David Keefe & Candace Keefe v. Commissioner

T.C. Memo. 2018-28UNITED STATES TAX COURT
DAVID KEEFE AND CANDACE KEEFE, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 15189-14, 29804-15. Filed March 15, 2018.
Richard Michael Gabor, for petitioners.
Eliezer Klein and Peter N. Scharff, for respondent.
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[*2] MEMORANDUM FINDINGS OF FACT AND OPINION
MARVEL, Chief Judge: Respondent determined the following deficiencies
in Federal income tax, accuracy-related penalties under section 6662(a),1 and
additions to tax under section 6651(a)(1) with respect to petitioners’ joint Federal
income tax returns:
Penalty Addition to tax
Year Deficiency sec. 6662(a) sec. 6651(a)(1)
2004 $78,292 $15,658 --
2005 144,053 28,811 --
2006 218,228 43,646 $408
2007 143,729 28,161 675
2008 141,870 12,817 35,468
2009 252,777 50,555 --
2010 309,060 61,812 --
After concessions, the issues for decision are: (1) whether petitioners held
Wrentham House Mansion as real property used in a trade or business or as a
capital asset; (2) whether certain interest payments petitioners made are properly
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the years at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. Some monetary amounts are rounded
to the nearest dollar.
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[*3] included in their adjusted basis in the property at the time of sale; (3) whether
petitioners are liable for additions to tax under section 6651(a)(1) for their failure
to timely file their joint Federal income tax returns for tax years 2006, 2007, and
2008; and (4) whether petitioners are liable for accuracy-related penalties under
section 6662(a) for tax years 2004 through 2010.
FINDINGS OF FACT
Some of the facts have been stipulated and are so found. The stipulated
facts and facts drawn from stipulated exhibits are incorporated herein by this
reference. Petitioners resided in New York when they petitioned this Court.
I. Petitioners
Petitioners are married and have seven children. Petitioner Candace Keefe
has a bachelor’s degree in art history and graduate degrees in education and
journalism. Petitioner David Keefe is a fertility doctor who was employed full
time during all years at issue in this case.
In 1996 Dr. Keefe was appointed Director of the Division of Reproductive
Endocrinology at Brown University and Women and Infants Hospital in
Providence, Rhode Island. Dr. Keefe and his family moved to Newport, Rhode
Island, that same year. Neither petitioner is or was ever a licensed architect or
contractor.
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[*4] In May 2000 petitioners rented Bois Doré, a 20,000-square-foot residence in
Newport, Rhode Island, and on August 23, 2004, they purchased it. Bois Doré is
near downtown Newport, the beach, and the library but does not have a view of
the Atlantic Ocean. Petitioners and their children resided at Bois Doré from May
2000 until they moved to Tampa, Florida, in September 2005. Petitioners lived in
Tampa, Florida, from September 2005 until they moved to New York, New York,
in October 2009, where they resided as of the date of the trial.
II. Real Estate Purchase
On January 21, 2000, petitioners purchased a historic waterfront mansion
and grounds on Ocean Avenue in Newport, Rhode Island (Ocean Avenue
property), for $1.35 million, intending to restore it. The Ocean Avenue property
was designed by Richard Morris Hunt, the founder of the American Institute of
Architects, and the grounds were designed by Frederick Law Olmstead, a well-
known landscape designer. The Ocean Avenue property is at the highest point on
Ocean Avenue, and each room provides a view of the Atlantic Ocean.
The Ocean Avenue property was built in 1890 as a summer residence and
was used as such until the mid-1960s when it was purchased by a neighboring
property owner who abandoned it. After four decades of sitting vacant and
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[*5] exposed to weather and vandals, the Ocean Avenue property was
uninhabitable when petitioners purchased it.
On October 30, 2002, petitioners executed a Declaration of Condominium
(declaration), dividing the Ocean Avenue property into two units, Unit 1
(Wrentham House Mansion), and Unit 2 (Carriage House) (collectively,
Wrentham House Condominium). Wrentham House Mansion constitutes 57% of
the Wrentham House Condominium, and the Carriage House constitutes the
remaining 43%. On November 1, 2002, petitioners executed a warranty deed in
which they conveyed Carriage House to Frank and Ashley O’Keefe. Petitioners
retained ownership of Wrentham House Mansion after the sale of Carriage House.
The O’Keefes paid petitioners $950,000 for Carriage House.
III. Financing and Tax Credits
Petitioners financed the purchase of the Ocean Avenue Property and the
restoration of Wrentham House Mansion through a series of loans. As restoration
costs increased, petitioners were forced to secure additional loans to continue the
renovations. Petitioners borrowed over $9 million at interest rates varying from
3.5% to 25% to renovate Wrentham House Mansion.
Petitioners were aware of State tax credits and the Federal Historic
Preservation Investment Tax Credit (tax credits) that could have helped them
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[*6] recover some of the costs of purchasing and restoring Wrentham House
Mansion. These tax credits could be obtained only if certain conditions relating to
the restoration and use of the property were satisfied. Specifically, the State of
Rhode Island Historical Preservation & Heritage Commission (commission)
required historically accurate restoration of the building in order for its owners to
receive both credits, and for the Federal tax credit the commission also required
that the property be rented to tenants for at least five years. Petitioners intended to
qualify for and obtain the State and Federal tax credits. They did not intend to
reside in Wrentham House Mansion.
In 2006 petitioners applied to the commission for the State tax credit, and in
2007 the commission determined that the restoration of Wrentham House Mansion
up to that point met the qualifications for the credit. Petitioners did not claim or
receive the Federal tax credit with respect to the Wrentham House Mansion
renovation.
IV. Wrentham House Mansion Construction
Before beginning the restoration, petitioners received cost estimates of
approximately $2 million for the restoration of Wrentham House Mansion from
several contractors. On the basis of an estimate submitted by M&M Marques
Construction Co., Inc., petitioners hired the company as the general contractor to
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[*7] restore Wrentham House Mansion. Restoration of Wrentham House Mansion
started at the end of 2002 and continued until 2008 with some unexpected delays
occurring along the way. For example, progress was delayed for several months in
2005 because of health problems of multiple subcontractors. Work was further
delayed when unforeseen structural problems with the building arose, adding time
and expense to the restoration.
From the time the construction began in 2002 through 2004, Mrs. Keefe
went to Wrentham House Mansion regularly to oversee the progress of the
restoration. In 2005 after the family had moved to Tampa, Florida, Mrs. Keefe
flew to Newport frequently to oversee the construction. When Mrs. Keefe was not
in Newport, she closely managed the progress of the restoration via telephone
calls. On April 11, 2007, petitioners received a temporary certificate of use and
occupancy for Wrentham House Mansion. On October 31, 2007, petitioners
received a second temporary certificate of use and occupancy, and on June 11,
2008, they received a final certificate of use and occupancy. The restoration of
Wrentham House Mansion was completed at the end of May 2008.
V. Attempted Rental of Wrentham House Mansion
Many of America’s wealthiest families live or vacation in Newport, Rhode
Island, during the summer. Summer rentals in Newport generally begin around
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[*8] Memorial Day and end around Labor Day. Petitioners intended to offer
Wrentham House Mansion for rent once the restoration of the property was
complete in order to obtain the Federal income tax credits. Petitioners were
informed that Wrentham House Mansion could produce rental income of $75,000
per month during the summer and $10,000 per month for the remainder of the
year.2
In 2006 petitioners met with Laurie Hewitt Burke, a rental agent for luxury
properties who was employed by Lila Delman Real Estate, to discuss renting
Wrentham House Mansion. Ms. Burke inspected Wrentham House Mansion, but
at that time it was not in a condition to be rented.
In 2007 Ms. Burke again visited Wrentham House Mansion and met with
petitioners, but the property was still not ready to be rented. However, because
petitioners hoped that the property would be ready to rent by the summer of 2007,
Ms. Burke began speaking to her clients who were interested in luxury rentals in
Newport about the prospect of renting Wrentham House Mansion.
2
Section 6.2(2) of the declaration states that “[n]o [u]nit may be leased or
rented more than one time in each calendar year” and, therefore, restricts the
amount of rental income that Wrentham House Mansion could generate in a
calendar year.
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[*9] Ms. Burke did not post any pictures or other information about Wrentham
House Mansion on any website during 2007 because she did not believe she could
market it online while it was still being renovated. Ms. Burke continued to visit
Wrentham House Mansion throughout 2007 and early 2008. Wrentham House
Mansion was still being renovated in early 2008, but petitioners hoped that it
would be ready to rent for the 2008 summer season.
Although Ms. Burke did not list Wrentham House Mansion for rent on her
website during 2007 or 2008, she communicated its availability orally to her
existing clients. In February 2008 one of Ms. Burke’s clients, who normally
rented property from Memorial Day to Labor Day, expressed an interest in renting
Wrentham House Mansion. However, because the renovations were still not
complete, no lessee executed a rental agreement or paid any rent to lease
Wrentham House Mansion.
Petitioners did not register Wrentham House Mansion with the Newport,
Rhode Island, city clerk’s office as a “Short-Term Rental” or a “Guest House”.3
Neither did they comply with the requirements of the declaration in order to rent
3
According to the City of Newport, Rhode Island, city clerk, the term
“Short-Term Rentals” refers to non-owner-occupied homes with rentals of nine
months or less, and the term “Guest Houses” refers to bed and breakfast
operations.
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[*10] out Wrentham House Mansion.4 Petitioners never secured a tenant for
Wrentham House Mansion and did not rent it before its sale.
VI. Sale Activities
Bank of America, one of petitioners’ lenders, required petitioners to offer
Wrentham House Mansion for sale during the construction process in order for
petitioners to carry two mortgages on the property. Petitioners contracted with
Lila Delman Real Estate from May 7, 2004, through August 31, 2008, and from
September 8, 2008, through July 31, 2009, to list Wrentham House Mansion for
sale. On or about June 22, 2005, petitioners received an appraisal report valuing
Wrentham House Mansion at $12.5 million as of that date, subject to completion
of the restoration work. Wrentham House Mansion was later appraised by the
Assessor’s Office of Newport, Rhode Island, as of August 31, 2008, at
$10,667,800, and as of July 31, 2009, at $9,610,200.
In 2008 around the time the prospective tenant decided not to rent
Wrentham House Mansion, Bank of America increased petitioners’ required
mortgage payment from $25,000 to $39,000 per month. Struggling to meet this
4
The declaration requires that all leases be recorded in writing; that all
leases of less than 12 months be approved by the executive board of the
condominium; and that written notice of any proposed lease be sent to the owners
of Carriage House at least 45 days before the proposed lease is to begin.
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[*11] financial burden, petitioners pursued other avenues to sell Wrentham House
Mansion. They contacted three auctioneers to arrange an auction, but for various
reasons an auction never took place. On July 31, 2009, petitioners sold Wrentham
House Mansion in a short sale for $6.51 million.
VII. Basis and Expenses
The parties agree that $751,750 is the proper allocation of the purchase
price of the Ocean Avenue Property to petitioners’ cost basis. The parties also
agree that petitioners are entitled to increase their basis by $4.5 million, which
they paid for various capital expenses associated with the restoration of Wrentham
House Mansion. Petitioners also paid $3.3 million of interest on loans secured by
mortgages allocable to Wrentham House Mansion. Although the parties agree that
the purchase price and restoration expenses are properly capitalized into the basis
of Wrentham House Mansion, they disagree on whether interest paid on the loans
must be capitalized.
VIII. Tax Returns, Notices of Deficiency, and Pleading Documents
Petitioners’ original Forms 1040, U.S. Individual Income Tax Return, for
tax years 2004 through 2009 were prepared by Arthur Yorkes & Co. Petitioners
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[*12] failed to timely file their 2006, 2007, and 2008 Federal income tax returns,5
and they failed to pay their Federal income tax liabilities for tax years 2004, 2005,
2006, and 2007. Respondent issued petitioners notices of intent to levy to collect
the unpaid tax liabilities for these years.
Petitioners prepared a list of various expenditures they made in 2009 to
assist Arthur Yorkes & Co. in the preparation of their original 2009 Federal
income tax return. On their original 2009 return, petitioners reported that their
adjusted basis in Wrentham House Mansion was $8,560,923, and they treated the
sale of the property as the sale of a capital asset. After speaking with an estate
planner, petitioners decided that Wrentham House Mansion should have been
treated as a business property for Federal income tax purposes and that they were
entitled to an ordinary loss deduction on its sale. Petitioners subsequently hired
Gabor & Associates to prepare amended tax returns for 2004 through 2009 and
their original 2010 return.
In their amended 2009 income tax return, petitioners reported that
Wrentham House Mansion was a business property and that their adjusted basis
was $10,045,000 on the date of sale. As a result of the change in the character of
5
Petitioners filed their Federal income tax returns for 2006, 2007, and 2008
on April 14, 2010.
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[*13] and their adjusted basis in Wrentham House Mansion, petitioners reported a
net operating loss (NOL), which they carried back to 2004 and then forward to
2010 using amended returns to eliminate existing tax liabilities. Petitioners’
amended returns were received and processed by respondent.6
On May 14, 2014, respondent mailed to petitioners, by certified mail, a
notice of deficiency for tax years 2008, 2009, and 2010 determining tax
deficiencies, penalties, and additions to tax. On August 27, 2015, respondent
mailed to petitioners, by certified mail, a notice of deficiency for tax years 2004,
2005, 2006, and 2007 determining tax deficiencies, penalties, and additions to tax.
Petitioners timely filed a petition for redetermination with this Court with respect
to the notices of deficiency. Respondent did not determine an addition to tax
under section 6651(a)(1) in the notice of deficiency for 2008, but did assert one in
an amended answer. As to all section 6662 penalties, respondent’s employee
secured supervisory approval as required by section 6751(b)(1).
6
Petitioners did not claim depreciation expenses on Wrentham House
Mansion or deduct any expenses attributable to Wrentham House Mansion for any
of the taxable years at issue.
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[*14] OPINION
I. Burden of Proof
Generally, the Commissioner’s determinations in a notice of deficiency are
presumed correct, and the taxpayer bears the burden of proving that those
determinations are erroneous. See Rule 142(a); Welch v. Helvering, 290 U.S. 111,
115 (1933). Moreover, tax deductions are a matter of legislative grace, and the
taxpayer has the burden of proving entitlement to the deductions claimed. Rule
142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial
Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). However, if a taxpayer produces
credible evidence7 with respect to any relevant factual issue and meets other
requirements imposed by section 7491(a)(2),8 the burden of proof on any such
issue shifts to the Commissioner. Sec. 7491(a)(1). Petitioners do not argue for a
7
“Credible evidence is the quality of evidence which, after critical analysis,
the court would find sufficient upon which to base a decision on the issue if no
contrary evidence were submitted (without regard to the judicial presumption of
IRS correctness).” Higbee v. Commissioner, 116 T.C. 438, 442 (2001) (quoting
H.R. Conf. Rept. No. 105-599, at 240-241 (1998), 1998-3 C.B. 747, 994-995).
8
Sec. 7491(a)(2) requires a taxpayer to demonstrate that he or she
(1) complied with the requirements under the Code to substantiate any item,
(2) maintained all records required under the Code, and (3) cooperated with
reasonable requests by the Secretary for witnesses, information, documents,
meetings, and interviews. See Higbee v. Commissioner, 116 T.C. at 440-441.
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[*15] shift in the burden of proof, and they have not proven that they have met the
section 7491(a)(2) requirements.
II. The Character of Wrentham House Mansion in the Hands of Petitioners
We first address whether petitioners held Wrentham House Mansion as real
property used in a trade or business or as a capital asset.
A capital asset is property held by a taxpayer (whether or not connected
with a trade or business), but that does not include property used in a taxpayer’s
trade or business for which depreciation is permitted under section 167,9 or real
property used in the taxpayer’s trade or business. Sec. 1221(a)(2). Property held
for the production of income, but not used in a trade or business of the taxpayer, is
a capital asset subject to the limitations on losses under section 1211(b). Sec.
1.1221-1(b), Income Tax Regs.
The Court of Appeals for the Second Circuit10 requires that taxpayers be
engaged in continuous, regular, and substantial activity in relation to the
9
Sec. 167 allows a depreciation deduction for the exhaustion, wear and tear,
and obsolescence of property used in a taxpayer’s trade or business or property
held for the production of income.
10
This Court will “follow a Court of Appeals decision which is squarely in
point where appeal from our decision lies to that Court of Appeals and to that
court alone.” Golsen v. Commissioner, 54 T.C. 742, 757 (1970), aff’d, 445 F.2d
985 (10th Cir. 1971). This case is appealable to the U.S. Court of Appeals for the
Second Circuit, absent a stipulation to the contrary. See sec. 7482(b)(1)(A), (2).
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[*16] management of the property to support a conclusion that the property was
used in a trade or business and was not a capital asset. See, e.g., Gilford v.
Commissioner, 201 F.2d 735, 736 (2d Cir. 1953) (the performance of sufficient
rental-related activity, either by the taxpayer or an agent of the taxpayer, will
support the conclusion that the taxpayer was engaged in a trade or business with
respect to the property); Union Natl. Bank of Troy v. United States, 195 F. Supp.
382, 384 (N.D.N.Y. 1961) (stating that Grier is “settled law” in the Second
Circuit); Grier v. United States, 120 F. Supp. 395 (D. Conn. 1954), aff’d per
curiam, 218 F.2d 603 (2d Cir. 1955).
Petitioners contend that they held Wrentham House Mansion as an asset
used in a rental real estate business. In deciding whether a rental property is used
in a trade or business or is a capital asset, the Court of Appeals for the Second
Circuit has examined the taxpayer’s rental-related activities for continuity,
regularity, and substance. Among the facts considered are the taxpayer’s efforts to
rent the property; the maintenance and repairs supplied by the taxpayer or an agent
of the taxpayer; the taxpayer’s employment of labor to manage the property or
provide services to tenants; the purchase of materials; the collection of rent; and
the payment of expenses. See Alvary v. United States, 302 F.2d 790, 796-797 (2d
Cir. 1962); Gilford v. Commissioner, 201 F.2d at 736; Pinchot v. Commissioner,
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[*17] 113 F.2d 718, 719 (2d Cir. 1940); Balsamo v. Commissioner, T.C. Memo.
1987-477; Grier, 120 F. Supp. at 398. The totality of the facts and circumstances
surrounding the use of the property must support a conclusion that the alleged
rental activities were sufficient, continuous, and substantial enough to constitute a
trade or business with respect to the rental of the property.
While we have no doubt that petitioners devoted a great deal of time, effort,
and expense to the renovation of Wrentham House Mansion, the record
overwhelmingly confirms that Wrentham House Mansion was never held out for
rent or rented after the restoration was complete. Quite simply, the rental activity
with respect to Wrentham House Mansion never commenced in any meaningful or
substantive way. The cases on which petitioners rely are distinguishable because
in each case where a rental trade or business was found to exist, the taxpayer had
already started the rental activity and had provided substantial and continuous
rental-related services. See Alvary, 302 F.2d at 796; Gilford v. Commissioner,
201 F.2d at 736; Pinchot v. Commissioner, 113 F.2d at 719. In contrast,
petitioners never started a rental trade or business involving Wrentham House
Mansion. Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th
Cir. 1965), vacated and remanded on other grounds, 382 U.S. 68 (1965); Glotov v.
Commissioner, T.C. Memo. 2007-147, slip op. at 5 (holding that a taxpayer is not
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[*18] carrying on a trade or business until the business is functioning as a going
concern and performing the activities for which it was organized).
Because petitioners did not commence or operate a rental activity with
respect to Wrentham House Mansion during the years at issue, we hold that
Wrentham House Mansion was a capital asset at the time of its sale. It follows
that any gain or loss was derived from the sale of a capital asset and respondent
properly disallowed the NOL carryovers.
III. Interest Expenses
The parties agree that petitioners’ basis in Wrentham House Mansion
includes the portion of the original purchase price allocable to Wrentham House
Mansion after the transfer of Carriage House, as well as the costs associated with
the restoration work. The parties disagree as to whether petitioners are required to
capitalize interest on loans taken out for the acquisition and restoration of
Wrentham House Mansion.
Certain direct and indirect costs associated with producing property,
including property held for investment, must be capitalized into the basis of that
property. Sec. 263A(a), (b)(2)(A), (c)(1). Interest expenses are capitalized to the
extent that they are paid or incurred during the period in which the property is
being constructed or produced, and are allocable to real property. Id. subsec.
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[*19] (f)(1)(A) and (B)(i). Improvements to property, including the rehabilitation
or preservation of a standing building, constitute the production of property for
purposes of section 263A. Sec. 1.263A-8(d)(3)(i) and (ii), Income Tax Regs. The
production period begins on the date on which the physical production activity is
first performed and ordinarily ends on the date that the property is ready to be
placed in service or held for sale. Sec. 263A(f)(4)(B); sec. 1.263A-12(c)(2),
(d)(1), Income Tax Regs. The production period, however, does not end for a unit
of property before the completion of physical production activities by the taxpayer
even though the property is held for sale or lease. Sec. 1.263A-12(d)(2), Income
Tax Regs.
Wrentham House Mansion is a capital asset in the hands of petitioners and
is subject to the uniform capitalization rules under section 263A. Their extensive
restoration work is the type of improvement for which interest is appropriately
capitalized under section 263A. The production period began on the date the
physical restoration work began and ended on the date when it was completely
finished. The date of completion of the physical construction work is the date
when the renovation of Wrentham House Mansion was completed and the
property was ready to be placed in service or held for sale. See sec. 1.263A-
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[*20] 12(d)(2), Income Tax Regs. Accordingly, we hold that interest expenses
paid or incurred during the production period must be capitalized.
IV. Additions to Tax and Penalties
The Commissioner has the initial burden of production with respect to
additions to tax and penalties and must produce sufficient evidence indicating that
it is appropriate to impose an addition to tax or a penalty. Sec. 7491(c); Higbee v.
Commissioner, 116 T.C. 438, 446-447 (2001). Once the Commissioner satisfies
his burden of production, the taxpayer may introduce evidence that the imposition
of the penalty is not justified. See Rule 142(a); Welch v. Helvering, 290 U.S. at
115; Higbee v. Commissioner, 116 T.C. at 447.
A. Section 6651(a)(1) Additions to Tax for Failure To Timely File
In the notice of deficiency respondent determined that petitioners were
liable for additions to tax for failure to timely file returns for tax years 2006 and
2007. In respondent’s amended answer, respondent also asserted additions to tax
for failure to timely file for tax year 2008. Section 6651(a)(1) imposes an addition
to tax for failure to file a timely Federal income tax return unless the taxpayer can
demonstrate that such failure was due to reasonable cause and not due to willful
neglect. See United States v. Boyle, 469 U.S. 241, 245 (1985).
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[*21] Respondent has met his burden of production and proof supporting the
imposition of these additions to tax. We find that petitioners failed to timely file
their Federal income tax returns for tax years 2006 through 2008. Petitioners have
made no argument and produced no evidence with respect to the additions to tax.
Accordingly, we sustain respondent’s determination as to the additions to tax.
B. Section 6662(a) Accuracy-Related Penalties
Respondent determined that petitioners are liable for accuracy-related
penalties under section 6662(a) and (b)(1) and (2) for tax years 2004 through 2010
for underpayments due to substantial understatements of income tax or,
alternatively, to negligence or disregard of rules and regulations. A taxpayer may
be liable for a 20% accuracy-related penalty on the portion of an underpayment of
income tax attributable to a substantial understatement of income tax or to
negligence or disregard of rules or regulations. Sec. 6662(a)-(d). Only one
section 6662 accuracy-related penalty may be imposed with respect to any given
portion of an underpayment, even if that portion is attributable to more than one
type of conduct listed in section 6662(b). See New Phoenix Sunrise Corp. v.
Commissioner, 132 T.C. 161, 187 (2009), aff’d, 408 F. App’x 908 (6th Cir. 2010);
sec. 1.6662-2(c), Income Tax Regs. Nevertheless, we consider both grounds for
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[*22] imposition of the penalty. The Commissioner bears the burden of
production with respect to a section 6662 penalty. Sec. 7491(c).
Section 6751(b)(1) provides that, subject to certain exceptions in section
6751(b)(2), no penalty shall be assessed unless the initial determination of such
assessment is personally approved in writing by the immediate supervisor of the
individual making such determination or such higher level official as the Secretary
may designate. Written approval of the initial penalty determination under section
6751(b)(1) must be obtained no later than the date the notice of deficiency is
issued or the date the Commissioner files an answer or amended answer asserting
such penalty. Chai v. Commissioner, 851 F.3d 190, 221 (2d Cir. 2017), aff’g in
part, rev’g in part T.C. Memo. 2015-42; see also Graev v. Commissioner, 149 T.C.
___ (Dec. 20, 2017), supplementing 147 T.C. __ (Nov. 30, 2016). Compliance
with section 6751(b)(1) is part of the Commissioner’s burden of production in any
deficiency case in which a penalty subject to section 6751(b)(1) is asserted. Chai
v. Commissioner, 851 F.3d at 221.
The section 6662 accuracy-related penalties determined in the notices of
deficiency were properly approved as required by section 6751(b) and respondent
has proven sufficient facts to satisfy the burden of production and proof as to that
issue.
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[*23] 1. Substantial Understatement of Income Tax
An understatement is the excess of the tax required to be shown on the tax
return over the tax actually shown on the return, reduced by any rebates. Sec.
6662(d)(2)(A). An understatement of income tax is substantial if it exceeds the
greater of $5,000 or 10% of the tax required to be shown on the return in the case
of an individual. Sec. 6662(d)(1)(A). Understatements are reduced by the portion
attributable to (1) an item for which the taxpayer had substantial authority or (2)
any item for which the taxpayer, in the return or an attached statement, adequately
disclosed the relevant facts affecting the item’s tax treatment and the taxpayer had
a reasonable basis for the tax treatment of the item. Sec. 6662(d)(2)(B).
The substantial authority standard is an objective standard that requires an
analysis of the law and relevant facts. Sec. 1.6662-4(d)(2), Income Tax Regs.
There is substantial authority for the tax treatment of an item only if the weight of
authorities supporting the treatment is substantial in relation to the weight of
authorities supporting contrary treatment. Sec. 1.6662-4(d)(3), Income Tax Regs.
Petitioners’ understatement for each tax year is greater than both $5,000 and
10% of the tax required to be shown on the return, and thus respondent has met his
remaining burden of production through calculation. Neither the relevant law nor
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[*24] the facts as found in this opinion are supportive of petitioners’ position,11
and petitioners have not introduced any evidence that they disclosed on their
return the relevant facts affecting the tax treatment of items in question or that they
had a reasonable basis for such treatment. See sec. 6662(d)(2)(B). So, unless
petitioners had reasonable cause and acted in good faith with respect to the
underpayments under section 6664(c)(1), respondent’s determination regarding
this penalty must be sustained.
2. Negligence or Disregard of Rules and Regulations
Alternatively, respondent argues that petitioners are liable for penalties
under section 6662(a) for negligence or disregard of rules and regulations, and
petitioners assert that they are not. For the sake of completeness, we address this
ground for imposing the penalty.
“Negligence” includes any failure to make a reasonable attempt to comply
with the Internal Revenue Code and any failure to keep adequate books and
records or to substantiate items properly. Sec. 6662(c); sec. 1.6662-3(b)(1),
Income Tax Regs. Negligence has also been defined as the failure to exercise due
11
Petitioners argue in their opening brief that “[b]ased on all the cases cited
herein, it is obvious that there is substantial legal justification for the position that
the loss is an ordinary loss”, which we interpret as an argument that substantial
authority exists for this tax treatment.
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[*25] care or the failure to do what a reasonable person would do under the
circumstances. See Allen v. Commissioner, 92 T.C. 1, 12 (1989), aff’d, 925 F.2d
348 (9th Cir. 1991). The term “disregard” includes any careless, reckless, or
intentional disregard. Sec. 6662(c). Disregard of rules or regulations is “careless”
if the taxpayer does not exercise reasonable diligence in determining the
correctness of a return position that is contrary to a rule or regulation. Sec.
1.6662-3(b)(2), Income Tax Regs. Disregard is “reckless” if the taxpayer makes
little or no effort to determine whether a rule or regulation exists, under
circumstances which demonstrate a substantial deviation from the standard of
conduct that a reasonable person would observe. Id. Disregard is “intentional” if
the taxpayer knows of the rule or regulation that is disregarded. Id.Petitioners’ original Federal income tax return for tax year 2009
characterized Wrentham House Mansion as a capital asset and claimed a lower
adjusted basis. Petitioners subsequently hired a different return preparer, Gabor &
Associates, to prepare amended returns that took a tax reporting position with
respect to Wrentham House Mansion that significantly reduced petitioners’
reported income tax liabilities for tax years 2004 through 2009. The amended
returns treated Wrentham House Mansion as a property used in an existing trade
or business, claimed a much higher adjusted basis, and claimed the NOL, which
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[*26] petitioners carried to other years to eliminate their tax liabilities for all the
years at issue.
Petitioners’ quest for a better tax result was not supported by any
meaningful analysis of the merits of their new tax reporting position. Moreover,
petitioners knew that their planned rental activity had never commenced.
Respondent has met his remaining burden of production with respect to his
alternative penalty determination that petitioners were negligent.
3. Section 6664 Reasonable Cause and Good Faith Exception
Section 6664(c)(1) provides an exception to the imposition of the accuracy-
related penalty if the taxpayer establishes that there was reasonable cause for, and
the taxpayer acted in good faith with respect to, the underpayment. Sec. 1.6664-
4(a), Income Tax Regs. The decision whether a taxpayer acted with reasonable
cause and in good faith is made on a case-by-case basis, taking into account all
pertinent facts and circumstances, including: (1) the taxpayer’s efforts to assess
the proper tax liability; (2) the knowledge and experience of the taxpayer; and (3)
reliance on the advice of a tax professional. Id. para. (b)(1). Generally, the most
important factor is the extent of the taxpayer’s efforts to assess his or her proper
tax liability. Id.- 27 -
[*27] Reliance on the advice of a tax professional or an honest misunderstanding
of the law that is reasonable in the light of the facts and circumstances may
support a conclusion that a taxpayer acted with reasonable cause and in good faith
with respect to a reported position. Id.; see Higbee v. Commissioner, 116 T.C. at
448-449. Reliance on the advice of a professional must be reasonable under the
circumstances. Sec. 1.6664-4(b)(i), Income Tax Regs.; see also Pasternak v.
Commissioner, 990 F.2d 893, 903 (6th Cir. 1993), aff’g Donahue v.
Commissioner, T.C. Memo. 1991-181; Neonatology Assocs., P.A. v.
Commissioner, 115 T.C. 43, 97-99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).
The advice must be based upon an analysis of all pertinent facts and the applicable
law and must not be based on unreasonable factual or legal assumptions. Sec.
1.6664-4(c)(1)(i) and (ii), Income Tax Regs. It cannot be based on an assumption
that the taxpayer knows, or has reason to know, is unlikely to be true. Id. subdiv.
(ii).
Petitioners failed to prove that they had reasonable cause and acted in good
faith within the meaning of section 6664(c)(1). Petitioners did not make a
reasonable, good-faith effort to correctly assess their tax liabilities and their
claimed reliance on a tax professional was both unreasonable and not credible.
Petitioners’ attempt to recharacterize the tax treatment of their investment in
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[*28] Wrentham House Mansion was opportunistic and appears to have been
motivated by their financial problems and unpaid income tax liabilities. This
attempted recharacterization had all the markings of being “too good to be true”,
yet petitioners forged ahead, knowing that they had never actually commenced a
rental activity involving Wrentham House Mansion and had not done all of the
things the law required to be able to rent Wrentham House Mansion. Because
petitioners failed to prove that they had reasonable cause for, and acted in good
faith with respect to, the positions taken on their amended income tax returns and
on their only return for 2010, we sustain respondent’s determination that they are
liable for the section 6662 accuracy-related penalties.
V. Conclusion
We hold that: (1) Wrentham House Mansion was a capital asset in the
hands of petitioners; (2) section 263A requires that the designated interest
payments made on Wrentham House Mansion be capitalized; (3) petitioners are
liable for additions to tax under section 6651(a)(1) for failure to timely file Federal
income tax returns for tax years 2006 through 2008; and (4) petitioners are liable
for the section 6662 accuracy-related penalties as determined by respondent.
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[*29] In reaching our holdings herein, we have considered all arguments made by
the parties, and to the extent not mentioned above, we find them to be moot,
irrelevant, or without merit.
To reflect the foregoing,
Decisions will be entered
under Rule 155.