T.C. Memo. 1998-296

UNITED STATES TAX COURT

TERRY F. AND CAROL J. ZDUN, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 12933-96. Filed August 17, 1998. 

William P. Koontz, for petitioners.

Kathey I. Shaw and Ann M. Murphy, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

PARR, Judge: Respondent determined deficiencies in, and 

penalties on, the Federal income tax for 1992, 1993, and 1994 of

Terry F. Zdun (petitioner) and Carol J. Zdun (Mrs. Zdun) as

follows: 

 Accuracy-Related Penalty

Year Deficiency Sec. 6662(a)

1992 $6,668 $1,334
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1 Respondent determined that petitioner was an employee of

a denturist from whom he rented an equipped office, rather than a

self-employed dentist. In the notice of deficiency, respondent

disallowed petitioners' self-employment tax deductions of $1,027,

$993, and $747 for 1992, 1993, and 1994, respectively. After

trial, respondent conceded that petitioner was self-employed

during the years at issue.

1993 9,683 1,937

1994 10,019 2,004

All section references are to the Internal Revenue Code in

effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure, unless otherwise

indicated. All dollar amounts are rounded to the nearest dollar,

unless otherwise indicated.

After concessions by the parties,1 the issues for decision

are: (1) Whether petitioners' apple orchard activity and

dentistry activity should be treated as one activity or two

separate activities for purposes of section 183, and whether

petitioners' apple orchard activity was engaged in with the

intent to make a profit within the meaning of section 183 during

the years at issue. We hold petitioners' apple orchard activity

and dentistry activity are two separate activities within the

meaning of section 183. We further hold petitioners' apple

orchard activity was not engaged in with a profit objective under

section 183. (2) Whether petitioners are liable for an accuracyrelated penalty pursuant to section 6662(a) for 1992, 1993, and
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2 At the end of trial, respondent moved orally to increase

the amount of the deficiency for each year if the Court found

that petitioner was self-employed. The Court denied this motion. 

We hold, however, that to the extent the amount of each

deficiency is not increased, petitioners are liable for selfemployment tax on petitioner's self-employment income. See secs.

1401 and 1402.

1994. We hold they are.2

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. 

The stipulated facts and the accompanying exhibits are

incorporated into our findings by this reference. At the time

the petition in this case was filed, petitioners were married and

resided in Tiller, Oregon.

The Dentistry Activity

Petitioner has been licenced to practice dentistry since

1967, and is licensed to practice in California, Michigan, and

Oregon. In addition to a consulting office in his home,

petitioner maintains dental offices in Grants Pass and Medford,

Oregon. Mrs. Zdun, who is a qualified dental assistant, assists

petitioner when he sees patients at their home office. 

Throughout the years at issue, petitioner devoted 3 days a week

to his dental practice. 

Petitioner practices what he calls holistic dentistry. 

According to petitioner, an organic apple is a special fruit rich

in vitamins, antioxidants, and bioflavonoids that contribute to

the health of gums and oral tissues. Thus, he counsels his
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patients to eat organic apples for their dental health. 

The Apple Orchard Activity

In 1982, petitioners moved from California to a 151-acre

homestead they purchased in Tiller. In the following year,

petitioners cleared the indigenous growth from 5 acres

surrounding their house and planted apple trees. The trees began

producing fruit sometime in the mid-1980's, and petitioner

estimates that he had 150 to 170 mature trees during the years at

issue. In 1992, however, due to a hard freeze, which is not

uncommon at the elevation of petitioners' property, no apples

were produced. Petitioner estimates that the trees produced

approximately 40,000 pounds of fruit in 1993 and 1994.

Petitioners do not hire any labor to help with the orchard;

petitioner does all the heavy work, including picking the apples.

Mrs. Zdun, who has a bad back, works at least 4 hours in the

orchard each day during the apple season, July through December. 

Although petitioner estimates that the orchard produced

40,000 pounds of apples during 1993 and 1994, he did not pick all

the apples that were produced. Instead, he picked only the best

apples and threw away many of the others.

Although organic apples are available for purchase in the

areas where petitioner practices, it has been his experience that

his patients will eat the apples only if they are made easily

available to them. To facilitate his patients' access to organic
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apples, petitioner grows the apples, picks and bags them, and

then takes the bags to his offices for sale to his patients. 

Thus, petitioner considers his apple orchard an integral part of

his dental practice. 

Petitioner testified that he has tried, but prefers not, to

sell the apples commercially. Some of the apples have suffered

injury from insects and are otherwise marked which makes much of

his fruit less valuable on the commercial market; thus, in

petitioner's opinion the profit margin from commercial sales is

not good. Instead, he prefers to grow the best, most nutritious

apples that he can and provide them to his patients. If a

patient cannot afford to purchase the apples, petitioner gives

them to the patient without charge. Petitioner estimates that of

all his patients, only 10 or 15 percent avail themselves of the

apples. There is no question that petitioners have never made a

profit with respect to the apple orchard activity during their

14-year involvement with the fruit.

Petitioners' Tax Returns 

Petitioners formed a partnership, Twin Creeks Organic Farm,

in 1992. Petitioners are the only partners in the partnership. 

For reporting purposes, petitioners combined their dentistry

activity gross receipts with their apple orchard activity income

and expenses on one Form 1065 (U.S. Partnership Return of

Income). In each of the years at issue, petitioners reported the
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3 The record does not show whether petitioners filed a

Schedule C (Profit or Loss From Business) with their Form 1040

(U.S. Individual Income Tax Return) for 1994.

income and expenses from the apple orchard activity on Schedule F

(Profit or Loss From Farming) and attached the schedule to Form

1065. In 1992 and 1993, petitioners reported the income from the

dental practice on Schedule C (Profit or Loss From Business),

which was attached to petitioners' Form 1040.3 In 1992,

petitioners transferred the dental practice income from Schedule

C to the Form 1065 filed by Twin Creeks Organic Farm, reporting

the dental practice income as if it were partnership gross

receipts, and then netted that amount with the apple orchard

losses. In 1993, petitioners transferred the dental practice

income from Schedule C to Schedule F, as farm income, and

attached Schedule F to Form 1065. In 1993 and 1994, petitioners

netted the income from the dentistry activity with the apple

orchard activity income on Schedule F and reported that net

amount as partnership income on Form 1065.

Petitioners reported dentistry activity gross receipts and

apple orchard activity income and expenses as follows:

Item 1992 1993 1994

Gross receipts:

Dentistry $57,920 $68,400 $67,600

Apple orchard -0-1 1,7002 8502

Expenses incurred:

Farm expenses3 ($23,008) ($56,052)4 ($57,887)4

Other expenses (19,462)5
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1 In 1992, petitioners improperly reported $500 of gross income

from the farm on Schedule F; this amount represents the

unrealized increase in value of their horse. The amount of

revenue from the sale of apples, or any other farm related

activity, was $0.

2 Although petitioners reported sales of farm products of $1,700

and $850 on Schedule F in 1993 and 1994, respectively, an unknown

portion of the amount reported in 1993 and $700 of the amount

reported in 1994 was for the estimated value of apples they

consumed.

3 These amounts are taken from part ll of petitioners' Schedule

F.

4 These amounts are the totals of the farm expenses reported on

line 35 of petitioners' Schedules F. The reported expenses

include a deduction for "Other expenses", which was reported

separately on line 34a of the schedules filed for 1993 and 1994. 

The amount of the Other expenses was $18,590 in 1993 and $22,455

in 1994.

5 This "Other expense" was reported on line 20 of petitioners'

Form 1065. The expenses were itemized on a self-made schedule

titled "Twin Creeks Organic Farm", which was attached to the

partnership return. 

OPINION

Issue 1. The Apple Orchard Activity

The first issue for decision is twofold: (1) Whether

petitioners' apple orchard activity and dentistry activity should

be treated as one activity or two separate activities for

purposes of section 183; and (2) whether petitioners' apple

orchard activity was engaged in with the intent to make a profit

within the meaning of section 183(a). Respondent determined that

petitioners' apple orchard activity is a separate and distinct

undertaking from the dentistry activity, and furthermore

petitioners engaged in the apple orchard activity with no bona

fide objective of profit. We agree.
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Separate or Single Activity

Section 1.183-1(d), Income Tax Regs., provides, where the

taxpayer is engaged in several undertakings, each of these may be

a separate activity, or several activities may constitute one

activity. In ascertaining whether two or more activities of the

taxpayer may be treated as one activity, we consider all of the

facts and circumstances, including the degree of organizational

and economic interrelationship, the business purpose served by

the undertakings together or separately, and the similarity of

the undertakings. Id.; see also Schlafer v. Commissioner, T.C.

Memo. 1990-66. The Commissioner will generally accept the

characterization by the taxpayer of several undertakings either

as a single activity or as separate activities. Sec. 1.183-1(d),

Income Tax Regs. The taxpayer's characterization will not be

accepted, however, when it appears that his or her

characterization is artificial and cannot be reasonably supported

under the facts and circumstances of the case. Id. If two

undertakings are treated as separate activities, deductions and

income from each separate activity are not aggregated either in

determining whether a particular activity is engaged in for

profit or in applying section 183. Id.

Respondent determined that petitioners' apple orchard

activity is separate and distinct from the dentistry activity. 

Petitioner asserts that the two undertakings are related in that

he cannot practice holistic dentistry without his apple orchard.
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Respondent's determinations are presumed correct, and petitioners

bear the burden of proving otherwise. Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).

An examination of the entire record fails to reveal any

evidence linking the two undertakings. Petitioners' trees

produce apples from August through December, and petitioners

testified that they have no facility for cold storage of the

fruit, yet petitioner is able to practice dentistry all year

round. Furthermore, petitioner testified that only 10 or 15

percent of his patients actually take his apples, even when he

provides the apples to them for no cost. The evidence does not

support a conclusion that the apple orchard is necessary to

either his dental practice or his patients. Thus, we find no

degree of organizational or economic relationship between the two

undertakings. Moreover, we do not accept petitioner's testimony

that a business purpose is served by carrying on the apple

orchard activity and dentistry activity together as a single

activity, nor do we find any similarity between the two.

In light of the criteria stated in section 1.183-1(d),

Income Tax Regs., and considering the facts and circumstances of

the instant case, we find that petitioners' apple orchard

activity and dentistry activity are two separate and distinct

activities within the meaning of section 183 as determined by

respondent.
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Apple Orchard Not Engaged In For Profit

As we have decided that petitioners' undertakings are two

separate activities, we now consider the income and expenses of

the apple orchard activity separately in deciding whether the

apple orchard activity was conducted with a profit objective. 

Section 183(a) generally limits the amount of expenses that a

taxpayer may deduct with respect to an activity "not engaged in

for profit" to the deductions provided in section 183(b). 

Section 183(b)(1) provides that deductions that would be

allowable without regard to whether such activity is engaged in

for profit are to be allowed. Section 183(b)(2) further provides

that deductions which would be allowable only if such activity

were engaged in for profit are to be allowed, but only to the

extent that the gross income derived from such activity during

the taxable year exceeds the deductions allowable under section

183(b)(1). An activity is "not engaged in for profit" if it is

an activity other than one with respect to which deductions are

allowable for the taxable years under section 162 or under

paragraph (1) or (2) of section 212. Sec. 183(c). 

In determining whether an activity is engaged in for profit,

the taxpayer must show that he or she engaged in the activity

with an "actual and honest objective of making a profit." 

Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), affd. without
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opinion 702 F.2d 1205 (D.C. Cir. 1983); Golanty v. Commissioner,

72 T.C. 411, 426 (1979), affd. without published opinion 647 F.2d

170 (9th Cir. 1981). Although the taxpayer's expectation of a

profit need not be reasonable, he or she must have a good faith

objective of making a profit. Dreicer v. Commissioner, supra at

645; Dunn v. Commissioner, 70 T.C. 715, 720 (1978), affd. on

another issue 615 F.2d 578 (2d Cir. 1980); sec. 1.183-2(a),

Income Tax Regs. Petitioners bear the burden of proving the

requisite intent. Golanty v. Commissioner, supra at 426. 

Whether a taxpayer is engaged in an activity with the requisite

profit objective is determined from all the facts and

circumstances. Hulter v. Commissioner, 91 T.C. 371, 393 (1988);

Golanty v. Commissioner, supra at 426; sec. 1.183-2(a) and (b),

Income Tax Regs. Petitioners assert that they engaged in the

apple orchard activity with the objective of making a profit;

however, more weight is given to objective facts than to the

taxpayers' mere statement of their intent. Dreicer v.

Commissioner, supra at 645; sec. 1.183-2(a), Income Tax Regs. 

The regulations promulgated under section 183 list the

following nine factors that should normally be taken into account

in determining whether an activity is engaged in for profit: (1)

The manner in which the taxpayer carried on the activity, (2) the

expertise of the taxpayer or his advisers, (3) the time and

effort expended by the taxpayer in carrying on the activity, (4)
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the expectation that the assets used in the activity may

appreciate in value, (5) the success of the taxpayer in carrying

on similar or dissimilar activities, (6) the taxpayer's history

of income or loss with respect to the activity, (7) the amount of

occasional profits, if any, which are earned, (8) the financial

status of the taxpayer, and (9) the extent to which elements of

personal pleasure are involved. Sec. 1.183-2(b), Income Tax

Regs. The list of factors in the regulations is not exclusive,

and other factors may be considered in determining whether an

activity is engaged in for profit. No single factor is

determinative. Golanty v. Commissioner, supra at 426; sec.

1.183-2(b), Income Tax Regs. The determination of a profit

objective does not depend on counting the number of factors that

support each party's position. Dunn v. Commissioner, supra at

720; sec. 1.183-2(b), Income Tax Regs.

A review of the entire record in this case persuades us that

petitioners have failed to carry their burden of proving that

their apple orchard activity was engaged in for profit. We find

that all of the above enumerated factors weigh against

petitioners.

First, the manner in which the taxpayer carries on the

activity is one indication of whether a profit objective exists. 

Sec. 1.183-2(b)(1), Income Tax Regs. Elements relevant to this

factor include whether the taxpayer maintained complete and
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accurate books and records, whether the activity was conducted in

a manner substantially similar to comparable businesses that are

profitable, and whether changes were attempted in order to

improve profitability. Engdahl v. Commissioner, 72 T.C. 659,

666-667 (1979).

Petitioners assert that they have maintained records for

their activities. However, their books of account for the apple

orchard consist of their bank deposit slips, check stubs, and tax

forms. Petitioners have two bank accounts, one in the name of

petitioner and the other in the name of Twin Creeks Farm.

Petitioner testified that when he received money, from whatever

source, he deposited it in whichever account needed the money. 

He further testified that he used both accounts as family

accounts.

Petitioners did not present any production records for the

apple orchard. In fact, at trial petitioner was not even certain

of the exact number of trees in the orchard. Thus, we find that

petitioners kept no separate complete and accurate books or

production records for the orchard activity.

Although petitioners' tax preparer, Susan Bladorn-Dukes,

testified that petitioners' canceled-checks method of recording

income and expenses was much like that of other farmers for whom

she prepares tax returns, she also testified that most of those

farms were "absolutely not" self-supporting. Thus, we do not
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find that petitioners' apple orchard activity is an activity

carried on in a manner substantially similar to other activities

of the same nature which are profitable. 

Petitioner testified that he made several changes in the

manner of operating the orchard. For example, he discontinued

spraying ground-up insects on the trees as a method of pest

control because it was too labor intensive. He also changed his

ground cover from a fescue type to a clover type because the

clover returns more nitrogen to the ground, allowing him to forgo

chemical fertilization. Finally, he replaced the overheadirrigation system he had installed previously with a ground-level

system.

Although these changes may have reduced petitioners' labor

burden, there is no evidence that the changes were made so that

the activity would become more profitable, or that the changes

were the abandonment of unprofitable methods. For instance,

petitioner testified that the ground-up insect method is an

effective method of pest control, but he abandoned it because it

was too much work. Petitioner did not provide any evidence of

the cost effectiveness of his present method of pest control

compared to the abandoned method. Nor did petitioner proffer any

evidence that he was actually using chemical fertilizers before

he changed the type of ground cover; therefore, there is no

evidence that the change was an abandonment of an unprofitable
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method in an attempt to improve profitability. Thus, we do not

conclude that these changes indicate a profit motive.

It is clear from the record that petitioners failed to

maintain complete and accurate books and records for the apple

orchard activity, did not conduct the activity in a manner

substantially similar to other comparable, profitable businesses,

and did not make changes in order to improve profitability. 

Accordingly, we find this factor weighs against petitioners.

Second, preparation for the start of an activity through

extensive study of its accepted business, economic, and

scientific practices, or consultation with those who are experts

therein indicates that the taxpayer has entered into the activity

for profit. Sec. 1.183-2(b)(2), Income Tax Regs. Petitioner

testified that although he had never raised any type of

commercial farm product before he and Mrs. Zdun purchased the

Tiller property, he had, however, "dabbled" in organic gardening

with his father and another man on 1 or 2 acres in Santa Maria,

California. Petitioner testified that he had attended shows and

exhibits on organic gardening, as well as a course on how to

prune fruit trees. In addition, petitioner consulted with his

neighbor, who has 2,000 trees, about how to grow trees in his

area. Finally, petitioner received advice about planting his

trees from the company in Michigan from which he ordered the

trees.
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Petitioner's testimony indicates that his preparation for

the apple orchard activity was casual, intermittent, and shortterm, rather than extensive. Petitioner did not mention how

attending the shows, exhibits, course on pruning trees, or

conversations with his neighbor in any way aided petitioners in

making the apple orchard activity profitable. Furthermore, there

is no evidence in the record that petitioners conducted a

thorough investigation into the profitability of their apple

orchard activity. They did not present evidence that they had a

business plan, or that they had made projections of revenue,

expenses, or profits that they expected would be generated by the

apple orchard activity. It is unlikely that one would incur such

substantial expenses with respect to an activity, which he or she

intends to be profitable, without first making a complete

investigation of how to do so. Pederson v. Commissioner, T.C.

Memo. 1994-555. Accordingly, we find this factor weighs against

petitioners. 

Third, the time and effort expended by the taxpayer in

carrying on the activity is an indication of whether a profit

motive existed. Sec. 1.183-2(b)(3), Income Tax Regs. 

Petitioners did expend time on their apple orchard activity as 

Mrs. Zdun testified that she spent 4 hours each day during the

apple season, and petitioner testified that he spent between 500

and 600 hours per year. Although the time that petitioners spent
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4 On an annual basis, petitioner spent between 9 and 12

hours per week in the orchard.

in the orchard was not extensive,4 it was apparently enough to

grow approximately 40,000 pounds of apples during 1993 and 1994. 

Petitioner testified that he did all of the picking himself;

however, he did not pick all of the apples. Thus, petitioner did

not make sufficient effort to profit by the time that he and Mrs.

Zdun spent in the orchard for the Court to find that making a

profit was the motive for their time in the orchard. We find

that this factor weighs against petitioners. 

Fourth, an expectation that the assets used in the activity

may appreciate in value is an indication of a profit motive. The

term "profit" encompasses an appreciation in the value of assets,

such as land, used in an activity. Thus, the taxpayer may intend

to derive a profit from the operation of the activity, and may

also intend that, even if no profit from current operations is

derived, an overall profit will result when appreciation in the

value of land used in the activity is realized since income from

the activity together with the appreciation of land will exceed

expenses of operation. Sec. 1.183-2(b)(4), Income Tax Regs. 

Petitioner asserts that one of the reasons he planted the trees

was to increase the value of the Tiller property, and that the

apple orchard has increased the property value by a minimum of 
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$500 per tree. Petitioners therefore assert that the appreciated

value of the land plus the trees will more than offset any losses

they take on current tax returns.

Other than petitioner's self-serving testimony, there is no

evidence on record to support his assertion of the value of the

trees. Although as coowner of the apple trees, petitioner is

qualified to testify as to their value, we are not required to,

and we do not, accept his self-serving testimony on this point. 

Harmon v. Commissioner, 13 T.C. 373, 383 (1949).

Even if we accepted, arguendo, petitioner's valuation of the

apple trees, and that petitioners have held the Tiller property

with the expectation of making an overall profit from the

operation due to the appreciation of the value of the land, this

factor would still not favor petitioners. The last sentence of

section 1.183-2(b)(4), Income Tax Regs., cross-refers to

paragraph (d) of section 1.183-1 for a definition of an activity

in this connection. Section 1.183-1(d)(1), Income Tax Regs.,

provides:

Where land is purchased or held or held primarily with

the intent to profit from increase in its value, and

the taxpayer also engages in farming on such land, the

farming and the holding of the land will ordinarily be

considered a single activity only if the farming

activity reduces the net cost of carrying the land for

its appreciation in value. Thus, the farming and

holding of the land will be considered a single

activity only if the income derived from farming

exceeds the deductions attributable to the farming

activity which are not directly attributable to the

holding of the land (that is, deductions other than
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those directly attributable to the holding of the land

such as interest on a mortgage secured by the land, 

annual property taxes attributable to the land and

improvements, and depreciation of improvements to the

land).

It is clear from petitioners' Schedules F that the costs

attributed to the orchard activity (apart from those directly

attributable to the holding of the land) substantially exceed the

income from the apple sales. Thus, petitioners do not satisfy

the test set forth in section 1.183-1(d), Income Tax Regs., for

combining their farming activity with their holding of the land

into a single profit-motivated activity. We find that this

factor weighs against petitioners.

Fifth, the fact that the taxpayer has engaged in similar

activities in the past and converted them from unprofitable to

profitable enterprises may indicate that he is engaged in an

activity for profit even though the activity is presently

unprofitable. Sec. 1.183-2(b)(5), Income Tax Regs. Petitioners

have never before engaged in commercial farming of any type. We

find that this factor weighs against petitioners. 

The taxpayer's history of income, losses, and occasional

profits with respect to an activity can be indicative of a profit

objective. Sec. 1.183-2(b)(6) and (7), Income Tax Regs. The

presence of losses in the formative years of a business is not

inconsistent with an intention to achieve a later profitable

level of operation, bearing in mind, however, that the goal must
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be to realize a profit on the entire operation, which presupposes

not only future net earnings but also sufficient net earnings to

recoup the losses that have meanwhile been incurred in the

intervening years. Bessenyey v. Commissioner, 45 T.C. 261, 274

(1965), affd. 379 F.2d 252 (2d Cir. 1967). We find it

significant that although petitioners' trees have been bearing

enough fruit to sell to the public since the mid-1980's, at no

time during petitioners' involvement in the apple orchard

activity did they realize a profit. Given the record of losses

over the 3 years at issue, we see no possibility that petitioners

ever intended to be able to recoup their substantial

expenditures. Accordingly, we find these factors weigh against

petitioners.

Substantial income from sources other than the activity in

question may also be an indication of the lack of a profit

objective especially where losses from the questioned activity

produce substantial tax benefits. Sec. 1.183-2(b)(8), Income Tax

Regs. Petitioner quite successfully carried on a part-time

dentistry practice earning more than $193,000 during the years at

issue. With such an income, petitioners could well afford a

hobby farm, particularly when it is partially financed through

the tax benefit derived from taking the losses.

Finally, the presence of personal motives in carrying on of

an activity may indicate that the activity is not engaged in for
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profit, especially where there are recreational or personal

elements involved. Sec. 1.183-2(b)(9), Income Tax Regs. In his

testimony, petitioner described the orchard in terms of how it

relates to petitioners' house. He described how the trees are

planted right up to the house, and how the air is filled with the

perfume of the blossoming trees. It is clear from petitioner's

testimony that petitioners planted the orchard with the intent of

living in a house nestled among flowering trees, and that they

derive great personal pleasure from living in the idyllic setting

they created. 

An activity will not be treated as not engaged in for profit

merely because the taxpayer derives personal pleasure from

engaging in the activity if the activity is in fact engaged in

for profit as evidenced by other factors. Id. The record in

this case, however, is entirely bereft of any evidence that

petitioners engaged in the activity with an honest and actual

objective of making a profit. Thus, we find that this factor

weighs against petitioners as personal pleasure is the dominant

factor in their undertaking the activity.

Accordingly, on the basis of all the facts and circumstances

of the instant case, and the factors considered in section 1.183-

2(b), Income Tax Regs., we find that petitioners did not have an

actual and honest objective to make a profit with respect to the

organic apple orchard activity within the meaning of section 183.
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Issue 2. Accuracy-Related Penalty Under Section 6662

Respondent determined that petitioners are liable for

accuracy-related penalties pursuant to section 6662 of $1,334,

$1,937, and $2,004 for 1992, 1993, and 1994, respectively. 

Respondent asserts that the section 6662(a) penalty in each year

is due to a substantial understatement of tax. See sec.

6662(b)(2). Petitioners assert that they are not liable for the

section 6662(a) penalty, because they reported all of their

income and the correct amount of tax for each of the years at

issue.

Section 6662(a) imposes a penalty in an amount equal to 20

percent of the portion of the underpayment of tax attributable to

one or more of the items set forth in subsection (b). Section

6662(b)(2) provides that section 6662 shall apply to any portion

of the underpayment attributable to any substantial

understatement of income tax. There is a substantial

understatement of income tax if the amount of the understatement

for the taxable year exceeds the greater of (1) 10 percent of the

tax required to be shown on the return, or (2) $5,000. Sec.

6662(d)(1)(A). For purposes of section 6662(d)(1),

"understatement" is defined as the excess of tax required to be

shown on the return over the amount of tax that is shown on the

return reduced by any rebate. Sec. 6662(d)(2)(A).
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5 In addition to disallowing certain deductions, respondent

determined that computational adjustments should be made which

would preclude petitioners from claiming the earned income credit

during the years at issue.

6 This subsection was amended by Omnibus Budget

Reconciliation Act of 1993, Pub. L. 103-66, sec. 13251(a), 107

Stat. 531, effective with respect to returns the due dates for

which (determined without regard to extensions) are after Dec.

31, 1993. The amended subsection provides, in part, that the

(continued...)

After adjustments,5 respondent determined that the amounts

of tax required to be shown on the returns are $7,701, $9,994,

and $9,473, and that the amounts of the understatements of tax

are $6,668, $9,683, and $10,019, for 1992, 1993, and 1994,

respectively. As each of these amounts exceeds the greater of 10

percent of the tax required to be shown on the return or $5,000

for the year at issue, respondent applied the penalty at issue. 

Petitioners assert that there was no understatement, and that if

the Court finds there was substantial understatement, the penalty

should not apply because reporting all of their income and

deductions on their tax returns is adequate disclosure.

Section 6662(d)(2)(B) provides that the amount of the

understatement shall be reduced by the portion of the

understatement that is attributable to tax treatment of any item

if: (1) There is or was substantial authority for such treatment;

or (2) if the relevant facts affecting the item's treatment are

adequately disclosed in the return or in a statement attached to

the return.6 
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6(...continued)

understatement shall be reduced by that portion of the

understatement which is attributable to 

(ii) any item if--

(I) the relevant facts affecting the item's tax

treatment are adequately disclosed in the return or in a

statement attached to the return, and

(II) there is a reasonable basis for the tax treatment

of such item by the taxpayer.

Thus, for 1993 and 1994, petitioners must not only

adequately disclose the relevant facts affecting the item's tax

treatment, but must also have a reasonable basis for such tax

treatment. Due to our finding that petitioners did not disclose

the relevant facts affecting the item's tax treatment, we do not

address whether petitioners had a reasonable basis for the tax

treatment of the item.

Respondent's regulations provide two types of disclosure

under section 6662(b)(2): Disclosure in attachments attached to

the return, sec. 1.6662-4(f)(1), Income Tax Regs., and disclosure

on the return, sec. 1.6662-4(f)(2), Income Tax Regs. Petitioners

did not attach a statement to their return; therefore we look to

the return to decide whether disclosure was adequate.

The Commissioner may by annual revenue procedure (or

otherwise) prescribe the circumstances under which disclosure of

information on a return in accordance with applicable forms and

instructions is adequate. Sec. 1.6662-4(f)(2), (5), Income Tax

Regs. The Commissioner issued Rev. Proc. 93-33, 1993-2 C.B. 470

(extending the application of Rev. Proc. 92-23, 1992-1 C.B. 737,

to 1992 returns), Rev. Proc. 94-36, 1994-1 C.B. 682, and Rev.

Proc. 94-74, 1994-2 C.B. 823, for tax years using 1992, 1993, and

1994 tax forms, respectively, which identify circumstances under
- 25 -

which the disclosure on a taxpayer's return of a position with

respect to an item is adequate disclosure for purposes of

reducing the understatement of income tax under section 6662. 

The expenses claimed by petitioners are not within the safe

harbor provided by the revenue procedures. If the revenue

procedure does not include an item, disclosure is adequate with

respect to that item only if made on a properly completed Form

8275 or 8275-R, as appropriate, attached to the return for the

year. Sec. 1.6662-4(f)(2), (5), Income Tax Regs. Petitioners

did not attach either form to their returns. Therefore, listing

the expenses related to the apple orchard activity on the tax

returns does not, by virtue of the revenue procedures, constitute

adequate disclosure under section 6662(d)(2)(B).

On their returns, petitioner reported his occupation as

"Farmer/Dental Nutrition", and Mrs. Zdun reported her occupation

as "Farmer/Nutrition Expert". Petitioners transferred the income

from the dentistry activity from Schedule C (Profit or Loss From

Business) to Schedule F (Profit or Loss From Farming), which was

attached to Form 1065 (U.S. Partnership Return of Income), and

then back to Form 1040. We note that petitioners' method of

reporting dental practice income grossed up the farm income,

providing the apple orchard activity with the appearance of a
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7 For example, in 1993 the apple orchard activity generated

actual sales of less than $1,700, yet petitioners reported net

farm profit of $14,048 by including petitioner's $68,400 of

dentistry income on Schedule F as farm income.

profit-making activity.7 Reporting income actually earned as a

dentist as income earned from an apple orchard is

misrepresentation, not disclosure.

We conclude that petitioners have failed to provide adequate

disclosure for purposes of section 6662(d)(2)(B), and we find

that petitioners are liable for the accuracy-related penalty for

each of the years at issue.

Decision will be entered

under Rule 155.