
techniques which may result in profits from the activity.”’

° Although we agree with the Tax Court's assessment of the other
Treasury Regulation factors, we find the factor focusing upon the finan-
cial status of the taxpayer to be a wash. See Treas. Reg. § 1.183-2(b)(8).

6 See Treas. Reg. § 1.183-2(b)(3).

7 See Treas. Reg. § 1.183-2(b\(5). The taxpayer's own previous
businesses included a profitable aeronautical business, an unprofitable
sheep-raising operation, a profitable woman’s exercise and health spa,
and a helicopter sales business for which success or lack of success was
not established. Record, vol. II, Transcript, Nov. 20, 1986, at 297-300.

oe ee,

a

si Sle get ela ia ae! *

A-45

the Tax Court that she was indeed motivated by a desire
to profit:

Counsel: What was your motive in — why did you
want to spend — make an investment down
there? do you enjoy mining?

Cannon: Well, I had heard a great deal about mining
all my life, but also, over and above that, I
obviously was down there to make money.

I have invested in several things throughout
my lifetime and this one looked very good .

I had no intention to do anything except
make money.

Record, vol. II, Transcript, Nov. 20, 1986, at 289-90. She
also discussed the profitability of her former ventures and
the anticipated profits of this venture. Jd. at 285, 293,
296-300.8

Vemco’s solicitation of expert advice further sup-
ports the taxpayer’s contention that the mining activity
was engaged in for profit. See Treas. Reg. § 1.183-2(b)(2).
Carl Weaver, an experienced miner since 1939 in Arizona,
Colorado, Utah, and Mexico and a limited partner in Vem-
co, explored the mines and prepared a report on their
histories and capabilities. Henry Ehrlinger, a professor of
mining and engineering at the university of Texas at El
Paso, also analyzed and reported on the mines. Ehrlinger

8 We note, however, that a taxpayer's statement of intent is given less
weight than objective factors in determining such intent. Treas. Reg. §
1.183-2(a); Engdahi v. Commissioner, 72 T.C. 659, 666 (1979); see also
Brodrick v. Derby, 236 F.2d 35, 38 (10th Cir. 1956) (circumstances may
indicate motive contrary to that stated).

A-46

had considerable experience in Mexican mining and had
operated a company similar to Vemco on his own. Ralph
Wilcox, Jr., a graduate geology student at the University
of Texas, analyzed ore samples taken from the mines. The
taxpayer relied upon this expertise. Record, vol. 2,
Transcript, Nov. 20, 1986, at 283-89.

Finally, the ninth factor, ‘‘Elements of personal
pleasure or recreation,’’ deserves more attention than it
was given by the Tax Court. Treas. Reg. § 1.183-2(b)(9)
clearly indicates that ‘‘a profit motivation may be in-
dicated where an activity lacks any appeal other than pro-
fit.’” Here, the absence of any suggestion of an alternative
motive in the record is a powerful factor in support of the
taxpayer’s position.?

Although it is unclear what besides profit might
have prompted Vemco to expend substantial amounts of
money on this venture, we cannot declare the court’s fin-
ding clearly erroneous. The Tax Court carefully applied the
appropriate factors and provided a solid basis for its
decision.

With respect to the experts’ reports, the Tax Court

9 Courts that fail to discern a profit motive often specify an alternative
explanation for a party's actions. See, e.g., Polakof, 820 F.2d at 324
(limited partnership that bought film properties was motivated by a
desire to create tax shelters rather than to profit); Thomas, 792 F.2d at
1258 (primary objective of coal mining program was to secure tax
benefits rather than to earn an economic profit); Estate of Power v. Com-
missioner, 736 F.2d 826, 831 (1st Cir. 1984) (taxpayer's horse-breeding
activity was engaged in for personal satisfaction, not profit); Eastman,
635 F.2d at 841 (family engaged in horse-breeding in order to utilize the
losses from that operation to offset other income). But see Antonides v.
Commissioner, 893 F.2d 656, 660 (4th Cir. 1990) (suggesting that the
court does not need to pinpoint the likely motivation, as long as it deter-
mines on the basis of the Treasury Regulation factors that the activity
was not engaged in for profit).

el bMS df

Data BG ite OOP Oe PD ad

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A-47

emphasized that Ehrlinger’s monthly profit projection of
$50,172.32 was erroneously based upon inconsistent data
regarding the ore grades that could be realized per ton of

- ore mined. 59 T.C.M. at 169. The actual assay work on the

ore veins showed a decidedly poorer ore body in general
than was assumed in the expert’s report. Jd. In addition,
Vemco did not implement the critical aspects of the ex-
perts’ advice, upon which any prospect of profits depended.
Id. at 170. See Treas. Reg. § 1.183-2(b)(2) (where a taxpayer
procures but does not follow expert advice, ‘‘a lack of intent
to derive profit may be indicated’’). Specifically, Weaver
and Ehrlinger recommended that Vemco install a higher
capacity mill in order to enhance the efficiency and pro-
fitability of the mines; indeed, their profit projections
depended upon this mill. Vemco never installed it, however,
thereby preclusing any chances of transforming this min-
ing venture into a profitable operation. 59 T.C.M. at 170.

The Tax Court also emphasized that Vemco did not
receive any profits from this mining venture for an entire
eleven-year-period. In fact, the mines had an unbroken
record of substantial losses totalling $2,205,045.10. Id. at
169. A record of such persistent and substantial losses is
persuasive evidence that Vemco did not possess the re-
quisite profit motive. See Treas. Reg. § 1.183-2(b)(6)
(‘‘[W]here losses continue to be sustained beyond the period
which customarily is necessary to bring the operation to

profitable status such continued losses, if not explainable,

... May be indicative that the activity is not being engaged
in for profit.’’). Furthermore, Vemco took few steps to in-
crease production in the face of these overwhelming losses,
and the record reveals that Vemco was unlikely to recoup
the losses.

Finally, Vemco maintained incomplete books and
records, as it was unable to verify many claimed

A-48

payments by tracing them back to a source document. See
Treas. Reg. § 1.183-(2)(b)(1).

In summary, the record reveals that several of the
factors set forth in Treas. Reg. § 1.183-2(b) support the tax-
payer's position, whereas others support the government’s
position. Taking all facts and circumstances into account,
we cannot say that the Tax Court’s application of the
Treasury Regulations accompanying section 183 was clear-
ly erroneous. Accordingly, we AFFIRM the findings of the
Tax Court.

In light of this ruling, we need not address the alter-
native basis that the Tax Court provided for its decision,
namely that the deductions that the petitioner claimed
through Vemco “‘are disallowed by virtue of their being the
expenses of another taxpayer.’’ 59 T.C.M. at 170.

AFFIRMED.

A-49
APPENDIX E

UNITED STATES COURT OF APPEALS

FOR THE TENTH CIRCUIT

CHARLA GATES CANNON,

Petitioner - Appellant,

COMMISSIONER OF IN-

)
)
)
)
)
Vv. ) No.90-9017
)
)
TERNAL REVENUE, )

)

)

Respondent - Appellee.

ORDER
Filed January 13, 1992

Before MOORE and EBEL, Circuit Judges, and ANDER-
SON, District Judge.*

This matter comes on for consideration of petitioner-
appellant’s petition for rehearing filed December 16, 1991.

* Honorable Aldon J. Anderson, District J udge, United States District
Court for the District of Utah, sitting by designation.

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Upon consideration thereof, the petition is denied.

Entered for the Court

Robert L. Hoecker, Clerk

By /s/_Partrick Fisher —

Patrick Fisher
Chief Deputy Cierk

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APPENDIX F

Senate Report 91-552
exchange tax-free property of a like-kind.

General reasons for change.—One aspect of the farm
loss problem called to the committee’s attention does not
involve a practice permitted by present law, but rather in-
volves an erroneous interpretation of the like-kind ex-
change rule of present law. It appears this rule has been in-
correctly represented by some persons who promote tax-
motivated livestock purchases. There appear to have been
representations that male calves can be traded for female
calves tax free as a like-kind exchange. The importance of
this arises from the fact that ordinarily the ratio of males
to females in a calf crop is approximately 50-50. Since few
males are normally retained in a typical cattle operation,
the remaining male calves are castrated and sold as steers
at ordinary income rates. If a tax-free trade of male calves
for female calves were allowed, a breeding herd of females
could be built up more quickly without tax consequences.

The committee understands that the Revenue Ser-
vice does not consider this to be a like-kind exchange
(although it has no published position). The House Ways
and Means Committee in its report on this bill noted this
problem and indicated it believed that Congress did not in-
tend this type of exchange to be considered as a like-kind
exchange. It also stated its belief that allowing this treat-
ment would be an incorrect interpretation of the statute.

The committee agrees with the House that this type
of exchange should not be considered a like-kind Exchange.
When male calves are exchanged for female calves, the ex-
change does not involve like-kind property since the male
animals are not held for breeding purposes and, in fact, are

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not of a “‘like-kind’’ with females. The committee believes,
however, that it would be more appropriate to specifically
deal with this matter in the bill.

Explanation of provision.—For the above reasons,
the committee amendments provide that, for purposes of
applying the tax-free, like-kind exchange rule of present
law, livestock of different sexes are not property of a like-
kind.

Effective date.—Since this provision is merely
declaratory of what Congress intended in present law, it is
to apply with respect to taxable years to which the Internal
Revenue Code of :954 applies.

5. Hobby Losses (sec. 213 of the bill and secs. 183 and
270 of the code)

Present law.— Present law contains a so-called ‘‘hob-
by loss’’ provision (section 270) which limits to $50,000 per
year the amount of losses from a trade or business carried
on by an individual that can be used to offset other income.
This limitation only applies, however, where the losses
from the business exceed $50,000 per year for a period of
at least 5 consecutive years. In computing the amount of
a loss for purposes of this provision, certain specially
treated deductions are disregarded. These deductions are
taxes, interest, casualty, and abandonment losses con-
nected with a trade or business, farm drought losses, net
operating loss carryovers, and expenditures which may
either be capitalized or currently deducted.

[103] General reasons for change.—The hobby loss provi-
sion generally has been of very limited application. It is
often possible for a taxpayer to slightly rearrange his in-
come and deductions so as to break the required string of

wha anid e

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5 years. In addition, the exclusion of certain specially
treated deductions from the loss computations means that
a number of expenses are not considered to give rise to a
loss even though they are in fact deducted. Moreover, in
the few cases in which the hobby loss provision has applied
so as to disallow the deduction of the loss, the taxpayer has
been faced in 1 year with a combined additional tax at-
tributable to a 5-year period.

In addition to the hobby loss provision, some court
cases have provided another basis on which the loss can be
denied; namely, that the activity carried on by the tax-
payer from which the loss results is not a business but is
merely a hobbv. The committee agrees with the House that
this basic principle provides a more effective and
reasonable basis for distinguishing situations where tax-
payers are not carrying on a business to realize a profit, but
rather are merely attempting to utilize the losses from the
operation to offset their other income.

The House bill replaced the present hoppy loss provi-
sion with a rule which provided that a taxpayer (individual
or corporate) could not deduct losses arising from an activi-
ty carried on by him if the activity was carried on without
a reasonable expectation of realizing a profit from it. Where
the losses from an activity were more than $25,000 in three
out of five consecutive years, then the activity would have
been presumed to have been carried on without the re-
quisite expectation of profit unless it was shown to the con-
trary by the taxpayer.

As previously indicated, the committee is in basic
agreement with the approach taken by the House to the
hobby loss problem. The committee is concerned, however,
that requiring a taxpayer to have a “reasonable expecta-
tion’’ of profit may cause losses to be disallowed in situa-

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tions where an activity is being carried on as a business
rather than as a hobby. Accordingly, the committee has
modied the House bill to provide that in determining
whether losses from an activity are to be allowed, the focus
is to be on whether the activity is engaged in for profit
rather than whether it is carried on with a reasonable ex-
pectation of profit. This will prevent the rule from being ap-
plicable to situations where many would consider that it is
not reasonable to expect an activity to result in a profit
even though the evidence available indicates that the ac-
tivity actually is engaged in for profit. For example, it
might be argued that these was not a ‘“‘reasonable’’ expec-
tation of profit in the case of a bona fide inventor or a per-
son who invests in a wildacat oil well. A similar argument
might be made in a case of a poor person engaged in what
appears to be an inefficient farming operation. The commit-
tee does not believe that this provision should apply to
these situations or that the House intended it to do so app-
ly, if the activity actually is engaged in for profit.

Concern also has been expressed as to whether there
would be a reasonable administration of this new provision.
In view of this, the committee believes that the Treasury
Department should establish two advisory groups down
from the cattle and horse industries (one concerned with
the cattle industry and one with the horse industry) to
assist the Commissioner of Internal Revenue in
establishing standards for the application of these rules to
achieve reasonable results and to resolve policy questions
in their application from time to time. This action should
help limit the disallowance by the Internal Revenue [104].
Service of the deduction of losses under this provision to
cases where it is generally recognized that this is ap-
propriate. The Treasury Department has indicated its will-
ingness to establish advisory groups of this nature.

a eet be ls WII gts As

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Explanation of provision.—The committee amend-
ments provide in general that an individual (or a sub-
chapter S corporation) is not to be allowed to deduct losses
(to the extent attributable to business deductions) arising
from an activity which is not engaged in for profit. The
committee amendments do not apply to corporate tax-
payers (other than shareholders of subchapter S corpora-
tions), as did the House bill, since it is primarily in the case
of individual taxpayers that the problem arises of a tax-
payer entering into an activity to obtain a loss from the ac-
tivity which is used to offset other income. In addition, the
application of the provision to corporations would present
a number of difficulties, such as its effect on shared
facilities provided on a cost basis. No inference should be
drawn from this action in the case of a corporation,
however, as to whether or not any activity of the corpora-
tion is a business, or is engaged in for profit, for purposes
of the tax laws.

The committee amendments provide that an activity
is not engaged in for profit if deductions with respect to the
activity not allowable as trade or business expenses or as
expenses incurred for the production of income or in con-
nection with property held for the production of income. In
making the determination of whether an activity is not
engaged in for profit, the committee intends that an objec-
tive rather than a subjective approach is to be employed.
Thus, although a reasonable expectation of profit is not to
be required, the facts and circumstances (without regard to
the taxpayer’s subjective intent) would have to indicate
that the taxpayer entered the activity, or continued the ac-
tivity, with the objective of making a profit. As previously
indicated, a taxpayer who engaged in an activity in which
there was a small chance of a large profit, such as a person
who invested in a wildcat oil well or an inventor could
qualify under this test even though the expectation of pro-

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fit might be considered unreasonable.

Where an activity is not engaged in for profit, this
provision specifically provides that a deduction is to be
allowed for items which may be deducted without regard to
whether they are incurred in a trade or business or for the
production of income. This would include the deductions
allowed for interest and state and local property taxes, and
the long’term capital gains deduction. It is further provid-
ed that, in the case of an activity not engaged in for profit.
a deduction is nevertheless to be allowed for the trade or
business or production in income items which could be
deducted if the activity were engaged in for profit, but only
to the extent these items do not exceed the amount off
gross income derived from the activity reduced by the
deductions which are allowed in any event such as interest
and certain state and local taxes. The deductions of this
type which are to be allowed first (but after taxes, etc.) are
those such as_ depreciation which involve basis
adjustments.

Under the committee amendments a taxpayer is to
be presumed to be engaged in an activity for profit for a
taxable year, unless established to the contrary by the
Secretary of the Treasury or his delegate, if in two or more
years of the period of five consecutive taxable years ending
with the current taxable year, the activity was carried on
at a profit (i.e., if the gross income from the activity ex-
ceeds the deductions [105] attributable to the activity
which would be allowed if it were engaged in for profit). For
purposes of this presumption, ail deductions attributable
to the activity other than that allowed for net operating
loss carryovers are to be taken into account.

Effective date.—This provision generally is to be ef-
fective with respect to taxable years beginning after

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December 31, 1969. For purposes of applying the presump-
tion, however, this provision also is to be applicable to prior
taxable years.

6. Gain From Disposition of Farm Land (sec. 214 of the bill
and sec. 1251 of the code)

Present Law.—Present law allows a taxpayer engaged in
the farming

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40386011_0508%3A1. Public record. Not legal advice.