Samarasinghe v. Comm'r , 103 T.C.M. 1152 ( 2012 )

T.C. Memo. 2012-23
UNITED STATES TAX COURT
L.A. AND RAYANI SAMARASINGHE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 5082-09. Filed January 19, 2012.
Matthew Pollick Cavitch, for petitioners.
Beth A. Nunnink, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
MARVEL, Judge: Respondent determined deficiencies in
petitioners’ Federal income tax and accuracy-related penalties
under section 6662(a)1 for 2005 and 2007 as follows:
1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
(continued...)
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Penalty
Year Deficiency Sec. 6662
2005 $18,068 $3,614
2007 29,803 5,961
After concessions,2 the issues for decision are: (1)
Whether rental income attributable to petitioners’ rental of a
commercial office building they owned to a related professional
corporation in 2005 and 2007 was passive income under the
transition rule set forth in section 1.469-11(c)(1)(ii), Income
Tax Regs., as petitioners contend, or was nonpassive income under
the self-rental rule of section 1.469-2(f)(6), Income Tax Regs.,
as respondent determined; and (2) whether petitioners are liable
for accuracy-related penalties under section 6662(a). In order
to decide issue (1), we must decide whether a lease executed in
1980 between petitioners and petitioner husband’s wholly owned
professional corporation constituted a written binding contract
within the meaning of section 1.469-11(c)(1)(ii), Income Tax
Regs., with respect to 2005 and 2007.
1
(...continued)
Procedure. Monetary amounts have been rounded to the nearest
dollar.
2
The parties stipulated that if the self-rental rule of sec.
1.469-2(f)(6), Income Tax Regs., is applicable, then petitioners
are liable for the deficiency. If the self-rental rule is not
applicable, then petitioners are not liable for the deficiency.
The parties also stipulated that the Westwood property “was
rented for use in a business activity in which petitioner-husband
materially participates.”
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FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulation of facts is incorporated herein by this
reference. Petitioners resided in New Jersey when they
petitioned this Court.
Petitioners are husband and wife. Petitioner L.A.
Samarasinghe (petitioner) graduated from medical school in 1967.
After graduation petitioner began to practice medicine. During
the years at issue, petitioner, who specializes in internal
medicine and in critical care, was an employee of his wholly
owned professional corporation, L.A. Samarasinghe, M.D., P.A.
(medical corporation).
In the late 1970s petitioner hired Ramesh Sarva (Mr. Sarva),
a certified public accountant (C.P.A.), to provide accounting
services to the medical corporation and to petitioners. Over the
years, Mr. Sarva, among other things, (1) helped petitioner
incorporate his medical practice, (2) performed accounting and
bookkeeping services for the corporation and for petitioners, (3)
provided tax planning advice, including advice on tax shelters
and real estate investments, and (4) prepared tax returns for the
medical corporation and for petitioners.
At some point before or during 1979 Mr. Sarva advised
petitioner to purchase real property for the medical
corporation’s use. Mr. Sarva also advised petitioner to purchase
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the real property in his individual capacity rather than through
the medical corporation. In 1979 petitioners purchased an office
building in Westwood, New Jersey (Westwood property), and titled
the property in both their names. The Westwood property is
conveniently situated only a few blocks from Pascack Valley
Hospital, which petitioner visits frequently in connection with
his medical practice.
After petitioners purchased the Westwood property, Mr. Sarva
prepared a lease using a standardized lease form that purported
to lease the Westwood property to the medical corporation in
exchange for monthly rent payments and other consideration. The
lease recited that the medical corporation would use the Westwood
property as a doctor’s office. The lease ran from July 1, 1980,
until June 30, 1981, with the term “to be renewed automatically
unless sooner terminated as hereinafter provided, at the ANNUAL
RENT of $30,000.00 with 5% increase every year all payable in
equal monthly installments in advance on the first day of each
and every calendar month”. The lease also provided as follows:
NINETEENTH.--The Landlord has made no representations
or promises in respect to said building or to the
demised premises except those contained herein, and
those, if any, contained in some written communication
to the Tenant, signed by the Landlord. This instrument
may not be changed, modified, discharged or terminated
orally.
Petitioners and the medical corporation executed the lease on
June 30, 1980 (the 1980 lease). From June 30, 1980, when
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petitioners and the medical corporation executed the 1980 lease,
through and including the years at issue, Mr. Sarva had no
knowledge of the existence of any document that formally amended
the 1980 lease or of any other written lease regarding the
Westwood property.3
The medical corporation maintained its offices in the
Westwood property through at least 2007. During its occupancy of
the Westwood property the medical corporation made numerous
improvements to the property, including basic renovations and the
installation of an in-house radiology system and a laboratory.
The medical corporation paid for all improvements, the aggregate
cost of which Mr. Sarva estimated to be approximately $100,000.
The medical corporation used a fiscal year that began on
December 1 and ended on November 30 for accounting and tax
purposes. During the course of a fiscal year the medical
corporation periodically issued checks to petitioner without
designating what the checks were for. The checks typically
ranged in amount from $1,000 to as much as $43,000 and were made
payable to petitioner. The checks did not contain any notation
regarding the purpose of the payments. The medical corporation
3
Although Mr. Sarva testified that there were no documents
amending or modifying the 1980 lease and that there was no other
written lease involving the Westwood property, we decline to find
these statements as facts because Mr. Sarva can testify only to
what he knew through personal knowledge. Because petitioners did
not appear at trial or testify, whatever information they might
possess is not before us.
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issued the checks to petitioner whenever petitioner needed or
wanted money.
Petitioner’s office periodically sent Mr. Sarva the bank
statements and canceled checks for the medical corporation, and
Mr. Sarva’s office would summarize the data using a software
program called QuickBooks. The checks made payable to petitioner
as well as other checks issued by the medical corporation for
petitioner’s personal expenses such as mortgage, property taxes,
and estimated tax payments were recorded in general ledger
account 241, Due Officer. At the end of the fiscal year Mr.
Sarva made adjusting entries which allocated the payments made to
petitioner during the year to specific expense accounts, such as
salary/payroll and rent. Mr. Sarva determined the amounts to be
allocated to salary and to rent. In making the allocation to
rent, Mr. Sarva did not consult the 1980 lease, and he assumed
that the annual rental period coincided with the medical
corporation’s fiscal year. With respect to the fiscal years
ending November 30, 2005 and 2007, Mr. Sarva did not calculate
what the annual rent should be under the 1980 lease, assuming it
was in effect for those years, nor did he determine the amount of
the required monthly lease payment under the lease. The record
contains no evidence that the medical corporation made monthly
rent payments to petitioners during 2005 and 2007 as would have
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been required by the 1980 lease, assuming that the lease was
still in effect for those years.
Mr. Sarva prepared Federal income tax returns for the
medical corporation for the fiscal years ending November 30, 2004
through 2009. At least some of those returns were filed
electronically. The medical corporation claimed deductions for
rental expenses attributable to the Westwood property4 on those
corporate tax returns as follows:
FYE Nov. 30 Rental expense deduction
2004 $100,000
2005 100,000
1
2006 133,319
2
2007 156,224
2008 38,621
2009 168,940
1
The parties stipulated petitioners’ retained copy of the
medical corporation’s 2006 Federal tax return. The retained copy
shows a rental expense deduction of $139,989. The parties also
stipulated a copy of the Tax Return Database electronic return
information for the medical corporation’s 2006 return. The
electronic return information summary reflects that the medical
corporation claimed a rental expense deduction of $133,319 .
4
The parties stipulated that the following amounts represent
the correct amounts of rent required by the 1980 lease if it was
still in effect for rental terms ending in 2004 through 2009:
Rental term ending June 30 Rental income
2004 $94,449
2005 99,172
2006 104,130
2007 109,337
2008 114,804
2009 120,554
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2
The parties stipulated petitioners’ retained copy of the
medical corporation’s 2007 Federal tax return. The retained copy
shows a rental expense deduction of $133,828. The parties also
stipulated a copy of the Tax Return Database electronic return
information for the medical corporation’s 2007 return. The
electronic return information summary reflects that the medical
corporation claimed a rental expense deduction of $156,224.
Petitioners timely filed their joint 2004 through 2009
Federal income tax returns, which Mr. Sarva also prepared.
Petitioners reported the following rental income attributable to
the Westwood property lease:
Year Rental income
2004 $100,000
2005 100,000
2006 -0-
2007 100,000
2008 -0-
2009 123,484
On Schedule E, Supplemental Income and Loss, of their 2005 and
2007 returns, petitioners treated the rental income of $100,000
as passive income, which was taken into account in calculating
the passive losses for those years.
On December 3, 2008, respondent mailed petitioners a notice
of deficiency for 2005 and 2007. Respondent determined that the
rental income attributable to the Westwood property constituted
self-rental income, which is nonpassive income that cannot be
taken into account in calculating the correct amount of a passive
loss. Respondent also determined that petitioners were liable
for the 20-percent accuracy-related penalty under section 6662(a)
for each of the years 2005 and 2007.
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Petitioners timely petitioned this Court to redetermine
respondent’s determinations, and the case was set for trial on
June 24, 2010. Petitioners, who were represented by counsel, did
not appear or testify at trial, and petitioners’ counsel called
only one witness, Mr. Sarva.
OPINION
I. Rental Payments as Nonpassive Income
A. Burden of Proof
The Commissioner’s determinations in a notice of deficiency
are presumed correct, and the taxpayer ordinarily bears the
burden of proving that those determinations are erroneous. Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Section
7491(a), however, provides that the burden of proof with respect
to a disputed factual issue shifts to the Commissioner if the
taxpayer produces credible evidence with respect to the issue,
the taxpayer complied with the substantiation requirements, and
the taxpayer cooperated with the Secretary5 with regard to all
reasonable requests for information. Sec. 7491(a)(2); see also
Higbee v. Commissioner, 116 T.C. 438, 440-441 (2001).
Petitioners do not contend that section 7491(a) applies, and the
5
The term “Secretary” means “the Secretary of the Treasury
or his delegate”, sec. 7701(a)(11)(B), and the term “or his
delegate” means “any officer, employee, or agency of the Treasury
Department duly authorized by the Secretary of the Treasury
directly, or indirectly by one or more redelegations of
authority, to perform the function mentioned or described in the
context”, sec. 7701(a)(12)(A)(i).
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record does not permit us to conclude that petitioners satisfied
the requirements of section 7491(a)(2). Accordingly, petitioners
bear the burden of proving that respondent erroneously determined
that their 2005 and 2007 rental income attributable to the
Westwood property was nonpassive income.
B. Passive Activity Losses and the Self-Rental Rule
Generally, a taxpayer may deduct a loss incurred in a trade
or business. Sec. 165(c)(1). However, a taxpayer may not deduct
a loss from a passive activity. Sec. 469(a). Ordinarily, a
passive activity is an activity involving the conduct of a trade
or business in which the taxpayer does not materially
participate. Sec. 469(c)(1). However, except as provided in
section 469(c)(7), the term “passive activity” also includes a
rental activity regardless of whether a taxpayer materially
participates in the activity. Sec. 469(c)(2), (4).
A passive activity loss is defined as the excess, if any, of
the aggregate losses from passive activities during a taxable
year over the aggregate income from passive activities for such
year. Sec. 469(d)(1). In order to calculate a taxpayer’s
passive activity loss for a taxable year, the taxpayer must
ascertain whether the taxpayer’s income and losses are from
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passive activities in accordance with rules set forth in section
469 and related regulations.6
Mr. Sarva characterized the rental income attributable to
petitioners’ rental of the Westwood property to the medical
corporation during 2005 and 2007 as passive income and, in
preparing petitioners’ 2005 and 2007 returns, offset that income
with passive losses to arrive at petitioners’ nondeductible
passive activity losses for 2005 and 2007. In the notice of
deficiency, respondent recharacterized the rental income as
nonpassive income, determining that the income was self-rental
income within the meaning of section 1.469-2(f)(6), Income Tax
Regs.
While section 469(c)(2) generally characterizes rental
activity as passive, section 1.469-2(f)(6), Income Tax Regs.,
provides that net rental income received by the taxpayer for use
of an item of the taxpayer’s property in a business in which the
taxpayer materially participates shall be treated as income not
from a passive activity. The rule of section 1.469-2(f)(6),
Income Tax Regs., which is sometimes referred to as the self-
rental rule or the recharacterization rule, creates an exception
to the normal rule set forth in section 469(c)(2) and (4) that
6
Sec. 469(l)(2) authorizes the Secretary to promulgate
regulations “which provide that certain items of gross income
will not be taken into account in determining income or loss from
any activity (and the treatment of expenses allocable to such
income)”.
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income from a rental activity is passive income for purposes of
section 469 regardless of whether a taxpayer materially
participates in the activity. See Carlos v. Commissioner, 123
T.C. 275, 279-280 (2004).
The parties stipulated that petitioners rented the Westwood
property to petitioner’s medical corporation for use in the
corporation’s business. The parties also stipulated that
petitioner materially participated in the business activity of
the medical corporation. Because petitioner materially
participated in the business activity and petitioners rented the
property for such use, the self-rental rule would appear to
apply. Therefore, unless an exception to the rule applies,
petitioners must characterize the Westwood property rental income
as nonpassive income and may not offset this income against
accumulated and unused passive losses.
C. Written Binding Contract Exception
Petitioners contend that the self-rental rule of section
1.469-2(f)(6), Income Tax Regs., does not apply because they are
entitled to transitional relief under section 1.469-11(c)(1)(ii),
Income Tax Regs. Section 1.469-11(c)(1)(ii), Income Tax Regs.,
provides that, in applying section 1.469-2(f)(6), Income Tax
Regs., a taxpayer’s rental income is passive if it is
attributable to the rental of property “pursuant to a written
binding contract entered into before February 19, 1988.” To
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qualify for transitional relief under the regulation, a taxpayer
must prove that the rental income in question was paid pursuant
to a written lease that was entered into before February 19,
1988, and was still in effect; i.e., was binding and enforceable
for the year at issue. Krukowski v. Commissioner, 279 F.3d 547,
550 (7th Cir. 2002), affg. 114 T.C. 366 (2000). “At a minimum,
for a lease to be binding on a party, it must be enforceable
under applicable state law.” Connor v. Commissioner, 218 F.3d
733, 740 (7th Cir. 2000), affg. T.C. Memo. 1999-185.
Petitioners executed a written lease with respect to the
Westwood property--the 1980 lease. Because the parties do not
dispute that the lease was entered into before February 19, 1988,
and was in writing, the sole issue remaining is whether the 1980
lease remained in force and was binding under State law for 2005
and 2007. We examine relevant State law and the actions of the
parties to the 1980 lease during the years at issue to decide
this issue. The parties agree that the relevant State law is the
law of the State of New Jersey.7
Under New Jersey law, an enforceable agreement exists when
“two parties ‘agree on essential terms and manifest an intention
7
The 1980 lease did not specify the law governing the
interpretation of the lease. In the absence of an agreement by
the parties to a lease regarding applicable law, we apply the law
of the State where the property is located. Krukowski v.
Commissioner, 279 F.3d 547, 550 (7th Cir. 2002), affg. 114 T.C.
366 (2000); Connor v. Commissioner, 218 F.3d 733, 740 (7th Cir.
2000), affg. T.C. Memo. 1999-185.
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to be bound by those terms.’” Barak v. Obioha, 74 Fed. Appx.
164, 166 (3d Cir. 2003). The essential terms of a lease include
“an adequate description of the property, a definite term
(including the commencement date), the agreed rental and the
manner of payment.” Brechman v. Adamar of N.J., Inc., 440 A.2d
480, 482 (N.J. Super. Ct. Ch. Div. 1981). If the lease term
exceeds 3 years, the lease also must comply with the statute of
frauds. N.J. Stat. Ann. 25:1-5 (West 1997).8 Under the statute
of frauds, the lease must be in writing and signed by both
landlord and tenant. Id.
Unlike some other jurisdictions, New Jersey does not
distinguish between a renewal and an extension of a lease.
Schnakenberg v. Gibraltar Sav. & Loan Association, 117 A.2d 191,
195 (N.J. Super. Ct. App. Div. 1955); see also Balsham v.
Koffler, 73 A.2d 272, 274 (N.J. Super. Ct. App. Div. 1950). If a
lease provides for renewal, the renewal merely continues the old
lease. Schnakenberg v. Gibraltar Sav. & Loan Association, supra
at 195. A general covenant to renew “implies a renewal or
extension for the same term as provided in the original lease,
and is sufficiently definite and certain to be enforceable.” Id.
8
The parties do not dispute that the 1980 lease complied
with the statute of frauds at the time of execution. Effective
Jan. 5, 1996, New Jersey amended its statute of frauds, repealing
N.J. Stat. Ann. 25:1-1 (1940). See P.L. 1995, c.360 (N.J. 1996).
The parties agree that the statute of frauds in effect for 1980
applies to the 1980 lease.
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No new lease is required. Jador Serv. Co. v. Werbel, 53 A.2d
182, 185 (N.J. 1947).
The 1980 lease contained the essential terms required to
make it a binding and enforceable agreement when it was executed
in 1980. The lease was in writing, contained an adequate legal
description of the leased premises, and included provisions that
specified the agreed term of the lease, the rent, and the manner
in which the rent should be paid. Its renewal and rent
adjustment provisions, if followed by the parties to the lease,
enabled the parties to renew the lease as a binding contract in
years9 after the initial rental term that ran from July 1, 1980,
through June 30, 1981.
The parties do not appear to dispute that the 1980 lease was
a binding contract that was enforceable under State law when it
was originally executed in 1980. The parties’ disagreement
focuses on whether the 1980 lease was still a binding contract
with respect to the years 2005 and 2007. Under New Jersey law,
parties to a contract may modify, abandon, abrogate, or rescind a
contract. Cnty. of Morris v. Fauver, 707 A.2d 958, 965 (N.J.
1998). We consider whether petitioners have proved by a
preponderance of credible evidence that the 1980 lease was still
9
Respondent would have us conclude that the ability to renew
under the 1980 lease was limited to one additional term. Neither
the lease as drafted nor any principle of New Jersey law appears
to support such a conclusion.
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a binding contract in effect for taxable years ending in 2005 and
2007.
Under New Jersey law, the parties to a contract may make
limited changes to the contract through modification, which can
be done either by express agreement or by conduct. Id. at 967.
For example, a landlord and tenant may alter the rent if the
lease authorizes modification, the parties comply with any
provisions regarding modification, and the modification is
supported by consideration. Oscar v. Simeonidis, 800 A.2d 271,
276 (N.J. Super. Ct. App. Div. 2002).
Under New Jersey law, the parties may also rescind the
initial contract in favor of a subsequent contract. Rosenberg v.
D. Kaltman & Co., 101 A.2d 94, 96 (N.J. Super. Ct. Ch. Div.
1953). If the parties enter into a subsequent contract covering
the same subject matter and the subsequent contract contains
terms inconsistent with the initial contract, the subsequent
contract rescinds the initial contract and “becomes the only
agreement on the part of the parties on the subject matter.” Id.
The difference in terms, however, must be so inconsistent that
the two contracts cannot stand together. Id.
Abandonment under New Jersey law refers to actions of
parties to a formerly binding contract that demonstrate that the
contract is no longer in effect. A court may infer abandonment
from the surrounding circumstances. Mossberg v. Standard Oil Co.
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of N.J., 237 A.2d 508, 516 (N.J. Super. Ct. Law Div. 1967). For
example, in Mossberg, the Superior Court of New Jersey found that
the parties had abandoned a formerly binding contract that the
parties had executed 30 years before, on the basis of evidence
that the parties had ignored the contract provisions during the
period then in dispute. Id. at 515-516.
With these principles in mind, we examine the very sparse
record for what it tells us about whether the 1980 lease was
still in effect for 2005 and 2007. Regardless of the
enforceability of the 1980 lease during the initial rental term,
which the parties appear to assume, the record contains no
credible evidence regarding the history and enforceability of the
1980 lease for periods between June 30, 1981, the end of the
initial rental term, and November 30, 2004, the earliest fiscal
year as to which there is evidence in the record of an allocation
to rental expense by Mr. Sarva. With respect to 2005 and 2007,
the record is replete with evidence demonstrating that
petitioners, the medical corporation, and Mr. Sarva did not pay
any attention to the terms of the 1980 lease. The parties to the
lease ignored the lease provision with respect to the amount of
required rent. The parties to the lease ignored the lease
requirement that monthly rent payments be made. The term of the
lease, which originally ran from July 1 through June 30, appears
to have been changed to a term corresponding to the fiscal year
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of the medical corporation. Mr. Sarva, who drafted the 1980
lease and supervised its execution by petitioners and the medical
corporation, did not consult the lease in making his annual
allocation between petitioner’s salary and rental income and his
determination of the rental income included in petitioners’
income, and the rental expense deducted on the medical
corporation’s returns for the taxable years ended in 2005 and
2007 did not coincide with what should have been reported under
the 1980 lease if it were still in effect for those years.10 The
record overwhelmingly demonstrates that, during the taxable years
ending in 2004 through 2009, the 1980 lease was a meaningless
document that was simply not followed by petitioners, the medical
corporation, or Mr. Sarva, who implemented and supervised the
rental arrangement.
Petitioners had the burden of convincing us that the 1980
lease was still a binding contract under New Jersey law in 2005
and 2007. They failed to do so. During the fiscal years ending
2005 and 2007, neither petitioners nor Mr. Sarva calculated the
correct amount of rent due under the 1980 lease, and the medical
10
In fact, Mr. Sarva did not include any rental income from
the Westwood property lease on petitioners’ 2006 and 2008 returns
even though the medical corporation claimed a rental expense
deduction on its returns for each of the related fiscal years.
Petitioners argue that their failure to report rental income on
their 2006 and 2008 returns was a mistake attributable to Mr.
Sarva and should not be treated as evidence that the 1980 lease
was no longer in effect.
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corporation did not make the required monthly rental payments.
The rental arrangement during those years was completely ad hoc--
the accountant determined the rent after the fact on the basis of
his analysis of petitioner’s financial situation at the time. On
these facts, we conclude that petitioners have not proved that
the 1980 lease was a binding contract during 2005 and 2007.
Because petitioners have not proved that the 1980 lease was a
binding contract under New Jersey law and in effect for 2005 and
2007, petitioners have failed to prove that they qualify for
transitional relief under section 1.469-11(c)(1)(ii), Income Tax
Regs., and respondent’s determination that the rental income
petitioners reported on their 2005 and 2007 returns is nonpassive
income under section 1.469-2(f)(6), Income Tax Regs., is
sustained.
II. Accuracy-Related Penalty Under Section 6662
Section 6662 authorizes the Commissioner to impose a penalty
on an underpayment of tax that is attributable to negligence or
disregard of rules or regulations or any substantial
understatement of income tax. Sec. 6662(a) and (b)(1) and (2).
The Commissioner bears the initial burden of production with
respect to the taxpayer’s liability for the section 6662 penalty.
Sec. 7491(c). At trial the Commissioner must introduce
sufficient evidence “indicating that it is appropriate to impose
the relevant penalty.” Higbee v. Commissioner, 116 T.C. at 446.
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If the Commissioner satisfies his initial burden of production,
the burden of producing evidence to refute the Commissioner’s
evidence shifts to the taxpayer, and the taxpayer must prove that
the penalty does not apply. Id. at 447.
Respondent contends that petitioners are liable for the
accuracy-related penalties because the underpayments of tax are
attributable to either negligence or disregard of rules or
regulations (2005 and 2007) or to a substantial understatement of
income tax (2007). Respondent’s contentions necessarily reflect
alternative grounds for imposing the section 6662 penalty because
only one section 6662 accuracy-related penalty may be imposed
with respect to any given portion of any underpayment, even if
the underpayment is attributable to more than one of the types of
listed conduct. New Phoenix Sunrise Corp. v. Commissioner, 132
T.C. 161, 187 (2009), affd. 408 Fed. Appx. 908 (6th Cir. 2010);
sec. 1.6662-2(c), Income Tax Regs.
We turn first to respondent’s contention that the section
6662 penalties should be imposed because the underpayments for
2005 and 2007 were attributable to petitioners’ negligence. See
sec. 6662(a) and (b)(1). For purposes of section 6662,
negligence is any failure to make a reasonable attempt to comply
with the provisions of the Internal Revenue Code, and disregard
includes any careless, reckless, or intentional disregard. Sec.
6662(c); see also Neely v. Commissioner, 85 T.C. 934, 947 (1985)
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(negligence is lack of due care or failure to do what a
reasonably prudent person would do under the circumstances); sec.
1.6662-3, Income Tax Regs. Negligence also includes any failure
to exercise ordinary and reasonable care in the preparation of a
tax return, or any failure to keep adequate books and records and
to properly substantiate items. Sec. 1.6662-3(b)(1), Income Tax
Regs. A return position that has a reasonable basis is not
attributable to negligence. Id.
Respondent introduced evidence at trial establishing that
the rent paid by the medical corporation during 2005 and 2007 did
not comply with the terms of the 1980 lease. Mr. Sarva’s
testimony confirmed that he made an allocation to rent at the end
of each taxable year without regard to the terms of the 1980
lease. Nevertheless, petitioners took the position on their 2005
and 2007 returns that the 1980 lease was still binding and
treated the 2005 and 2007 rental income as passive income under
the transition rule of section 1.469-11(c)(1)(ii), Income Tax
Regs. This evidence was sufficient to satisfy respondent’s
initial burden of production and shift the burden of production
to petitioners. Petitioners did not prove that they were not
negligent in treating their 2005 and 2007 rental income from the
medical corporation as passive income under the transition rule
of section 1.469-11(c)(1)(ii), Income Tax Regs. Because we hold
that the underpayments were attributable to negligence, we need
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not address whether a substantial understatement of income tax
exists for either or both of the years at issue.11
We turn then to petitioners’ contention that they are
entitled to relief under section 6664(c) from the section 6662
penalties. A taxpayer may avoid liability for the section 6662
penalty if the taxpayer demonstrates that he or she had a
reasonable basis for the underpayment and that he or she acted in
good faith with respect to the underpayment. Sec. 6664(c)(1);
sec. 1.6664-4(a), Income Tax Regs. Reasonable cause and good
faith are determined on a case-by-case basis, taking into account
all pertinent facts and circumstances. Sec. 1.6664-4(b)(1),
Income Tax Regs. The most important factor in determining
reasonable cause and good faith is the extent of the taxpayer’s
effort to assess his or her proper income tax liability. Id.;
see also Woodsum v. Commissioner, 136 T.C. 585, 591 (2011).
A taxpayer may establish reasonable cause and good faith
within the meaning of section 6664(c) if the taxpayer
demonstrates that he or she reasonably relied in good faith on
the informed advice of an independent professional adviser as to
the proper tax treatment of an item. Sec. 1.6664-4(c), Income
11
A substantial understatement of income tax exists with
respect to an individual taxpayer if the amount of the
understatement exceeds the greater of 10 percent of the tax
required to be shown on the return or $5,000. Sec.
6662(d)(1)(A). In any event, it would appear that a substantial
understatement exists for 2007.
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Tax Regs.; see also United States v. Boyle, 469 U.S. 241, 250
(1985); Neonatology Associates, P.A. v. Commissioner, 115 T.C.
43, 98 (2000), affd. 299 F.3d 221 (3d Cir. 2002). The taxpayer
must show that: (1) The adviser was a competent and qualified
professional who had sufficient expertise to justify the
taxpayer’s reliance, (2) the taxpayer provided all necessary and
accurate information to the adviser, and (3) the taxpayer
actually relied in good faith on the adviser’s judgment in
deciding on the proper tax treatment of the item. See
Neonatology Associates, P.A. v. Commissioner, supra at 99.
Mr. Sarva has been a practicing C.P.A. for over 30 years.
He has extensive experience in tax planning and return
preparation12 and has advised clients with respect to real estate
transactions.13 Petitioners relied on Mr. Sarva’s judgment in
purchasing the Woodside property in 1979, in setting up the
leasing transaction, and in preparing their and the medical
corporation’s tax returns each year. Given Mr. Sarva’s
credentials and the longstanding professional relationship
between petitioners and Mr. Sarva, we find that petitioners were
justified in relying on Mr. Sarva.
12
Mr. Sarva testified that he serves approximately 180
clients residing in 17 States.
13
Mr. Sarva also has real estate investment experience.
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Petitioners depended upon Mr. Sarva to handle their books
and records and those of the medical corporation, to advise them
on their tax situation, and to prepare their tax returns. Mr.
Sarva was either in possession of all necessary information and
records, including a copy of the 1980 lease, to perform his work
for petitioners and the medical corporation competently or could
get access to the information through petitioners.
Finally, we are satisfied that, even though petitioners did
not testify, they nevertheless relied in good faith on Mr.
Sarva’s judgment regarding the proper tax treatment of the 2005
and 2007 rental income. Mr. Sarva testified that he made all of
the rental expense allocations and that he determined that
petitioners’ rental income during 2005 and 2007 constituted
passive income. Petitioners had no reason not to trust the
judgment of Mr. Sarva, who has served as their tax professional
for over two decades.
Under the circumstances, we find that petitioners reasonably
relied in good faith on Mr. Sarva’s advice and judgment as
reflected on petitioners’ 2005 and 2007 returns. We conclude
therefore that petitioners are not liable for the section 6662
accuracy-related penalties for 2005 and 2007.
We have considered the parties’ remaining arguments and, to
the extent not discussed above, conclude those arguments are
irrelevant, moot, or without merit.
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To reflect the foregoing,
Decision will be entered for
respondent as to the deficiencies
and for petitioners as to the
accuracy-related penalties under
section 6662(a).