Rosenblatt v. Comm'r ( 2008 )

T.C. Summary Opinion 2008-137
UNITED STATES TAX COURT
RONALD AND SUSAN ROSENBLATT, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 17002-06S. Filed October 30, 2008.
Elizabeth Opalka and Suzanne Meiners-Levy, for petitioners.
Jeffrey S. Luechtefeld, for respondent.
RUWE, Judge: This case was heard pursuant to the provisions
of section 7463 of the Internal Revenue Code in effect when the
petition was filed.1 Pursuant to section 7463(b), the decision
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
Procedure.
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to be entered is not reviewable by any other court, and this
opinion shall not be treated as precedent for any other case.
Respondent determined deficiencies in petitioners’ Federal
income taxes of $33,583 and $20,684 and section 6662 accuracy-
related penalties of $6,716.60 and $4,136.80 for the taxable
years 2002 and 2003, respectively. The issues for decision are:2
(1) Whether petitioners’ aircraft activity during 2002 and 2003
was engaged in for profit within the meaning of section 183; (2)
whether petitioners are entitled to deductions for worthless
stock and bad debts incurred in 2002; and (3) whether petitioners
are liable for section 6662 accuracy-related penalties for 2002
and 2003.3
2
Before trial, petitioners’ counsel submitted to the Court
a document entitled “Petitioners’ Consolidated Pre-Trial Motion”,
which the Court treated as petitioners’ pretrial memorandum. At
trial, petitioners’ counsel requested that the Court treat part
of their pretrial memorandum as a motion for partial summary
judgment (motion). The Court obliged the request but denied the
motion and declined to rule on petitioners’ counsel’s request to
shift the burden of proof. Petitioners failed to pursue some of
the arguments made in their motion at trial or in their post-
trial briefs. Accordingly, we deem those arguments to have been
abandoned and will decide only the issues that petitioners’
counsel disputed in their posttrial briefs. See Nicklaus v.
Commissioner, 117 T.C. 117, 120 n.4 (2001).
3
Respondent also determined that petitioners’ itemized
deductions should be decreased by $2,534 in 2002 and $2,052 in
2003. These are computational adjustments that depend on our
disposition of the other issues in this case.
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Background
Some facts have been stipulated and are so found. The
stipulation of facts and the attached exhibits are incorporated
by this reference. At the time of filing the petition,
petitioners resided in Iowa.
Ronald Rosenblatt (petitioner) is a graduate of Columbia
University with a bachelor’s degree in art history, a minor in
economics, and a master’s of art. Petitioner also holds a Ph.D.
in economics from the University of Idaho. Petitioner worked as
a professor and taught economics for 7 years after he received
his Ph.D.
In 2002, petitioner was employed by Principal Residential
Mortgage, Inc. (PRM), a subsidiary of Principal Financial Group.
Petitioner directly managed six or seven people. Indirectly, he
managed approximately 500 people. Petitioner worked
approximately 50 hours per week in 2002, and he spent most of his
work week in the offices of PRM in downtown Des Moines. Most of
petitioner’s income in 2002 came from his position at PRM.
Between 2002 and 2003, PRM sold the division that petitioner
managed to American Home Mortgage (AHM). In 2003, petitioner was
employed by AHM as an executive vice president of sales support
and development. Petitioner’s work hours and responsibilities
did not change very much between 2002 and 2003. Petitioner Susan
Rosenblatt (Mrs. Rosenblatt) is an anchor reporter for the local
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FOX news network in Des Moines, Iowa. Petitioners reported wages
on their Federal income tax returns in excess of $593,000 for
2002 and $742,000 for 2003.
Petitioner always had an interest in flying. Petitioner had
been interested in being a pilot since his youth. In 1965, when
petitioner graduated from high school, he had an appointment to
the Air Force Academy, and he intended to become an Air Force
pilot. However, petitioner did not attend the Air Force Academy
because his eyesight did not meet the requirements for him to
train as a pilot.
Petitioners’ daughter Katie received flight instruction from
Executive One Aviation (EOA), beginning in 2001. In the fall of
2001, petitioner also began taking flight training lessons from
EOA. On June 6, 2002, petitioner formed KAR RRR Aviation
Leasing, LLC (KAR RRR). Mrs. Rosenblatt purchased a one-half
interest in KAR RRR on September 30, 2002. Before Mrs.
Rosenblatt became a member of KAR RRR, petitioner was the sole
member, and they were the only two members thereafter.4 Aside
from petitioners, KAR RRR had no employees.
4
Petitioners apparently accounted for the aircraft activity
as a sole proprietorship on a Schedule C, Profit or Loss From
Business, until Mrs. Rosenblatt became a member of KAR RRR in
2002. Thereafter, petitioners accounted for the aircraft
activity as a partnership on a Schedule E, Supplemental Income
and Loss.
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In June 2002, KAR RRR purchased a Cessna 172 R (N3529D)
aircraft (Cessna) from EOA. Petitioner has never been a licensed
pilot. Before the Cessna was purchased, petitioner had no
experience in the aviation industry other than being a “frequent
flyer”. Petitioner described his decision to purchase the Cessna
“as a way of having a good new plane upon which to learn, and as
a way of starting a new business with the plane.”
KAR RRR financed the Cessna with Cessna Finance Corp. (CFC).
Petitioners paid 10 percent of the purchase price for the Cessna
as a down payment, and KAR RRR financed $144,350, the balance of
the purchase price for the Cessna, through CFC. Petitioner
personally guaranteed the loan from CFC to KAR RRR. The Cessna
was hangared at Ankeny Regional Airport in Ankeny, Iowa.
On May 6, 2002, before petitioner purchased the Cessna, EOA
provided a written projection of net income to petitioners
related to a purchase and leaseback of a Cessna. EOA projected
that if the Cessna was rented out for 700 hours per year at $95
per Hobbs hour,5 it could potentially generate $66,500 in gross
receipts.6 After subtracting expenses for insurance, hangar,
fuel, maintenance, engine reserve, and management fees totaling
5
A Hobbs meter is a device used to measure the amount of
time an aircraft is in operation.
6
Petitioners had actual gross receipts from the aircraft
activity of $21,645 in 2002 and $31,865 in 2003.
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$44,725, EOA projected a net income of $21,775 on a leaseback by
EOA of the Cessna. Petitioner did not produce any other formal
business plan for KAR RRR.7
EOA’s projection did not include finance expenses,
commissions, legal and professional services expenses, or
depreciation. Reported expenses for petitioners’ 2002 and 2003
aircraft activity were as follows:
2002 Expenses
Deductions Schedule C Schedule E Total
Repairs and $1,210 $2,146 $3,356
maintenance
Interest 1,777 1,777 3,554
Depreciation 73,447 5,924 79,371
(and sec. 179)
Commissions 1,595 1,160 2,755
(and fees)
Fuel 3,513 2,385 5,898
Hangar 375 375 750
Insurance 2,495 2,709 5,204
Miscellaneous -- 39 39
Legal and professional 3,100 -- 3,100
services
Management fees 2,087 -- 2,087
Total 89,599 16,515 106,114
7
Petitioner testified that he “worked off * * * [a] pro
forma and * * * [his] own notes about marketing and so on” and
that those materials indicated that, “given a certain number of
hours per month of * * * lease that it would be profitable.”
Petitioner’s “pro forma” and marketing notes were not offered
into evidence.
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2003 Expenses
Deductions Schedule E
Repairs and maintenance $8,739
Interest 5,942
Depreciation (and 35,882
sec. 179)
Commissions (and fees) 4,282
Fuel 6,203
Hangar 1,500
Insurance 10,762
Miscellaneous 906
Legal and professional 1,500
services
Instruction 591
Total 76,307
On June 14, 2002, KAR RRR, CFC, and EOA entered into a
“Consent to Lease Agreement” (lease agreement), related to the
Cessna. CFC required the lease agreement as a condition
precedent to obtaining financing on the Cessna because the Cessna
would be rented out to the general public. Under the lease
agreement, KAR RRR was designated the “Lessor” and EOA was
designated the “Lessee”. The lease agreement stated in pertinent
part: “Neither Lessor [KAR RRR] nor Lessee [EOA] shall further
lease the * * * [Cessna] or assign the Lease without first
obtaining the prior written consent of CFC, which consent may be
withheld at the sole discretion of CFC.”
KAR RRR and EOA also entered into an “Aircraft Marketing
Agreement” (marketing agreement), drafted by Advocate Consulting,
which stated as follows:
AIRCRAFT MARKETING AGREEMENT
This agreement, made on this 14th day of June, 2002 by
and between KAR RRR Aviation Leasing, LLC., hereinafter
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referred to as the Owner, and * * * [EOA], hereinafter
referred to as the Agent.
WITNESSETH
WHEREAS, Owner is the owner of one (1) Cessna 172R,
Registration Number N3529D;
WHEREAS, Agent in the ordinary course of business
develops relationships with prospective customers for
owner seeking to rent aircraft;
WHEREAS, Agent is willing to serve as marketing and
compliance agent on a non-exclusive basis upon the
terms and conditions herein set forth.
NOW, THEREFORE, in consideration of the mutual
covenants and agreements herein contained, the parties
hereto do hereby agree as follows;
1) Aircraft: Owner hereby authorizes Agent to
serve as a nonexclusive marketer for the aircraft
outlined on Exhibit A.
2) Terms of Agreement: The term of this agreement
shall be for a period of seven (7) days commencing on
the date hereof, and automatically renew each seven (7)
days thereafter. This agreement shall be subject to
termination by either the Owner or Agent for any reason
whatsoever upon five (5) days advance written notice
given to the other party.
3) The aircraft will be based at the Ankeny
Airport, and the owner will assume all responsibility
for storage fees in the amount of $125.– per month for
heated, community hangar space.
4) Owner has had the aircraft inspected by * * *
[EOA], verifying that the aircraft meets the standards
required by the Federal Aviation Regulations and that a
valid Airworthiness Certificate exists in respect
thereto, and that all other requirements and paperwork
are in good order and effect.
5) The fees payable by Owner to Agent for the
rental of said aircraft shall be calculated at the rate
of 15% of the gross Hobbs rental charge. At the start
of this agreement, said hourly rate shall be $90.00,
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and may be adjusted with approval of both parties. The
rent shall be paid within ten days after the end of
each calendar month, based upon the hours rented during
each prior month. Agent agrees to waive charges for
the use of the aircraft by Owner. Owner agrees to
follow scheduling procedures established by Agent for
the reservations of aircraft and to return aircraft
with full fuel to the Agent.
6) Owner shall maintain the aircraft to
satisfactorily retain its airworthiness certificate
thereby meeting the requirements of the Federal
Aviation Administration.
7) Owner shall furnish at their own expense all
fuel, oil, lubricants and other materials necessary for
the operation of said aircraft. Fuel shall be priced
by Agent to Owner at the leaseback rate of twenty (20)
cents below the then current retail rate. In addition
all shop labor shall be priced at $5 per hour below
current list and parts shall be charged at 15% above
cost, plus freight or other added charges. All
required & routine maintenance may be performed by the
* * * [EOA] maintenance facility without prior notice
to Owner.
8) Renters shall be required at a minimum to have
12 hours total time plus a sign-off from an FAA
Approved Current Flight Instructor in order to solo
this aircraft. Other than for maintenance down time,
this aircraft shall be available for scheduled rent at
all times.
9) Owner shall provide and keep insurance in full
force and effect, at their own expense. Such insurance
shall be written by an underwriter satisfactory to all
parties and naming the Owner, Agent and Current
Lienholder as insured, and shall protect the interests
of the Owner, Agent and Current Lienholder. If the
risk is covered by the insurance policy of the Agent,
the Owner shall prepay Agent the amount of such
insurance at the first of each calendar month and Agent
shall provide Owner evidence of such Insurance coverage
in force and satisfactory to the Owner and Current Lien
holder. Agent shall be responsible for deductible if
the aircraft is damaged while hangared at * * * [EOA],
if such damage is caused by an * * * [EOA] employee or
by a customer renting the aircraft through * * * [EOA].
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10) The term of this agreement shall be 5 years,
commencing on the below mentioned execution date.
Owner may terminate this agreement for any reason upon
thirty (30) days written notice to Agent.
Petitioner provided documents (logs) indicating his
involvement with KAR RRR during 2002 and 2003. These logs show
that petitioner spent approximately 197.058 and 208.25 hours on
KAR RRR activities in 2002 and 2003, respectively.9 Petitioner
prepared these logs himself, though he admits they are
incomplete. Much of the time reflected in petitioner’s logs
represents time during which he participated in flight
instruction, ground school, and test flights.
Petitioners relied on the services of EOA for taking
reservations for the Cessna, providing storage for the Cessna,
and providing licensed flight instructors to fly the Cessna. The
customers who rented the Cessna did not enter into written lease
agreements, but they did sign a document ensuring that the people
who flew the Cessna were licensed pilots. These agreements were
maintained by EOA. The people who flew the Cessna included both
flight instruction students and private pilots. KAR RRR’s Cessna
8
The total time on petitioner’s log for 2002 is listed as
191.3 hours but actually adds up to 197.05 hours.
9
The logs separate petitioner’s “Business Time” and “Travel
Time” spent on KAR RRR. In 2002, petitioner’s log reflects 52.75
hours of travel time and 144.3 hours of business time. In 2003,
petitioner’s log reflects 41 hours of travel time and 167.25
hours of business time.
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was one of three or four aircraft available to rent at the Ankeny
Regional Airport in 2002 and 2003.
Benefit Technologies, Inc. (BTI), is a research and
development business specializing in full flexible benefit plans
for small to midsize companies. Andrew Hyman (Mr. Hyman) was the
founder of BTI and is still actively involved with BTI. BTI
filed for chapter 7 bankruptcy protection in February 2001,
shortly after BTI defaulted on a $250,000 interest payment to a
venture capital firm on January 15, 2001. Sometime after filing
for bankruptcy, BTI’s bankruptcy proceedings were converted from
chapter 7 to chapter 11.
Petitioner owned BTI stock, lent money to BTI, and served on
BTI’s board of directors, but petitioner was not an employee of
BTI. Petitioner was never actively involved in BTI, other than
having attended occasional board meetings. Petitioners claimed
losses of $432,346 in 2002 relating to the alleged worthlessness
of their BTI stock and loans that petitioner made to BTI.
Discussion
Generally, the Commissioner’s determinations in a notice of
deficiency are presumed correct, and the taxpayer bears the
burden of proving that the determinations are incorrect. Rule
142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).
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I. Claimed Losses From Aircraft Activity
Pursuant to section 183(b), deductions with respect to an
activity “not engaged in for profit” generally are limited to the
amount of gross income derived from such activity. Section
183(c) defines an activity not engaged in for profit as “any
activity other than one with respect to which deductions are
allowable for the taxable year under section 162 or under
paragraph (1) or (2) of section 212.”
Deductions are allowed under section 162 for the ordinary
and necessary expenses of carrying on an activity which
constitutes the taxpayer’s trade or business. Deductions are
allowed under section 212 for expenses paid or incurred in
connection with an activity engaged in for the production or
collection of income, or for the management, conservation, or
maintenance of property held for the production of income. With
respect to either section, however, the taxpayer must demonstrate
a profit objective for the activities in order to deduct
associated expenses. Dreicer v. Commissioner, 78 T.C. 642, 644-
645 (1982), affd. without published opinion 702 F.2d 1205 (D.C.
Cir. 1983); Warden v. Commissioner, T.C. Memo. 1995-176, affd.
without published opinion 111 F.3d 139 (9th Cir. 1997); sec.
1.183-2(a), Income Tax Regs. In order to meet the required
profit objective, “the taxpayer’s primary purpose for engaging in
the activity must be for income or profit.” Commissioner v.
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Groetzinger, 480 U.S. 23, 35 (1987); Bot v. Commissioner, 353
F.3d 595, 599 (8th Cir. 2003), affg. 118 T.C. 138 (2002); Am.
Acad. of Family Physicians v. United States, 91 F.3d 1155, 1157-
1158 (8th Cir. 1996).
Section 1.183-2(b), Income Tax Regs., provides factors to be
considered when determining whether an activity is engaged in for
profit as follows:
(b). Relevant factors.--In determining whether an
activity is engaged in for profit, all facts and
circumstances with respect to the activity are to be
taken into account. No one factor is determinative in
making this determination. In addition, it is not
intended that only the factors described in this
paragraph are to be taken into 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 exceeds the number of factors indicating a
profit objective, or vice versa. * * *
Nine nonexclusive factors are set forth in the regulations
which are to be considered when determining profit intent. Those
factors are: (1) The manner in which the taxpayer carried on the
activity; (2) the expertise of the taxpayer or his advisers; (3)
the time and effort expended by the taxpayer in carrying on the
activity; (4) the expectation that assets used in the activity
may appreciate in value; (5) the success of the taxpayer in
carrying on other similar or dissimilar activities; (6) the
taxpayer’s history of income or losses with respect to the
activity; (7) the amount of occasional profits, if any, which are
earned; (8) the financial status of the taxpayer; and (9) whether
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elements of personal pleasure or recreation exist. Id. Not all
of the factors are applicable in every case, and no one factor is
controlling. See Abramson v. Commissioner, 86 T.C. 360, 371
(1986); sec. 1.183-2(b), Income Tax Regs. We begin by applying
each of these factors to the facts relating to petitioners’
aircraft activity.
The fact that a taxpayer carries on an activity in a
businesslike manner and maintains complete and accurate books and
records may indicate that the activity was engaged in for profit.
See Engdahl v. Commissioner, 72 T.C. 659, 666 (1979); sec. 1.183-
2(b)(1), Income Tax Regs. During the years at issue, petitioner
kept logs noting his involvement with KAR RRR, but he admitted
that those logs were incomplete. The logs were not made
contemporaneously with the activities petitioner noted therein.
Much of the time memorialized in the logs is attributable to
travel time and time that petitioner spent on his own flight
training activities and classes.
Petitioner failed to develop a formal business plan.
Although petitioner testified that he used a “pro forma”, it was
not produced at trial. EOA’s financial projections overestimated
the profitability of renting the Cessna, and the projected
expenses did not include finance expenses, sales tax, or
registration fees and did not take into account actual
depreciation of the Cessna.
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Petitioner testified that he was active in advertising the
Cessna throughout the community, but he failed to adequately
corroborate that testimony with evidence of such marketing
activities. Petitioner also did bookkeeping for KAR RRR,
including the establishment and maintenance of the company bank
account. However, petitioners relied on the services of EOA for
the day-to-day rental of the Cessna, including taking
reservations for the Cessna, providing storage for the Cessna,
and providing licensed flight instructors to fly the Cessna.
Moreover, the maintenance, rental of the aircraft, and collection
of rental receipts were performed by either EOA or the flight
instructors associated with the rental flights. Petitioner
explained at trial that student pilots and renters would pay EOA
directly for the use of the Cessna at the end of the rental
period. EOA would then credit the account of KAR RRR for the fee
generated. At the end of the month, EOA would deduct their
commission and other expenses, such as fuel and maintenance.
Petitioner was not qualified to perform the maintenance on the
Cessna necessary to keep it airworthy. Petitioner reviewed some
of these activities but did not perform them himself and
otherwise had limited involvement in the day-to-day activities
involving the Cessna. Consequently, consideration of the first
factor weighs against the finding of a profit objective.
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A taxpayer’s expertise or that of his advisers is a factor
in determining profitability. Sec. 1.183-2(b)(2), Income Tax
Regs. Before his purchase of the Cessna, petitioner had no
relevant experience in the aircraft industry. Petitioner spent
time “going on the FAA’s website” to understand what rules and
regulations governed private aviation. He also researched
Cessna’s advisories about his type of aircraft to determine
“whether there were recalls or anything like that.”
Petitioner sought advice in selecting the appropriate
aircraft for the activity, relying in part on the knowledge of
local flight instructors. Otherwise, petitioner relied on EOA,
the seller of the Cessna, and Advocate Consulting. Before the
purchase of the Cessna, petitioner was informed by EOA’s
president that the Cessna could be rapidly depreciated for tax
purposes. At the same time, employees of EOA informed petitioner
that Advocate Consulting could structure the purchase of the
Cessna in a tax-advantageous manner. Petitioner’s independent
research on Advocate Consulting entailed going online and trying
“to get a little background on the * * * company.” Petitioner
did not know anyone else who was referred to Advocate Consulting.
Petitioner testified that Advocate Consulting agreed to represent
petitioners before the IRS as part of their agreement with KAR
RRR.
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Petitioners retained the services of Advocate Consulting on
a yearly basis. Petitioners sought the advice of Advocate
Consulting because aircraft leasing “was a field that * * *
[petitioner] really didn’t know in terms of legal or tax issues.”
When asked at trial if he ever thought that the tax advice he
received was too good to be true, petitioner responded that if
he’s “paying for their advice and their counsel tells me that
this is the way it is, then * * * I believe them.”
As we have already noted, EOA provided a written projection
of net income that did not include finance expenses, commissions,
legal and professional services expenses, or tax depreciation
expenses related to the Cessna. Given petitioner’s educational
background in economics and his discussions with employees of EOA
and Advocate Consulting about structuring the purchase of the
Cessna in a tax-advantageous manner, it is reasonable to assume
that petitioner recognized the significant distortions these
omissions would create between the projected profits and the
profits or losses from the aircraft activity that petitioners
would report on their tax returns. In preparing for an activity,
a taxpayer need not make a formal market study, but might be
expected to undertake a basic investigation of the factors that
would affect profit. Westbrook v. Commissioner, T.C. Memo. 1993-
634, affd. 68 F.3d 868 (5th Cir. 1995). Yet petitioner failed to
seek an objective opinion about the profit potential of such an
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undertaking and relied heavily on parties with their own
subjective interest in the transaction. Under the circumstances,
petitioner’s independent research of profitability of the
aircraft activity was insufficient. Consequently, the second
factor weighs against a finding of a profit objective.
The fact that a taxpayer devotes much of his personal time
and effort to carrying on an activity, particularly if there are
no substantial personal or recreational elements, may indicate a
profit motive. Sec. 1.183-2(b)(3), Income Tax Regs. Much of the
time that petitioner spent on the aircraft activity involved his
own flying lessons. Petitioner and his daughter had decided to
learn how to fly, and petitioner purchased the Cessna as a way to
do that. Petitioner had long wanted to learn to fly airplanes,
having attempted to join the Air Force when he was younger.
Petitioner created logs documenting his activities related to the
Cessna. The logs, though incomplete, indicate that petitioner
spent approximately 197.05 and 208.25 hours on KAR RRR activities
in 2002 and 2003, respectively. Much of that time represents
petitioner’s own flying instruction. While the logs petitioner
kept indicate some activity that could be construed as business
related, it could also be construed as a genuine interest in a
recreational activity. Regardless, the relatively small amount
of time spent on this activity that was substantiated in the
record does not outweigh the evidence indicating that petitioner
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had a significant interest in the recreational elements of the
activity. Consequently, the third factor does not support a
finding of a profit objective.
An expectation that the assets used in the activity will
appreciate in value might indicate a profit objective. Sec.
1.183-2(b)(4), Income Tax Regs. It is unlikely that petitioner
expected the Cessna, the only asset owned by KAR RRR, to
appreciate in value. Additionally, absent extenuating
circumstances, none of which were established in this case, the
regular wear and tear on a Cessna would likely cause economic
depreciation. Accordingly, the fourth factor weighs against
finding a profit objective.
The fact that the taxpayer has engaged in similar activities
in the past and converted them from unprofitable to profitable
enterprises may indicate that he is engaged in the present
activity for profit, even though the activity is presently
unprofitable. Sec. 1.183-2(b)(5), Income Tax Regs. Petitioner
had no previous experience in the aircraft industry, and provided
no evidence that he had engaged in any similar activities for
profit. Consequently, the fifth factor is neutral.
A series of losses during the initial or startup stage of an
activity may not necessarily be an indication that the activity
is not engaged in for profit. Sec. 1.183-2(b)(6), Income Tax
Regs. However, where losses continue to be sustained beyond the
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period that customarily is necessary to bring the operation to
profitable status, such continued losses, if not explainable as
due to customary business risks or reverses, may be indicative
that the activity is not being engaged in for profit. Id.
Ultimately, a taxpayer must demonstrate an ability to make a
profit in the long term to offset any startup losses. See
Bessenyey v. Commissioner, 45 T.C. 261 (1965), affd. 379 F.2d 252
(2d Cir. 1967).
There was no prior history of either profits or losses from
petitioner’s aircraft activity because the years at issue were
the first 2 years in which petitioner’s aircraft activity
existed. In neither 2002 nor 2003 did the aircraft activity
generate a profit.10 Petitioner testified and submitted evidence
indicating that in the years following the years at issue,
several flight instructors who had used petitioner’s Cessna to
give lessons decided to start their own flight instruction
business using petitioner’s Cessna at Des Moines International
Airport. Petitioner explained that he became very involved in
the marketing and organization of this new business and had plans
to merge his aircraft activity with the flight instructors’
business. However, petitioner failed to submit evidence
regarding the profitability of the aircraft activity in the years
10
The aircraft activity generated losses of $84,469 for
2002 and $44,442 for 2003.
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after 2003. Without any proof of profitability in later years,
the sixth factor is neutral.
The amount of occasional profits earned in relation to the
amount of losses incurred may provide useful criteria in
determining the taxpayer’s intent. Sec. 1.183-2(b)(7), Income
Tax Regs. As we have established, there is no history of the
aircraft activity’s being profitable. Consequently, the seventh
factor is neutral.
Substantial income from sources other than the activity may
indicate that the activity is not engaged in for profit,
especially if there are personal or recreational elements
involved. Sec. 1.183-2(b)(8), Income Tax Regs. Petitioner
worked approximately 50 hours per week in 2002, and he spent most
of his work week in the offices of PRM in downtown Des Moines.
Most of petitioner’s income came from his position at PRM.
Petitioner’s hours and responsibilities did not change very much
between 2002 and 2003. Petitioners reported salaries in excess
of $593,000 in 2002 and $742,000 in 2003. The losses created by
the aircraft activity, if found to be deductible, would offset
some of petitioners’ substantial salaries and generate a
significant tax savings in the years at issue. Consequently, the
eighth factor weighs against a profit objective.
Finally, the presence of personal motives in carrying on an
activity may indicate that the activity is not engaged in for
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profit, especially where there are recreational or personal
elements involved. Sec. 1.183-2(b)(9), Income Tax Regs.
Petitioners’ daughter Katie received flight instruction from EOA
beginning in 2001. In the fall of 2001, petitioner also began
taking flight training lessons from EOA. Before taking flying
lessons, petitioner always had an interest in flying. Being a
pilot had been a long-term interest of petitioner since his
youth. Petitioner acknowledges the purchase of the Cessna as “a
way of having a good new plane upon which to learn”.
Consequently, the ninth factor weighs against a finding of a
profit objective.
When considering whether a taxpayer engaged in an activity
for profit, greater weight must be given to the objective facts
than to a taxpayer’s mere statement of intent. Beck v.
Commissioner, 85 T.C. 557, 570 (1985). While some of
petitioner’s efforts could support an argument in favor of a
profit objective, they could also be construed as a genuine
interest in and an effort to contribute to an activity that
provided personal pleasure in the form of a hobby. Regardless,
petitioner’s testimony and the evidence on record in favor of
petitioners’ argument are insufficient to overcome the weight of
the objective facts indicating that petitioners were not engaging
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in the activity primarily for profit.11 Accordingly, we will
sustain respondent’s determination with regard to the
disallowance of losses created by the aircraft activity.
II. Claimed Loss from Worthless Stock and Loans
On their 2002 Federal income tax return, petitioners claimed
losses of $432,346 relating to the alleged worthlessness of their
BTI stock and loans petitioner made to BTI. On petitioners’ 2002
Schedule D, Capital Gains and Losses, they reported a short-term
capital loss of $332,346 related to BTI, which contributed to a
total net short-term loss of $412,033 reported for that year.
Petitioners also reported a $100,000 long-term capital loss
related to BTI on their Schedule D for 2002, which contributed to
a total net long-term capital loss of $26,245. Petitioners were
limited by section 1211(b)(1) to a recognized capital loss of
$3,000 on their 2002 Federal income tax return. Petitioners
carried forward a short-term capital loss of $409,033 and a long-
term capital loss of $26,245 to 2003.
Respondent disallowed petitioners’ claimed capital losses
relating to BTI. However, respondent concedes that after
application of the section 1211(b)(1) capital loss limitation in
2002, petitioners’ Federal income tax return for 2002 reflected
11
Because we find that petitioners’ aircraft activity was
not engaged in with the required profit objective, we need not
decide whether petitioners’ losses were nondeductible passive
activity losses subject to the limitations imposed under sec.
469.
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the appropriate amount of capital losses (i.e., capital loss of
$3,000). Accordingly, the disallowance of the reported loss with
respect to BTI affects only petitioners’ taxable income for 2003.
Petitioners argue that the BTI stock became worthless and
that their loans to BTI became nonbusiness bad debt when BTI “ran
out of opportunities to sell the company” in 2002. Respondent
argues that neither the stock nor the loans became worthless in
2002.
In order for a taxpayer to claim a loss for worthless
securities in a taxable year, the security must become worthless
in that taxable year. Sec. 165(g)(1). A loss shall be treated
as sustained during the taxable year in which the loss occurs as
evidenced by closed and completed transactions and as fixed by
identifiable events occurring in such taxable year. Sec. 1.165-
1(d)(1), Income Tax Regs. Total worthlessness of the security is
required for the deduction. Sec. 1.165-4, Income Tax Regs. No
loss deduction is allowed for partial worthlessness or for mere
decline in value. Sec. 1.165-5, Income Tax Regs. Stock becomes
worthless and the loss is sustained only when the stock has no
liquidating value and there is no reasonable hope and expectation
that at some future point in time it will become valuable.
Duncan v. Commissioner, T.C. Memo. 1986-122. The burden is on
the taxpayer to establish the worthlessness of the stock and the
year in which it became worthless. Id. (citing Boehm v.
 - 25 -
Commissioner, 326 U.S. 287, 292 (1945)). The loss can be
established satisfactorily only by some “identifiable event” in
the corporation’s life which extinguishes all hope and
expectation of revitalization, such as bankruptcy, cessation of
business operations, liquidation of the corporation, or
appointment of a receiver for it. Morton v. Commissioner, 38
B.T.A. 1270, 1279 (1938), affd. 112 F.2d 320 (7th Cir. 1940).
In the case of a taxpayer other than a corporation, where
any nonbusiness debt becomes worthless within the taxable year,
the loss resulting therefrom shall be considered a loss from the
sale or exchange, during the taxable year, of a capital asset
held for not more than 1 year. Sec. 166(d)(1)(B). A loss on a
nonbusiness debt is treated as sustained only if and when the
debt has become totally worthless. Sec. 1.166-5(a)(2), Income
Tax Regs. The burden is on the taxpayer to establish the
worthlessness of the debt and the year in which it became
worthless. Crown v. Commissioner, 77 T.C. 582, 598 (1981). It
is generally accepted that the year of worthlessness is to be
fixed by identifiable events which form the basis of reasonable
grounds for abandoning hope of recovery. Id.
Whether petitioner’s loans made to BTI should be evaluated
for fitting the definition of worthless securities or nonbusiness
bad debt depends on whether the debt is evidenced by a security
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as defined in section 165(g)(2)(C).12 Sec. 166(e). However,
each of these alternatives requires petitioners to show that, at
the end of 2002, there was no reasonable prospect for recovery.
See Boulafendis v. Commissioner, T.C. Memo. 1984-321 (citing
Boehm v. Commissioner, supra at 291-292; Crown v. Commissioner,
supra at 598). Accordingly, we begin our analysis by addressing
this issue.
Mr. Hyman testified that BTI owned furniture, fixtures, and
a patent on the use of linear programming at the time it filed
for bankruptcy in 2001. He testified that BTI had substantial
value at that time. Almost immediately after the bankruptcy
filing, the venture capital firm on whose interest payment BTI
defaulted and another company submitted separate bids to purchase
the assets of BTI for $2 million. Mr. Hyman testified that if a
sale had occurred in 2001, BTI shareholders would have benefited.
However, Mr. Hyman believed that BTI could be sold for, and the
assets were worth, significantly more than $2 million. According
to Mr. Hyman, that is the reason that BTI’s bankruptcy trustee
turned down both of the $2 million offers.
Mr. Hyman testified that it was reasonable for petitioner to
believe that he could get something for his investment in BTI at
12
Sec. 165(g)(2)(C) defines a “security” as “a bond,
debenture, note, or certificate, or other evidence of
indebtedness, issued by a corporation or by a government or
political subdivision thereof, with interest coupons or in
registered form.”
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the end of 2001, even after it filed for bankruptcy. At that
time, Mr. Hyman was hopeful that a sale was going to occur. Mr.
Hyman testified that, when no sale occurred, the company was “put
into cold storage” with the goal of trying to raise money. BTI’s
bankruptcy proceeding was later converted from chapter 7 to
chapter 11. BTI is presently operating as a business in chapter
11, and Mr. Hyman testified that “there’s activity now starting
to try to raise capital within the chapter 11 environment to be
able to, to bring the company potentially out of chapter 11 and
operate * * * the company.”
The evidence presented at trial, combined with Mr. Hyman’s
testimony, indicates that BTI had value at all times in 2002 and
still has value. Petitioners have failed to carry their burden
of proof to show that there was no reasonable prospect of
recovery for their stock and loans in 2002. Accordingly, we hold
that petitioners are not entitled to deductions for worthless
securities or nonbusiness bad debt.
III. Accuracy-Related Penalty
With respect to the accuracy-related penalty under section
6662(a), the Commissioner has the burden of production. Sec.
7491(c). To prevail, the Commissioner must produce sufficient
evidence that it is appropriate to apply the penalty to the
taxpayer. Higbee v. Commissioner, 116 T.C. 438, 446 (2001).
Once the Commissioner meets his burden of production, the
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taxpayer bears the burden of supplying sufficient evidence to
persuade the Court that the Commissioner’s determination is
incorrect. Id. at 447.
Section 6662(a) and (b)(1) provides accuracy-related
penalties equal to 20 percent of the underpayment of tax required
to be shown on a return if the underpayment is due to negligence
or disregard of rules or regulations.13 For purposes of section
6662, the term “negligence” includes “any failure to make a
reasonable attempt to comply with the provisions of * * * [the
Code], and the term ‘disregard’ includes any careless, reckless,
or intentional disregard.” Sec. 6662(c). “Negligence” also
includes any failure by a taxpayer to keep adequate books and
records or to substantiate items properly. Sec. 1.6662-3(b)(1),
Income Tax Regs.
An accuracy-related penalty is not imposed with respect to
any portion of the underpayment as to which the taxpayer acted
with reasonable cause and in good faith. Sec. 6664(c)(1); see
Higbee v. Commissioner, supra at 448. This determination is made
based on all the relevant facts and circumstances. Higbee v.
Commissioner, supra at 448; sec. 1.6664-4(b)(1), Income Tax Regs.
13
Sec. 6662 can also apply when there is a substantial
understatement of tax. See sec. 6662(b)(2). However, since the
only reason given in the notice of deficiency for imposing the
penalty was negligence or intentional disregard of rules and
regulations, and respondent did not raise sec. 6662(b)(2) until
after trial, we will only consider the issue raised in the notice
of deficiency.
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Relevant factors include the taxpayer’s efforts to assess his
proper tax liability.
While we have held that petitioners did not have profit as
their primary objective for entering into the aircraft activity,
we believe that they had both personal and profit objectives in
the sense that they actually hoped that their activity might
produce a profit. See Warden v. Commissioner, T.C. Memo. 1995-
176. Sometimes it is difficult to determine which of two motives
for engaging in an activity is primary. That is one of the basic
reasons for using objective facts to determine subjective intent.
But a finding that profit was not the primary motive does not
automatically result in a conclusion that petitioners were
negligent or intentionally disregarded the rules and regulations.
See Bernardo v. Commissioner, T.C. Memo. 2004-199; Sherman v.
Commissioner, T.C. Memo. 1989-269. On the basis of the
previously stated facts, we find that petitioners’ reporting of
their aircraft activity was not due to negligence and that they
are not liable for the penalties with respect to the portions of
the underpayments due to their aircraft activity. Likewise, we
find that petitioners are not liable for the penalty on the
portion of the 2003 underpayment due to their claimed losses from
worthless stock and loans. The determination of worthlessness in
the situation described in this case is not without some doubt,
and while we have found that petitioners have not proven
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worthlessness, we believe that they honestly believed that their
stock and loans were worthless in 2002.14 We therefore hold that
petitioners are not liable for the section 6662 penalties.
To reflect the foregoing,
Decision will be entered
for respondent as to the
deficiencies and for
petitioners as to the
accuracy-related penalties.
14
In petitioners’ posttrial brief, they requested the
following finding of fact:
62. Dr. Rosenblatt believes his investments in Benefit
Technologies became worthless in 2002 because during
that year the bankruptcy trustee ran out of
opportunities to the [sic] sell the company.
In his answering brief, respondent had no objection to this
proposed finding of fact.