T.C. M em o . 2 0 1 7 -1 6

UNITED STATES TAX COURT

STEPHEN P. HARDY AND ANGELA M . HARDY, Pet i t i o n ers v . COM M ISSIONER OF INTERNAL REVENUE, Res po n d en t

Do ck etNo . 2 2 4 09 -1 4
. Fi l edJ an uary1 7 , 2 0 1 7
.
St ep hen L. Kad is h , M at t h ew F. Kad i s h , an dDean M
. Ro o n ey , fo r p et i t i o n ers . An i t a A. Gi l l an d Nan cy

P. Kl i n g sh i rn , fo r res p o n den t .

M EM ORANDUM FINDINGS OF FACT AND OPINION BUCH, J u d g e: Dr. St ep h en P. Hard y i s a p l as t i c s u rg eo n wh o p erfo rm s
s u rg eri es i n v ari ou s faci l i t i es , i n cl ud i n g M i ss o u l a Bo n e & J o i n t Su rg ery Cen t er, LLC (M BJ ). Dr. Hardy o wn s a m i n o ri t y i n t eres t i n M BJ , b u t h e h as n o d ay -t o -d ay
m an ag em en tres p on s i b i l i t i es . Beg i n n i n g wi th 2 0 08 th e Hardy s rep o rt ed t h e- 2
-

[* 2 ] i n co m e fro m

M BJas p as s iv e aft er h av in g rep o rt edth e i n co m e as n o np as s i v e fo r p rev i o u s y ears . Th e p as s i v e i n co m e al lo wed t h e Hard y s t o ab s o rb u n rel at ed p as s i v e act i v i t y

l os s es . Th e Co m

m i s s i o n er i s s u eda n o t i ce o f d efi ci en cy fo r 2 0 0 8 th ro u g h 2 0 1 0 rech aract eri zi n g th e i n co m e as n o np as s i v e an dd et erm i n in g d efi ci en ci es . Th e Co m

m i ss i o n er al s o d et erm i n ed a s ect i o n 6 6 6 2 (a) accu racy rel at ed p en al t y

fo r each y ear. Th e Co m

m i ss i o ner arg u es th at Dr. Hard y ’ s act i v i t y
as a p l as t i c s u rg eo n s h o u l d b e g ro up edwi t h h is act iv it y atM BJ . Aft er co n ces s i on s b y b o th p art i es , we m

u s td eci d e wh et h er t h e Hard y s m ay rep o rtDr. Hardy ’ s i n co m e fro m

M BJas p as s iv e. If s o , we m u s tal s o d eci de wh et h er t h ey m ay d edu ct a p as s i v e act i v i t y l o s s carry ov er fro m p ri or y ears . If the Hard y s are l i ab l e fo r d efi ci en ci es , th en we m

u std eci d e wh et h er t h ey

are l i ab l e fo r accu racy -rel at ed p en al t i es . Attri al th e Hard y s m o v edt o am en d t h e p l ead i n g s t o co nfo rm t o th e
ev i d en ce, arg u i n g th atth ey o v erp ai ds el f-em

pl o ym en tt ax fo r 2 0 0 8 an d2 0 0 9 . W e wi l l g ran tth i s m o t i o n . Th e Hard y s m ay

treat Dr. Hardy ’ s i n co m e fro m M BJ as p as s iv e fo r al l th ree y ears . Becau s e t h ey

d i dn o tp rev i o u s l y g ro up Dr. Hard y ’ s m ed i cal p ract ice wi t h h i s o wn ers h ip i n t eres ti n M BJ , th ey are n o t reg ro up i n g h i s i n teres ti n M BJ
. M o reo v er, th e Co m

m i s s i o n er m ay

n o treg ro up Dr. Hardy ’ s act i v i t i es i n to a s i n g l e
u n i tb ecau s e t h ere i s m o re t h ano n e reas o n ab l e m et h o dfo r g ro up i n g h i s act i v i t i es- 3
-

[* 3 ] an d th e Hard y s ’ g ro up in g d o es n o th av e t h e p ri n ci pal p u rp o s e o f ci rcu m v en t i n g t h e u n d erl y i ng p o l i ci es o f s ect i o n 4 6 9
. 1 Ho wev er, th e Hard y s m ay
n o td edu cta p as s iv e act i v i t y l o s s carry o v er fo r 2 0 0 8 b ecau s e t h ey s h o u l d h av e d educt edth e l o s s fo r t he y ear i n wh i ch t h e l o s s was i n cu rred . M o reo v er, t h e Hard y s are n o tl iab l e fo r s el f-em p l o ym en t t ax fo r 2 0 0 8 o r 2 0 0 9 b ecau s e Dr. Hard y recei v edth e d is t ri b u t i on s fro m M BJ as a l i m i t edp art n er act i n g i n h i s cap aci t y as
an i n v es t o r. Al t h o u g h the Co m m i s s i o n er d i d n otm eeth i s b u rd en o f p ro du ct i o n fo r s ect i o n 6 6 6 2 (a) accu racy -rel at edp en al t i es fo r u n d erp aym en t s du e t o
n eg li g en ce, h e m ay

h av e m eth i s b u rd en o f p ro duct i o n fo r u nd erp aym en ts du e t o
s ub s t an t i al u n ders t at em en t s o f i n co m e t ax , d ep en d in g o n th e Ru le 1 5 5
co m p u t at i o n s . Ho wev er, the Hard y s es t ab l i sh edth atthey h adreas o n ab l e cau s e
an d act edi n g o od fai t h wh en th ey rel i edo n th e ad v i ce o f a t ax p ro fes s i o n al fo r cl ai m i ng a p as s i v e act i v i t y l o s s carry o v er d edu ct i o n fro m y ears th atare n otb efo re
u s . Th ey d i dn o t es t ab l i sh th atth ey h adreas o n ab l e cau s e an d act ed i n g o o d fai t h wi th res p ect t o th e p o rt i o n s o f t h e u n d erp aym en t s du e t o th e d i s al l o wedch ari t ab l e
co n tri b u t i o n d edu ct i o n s , wh i ch were am o n g th e i t em s th ey co n ced ed
.

1 Un l es s o t h erwi s e i nd i cat ed , al l s ect i o n referen ces are t o th e In t ern al Rev enu e Co de (Co d e) i n effect fo r t h e y ears i n i s su e, an d al l Ru l e referen ces are t o th e Tax Co u rt Ru l es o f Pract ice an dPro cedu re. Al l m on et ary am ou n t s are ro u n dedt o th e n eares td o ll ar.- 4
-

[* 4 ] FINDINGS OF FACT I. Th e Hard y s Th e Hard y s were m arri eddu ri n g 2 0 08 th ro ug h 2 0 10 , th e y ears i n i s s u e. Dr. Hard y

i s a p l as t i c s u rg eo n . Si n ce t h e earl y n i n et i es h e h as p ract i cedas a p l as t ic s u rg eo n s p eci al i zi ng i n p ed i atri c reco n s t ru ct iv e s u rg ery . Dr. Hardy
co n du ct s h i s m ed i cal p ract i ce t h ro u g h No rt h wes tPl as t i c Su rg ery As s o ci at es , a
s i ng l e-m em

b er PLLC, wh i ch M rs . Hard y ru ns as th e ch i ef o p erat i n g o ffi cer. Befo re jo in i n g a s u rg ery

cen t er, Dr. Hard y o p erat edo n h i s p at i en t s ath i s
o ffi ce o r attw o l o cal h o s p i t al s . Dr. Hardy can o perat e ath i s o ffi ce o n l y i f t h e p ro cedure req u i res l ocal an es t hes i a. If a p ro cedu re req u i res g en eral an es t h es i a, Dr. Hard y op erat es at a h o s p i t al . An di f a p ro cedure req u ires an o v ern i g hts t ay , th en th e p ro cedu re m

u s tb e p erfo rm edata h o s p i t al
. Dr. Hardy wi l l ex p l ai n t o h i s p at i en t s th e o p t i on s fo r wh ere a s u rg ery can t ak e p lace, an d t h e p ract i ce m an ag er wi l l g i ve t h em

a co s tes t i m at e fo r d i fferen tl o cat i o n s. Hi s p at i en t s d et erm i n e wh ere a s u rg ery

wi l l b e p erfo rm ed . Becau s e o f th e l i m i t edav ai l ab i li t y o f
o p erat i n g ro o m s , h o wev er, Dr. Hard y s t ru g g l es t o o b tai n s p ace at a h os p i tal fo r t h e p ro cedures . Dr. Hard y

i s p ai d fo r t h e s u rg eri es t h ath e p erfo rm s . Su rg i cal p ro cedu res g en eral l y h av e t h ree fee co m

p o n en t s : (1 ) a fee fo r s u rg i cal s erv i ces p ro v i d edb y- 5
-

[* 5 ] th e s u rg eo n ; (2 ) a fee fo r an es t h es i a s erv i ces p ro v id edb y t h e an es t h es i o l o g i s t ;
an d (3 ) a fee fo r t h e u s e o f a s u rg i cal faci l i t y an di t s acco m

p an y i n g s erv i ces . Pat i en t s p ay

th e faci l i t y

fee s ep arat el y

fro m Dr. Hardy ’ s fee as a s u rg eo n. Faci l i t y fees ty p ical l y i n cl ud e t he u se o f m ed ical equ i p m en t , s up p l i es , an ds t aff, wh o i n cl u d e t h e fro n to ffi ce cl erkan dthe n urs es wh o p ro v i de p re- an dp o st -o p erat i v e
care. In 2 0 0 1 th e Hard y s fi rs t co n s i d eredo p en in g th ei r o wn s u rg ery cen t er. Th e Hard y s b el i ev ed t h at a s u rg ery cen t er wo u ldb en efi tp at i en t s b ecau s e i two u l d p ro v id e a co s t -effi ci en t al t ern at i v e t o h av i n g s urg eri es p erfo rm edata h o s p i t al , an d i t w o u ldp ro v i d e Dr. Hard y wi t h g reat er l at i tu d e i n s ch edu l i n g tho s e s u rg eri es . Th e fo l l o w i n g y ear, t h e Hard y s p u rch as edl an d an ddrew up p l an s t o b u i l d a
s u rg ery cen t er. Befo re t h e Hardy s b eg an co n s tru ct i on , rep res en t at i v es o f M BJ an d two o th er s u rg ery

cen t ers ap p ro ach edDr. Hardy ab o u t h i s b eco m i n g a m em b er. Th e Hard y s d et erm in edth ati two u l db e a wi s er b u s i n es s d eci s i o n t o jo i n an al read y o p erat i o n al s urg ery cen t er b ecau s e o f th e ex p en s es o f co n st ru ct i n g , s t affi n g , cert i fy i n g , an d o p erat i n g th e cen t er. II. M BJ M BJ was a l im i t edl i ab i l i t y co m pan y fo rm edb y

a g ro up o f p ract i ci n g p h y s i ci an s i n 2 0 0 4 fo r t h e p u rp o s e o f o p erat i ng a s u rg ery cen t er. Iti s t reat edas a- 6
-

[* 6 ] p art n ers h i p fo r Fed eral i n co m e t ax p u rp o s es . In 2 0 0 5 M BJb eg an o p erat i n g a
s u rg ery cen t er. 2 M BJ p ro vi d es p at i en t s wi t h a co s t -effi ci en tal tern at i v e t o h av i n g p ro cedures p erfo rm ed ata h os p i t al . M BJ i s equ ip p ed fo r d o ct o rs t o p erfo rm p ro cedures thatreq ui re l o cal o r g en eral an es t h es i a; h o wev er, co m pl ex p ro cedu res
an d p ro cedu res th atreq u i re an o v ern i g h t s tay m u s tb e p erfo rm edata h os p it al
. M BJ i s p ro fes si o n al l y

m an ag ed . M BJ h i res i t s o wnem p l o y ees an dd o es n o t
s h are an y em pl o y ees wi th No rt h wes tPl as t i c Su rg ery . Li k e h o s p i t al s , M BJ d i rect l y b i l l s p at i en t s fo r faci li t y

fees . M BJ th en d is t ri b u t es t o each o f i t s m em bers h i s o r h er s h are o f t h e earn i n g s b as edo n th e faci l i t y fees l es s ex p en s es . M BJ u ses a th i rd -p art y acco un t i n g fi rm t o p rep are t h e Sch edu les K-1 , Part n er’ s Sh are o f In co m e, Deduct i o n s , Cred i t s , et c., fo r t h e m em b ers . M BJd o es n o tp ay

p hy s i ci an s fo r t h ei r p ro cedu res . In 2 0 0 6 Dr. Hardy

p urch as eda 1 2.5 % i n teres tt o jo i n s ev eno t h er p ract i ci n g p h y s i ci an s i n M BJ . He p ai d$ 1 6 3 ,9 7 4 fo r h is i n t eres t . Dr. Hardy can n o ts el l h i s i n t eres ti n M BJt o a t h i rdp art y . Th e fo l lo wi n g y ear, t h e Hard y s b u i l tan o ffi ce
n ex t t o M BJ fo r No rt h wes tPl as t i c Su rg ery .

2 M BJ Orth op ed i c Cen ter i s a s ep arat e en t i t y th atwas fo rm edb y

s o m e o f t h e s am e d o ct o rs as M BJ . Iti s i n th e s am e b u i l di n g as M BJ . Dr. Hardy h as n o i n t eres ti n th e o rt h o p ed i c cen t er.- 7
-

[* 7 ] Dr. Hard y

h as n ev er m an ag edM BJ , an dh e h as n o d ay -t o -d ay
res p o n s i b i l i t ies th ere. Al t h o ug h h e m eet s wi t h the o t h er m em bers qu art erl y , h e d o es no th av e an y

i np u ti n t o m an ag em en td eci s i o ns . He g en eral l y i s n oti n v o l v ed i n h i ri n g o r fi ri n g d eci si o ns . Hi s ro l e an d p art i ci pat i o n i n M BJ h av e n otch an g ed
s i nce h e b ecam e a m em

ber. Dr. Hard y

p erfo rm s s u rg eri es o n p at i en t s atM BJo n M o nd ay s . Rarel y , Dr. Hard y w i l l o p erat e atM BJ o n o t h er d ay s o f t h e week . Dr. Hardy d o es n o tp ay

ren t t o p erfo rm

s u rg eri es at M BJ ; th e p at i en t s p ay th e faci l i t y fees d i rect l y . In2 0 0 8
an d 2 0 0 9 Dr. Hardy

p erfo rm ed1 1 % o f t h e s u rg eri es atM BJ . In 2 0 1 0 Dr. Hardy p erfo rm ed9 % o f t h e s u rg eri es atM BJ . He al s o h add es i g nat edal t ern at in g Tu es d ay s as h is s u rg i cal d ay s attwo area h o s p i t al s. On t h e o t h er d ay s o f t he week , Dr. Hard y

co n ti n u edt o p erfo rm

s u rg eri es ath i s m ed i cal p ract i ce. He p erfo rm ed ap p ro x i m at el y 5 0 % o f h i s s u rg eri es ath i s o ffi ce, 2 0 % atM BJ , an dth e rem ai n d er ato th er faci l i t i es . Dr. Hard y

recei v es a d i s t ri b u t i o n fro m M BJ reg ard l es s o f wh et h er h e p erfo rm s an y

s u rg eri es atth e s u rg ery

cen t er, an dh i s d i s t ri b u t i o n i s n o td ep en d en t
o n h o w m an y

s u rg eri es h e p erfo rm s atM BJ . M BJd o es n o t h av e a m in i m um
s u rg ery req u i rem en tt o recei v e a d is t ri b u t i o n.- 8
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[* 8 ] Aft er 2 0 1 0 Dr. Hard y h i redan o t her s urg eo n atNo rth wes tPl as t i c Su rg ery . If t h ats u rg eo n ’ s p at i en tch o o s es , th e s u rg eo n p erfo rm s th e s u rg ery atM BJ . Th at
s u rg eo n d o es n o t h o l d an i n t eres ti n M BJ
. III. Rep o rt i n g Si n ce 2 0 0 4 t h e Hard y s h av e b een h iri n g W al t er Kero , a p art n er an dt ax d i rect o r atJ u n k erm i er, Cl ark , Cam p an el l a, St ev en s , PC, t o p rep are an d fi le t h ei r Fo rm s 1 0 4 0 , U.S. In d i v i du al In co m e Tax Retu rn . M r. Kero i s a cert i fi edp ub l i c
acco u n t an twi t h o v er 4 0 y ears o f ex p eri en ce. Fo r 2 0 0 6 an d2 00 7 t h e Hard y s rep o rt edthei r M BJ i nco m e as n o np as s i v e. Us i n g h i s trai n i n g an dex p eri en ce, M r. Kero tri es t o i d en t ify i n co m e as ei t h er p ayro l l , p as s i v e, o r p o rt fo l i o. M r. Kero d et erm i n edth atth e i n co m e fro m M BJ was
n o np as s i ve b y rel y i n g o n t h e Sch edu l e K-1 . Th e Sch edu l e K-1 s t at edth atth e i n co m e was fro m

a t rad e o r b u s i n es s an di n cl ud eds el f-em p l o ym en tt ax . He d i d
n o tg ro up Dr. Hardy ’ s o wn ers h i p i n t eres ti n M BJ wi t h Dr. Hardy ’ s m ed i cal p ract i ce act i vi t y , an dh e d i dn o tco n s i d er t h e g ro upi n g reg ul at io n s . Th e Hard y s fi l edth ei r 2 00 6 return an dat t ach eda Sch edul e E, Sup p l em en t al In co m e an dLo s s, rep o rt i n g $ 2 7 9 ,9 88 o f n o np as s i v e i n co m e fro m M BJ . Th ey

at t ach eda Fo rm

8 5 8 2, Pas s i v e Act i v it y

Lo s s Li m i t at i o ns , rep ort i n g a t o t al u nal l o wedl o s s o f $ 5 8 ,7 8 6 . Th ey d i d n o t at t ach an y

s t at em en t rep o rt i n g th at- 9
-

[* 9 ] th ey h adg ro up edDr. Hardy ’ s o wn ers hi p i n t eres ti n M BJ wi t h h i s m ed i cal p ract i ce act i vi t y . Th e Hard y s fi l edth ei r 2 00 7 return an dat t ach eda Sch edul e E, rep o rt i n g
n o np as s i ve i n co m e fro m

M BJ o f $ 1 9 9,1 2 1 . Th ey at t ach eda Fo rm

8 5 8 2 , rep o rt i n g a t ot al un al l o w edl o s s o f $ 1 1 9 ,6 1 5 , wh i ch i n cl u d edcarry o v er l o s s es fro m th e p rev i o u s y ear o f $ 5 8 ,7 8 6 . Th ey d i dn otat t ach an y

s t at em en trep o rt in g t h atth ey h ad g ro up edDr. Hardy ’ s o wn ers h i p i n t eres ti n M BJ wi th h i s m ed ical p ract i ce act i vi ty . In 2 0 0 8 M r. Kero d et erm i n edth atth e i n co m e fro m M BJ was p as s i v e, an d h e b eg an rep o rt i n g i tas s u ch . M r. Kero l earn edth atDr. Hardy was n o ti n v o l v ed i n the m an ag em en to f M BJ an d was n o tl i ab l e fo r t h e d eb t s o f M BJ
. In d et erm i n i n g th atth e i n co m e was p as s i v e, h e wen tth ro u g h a ch eck l i s to f p as s i v e act i vi ty cri t eri a an do b t ai n edco rro b o rat in g i n fo rm at i o n fro m t h e Hard y s . He d et erm i n edth atth e rel at i on s h i p o f Dr. Hardy t o M BJ was p as s iv e. M r. Kero d i d n o tam en dth e Hard y s’ retu rn fo r 2 0 0 6 o r 2 00 7 . M r. Kero
u n d ers t o o dth atth e d i fferen ce b et ween p as s i v e an dact i v e ch aract eri zat i o n can h av e a p ro fo u n deffect o n a t ax p ay er’ s i n co m e. Ho wev er, b ecau s e h e d i dn o t b el i ev e t h e ch an g e wo u l db e m at eri al , h e d i dn o t am en dth e Hard y s ’ retu rn fo r 2 0 0 6 o r 2 0 0 7
.- 1 0 -

[* 1 0 ] Th e Hard y s fi l edth ei r 2 0 0 8 retu rn an dat t ach eda Sch edu le E, rep o rt i n g p as s i v e i n co m e fro m

M BJ o f $ 2 5 0 ,4 9 4
. Th ey at t ach eda Fo rm

8 5 8 2 , rep o rt i n g a t o t al p as s i v e act i v i ty

l o s s o f $ 2 5 6 ,4 1 1 , wh ich i n cl u dedcarry o v er l o ss es fro m p rev i o u s y ears o f $ 11 9 ,6 1 5 . Aft er n et t i n g th ei r p as s i ve i n co m e ag ai ns tth ei r p as s i v e l o s s es , th ey

al s o rep ort edan al l o wab l e l o s s o f $ 2 5 0,4 9 4 , l eav i n g $ 5 ,9 1 7 as
a s u s p en d edl o s s. Ad di ti o n al l y , th e Hard y s rep o rt eds el f-em p lo ym en tt ax o f $ 2 6 ,7 4 5 fro m

th e i n co m e Dr. Hard y

recei vedfro m

No rt h wes t Pl as t i c Su rg ery an d M BJ
. Th e Hard y s fi l edth ei r 2 00 9 return an dat t ach eda Sch edul e E, rep o rt i n g p as s i v e i n co m e fro m

M BJ o f $ 2 4 5 ,0 1 2
. Th ey at t ach eda Fo rm

8 5 8 2 , rep o rt i n g an al l o wed pas s i v e act i v i ty

l o s s o f $ 1 0 4 ,2 2 4, wh i ch i n cl ud eda $ 5,9 1 7 carry o v er l o s s fro m th e p rev i o u s y ear. Ad d i t i o n al l y , th e Hard y s rep ort eds el f-em p l o ym en tt ax o f $ 2 6 ,5 3 0 fro m

th e i n co m e Dr. Hard y

recei vedfro m

No rt h wes t Pl as t i c Su rg ery an d M BJ
. Th e Hard y s fi l edth ei r 2 01 0 return an dat t ach eda Sch edul e E, rep o rt i n g p as s i v e i n co m e fro m

M BJ o f $ 2 7 0 ,5 2 1
. Th ey at t ach eda Fo rm

8 5 8 2 , rep o rt i n g an al l o wed pas s i v e act i v i ty

l o s s o f $ 1 5 7 ,1 8 7.- 1 1 -

[* 1 1 ] IV. No t i ce o f Defi ci en cy Th e Co m m is s i o n er i s s u eda n o t i ce o f d efi ci en cy fo r t ax y ears 2 0 0 8 t h ro u g h 2 0 1 0 o n J u n e 2 4 , 2 0 1 4 . Fo r each y ear, t h e Co m m i s s io ner d i s al l o wedthe Hard y s’ p as s i v e act i v i t y

l os s d educt i o n an di t em i zedd edu ct i o n fo r ch ari t ab l e co n tri b u t i o n s
an d d et erm i n eda s ect i o n 6 6 6 2 (a) accu racy -rel at ed p en al t y . Wh i le res i d i n g i n M o n tan a, the Hard y s t i m el y p et i t i o nedfo r red et erm i n at i o n o f t h e d efi ci en ci es . Th ey ch al l en gedthe Co m

m i s s i o n er’ s d et erm i n at i o n t h atth ey m ay n o tcl ai m p as s i v e act i v i t y

l os s d educt i o n s ag ai n s tth e i n co m e o f M BJ . Th ey al s o ch al l en g ed th e d i s al l o wan ce o f t he ch ari tab l e co n t ri b u t i on d edu ct i o n s an d t h e i m p o si t io n o f
accu racy -rel at edp en al ti es . Tri al was h el d i n Cl ev el an d , Oh i o , o n Decem b er 4 , 2 01 5 . Duri n g t ri al th e Hard y s m o v edt o co n fo rm th e p l ead i n g s t o th e ev i d en ce, arg u i n g t hatth ey
o v erp ai ds el f-em

p l o ym en tt ax fo r 2 0 08 an d2 0 0 9 . Aft er t ri al th e p art i es s ub m i t t ed
a s t i p u l at i o n o f s et t l ed i s s u es , res o l v i n g t he rem ai n in g ch ari t ab l e co n t ri b u t i o n d educt i o n d i s p u t e fo r 2 0 0 8 an d2 0 1 0
. Sub s equ en tl y , th e In t ern al Rev en u e Serv i ce (IRS) rel eas eda t ech n ical ad v i ce m em o ran du m wh ich p res en t ed t h e s am e i s s u es as th i s cas e. 3 W e o rd ereds up p l em en t al b ri efs , wh i ch th e p art i es fi l ed
.

3 Tech . Adv . M em . 2 0 1 6 34 0 2 2 (Au g . 1 9 , 2 0 1 6).- 1 2 -

[* 1 2 ] OPINION W e m u s td eci d e wh et h er t h e Hard y s p ro p erl y rep o rt edDr. Hardy ’ s i nco m e fro m M BJ as p as s i v e. If s o , we m u s td eci d e wh et h er t h e Hard y s m ay d edu cta p as s i v e act i v i t y

l os s carry o v er fro m

p rev i o us y ears an dwh et h er t h ey o v erp ai d th ei r s el f-em

p l o y m en tt ax . Fi n al l y , we m

u s t d eci de wh et h er th e Hard y s are l i ab l e fo r s ect i o n 6 6 6 2 (a) accu racy -rel at edp en al t i es . I. Bu rd en o f Pro o f Th e Co m m is s i o n er’ s d et erm i n at i o n s i n th e n o t i ce o f d efi ci en cy are g en eral l y p res u m edco rrect , an dt ax p ay ers b ear t h e b u rd en o f p ro vi n g o t h erwi s e. 4 Inl i m i t ed
s i tu at i o n s t h e b u rd en m ay s h i ftt o th e Co m

m i s s i o ner u n d er s ect i o n 7 4 9 1 (a), b u t th ere i s n o t en o u g h i n fo rm at i o n i n th e reco rd t o co n cl u d e t h atth e b u rd en s h o u l d
s h i ftu nd er s ect i o n 7 4 9 1 (a), an dth e Hard y s d o n o targ ue t h at i t s h o u l d
. Acco rd in g ly , th e b u rd en rem ai n s o n th em . Tax p ay ers b ear t h e b u rd en o f p ro v i n g th atth ey h av e m etal l req u i rem en t s n eces s ary t o b e en t i t l ed t o th e cl ai m ed d educt i o n s . 5

4 Ru l e 1 4 2 (a); W el ch v . Hel v eri n g , 2 90 U.S. 1 1 1 , 1 1 5 (1 9 3 3 ).
5 Ru l e 1 4 2 (a); INDOPCO, In c. v . Co m m i ss i o ner, 5 03 U.S. 7 9 , 8 4 (1 9 9 2 ).- 1 3 -

[* 1 3 ] II. Wh et h er t he Hard y s M ay Dedu ctPo rt i o n s o f Th ei r Pas s i ve Act i v i t y Lo s s es In m o s tp as si v e act iv i t y

l o s s cas es , t ax p ay ers cl ai m a d edu ct i o n fo r cert ai n b u s i n es s an di n v es tm en tex pen s es u n d er s ect io n s 1 6 2 an d2 1 2. Th e Co m m i s s i on er d et erm i n es th atth e act i v i ty i s p as si v e u n der s ect i o n 4 6 9 an dd i s al l o ws a d educt i o n . Th e Hard y s rep o rt edi n co m e as p as s i v e fo r 2 0 0 8 t h ro u g h 2 0 1 0 an d ab s o rb eda p as s i v e act i v it y l o s s carry o v er fro m

p rev i o us y ears , an dth e Co m m i s s i o n er h as d et erm i n edth atth e act i v i t y i s n o np as si v e. Acco rd i n g ly , each p art y i s ad v an ci n g a p o s i t io n thati s m o re co m m on l y arg u edb y t he o t h er s i d e. Sect io n 4 6 9 g en eral l y

d i s al l o ws a d educt i on fo r an y p as s iv e act iv i t y l o s s . 6 A p as si v e act i vi ty

l os s i s d efi n edas th e ex ces s o f t h e ag g reg at e l o s s es fro m al l p as s i v e act i v i t ies fo r t h e t ax ab l e y ear o v er t h e ag g reg at e i n co m e fro m al l p as s i v e act i vi t i es fo r t h aty ear. 7 Ing en eral , a p as si v e act i v i t y i s an y trad e o r b u s i n es s i n wh i ch th e t ax p ay er d o es n o tm at eri al l y p art ici p at e. 8 A t ax p ay er m at eri al l y p art i ci p at es i n an act i v i t y i f t h e t ax p ay er i s i n v o lv edi n th e o p erat i on s o f th e

6 Sec. 4 6 9 (a).
7 Sec. 4 6 9 (d )(1 ).
8 Sec. 4 6 9 (c)(1 ).- 1 4 -

[* 1 4 ] act i v i t y

o n a reg u lar, co n t i n u o u s, an d s ub s t an t i al b as i s . 9 Wh en a t ax p ay er’ s p as s i v e act i v i t y

l os s d educt i o n i s d i s al l o wed , i ti s treat edas a d edu ct i o n fo r t h e
n ex t t ax ab l e y ear. 1 0 Dr. Hardy ’ s act i v i ty atM BJ d oes n o tm eetth e m at eri al p art i ci p at i o n t es t . A. Th e Hard y s Di d No tGro up Dr. Hardy ’ s Act i v i t ies
. Sect io n 4 6 9 d o es n o td efi n e “ act i v i t y ”. Th e Secret ary , h o w ev er, h as p res cri bed reg ul at i o n s p u rs u an tt o s ect i o n 4 6 9 (l ) wh i ch s p eci fy wh atco n st i tu t es an

“ act i v i ty ”. Sect i o n 1 .4 6 9 -4 (c), In co m e Tax Reg s ., s et s fo rt h th e ci rcu m s t an ces fo r g ro upi n g t ax i t em s t o d et erm i n e wh at co n st i tu t es a s i n gl e act i v i t y . Th atreg u l at i o n p ro v id es th at“ [o ] n e o r m o re t rad e o r b u s i n es s act i v i t ies o r ren t al act i vi t i es m ay b e treat ed as a s in g l e act i v i t y i f t h e act i vi t i es co n s t i tut e an ap p ro p ri at e eco n o m i c u n i t fo r t h e m eas urem en to f g ai n o r l o ss fo r p urp o ses o f s ect io n 4 69 .” Wh et h er act i vi t i es co n s ti tu t e an “ ap p ro p ri at e eco n o m ic u n i t ” d ep en d s o n th e fact s an d ci rcu m s t an ces . 1 1 Th e reg ul at i o n g i v es th e g reat es twei g ht t o fi ve fact o rs : (i ) Si m i l ari t i es an d d i fferen ces i n t y p es o f t rad es o r b us i n es s es ; (i i) Th e ex t en to f co m

m o n co n t ro l ;

9 Sec. 4 6 9 (h )(1 ).
1 0 Sec. 4 6 9(b ).
1 1 Sec. 1 .4 69 -4 (c)(2 ), In co m e Tax Reg s.- 1 5 -

[* 1 5 ] (i ii ) Th e ex ten to f co m m o n o wn ers h i p ; (i v) Geo g rap hi cal l ocat io n ; an d (v ) In t erd ep en den ci es b et ween o r am o n g th e act iv i t i es * * * [ 1 2 ] Th i s reg u l at io n fu rt her p ro v i d es th att ax p ay ers can “ u se an y reas o n ab l e m et h o do f ap p ly i n g th e rel ev an t fact s an dci rcu m s t an ces ” t o g ro up act i v i ti es an dth atn o tal l
o f t h e fi ve fact o rs are “ n eces saryfo r a t ax p ay er t o t reat m o re th an o n e act i v i t y as a
s i ng l e act i v i t y ”. 1 3 Th u s , t ax p ay ers h av e s o m e fl ex i b i li t y i n d et erm i n i n g wh at
co n st i tu t es an ap p ro p ri at e eco no m i c u n i t . Im p ort an t l y , s ect i o n 1 .4 69 -4 (e), In co m e Tax Reg s ., p ro vi d es th ato n ce a t ax p ay er h as g ro up edact i v i t i es , th e t ax p ay er
can n otreg ro up th o se act i v i ti es u n l es s “ i ti s d et erm i nedth at a t ax p ay er’ s o ri g i n al g ro upi n g was cl earl y

i nap p ro p ri at e o r a m at eri al ch an g e i n th e fact s an d ci rcu m s t an ces h as o ccu rred t h atm ak es th e o ri g i n al g ro up i ng cl earl y i n ap p ro p ri at e”. 1 4 Th e Co m m is s i o n er en co u rag es u s t o fi n dth atth e Hardy s g ro up edDr. Hard y ’ s o wn ers h ip i n teres ti n M BJ wi t h h i s m ed i cal p ract ice b ecau se t he Hard y s

1 2 Sec. 1 .4 69 -4 (c)(2 ), In co m e Tax Reg s.; s ee al s o Lam as v . Co m m i s s i o n er, T.C. M em o . 2 01 5 -5 9 , at* 3 0 -* 3 1
.

1 3 Sec. 1 .4 69 -4 (c)(2 ), In co m e Tax Reg s. 1 4 Sec. 1 .4 69 -4 (e), In co m e Tax Reg s .- 1 6 -

[* 1 6 ] h adp rev i o u s ly

rep o rt edth e i n co m e fro m M BJ as n o npas s i v e. Th e Hard y s d i dn o t ex p l i ci t l y

g ro up th ei r act i v i t i es , an dfo r th e y ears i n i s su e t h ey were n o t req u i redt o d o s o . 1 5 Bu t t h e Co m m i s s i o n er as k s u s t o i n fer t hatth e Hard y s g ro upedDr. Hardy ’ s o wn ers hi p i n t eres ti n M BJ wi t h h i s m ed i cal p ract i ce i n t o a
s i ng l e u n i tt o treatth e i n co m e as n o np as s i v e. W e wi l l n o ti nfer t h atth e Hard y s g ro up edDr. Hardy ’ s o wn ers hi p i n teres ti n M BJ wi th h i s m ed i cal p ract i ce as th e Co m m i s s i o n er req u es ts b ecau s e s u ch a g ro upi n g i s n o ts up p o rt ed b y t h e ev i d en ce. Th e m ere fact th atth e Hard y s rep o rt ed Dr. Hard y ’ s act i v it y

as n o np as s i v e i s n o t en o u gh fo r u s t o fi n dth atthey g ro up ed Dr. Hard y ’ s o wn ers h ip i n teres ti n M BJ wi t h h i s m ed ical p ract i ce. In s t ead , M r. Kero ex p l ai n edth ath e d i dn o tg ro up the act i v i t ies . He ex p lai n edth ath e d et erm i n edth atth e i n co m e fro m M BJwas n o np as s i v e b y ap p l y i n g h i s trai ni n g
an d ex p eri en ce an db y

rel y i n g o n th e Sch edu l e K-1 , wh i ch rep o rt edi n co m e fro m a trad e o r b u si n es s an d s el f-em p lo ym en tt ax . M o reo ver, h e s t at edthath e d i dn o t
co n si d er s ect i o n 1 .4 6 9 -4 , In co m e Tax Reg s . W e fi n d h i m cred i bl e. Th ere i s n o

1 5 Rev enu e Pro cedu re 2 0 10 -1 3 , s ec. 4 .0 2 , 2 0 1 0 -4 I.R.B. 3 2 9, 3 3 0 , requ i res t ax p ay ers t o fi le a wri t t en s t at em en tth atth e t ax p ay er i s g ro up i n g t wo o r m o re trad e o r b u si n es s act iv i t i es i n t o a s i n g l e act iv i t y fo r t ax ab l e y ears b eg in n i n g aft er J an u ary 2 5 , 2 0 1 0. Al t h o u g h Rev . Pro c. 2 0 1 0 -1 3 , s up ra, was n o ti n effect fo r t h e y ears i n i s s u e, Rev . Pro c. 2 01 0 -1 3 , s ect i on 4 .0 6 , 2 0 10 -4 I.R.B. at3 3 0 -3 3 1 , ap p l i es t o ch an g es t o p reex i s ti n g g ro upi n g s . Becau se we co n cl u d e t h at t h ere was n o p reex i s t in g g ro up in g , th i s p ro v i s i o n d o es n o tap p l y .- 1 7 -

[* 1 7 ] ev id en ce t h at t h e Hard y s g ro up edDr. Hardy ’ s o wn ers h i p i n t eres ti n M BJ wi th h is m ed i cal p ract ice act i v i t y fo r 2 0 0 6 o r 2 0 0 7 . Acco rd i n g l y , th e Hardy s d id
n o treg ro up thei r act iv i t i es fo r 2 0 0 8 wh en th ey b eg an rep o rt i n g th e i n co m e as p as s i v e. Th ey

h av e co n s i s t en t l y

treat edth e act i v i t i es as s ep arat e eco n o m i c u n i t s . B. Th e Co m

m is s i o n er Can n o t Reg ro up a Tax p ay er’ s Reas o n ab l e Gro up i n g . Sect io n 1 .4 6 9 -4 (f), In co m e Tax Reg s ., p ro vi d es t h e ru les fo r wh en t he Co m m i s s i o n er can reg ro up a t ax p ay er’ s act i v i t i es . He m ay d o s o i f “ an y

o f t h e act i vi t i es res u l t i n g fro m

th e t ax p ay er’ s g ro up in g i s n ot an ap p ro pri at e eco no m i c
u n i tan da p ri n ci p al p u rp o s e o f th e t ax p ay er’ s g ro up i ng (o r fai l u re t o reg ro up u n d er p arag rap h (e) o f t h is s ect i on ) i s t o ci rcu m v en t t he u n derl y i n g p u rp o s es o f s ect i o n 4 6 9 .” 1 6 Th e reg u l at i on i s co n jun ct i v e; each req u i rem en tm u s t b e m eti n o rd er fo r th e Co u rtt o d et erm in e t hatthe t ax p ay ers m u s t reg ro up . 1 7 Th e reg u l at i o n i l lu s trat es th e Co m

m is s i o n er’ s reg ro up i n g au t h ori t y i n an ex am

pl e i n v ol v i n g d o ct o rs wh o co n v ert eda p ort i o n o f t h ei r p ract i ces i n t o a p as s i v e i n co m e g en erat i ng act i v i t y . Th e fact s o f t h e ex am pl e s t at e: Tax p ay ers D, E, F, G, an dH are d o ct o rs wh o o p erat e s ep arat e m ed i cal p ract i ces . D i n ves t edi n a t ax s h el t er s ev eral y ears ag o t h at

1 6 Sec. 1 .4 69 -4 (f)(1 ), In co m e Tax Reg s . 1 7 See M i n ah an v . Co m

m i s s i o n er, 8 8 T.C. 4 9 2 , 4 9 7 (1 9 8 7 ).- 1 8 -

[* 1 8 ] g en erat es p as s iv e l os s es an dth e o th er d o ct o rs i n t en dt o i n ves ti n real es t at e t h atwi l l g en erat e p as s i v e l o s ses . Th e t ax pay ers fo rm a p art n ers h i p t o en g ag e i n th e t rad e o r b u s in es s o f acq u iri n g an d o p erat i n g X-ray

equ i p m en t . In ex ch an ge fo r equ i p m en t co n t ri b u ted t o th e p art n ers h ip , the t ax p ay ers recei v e l i m i t edp art n ers hi p i n teres t s . Th e p art n ers h i p i s m an ag edb y a g en eral p artn er s el ect edb y th e t ax p ay ers ; th e t ax pay ers d o n o tm at eri al l y p art i ci p at e i n i t s o perat i o n s . Sub s t an t i al l y

al l o f t h e p art n ers h i p ’ s s erv i ces are p ro v i d edt o th e t ax p ay ers o r t h ei r p at i en t s , ro u g h l y i n p ro p o rt i o n t o th e d o ct ors ’ i n t eres t s i n t h e p art n ers h i p . Fees fo r t h e p art n ers h ip ’ s s erv i ces are s et ata l ev el equ al t o th e am o u n t s th atwo ul db e ch arg edi f t h e p art n ers h i p were d eal i ng wi t h th e t ax p ay ers atarm ’ s l en gt h an dare ex p ect edt o as s u re t h e p art n ers h ip a p ro fi t . Th e t ax p ay ers treat th e p art n ers h i p ’ s s erv i ces as a s ep arat e act i vi t y fro m t h ei r m ed i cal p ract i ces an do ffs etthe i n co m e g en erat edb y the p art n ers h i p ag ai n s t th ei r p as s i v e l o s s es . [ 1 8 ] Th e ex am p l e i n t he reg u l at io n co n cl u d es th atth e Co m m is s i o n er can reg ro up th e t ax p ay ers ’ act i v i t i es i n t o a s i ng l e u n i t . Itex p l ai n s fu rt h er t h atth e t ax p ay ers ’
m ed i cal p ract i ce s erv i ces an dthe s erv i ces p ro v id edb y t h e p art n ers h i p are an ap p ro p ri at e eco n o m i c u n i t , an d t h e p ri n ci pal p u rp os e o f t reat i n g t h e m ed i cal p ract i ces an dth e s erv ices p ro v i d edb y the p art n ers h i p s as a s ep arat e act i v i t y i s t o ci rcu m v en tth e u n d erl y i n g p u rp o s es o f s ect i o n 4 6 9
. 1 9 Th e Co m m is s i o n er arg u es th atth e Hard y s’ fact s are al m o s t i den t i cal t o th e fact s o f t h e ex am

p l e i n th e reg u l at i o n s . He arg u es th at , s i m i lar t o t h e p art n ers h i p

1 8 Sec. 1 .4 69 -4 (f)(2 ), Ex am pl e, In co m e Tax Reg s . 1 9 Sec. 1 .4 69 -4 (f)(2 ), Ex am pl e, In co m e Tax Reg s .- 1 9 -

[* 1 9 ] i n th e ex am

p le i n th e reg u l at i o n , M BJ i s o wn edb y p h y s i ci an s , an dM BJ p ro v id es s erv i ces t o th ei r p at ien t s . Th e Hard y s d i st i n gu i s h th ei r fact s fro m th e fact s o f t h i s ex am

pl e. Th ey arg u e t h atDr. Hardy ’ s o wn ers h i p i n t eres t i n M BJ an dh i s m ed i cal p ract i ce d o n o t
co n st i tu t e anap pro pri at e eco n o m i c u n i tas a s i ng l e act i vi t y b ecau s e t h e act i v i t i es are d i fferen t t y

p es o f b u s i n es s es : M BJ i s a ren t al s u rg i cal faci l i t y an dDr. Hardy ’ s p ract i ce i s an act i ve m ed i cal p ract i ce. Ad d i t i o nal l y , th ey arg u e t h at t h ey

d i dn o t h av e a p ri n ci p al p u rp o s e o f ci rcu m v en t i n g s ect i o n 4 6 9 wh en th ey treat ed t he act i vi t i es as s ep arat e b ecau s e Dr. Hard y d i dn o tjo i n M BJ t o art i fi ci al l y creat e a p as s i v e act i v i t y

l os s . Th ey

co nt en dth ath e h ad a b u s i n es s p u rp o s e i n jo in i n g M BJ
. Aft er t ri al the IRS rel eas eda t ech n i cal ad v i ce m em o ran du m fu rt h er i l lu s trat i n g th e Co m

m i s s i o n er’ s reg ro upi n g au t h o ri t y . 2 0 A t ech n i cal ad v i ce
m em o ran du m

i s a d et erm i n at io n b as edo n th e s p eci fi c fact s o f a cas e an di s n o ta
ru l i n g o f g en eral ap p li cab i l it y . 2 1 Al t h o u g h we reco g n i ze t hata t ech ni cal ad v i ce
m em o ran du m

m ay n o t b e ci t edfo r i ts p reced en t i al v al u e, i td o es rev eal “ ‘ t h e i n t erp ret at io n p u tupo n th e s t atu t e b y th e ag en cy

ch arg edwi t h th e res p on s i b i l i t y o f

2 0 Tech . Adv . M em . 2 0 1 63 4 0 2 2 (Au g . 1 9, 2 0 16 ).
2 1 See Go l den Bel tTel . As s ’ n , In c. v . Co m m i s s i o n er, 1 0 8 T.C. 4 9 8 , 5 0 6 (1 9 7 7).- 2 0 -

[* 2 0 ] ad m in i s t eri n g th e rev en u e l aws ’ an dm ay p ro v i d e ‘ ev i d en ce’ th at s uch
co n st ru ct i o n ‘ i s co m

p el ledb y th e l an g u ag e o f th e s t atu t e.’ ” 2 2 Th e Hard y s arg ue t h at t h ei r fact s are s i m i lar t o th e fact s i n th e t ech n ical ad v ice m em o ran du m . Inth e t ech n i cal ad v ice m em o ran du m , th e t ax pay er i s a p h y s i ci an . Duri n g th e fi rs ty ear h e i s an em p l o y ee an dp art i al o wn er o f a m ed i cal p ract i ce. Du ri n g th e rem ai ni ng y ears i n i s s u e h e i s an em pl oy ee an dp art i al o wn er
o f a s eco n dm ed i cal p ract i ce. Bo t h m ed ical p ract i ces are S co rp o rat i on s . Du ri n g al l th e y ears th e p h y s i ci anh ada s m al l o wn ers h i p i n t eres ti n an LLC cl as s i fi edas a p art n ers hi p , wh i ch i n turn h el dan i n t eres ti n a s u rg ery cen t er al s o cl as si fi edas a p art n ers hi p . Anu n rel at eden t i ty o wn s t h e rem ai n i n g i n t eres ti n th e s u rg ery cen t er. Th e p hy s i ci an ex p l ai nedth atth e LLC was es t ab l i s h edb y a g ro up o f p h y s i ci an s t o acq u ire an i n t eres ti n t h e s u rg ery cen t er. Th e s u rg ery

cen t er p ro v i d es s u rg ery faci li t i es fo r qu al i fi edl i cen sedp h y s i ci an s. Th e p hy s i ci an s are n o treq u i redt o b e
o wn ers o f t h e p ract ice. An dth ey are n o ti n v o l v edi n th e d ay -t o -d ay m an ag em en t
o f t h e s u rg ery

cen t er. Th e p h y si ci anrep res en t edth atp hy s i ci an s can n otrefer t h ei r p at i en t s t o th e s u rg ery

cen t er wh en th ey

h o lda fi n an ci al i n t eres t . Ho wev er, t h e p at i en t s o ft en ch o s e t h e s u rg ery cen t er b ecau s e i twas m o re co s teffi ci en t . Th e

2 2 W o o d s In v . Co . v . Co m m i ss i o n er, 8 5 T.C. 2 7 4 , 2 8 1 n .1 5 (1 98 9 ) (qu o t i n g Han ov er Ban kv . Co m

m i s s i o n er, 3 6 9 U.S. 6 72 , 6 86 -6 8 7 (1 9 6 2 )).- 2 1 -

[* 2 1 ] p h y s i ci an al s o ex p l ai n ed t h atth e i nco m e g en erat ed b y th e s u rg ery

cen t er i s
n o tt i edt o th e n um

b er o f s u rg eri es h e p erfo rm s atth e s u rg ery cen t er. An db efo re th e o p en i n g o f t h e faci li t y , th e s u rg eri es th atco u l dn o t b e p erfo rm ed i n th e p h y s i ci an ’ s p ract i ce were p erfo rm edata l o cal h o s p i t al . Th e rev en u e g en erat edb y th e s u rg ery

cen t er t h ro u g h faci l i t y

ch arg es i s s ep arat e fro m

th e ch arg es fo r m ed i cal
s erv i ces ren d ered b y t h e p h y s i ci an t o h i s p at i en t s . Th e p h y s i ci an h adp as s iv e act i vi ty l os s es an ds u s p en d edl o s s es . Th e p h y s i ci antreat edthe i n co m e fro m th e LLC as p as s i v e an dd educt edth e en t i re p as s iv e act iv it y l o s s . 2 3 In th e t ech n i cal ad vi ce m em o ran du m , th e IRS ex pl ai n edth at t h es e fact s are d i s t i n gu i sh ab l e fro m

tho s e o f t h e ex am

pl e p ro v id edi n s ect i o n 1 .4 69 -4 (f)(2 ), In co m e Tax Reg s . Inl o o k i n g atth e fact s an d ci rcu m s t an ces p ro vi d ed i n s ect i o n 1 .4 69 -4 (c), Ex am

p l e, In co m e Tax Reg s ., th e IRS ex p l ai n edi n th e t ech n i cal ad v i ce
m em o ran du m

th atth ere i s m o re t h an o n e way t o g ro up th e act i v i t ies i n t o ap p ro p ri at e eco n o m i c u n i t s . Th e IRS l o ok edatth e fact th atth e p h y s ici an an dth e
s u rg ery cen t er p ro v i d e d i fferen tty p es o f m ed i cal s erv i ces . Th e p h y s i ci an h as d i fferen t o wn ers h i p i n t eres t s an dco n t ro l . An d , th e s erv i ces p at i en t s recei v e at t h e
s u rg ery cen t er d o n o tco n s t i tu t e al l o f t h e s erv i ces p erfo rm edatthe s u rg ery cen t er.

2 3 Tech . Adv . M em . 2 0 1 63 4 0 2 2
.- 2 2 -

[* 2 2 ] Th us , th e IRS ex p l ai n ed t h atth ere m ay b e m o re t h an o n e reas o n ab l e m et h o d
o f g ro up i n g the t ax p ay er’ s act i v i t i es i n t o an ap p ro p ri at e eco n om i c u n i t . 2 4 Li k ewi s e, the IRS d et erm i n edth at t h e fact s d o n o ts up p o rt a fi n d in g th atth e p h y s i ci anacq u i red h i s i n t eres twi t h a p ri n ci p al p u rp os e o f ci rcu m v en t i n g th e
u n d erl y i n g p u rp o s es o f s ect i o n 4 6 9 . Th e IRS ex p l ai n edth atu n l ik e t h e d o ct o r i n th e ex am p le i n t h e reg u l at i on , th e p h y s i ci an i n th e t ech n i cal ad v i ce m em o ran du m d i dn o t co n v erta p ort i on o f h i s p ract i ce i n to a s in g l e p as s i ve i n co m e g en erat o r b y
co n tri b u t i n g equ i pm en tt o a s ep arat e en t i t y an d l eas i n g b ackth e eq u i pm en tat
arm ’ s -l en g t h rat es . Thu s , th e IRS co n cl u d edth at t h e Co m m i s s i on er d o es n o th av e th e au th o ri t y

t o reg ro up th e p h y s i ci an ’ s i n t eres ti n t o a s i ng l e act i vi t y . 2 5 Th e Co m m is s i o n er arg u es th atth e fact s i n t h i s cas e are d i s t i n g u i s h ab l e fro m th e fact s i n the t ech n i cal ad vi ce m em o ran du m . Th e Co m m is s i o n er’ s p ri n ci p al arg u m en ti s th atth e Hardy s o ri g i n al l y g ro up edDr. Hardy ’ s m ed i cal p ract i ce wi t h M BJ . Ho wev er, as p rev i o u s l y ad dres s ed , wh en th e Hard y s rep o rt edth ei r M BJ i n co m e as n onp as s i v e fo r 2 00 6 an d2 00 7 , th ey d idn o t g ro up Dr. Hard y ’ s
o wn ers hi p i n t eres t i n M BJ an dh i s m ed ical p ract i ce i n t o a s i n g le eco n o m ic u n i t .

2 4 Tech . Adv . M em . 2 0 1 63 4 0 2 2
. 2 5 Tech . Adv . M em . 2 0 1 63 4 0 2 2
.- 2 3 -

[* 2 3 ] Th e Co m

m i s si o ner m ai n t ai n s th atth e fact s are m o re cl o s el y al i g n edwi t h th o s e o f t h e ex am

p le i n th e reg u l at i o n . W e d i s ag ree. Th ere i s m o re t h an o ne reas o n ab l e m eth o do f g ro upi n g Dr. Hardy ’ s act i vi t i es . Sect io n 1 .4 6 9 -4 (c)(1 ), In co m e Tax Reg s ., p ro v i d es a l i st o f fact s an d ci rcu m s t an ces t h atare g i v en th e g reat es twei g h ti n d et erm i n i n g wh et h er t h e act i vi t i es are an ap p ro p ri at e eco n o m i c u n i t . Th e fact s i n t h i s cas e l en ds upp o rtt o
m o re th an o ne reas o n ab l e m et h o do f g ro up in g Dr. Hard y ’ s o wn ers h i p i nt eres ti n M BJ an dh i s m ed i cal p ract ice. Wh i l e s o m e fact s s up p o rttreat i n g Dr. Hardy ’ s o wn ers h i p i n t eres ti n M BJ
an d h i s m ed i cal p ract i ce as a s i n g l e eco n o m ic u ni t , th e wei gh to f th e ev i den ce
s up p ort s treat i ng th em as s ep arat e eco n om i c u n i ts . Dr. Hardy i s t h e s o l e o wn er o f h i s m ed ical p ract i ce an do n l y a m i no ri t y

o wn er o f M BJ . Al t h o u gh h e act i v el y
m an ag es h i s m ed i cal p ract i ce, Dr. Hard y d o es n o t h av e an y

m an ag em en t
res p o n s i b i l i t ies in M BJ . Hi s m ed i cal p ract i ce an dM BJ d o n o t s h are an y b u i l d i n g
s p ace, em p l o y ees , b i l l in g fu n ct i o n s , o r acco u n t in g s erv ices
. Dr. Hardy p erfo rm s
s erv i ces d i fferen tfro m

M BJ ’ s : Dr. Hardy

i s a s u rg eo n p ro v i d i n g care, an dM BJ i s
a s u rg i cal cen t er p ro v id in g s p ace an das s o ci at eds erv i ces . Dr. Hardy i s l i m i t edi n th e care h e can p ro v i de at h i s o ffi ce. Hi s o ffi ce i s equ i pp edfo r p ro cedu res req u i ri n g l o cal an es t h es i a wh ereas M BJ i s equ ip p edfo r p ro cedu res req u iri n g l o cal- 2 4 -

[* 2 4 ] o r g en eral an es t h es i a. Wh en p at i en t s d eci d e t o h av e p ro cedu res p erfo rm ed atM BJ , th ey s ep arat el y

p ay a s u rg i cal fee t o Dr. Hard y an da faci l i t y fee t o M BJ
. M BJ th en d i s t ri bu t es earn i n g s fro m th o s e faci l it y fees , b u t t h e d i s t ri b u t i o n i s
u n rel at edt o wh et h er Dr. Hard y p erfo rm s s urg eri es atM BJ
. Inco n t ras t , Dr. Hardy wi l l recei v e i n co m e fro m h i s m ed i cal p ract i ce o n ly i f h e p erfo rm s p ro cedu res . Th u s, the i n co m e Dr. Hardy recei ves fro m M BJ i s n o tl i n k edt o h i s m ed i cal p ract i ce. Acco rd i n gl y , Dr. Hardy ’ s o wn ers hi p i n t eres ti n M BJ an dh i s m ed i cal p ract i ce m ay

b e t reat edas s ep arat e eco n om i c u n i ts . 2 6 Ad d it i on al l y , th e Hardy s d i dn oth av e a p ri n ci p al p u rp o s e o f ci rcu m v en t i n g th e u n derl y i n g p u rp o s es o f s ect i o n 4 6 9 wh en th ey treat ed t h e act i v i ti es as s ep arat e. Un l ik e t h e t ax p ay ers i n th e ex am p l e i n s ect i o n 1 .4 6 9 -4 (f)(2 ), In co m e Tax Reg s ., Dr. Hard y

d i d n o tfo rm

an en t i ty t o g en erat e p as s iv e act iv it y l o s s es . M BJwas al read y es t ab li s hedwh en Dr. Hardy b ecam e a m em ber. M o reo v er, Dr. Hard y h as
n ev er b een ab le t o p erfo rm p ro cedu res req u i ri n g g en eral an es t h es i a atNo rt h wes t Pl as t ic Su rg ery . Thu s , h e d i dn o tt ak e a p o rt i o n o f h i s m ed ical p ract i ce an d
co n vert i ti n t o a p as s i v e act i v i ty . Ad d i t i o n al l y , th e Hardy s co n s i d eredo p en i n g

2 6 Becau s e t h e Hardy s m ay g ro up Dr. Hardy ’ s act i v i t i es i n m o re t h ano n e way , th e Hard y s’ g ro upi n g was n o ta “ cl earl y i n ap pro p ri at e” o n e wh ich wo u l d req u i re t hem

t o reg ro up th ei r act i v i t i es u n d er s ect i o n 1 .4 6 9-4 (e) an d(f)(1 ), In co m e Tax Reg s .- 2 5 -

[* 2 5 ] th ei r o wns u rg i cal faci l i t y b efo re Dr. Hard y

b ecam e a m em

b er o f M BJ . Iti s cl ear t h ath i s p u rp o s e i n jo i n i n g M BJ was t o creat e a co s t -effi ci en tal tern at i v e t o a h o s p it al p ro cedu re an dn o t t o g en erat e p as s i v e act i v i ty l o ss es . Acco rd i n g l y , th e Hard y s’ p ri n ci p al p u rp o s e was n o tt o av oi dth e u nd erl y i n g p u rp o ses o f s ect i o n 4 6 9
. Th e Co m

m is s i o n er m ay

n o treg ro up Dr. Hardy ’ s act i v it i es fo r t h e y ears i n i s su e. Th e Co m

m i ss i o n er m ay

n o treg ro up a t ax p ay er’ s g ro up i n g i f t h at g ro up i n g i s reas on ab l e. 2 7 Th e fact s o f t hi s cas e are v ery s im il ar t o th os e p res en t edi n Tech
. Ad v . M em . 2 0 1 6 3 4 0 22 , i n wh i ch th e IRS al l o weda m ed ical p ract i ce an da
s u rg i cal cen ter t o b e t reat edas s ep arat e act i v i t i es . Al t h o u g h the t ech n i cal ad v i ce
m em o ran du m

i s n o t p reced en t i al , 2 8 i ts h o ws t h atth e Hard y s ’ g ro up in g was n o t cl earl y i n ap p ro p ri at e. 2 9 Fu rt h er, t h ey d i dn o t h av e a p ri nci p al p u rp o s e o f ci rcu m v en t i n g t h e u n d erl y i ng p o l i ci es o f s ect i o n 4 6 9
.

2 7 Sec. 1 .4 69 -4 (c)(2 ), (f)(1 ), In co m e Tax Reg s . 2 8 Sec. 6 1 10 (k )(3 ).
2 9 See s ec. 1 .4 6 9 -4 (e)(2 ), In co m e Tax Reg s .- 2 6 -

[* 2 6 ] C. Th e Hard y s M ay N o tDedu cta Pas s i v e Act i v it y Lo s s Carry o v er Fro m Pri o r Years
. In fi n d i n g th atth e Hard y s m ay rep o rtDr. Hardy ’ s i n co m e fro m M BJ as p as s i v e fo r t h e y ears i n i s s u e, we are l eftt o d et erm i ne t he p ro p er am o un to f t h e p as s i v e act i v i t y

l os s carry o v er fro m

p ri o r y ears . Sect i on 6 2 1 4(b ) p ro v i d es th ati n red et erm i n i n g a d efi ci en cy i n i n co m e t ax fo r an y

t ax ab l e y ear, we m

u stco n s i d er fact s rel at i n g t o t h e t ax fo r o th er y ears as m ay b e n eces s ary

co rrect l y t o red et erm i n e t h e am o u n to f t h e d efi ci en cy fo r t h e y ear b efo re u s . Becau s e t h e Hard y s cl ai m

th atth ey h ada p as s i ve act i v i t y

l o s s th atcarri edo v er t o 2 0 0 8 (a y ear b efo re u s ), we m

u s tl o okt o t h e p ri o r y ears t o co m p u t e t h e p ro p er am o u nto f t h at p as s i v e act i v i t y

l os s carry o v er. Aft er al l , a t ax p ay er i s en t i t l edt o a p as s i v e act i vi t y l o s s carry o v er o n l y

wh en th ere i s an ex ces s o f p as s iv e l o s s es o ver p as s i v e i n co m e. 3 0 An d“ we fi n dn o i m p ed i m en tt o o u r u se o f fact s i n a l at er y ear as p arto f th e p ro ces s o f reco m

p ut i n g a t ax l i ab i li t y

fo r an earl i er b arred y ear i n o rd er t o arri v e atth e co rrect t ax l i ab i l i t y fo r an o p en y ear i n i s s ue”. 3 1 W e h av e co n cl u d edth atth e Hard y s d i dn ot g ro up Dr. Hardy ’ s o wn ers h i p i n t eres ti n M BJwi t h h is m ed i cal p ract ice fo r 2 0 0 6 o r 2 0 0 7
. An dwe h av e

3 0 Sec. 4 6 9(b ).
3 1 Lo n e M an o r Farm s , In c. v . Co m m i s s i on er, 6 1 T.C. 4 36 , 4 4 1 (1 9 74 ), aff’ d wi th o u tp ub l i s hedo p i n i o n , 5 1 0 F.2 d 9 70 (3 d Ci r. 1 97 5 ).- 2 7 -

[* 2 7 ] co ncl u d edth atDr. Hardy m ay treat h i s o wn ers h i p i nt eres t i n M BJ as p as s i v e. Th atl ead s u s t o th e i n es cap ab l e co n cl u s i o n thatth e Hard y s erro n eo u s l y treat ed Dr. Hard y ’ s i n co m e fro m M BJ as n o np as si v e fo r 2 0 0 6 an d2 0 0 7. Th e Hard y s rep o rt ed a t ot al u n al l o w edl o ss o f $ 5 8 , 7 8 6 fo r 2 00 6
. Fo r 2 00 7 th ey rep o rt edu n al l owedl o ss es o f $ 1 1 9 ,6 1 5 , wh i ch i n cl u dedth e $ 5 8 ,7 86 carry o v er fro m 2 0 06 . Th e Hard y s rep o rt edDr. Hardy ’ s d i s t ri b ut io n s fro m M BJ o f $ 27 9 ,9 8 8
an d $ 1 9 9 ,1 2 1 as n o np as s iv e fo r 2 0 0 6 an d2 0 0 7 , res p ect i v el y . Hadth e Hard y s p ro p erl y rep o rt edth e M BJ i n co m e as p as s iv e fo r 2 00 6 an d2 00 7 , i two u l d h av e fu l l y ab s orb edth ei r p as s i v e l os s es an d t h ere wo ul dh av e b een n o p as s i v e l os s t o carryfo rwardt o 2 0 0 8 . Acco rd i n g l y , th ey are n o ten t i t l ed t o th e fu l l p as s i v e act i vi ty l os s d edu ct io n cl ai m ed
. Th e Hard y s arg ue fo r t h e fi rs tt i m e i n th ei r o p en in g b ri ef t h atth e d o ct ri n e o f equ it ab l e reco up m en tap p l i es . Equ i t ab le reco upm en ti s an affi rm at i v e d efen s e. 3 2 Sect i o n 6 2 1 4(b ) g ran t s th e Co u rtjuri s d ict i o n t o co n s i d er cl ai m s o f eq u i t ab l e
reco up m en t ; h o wev er, t h e p art y rai si n g an affi rm at i v e d efen s e wi ll wai v e t h e d efen s e i f t h ey d o n o ts p eci fi cal l y p l eadi t . 3 3 W e h av e en t ert ai nedan arg u m en tfo r

3 2 M en ard , In c. v . Co m

m is s i o n er, 1 3 0 T.C. 5 4 , 6 2 -6 3 (2 0 0 8 ); W o l fi n g t o n v . Co m m i s s i o n er, T.C. M em o . 2 0 1 4 -4 5 , at* 1 2
. 3 3 See Ru l e 3 9 ; W o l fi n g to n v . Co m m i s s i o n er, at* 1 2
.- 2 8 -

[* 2 8 ] equi t ab l e reco up m en twh en the Co m m i s si on er h ad n o t i ce o f t h e arg u m en t b efo re t ri al , 3 4 b u t h ere, t h e Co m m i s s i o n er h adn o s u ch n o t i ce. Th e Hard y s d i d n o t p l eadequ i t ab l e reco up m en ti n th ei r p et i t i o n , an dth ey h av e n o tm o v edt o am en dth ei r p et i t i o n . Th ey h av e wai v edthi s d efen s e. III. Wh et h er t he Hard y s Are Li ab l e fo r Sel f-Em p l o ym en tTax o n Dr. Hardy ’ s Di s t ri b u t i v e Sh ares o f In co m e Fro m M BJ A. M o t i o n To Co n fo rm th e Pl ead i n g s In ap p ro p ri at e ci rcu m s t an ces , we m ay treatan i s s u e th atwas n o tex p res s l y p l ead ed bu twas tri edb y

ex p res s o r i m

p l i edco n sen to f t h e p art i es as i f rai sedi n th e p l ead i n g s . 3 5 Ho wev er, wh et h er a m o ti o n t o co n fo rm th e p l ead i n g s s h o u l db e al l o wed is wi t hi n t h e d i s cret i o n o f t h e Co u rt . 3 6 If t h e o p p os i n g p art y i s p reju d i ced
o r u n fai rl y

s u rp ri sed , th enth e m o t i o n s ho u l db e d en i ed
. 3 7

3 4 See, e.g ., Wh al en v . Co m m i s s i o n er, T.C. M em o. 2 0 0 9 -3 7 (ex p l ai n in g th at th e Co u rten t ert ai n edan arg u m en t o f eq u i t ab l e reco up m en tb ecau se t h e Co m m i s s i o n er was p u to n n o t i ce wh en th e i ss u e was rai s edi n th e p ret ri al m em o ran du m ).

3 5 Ru l e 4 1 (b )(1 ); LeFev er v . Co m m i s s i o ner, 1 0 3 T.C. 5 25 , 5 3 8 -5 3 9 (1 9 9 4 ), aff’ d , 1 0 0 F.3 d7 7 8 (1 0 t h Ci r. 1 9 9 6 ).

3 6 Co m m i s s i o n er v . Es tat e o f Lo n g, 3 0 4 F.2 d1 36 , 1 44 (9 t h Ci r. 1 9 62 ); Es t at e o f Qu ick v . Co m

m i ss i o n er, 1 1 0 T.C. 1 7 2 , 1 7 8 -1 80 (1 9 98 ).
3 7 See, e.g ., Es t at e o f Qu i ckv . Co m m i s s i o n er, 1 1 0 T.C. at1 7 8-1 8 0; Ph i l l i p s v . Co m m i s s i o n er, T.C. M em o . 2 0 1 3 -2 1 5 , at* 9
.- 2 9 -

[* 2 9 ] Aft er a rev i ew o f t h e en t i re reco rd , we fi n dth atth e factu al i ss u es g iv i n g ri s e t o the Hard y s ’ m o t i o n were rai s eddu ri n g tri al wi t h t h e Co m m i s s i o n er’ s co n s en t . Th e ev i d en ce o n wh i ch th e Hard y s b as e t h ei r m o t i o n was ad m i t t edattri al i n th e p art i es ’ s t i p u l at i o n o f fact s . Th e Co m m i ss i o ner ad dres s edth e l i ab i l i t y fo r s el fem pl o y m en tt ax i n h is o p en i ng b ri ef. Acco rd i n g l y , we wi ll g ran t t h e Hard y s ’
m o ti o n t o co n fo rm

the p l ead i n g s t o th e ev id en ce t h atth ey are n o tl i ab l e fo r s el fem pl o y m en tt ax fo r 2 0 0 8 o r 2 0 0 9
. B. Li m i tedPart n ers Act i n g as In v es t ors Sect io n 1 4 0 1 (a) an d(b ) i m p o s es a t ax o n s el f-em

p l o ym en ti n co m e. “ Sel fem pl o y m en ti n co m e” g en eral l y

m ean s n etearn i n g s fro m s el f-em p l o ym en t, 3 8 wh i ch i n turn m ean s g ro s s i nco m e l es s al l o wab l e d educt i o ns fro m a t ax pay er’ s trad e o r b u s i n es s p l u s th e “ d i s t ri bu t i v e s h are (wh ether o r n otd i s tri b ut ed ) o f i n co m e o r l o s s d es cri b edi n s ect i o n 7 0 2 (a)(8 ) fro m an y trad e o r b u s i nes s carri edo n b y a p art n ers hi p o f wh i ch h e i s a m em b er”. 3 9 Sect i o n 7 0 2 (a)(8 ) p ro v i d es th ati n d et erm i n i n g i n co m e t ax , each p art n er m u s tt ak e i n t o acco u n t s ep arat el y h i s d i s tri b u t i v e s h are o f th e p artners h i p ’ s t ax ab l e i n co m e o r l o s s . Th erefo re, a p art n er

3 8 Sec. 1 4 02 (b ).
3 9 Sec. 1 4 02 (a).- 3 0 -

[* 3 0 ] m us tg en eral l y i n cl ud e h is d i s t ri b u t iv e s h are o f p art ners h i p i n co m e i n cal cu l at in g h i s n etearn i ng s fro m s el f-em p l o ym en t. Sect io n 1 4 0 2 (a) p ro v i d es s ev eral ex cl u si o n s fro m t h e g en eral ru le. In p art i cu l ar, s ect i o n 1 4 02 (a)(1 3 ) ex cl u des “ t h e d i s t ri b ut i v e s h are o f an y i t em o f i n co m e o r l o s s o f a l i m i tedp art n er, as s u ch , o t h er t han g u aran t eedp aym en t s d es cri b edi n s ect i o n 7 0 7 (c) t o th atp art n er fo r s erv i ces actu al l y ren d eredt o o r o n b eh al f o f t h e p art n ers h i p t o t h e ex t en tth atth o s e p aym en t s are es t ab l i s h edt o b e i n th e n atu re o f rem

u n erat i o n fo r t h o s e s erv i ces ”. Th e Co m m i s s i o n er arg u es th atthe
s ect i on 1 4 0 2 (a)(1 3 ) ex cl u s i o n d o es n o tap p ly i n thi s cas e. He arg u es t h atb ecau s e Dr. Hard y

p erfo rm s s u rg eri es atM BJ , h e i s n o t act i n g as a l i m i t ed p artn er. W e d i s ag ree. Th e Co d e d o es n o t d efi n e “ l i m i t ed p art ner” fo r p u rp os es o f s ect i o n 1 4 0 2 (a)(1 3 ). Ho wev er, we d i s cu s s edth e d efi n i t i o n o f l im i t edp art ner i n Ren kem ey er, Cam

p b el l & W eav er, LLP v . Co m m i s s i o n er, 1 3 6 T.C. 1 3 7 (2 0 1 1 ). In th at cas e, t h e p art n ers were l awy ers o perat in g o uto f a l aw fi rm , wh i ch was fo rm edas a l i m i t edl i ab i l i t y p art n ers h ip
. 4 0 Th e l aw fi rm recei v ed rev en ue fro m t h e p art n ers ’ l eg al fees , b u t t h e fi rm d idn o trep o rtth o se rev enu es o n th e fi rm ’ s t ax

4 0 Ren kem ey er, Cam

p b el l & W eav er, LLP v . Co m m i ss i o ner, 1 3 6 T.C. 1 3 7 , 1 3 8 -1 3 9 (2 0 1 1 ).- 3 1 -

[* 3 1 ] retu rn as n et earn i n g s fro m s el f-em p l o y m en t . 4 1 Th e Co m

m i s s i o ner d et erm i n edth atth e p art n ers ’ d is t ri b u ti v e s h ares o f th e l aw fi rm ’ s n etb u s i nes s i n co m e were s ubjectt o s el f-em p l o ym en tt ax . 4 2 W e ag reed
. 4 3 Becau s e s ect i o n 1 4 0 2 (a)(1 3 ) was en act edb efo re l i m i t edl i ab i l i t y en t i t i es were co n t em

p l at edan d th e t erm “ l i m i t edp art n er” rem ai n edu n d efi n ed , we i n t erp ret edth e s tatu t e b y l o o k i n g atl eg i s lat i v e h i s t ory an d ex p lai n ed t hat [t ] h e i n t en t o f s ect i o n 1 4 0 2 (a)(1 3) was t o en s u re thati n d iv i dual s wh o m erel y i n v es t ed i n a p artn ers h i p an dwh o were n otact i v el y p art i ci pat i n g i n th e p artners h i p ’ s b u si n es s o p erat i o n s (wh i ch was th e arch ety p e o f l i m i t edp art n ers atth e t i m e) wo u l d n o t recei v e cred i t s t o wardSo ci al Secu ri ty

co v erag e. Th e l eg i s l at i v e h is t ory o f s ect i o n 1 4 0 2 (a)(1 3 ) d o es n o ts upp o rta h ol d i n g th atCo n g res s co nt em p l at ed ex cl ud i n g p art n ers wh o p erfo rm eds erv i ces fo r a p art n ers h i p i n t h ei r cap aci t y as p art n ers (i .e., act i n g i n th e m an n er o f s el f-em p l oy ed p ers on s ), fro m l i ab il i t y

fo r s el f-em

p l o ym en t t ax es . [ 4 4 ] W e h el dth atb ecau s e t h e rev en u e was d eri v ed fro m l eg al s erv i ces p erfo rm edb y th e p art n ers i n th ei r cap aci t y as p art n ers , th ey

were n o tact i n g as i n v es t o rs i n th e l aw fi rm . Thus , we h el dthatthey were l i ab l e fo r s el f-em

p l o ym en tt ax .

4 1 Ren kem ey er, Cam

p b el l & W eav er, LLP v . Co m m i ss i o ner, 1 3 6 T.C. at1 4 0
. 4 2 Ren kem ey er, Cam

p b el l & W eav er, LLP v . Co m m i ss i o ner, 1 3 6 T.C. at1 4 1
. 4 3 Ren kem ey er, Cam

p b el l & W eav er, LLP v . Co m m i ss i o ner, 1 3 6 T.C. at1 4 6
. 4 4 Ren kem ey er, Cam

p b el l & W eav er, LLP v . Co m m i ss i o ner, 1 3 6 T.C. at 1 4 8 -1 5 0
.- 3 2 -

[* 3 2 ] Dr. Hardy

i s an i n v es t or i n M BJ , wh i ch i s d i s t i n g u i sh ab l e fro m th e l i m i t ed l i ab i l i ty part ners h ip fo rm edb y th e p art n ers i n th e l aw fi rm i n Ren kem ey er, Cam p b el l & W eav er, LLP v . Co m m is s i o n er. M BJ o wn s an do p erat es a s urg i cal
cen t er. M BJ i s eq u i p p edfo r d o ct o rs t o p erfo rm s u rg eri es th atreq u i re l o cal an d g en eral an es th es i a. M BJ b i l l s p at ien t s fo r t he u s e o f th e faci l it y . Al th o u g h Dr. Hard y perfo rm s s u rg eri es atM BJ , h e i s n o ti n v ol v edi n t h e o p erat i o n s o f M BJ as a b u s i n es s . Inco n t ras tt o th e p art n ers i n Ren k em ey er, Cam pb el l & W eav er, LLP, wh o are l awy ers p ract i ci n g l aw an d recei v in g d is t ri bu t i v e s h ares b as edo n t h o s e fees fro m p ract i ci ng l aw, 4 5 Dr. Hardy i s recei v i n g a d i s t ri b ut i o n b as edo n th e fees th atp at i en t s p ay

t o u s e t h e faci l i t y . Th e p at i en t s s ep arat el y p ay Dr. Hardy

h i s fees
as a s u rg eo n , an d t h ey s ep arat el y p ay the s u rg i cal cen t er fo r u s e o f t h e faci l i t y i n th e s am e m an n er as wi t h a h o s p i t al . Acco rd i ng l y , Dr. Hardy ’ s d i s t ri b u t i v e s h ares
are n o ts ub

jectt o s el f-em

p l o ym en tt ax b ecau se h e recei v ed t h e i nco m e i n h i s cap aci ty as an i n v es t o r. IV. Sect io n 6 6 6 2 Sect io n 6 6 6 2 (a) an d(b ) i m p o s es a 2 0 % accu racy -rel at ed p en al t y o n an y p o rt i on o f an u n d erp aym en to f t ax t h ati s du e t o, am on g o t h er t h i n g s , an y

4 5 Ren kem ey er, Cam

p b el l & W eav er, LLP v . Co m m i ss i o ner, 1 3 6 T.C. at 1 3 8 -1 3 9
.- 3 3 -

[* 3 3 ] n eg l i g en ce o r d i s reg ardo f ru l es o r reg u l at io n s o r a s ub s t an t ial
u n d ers t at em en to f i n co m e t ax . Th e t erm “ neg l i g en ce” i n cl u d es an y fai l u re t o m ak e
a reas on ab l e at t em

p t t o co m p l y wi t h th e p ro v i s i o n s o f t h e Co d e, an dth e t erm

“ d i sreg ard ” i n cl ud es an y

carel es s , reck l es s , o r i n t en t i o n al d i s reg ard
. 4 6 Neg l i g en ce h as b een fu rt h er d efi nedas a “ lacko f du e care o r fai l u re t o d o wh ata reas o n ab l e
an d o rd i n ari l y

p ru d en t p ers on wo u l dd o u nd er t h e ci rcu m s t an ces .” 4 7 Ad d it i o n al l y , a t ax p ay er i s n eg l i g en t i f h e fai l s t o m ai n t ai n s u ffi ci en treco rd s t o s ub s tan t iat e t h e i t em s i n qu es t io n. 4 8 Anu n d ers t at em en t o f i n co m e t ax i s “ s ubs t an ti al ” wh enth at
u n d ers t at em en tex ceed s th e g reat er o f 1 0 % o f th e t ax req u i redt o b e s h own o n th e retu rn o r $ 5,0 0 0
. 4 9 Th e Co m m is s i o n er b ears th e b u rd en o f p ro du ct i o n fo r t h i s p en al ty b efo re th e b u rd en s h i ft s t o t ax p ay ers t o p ro v e t h atth e p en al t y s ho u l dn o tap p ly
. 5 0 Th e Co m m i s s i o n er h as n o t p ro v en th atth e Hard y s act edn eg l i g en t l y . Th e

4 6 Sec. 6 6 62 (c).
4 7 Neel y v . Co m m is s i o n er, 8 5 T.C. 9 3 4 , 9 4 7 (1 9 8 5 ) (qu o ti n g M arcel l o v . Co m m i s s i o n er, 3 8 0 F.2 d4 9 9 , 5 0 6 (5 t h Ci r. 1 9 6 7 ), aff’ g i n p art , rem an d i n g i n p art 4 3 T.C. 1 6 8 (1 9 64 ) an d T.C. M em o . 1 9 6 4 -2 9 9 ).

4 8 See Hi g bee v . Co m

m i s s i o n er, 1 1 6 T.C. 4 3 8 , 4 4 9 (2 0 0 1 ); s ec. 1 .6 6 62
- 3 (b )(1 ), In co m e Tax Reg s .

4 9 Sec. 6 6 62 (d )(1 )(A).
5 0 See s ec. 7 4 91 (c); Hi g b ee v . Co m m i s s io n er, 1 1 6 T.C. at4 4 6 -4 4 7
.- 3 4 -

[* 3 4 ] Co m

m i s si o n er d i dn o tp ro v i de an y ev i d en ce th atan y

p o rt i o n o f t h e
u n d erp aym en t o f t ax was du e t o th e Hard y s’ fai l u re t o m ak e a reas on ab le at t em p t t o co m p l y wi t h th e Co d e, l acko f du e care o r fai lu re t o d o wh ata reas o n ab l e an d
o rd i n ari ly p ru d en t p ers o n wo u ldd o, o r fai l u re t o m ai nt ai n s u ffi ci en treco rd s . Acco rd in g ly , th e Co m

m i ss io n er h as n o tm et h i s b u rd enreg ard i n g n eg l i g en ce. Ho wev er, i n acco rd an ce wi t h th i s o p i ni o n, t he Hard y s ’ ex actu n d erp aym en t fo r each y ear d ep en d s o n th e Ru l e 1 5 5 co m pu t at i o n s . If th es e co m

p u t at i o n s
es t ab l i s h a s ub s t an ti al u n d ers t at em en to f i n co m e t ax fo r an y y ear, t h e Co m m i s s i o n er wi ll h av e m eth i s b u rd en o f p ro du ct i o n wi t h res p ect t o th aty ear. 5 1 If t h e Ru l e 1 5 5 co m

p u t at i o n s es t ab l i s h a s ubs t an t i al u n d ers t at em en to f i n co m e t ax fo r an y

y ear, t h e accu racy -rel at edp en al t y wi l l n o t ap p l y

t o an y p o rt i o n
o f t h e u n d erp aym en t wh ere t he t ax p ay ers es t ab l i s h thatth ey h adreas on ab l e cau se
an d act edi n g o od fai t h
. 5 2 Tax p ay ers m ay es t ab l i s h thatth ey

h adreas o n ab l e cau s e
an d act edi n g o od fai t h thro u g h rel i an ce o n th e ad v i ce o f a t ax p ro fes s i o n al
. 5 3 Th e rel i an ce m

us th av e b een reas o nab l e an d i n g o odfai t h u nd er al l th e

5 1 See Ol ag u n

juv . Co m

m i s s i o n er, T.C. M em o . 2 0 1 2 -1 1 9 ; J arm an v . Co m m i s s i o n er, T.C. M em o . 2 0 1 0 -2 8 5
. 5 2 Sec. 6 6 64 (c)(1 ).
5 3 Neo nat o l o g y As s o cs ., P.A. v . Co m m i s s io n er, 1 1 5 T.C. 4 3 , 9 8 (2 00 0 ), aff’ d , 2 9 9 F.3 d2 2 1 (3 dCi r. 2 0 0 2 ); s ec. 1 .6 6 6 4 -4 (c), In co m e Tax Reg s .- 3 5 -

[* 3 5 ] ci rcu m st an ces . 5 4 To d em o n s t rat e t h atthe rel i an ce was reas o nab l e an di n g o o dfai th , th e t ax p ay er m u s tp ro v e b y

a p rep o nd eran ce o f t he ev i d en ce t h at“ (1 ) [t ] h e ad v is er was a co m

p et en tp ro fes s io n al wh o h ads u ffi ci en tex p ert is e t o ju s t i fy rel i an ce, (2 ) t h e t ax p ay er p ro vi d edn eces s ary an d accu rat e i n fo rm at io n t o the ad v is er, an d (3 ) t h e t ax p ay er act u al l y rel i edi n g o o dfai t h o n t h e ad v i s er’ s ju d g m en t .” 5 5 Tak i n g i n t o co n s i d erat i o n al l th e fact s an d ci rcu m s t an ces , we fi ndth atth e Hard y s reas o n ab l y

rel iedo n M r. Kero i n g o o dfai t h reg ard i n g t he p o rt i o n o f t h e
u n d erp aym en t fo r 2 0 0 8 th ati s at t ri b u t ab l e t o the p as s i v e act i v i ty l o ss carry o v er. M r. Kero h as 4 0 y ears o f ex p eri en ce. He p rep aredth e ret u rn s fo r 2 0 06 th ro u g h 2 0 1 0 . He rep o rt edth e i n co m e fro m M BJ as n onp as s i v e fo r 2 0 06 an d 2 0 0 7 an d p as s i v e fo r 2 00 8 thro u g h 2 0 1 0 , an d t h e Hard y s p ro vi d ed h i m wi t h co rro b orat i n g i n fo rm at i o n . Al th o u g h h e u n d ers t o o dth atch aract eri zi n g i n co m e as p as s i v e o r
n o np as s i ve can h av e a p ro fo un deffect o n a t ax p ay er’ s i n co m e, h e d idn o t t ak e i n t o
acco u n t th e p ro p er ch aract eri zat i o n o f Dr. Hard y ’ s i nco m e fro m M BJwh en
co n si d eri n g th e am o un to f t h e p as s i v e act i v i t y l o s s carry ov er. Th e Hardy s rel i ed

5 4 Neo nat o l o g y As s o cs ., P.A. v . Co m m i s s io n er, 1 1 5 T.C. at9 8 -9 9 ; s ec. 1 .6 66 4 -4 (b )(1 ), (c), In co m e Tax Reg s .

5 5 Neo nat o l o g y As s o cs ., P.A. v . Co m m i s s io n er, 1 1 5 T.C. at9 9
.- 3 6 -

[* 3 6 ] o n h is ad v i ce an dex p eri en ce i n p rep ari n g th ei r return s . Acco rd i n g l y , th e Hard y s h adreas o n ab le cau s e an dact edi n g o odfai t h t h ro u gh rel i an ce o n th e ad v ice o f a t ax p ro fes s i on al
. Th e Hard y s d i d n o t p ro v i d e an y ev i d en ce reg ard i ng th e p o rt i o n o f t h e
u n d erp aym en t fo r each y ear t h ati s at t ri b u t ab l e t o th e d i sal l owedch ari t ab l e
co n tri b u t i o n d edu ct i o n . Acco rd i n g l y , th ey h av e n o tes t ab li s h edth at t hey h ad
reas on ab l e cau s e an dact ed i n go o d fai t h wi t h res p ectt o th e p o rt i o n o f t he
u n d erp aym en t fo r each y ear ari s i n g fro m th ati tem . V. Co n cl u si o n Th e Hard y s m ay

treat th ei r i n co m e fro m

M BJ as p as s i v e. Ho wev er, t h ey h av e n o tes t ab l i sh edth atth ey m ay d edu ctth e p as s i v e act i v i t y l o s s carry o v er fro m y ears i n wh i ch t h ey

treat edth e i n co m e as n o np as s i v e. Fo r 2 0 0 8 an d2 0 0 9 th e Hard y s o v erp ai dthei r s el f-em pl o ym en t t ax b ecau s e Dr. Hard y ’ s d i s t ri b u t i v e s h are fro m M BJ i s ex cl u d edfro m

n etearn i n g s fro m

s el f-em p l oym en t . Th e Co m m i s s i o n er d i dn o tm eeth i s b u rd en o f p ro du ct i o n reg ard i n g the s ect i o n 6 6 6 2(a)
accu racy -rel at edp en al ti es fo r n eg l i g en ce; h o wev er, h e m ay h av e m eth i s b u rd en o f p ro duct i o n fo r u nd erp aym en t s at t ri b u t ab l e t o s ubs t an ti al u nd ers t at em en t s o f i n co m e t ax i f t h e Ru le 1 5 5 co m p u t at i o ns es t ab li s h s ub s t an t i al u n d ers t at em en t s o f i n co m e t ax . If thatth res h o ldi s m et fo r an y y ear, n o p en al t y ap p l i es t o th e p o rt io n- 3 7 -

[* 3 7 ] o f t h e u n d erp aym en tfo r t h aty ear at t ri b u tab l e t o the p as s i v e act i v i ty l o s s carry o ver b ecau se t h e Hard y s es t ab l i s h edthatth ey h adreas o n ab l e cau s e an dact ed i n g o o d fai t h thro ug h rel i an ce o n th e ad v ice o f a t ax p ro fes s io n al . Becau s e t h e Hard y s d i dn o t p ro v i d e an y d efen s e fo r an y o f t h e y ears i n i s su e fo r t h e p o rt i o n o f th e u n derp aym en t th ati s at t ri b u t ab l e t o t he ch ari tab l e co n t ri b u ti o n d edu ct i o n , th ey h av e n o tes t ab l i sh edan y

d efen s e t o a p en al t y at t ri b u tab l e t o th atp o rt i o n o f t h e
res u l ti n g u n d erp aym en t . Anap p ro p ri at e o rd er wi ll b e i s s u ed , an dd eci s i o n wi ll b e en t eredu n d er Ru l e 1 5 5.