1Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years under

consideration, and all Rule references are to this Court's Rules

of Practice and Procedure.

T.C. Memo. 1997-503

UNITED STATES TAX COURT

DAVID E. AND CHERYL G. SMITH, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 17071-95. Filed November 10, 1997.

Jon R. Vaught, for petitioners.

Kimberley J. Peterson, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Judge: Respondent, by means of a statutory notice

of deficiency, determined the following income tax deficiencies

and section 6662(a)1 penalties with respect to petitioners:
- 2 -

2However, petitioners have not conceded that they are liable

for the increased sec. 6662(a) accuracy-related penalties

asserted in respondent's Amendment to Answer.

 Penalty 

Year Deficiency Sec. 6662

1990 $11,276 $2,255

1991 22,232 4,446

1992 36,483 7,297

By way of an amendment to respondent's answer, respondent

sought increased deficiencies and penalties against petitioners

under section 6214 for each of the years in issue, alleging that

petitioner David Smith received taxable distributions from a

pension plan under section 72(p) and (t). Respondent asserted

that petitioners are liable for increased income tax deficiencies

and section 6662 penalties of:

 Penalty

Year Deficiency Sec. 6662

1990 $3,185 $637

1991 13,939 2,788

1992 21,413 4,283

The increases result in combined income tax deficiencies and

penalties in controversy as follows:

 Penalty

Year Deficiency Sec. 6662 

1990 $14,461 $2,892

1991 36,171 7,234

1992 57,896 11,580

On brief, petitioners conceded that petitioner Mr. Smith received

distributions from his pension plan taxable under section 72(p)

and (t).2 The following issues remain for our consideration: (1)
- 3 -

Whether petitioners' dog-breeding activity during the taxable

years 1990, 1991, and 1992 was engaged in for a profit; and (2)

whether any underpayment of tax is due to negligence or

intentional disregard of rules or regulations.

FINDINGS OF FACT

At all times relevant to this case petitioners were husband

and wife and resided in Los Gatos, California. They filed joint

Federal income tax returns for all 3 years at issue.

David Smith (Mr. Smith) is a medical doctor and was employed

as a vascular surgeon during the taxable years at issue at Good

Samaritan Hospital in San Jose, California. Mr. Smith generally

worked 10 hours per day, 5 days a week as a physician. In

addition, he was required to be "on-call" as a physician every

third night and every third weekend. Cheryl Smith (Mrs. Smith)

was not employed outside of petitioners’ household during the

taxable years at issue. 

Mr. Smith received wages from his medical practice totaling

$289,347, $278,419, and $242,960 for the taxable years 1990,

1991, and 1992, respectively. In addition to the wages, Mr.

Smith received rental income from the leasing of medical

equipment to Good Samaritan Hospital. His net rental income was

$47,872, $51,957, and $38,405 for the taxable years 1990, 1991,

and 1992, respectively. Petitioners also owned an agricultural
- 4 -

business named Madera Farm. Primarily, farm income was from the

sale of figs and pistachios.

Petitioners first became involved in dog-showing activities

in 1987 when they purchased their first show dog, a standard

poodle. Although petitioners had no interest in dog-breeding

activity in 1987, they built a kennel at their Los Gatos

residence in order to care for a growing number of dogs. 

Petitioners became interested in dog-breeding activity during

1989, at which time they began to consult with dog breeders and

research the subject of dog breeding. Mr. Smith also attended

veterinarian seminars for dog breeders.

Petitioners, in addition to breeding standard poodles (a

more common breed), decided to breed Portuguese water dogs (a

rare breed) in the hopes of commanding higher prices. Their goal

was to produce the highest quality dog possible. Mr. Smith did

not prepare formal spreadsheets on the potential profitability of

dog breeding, but he did estimate the annual potential to earn

between $30,000 and $50,000 in gross receipts from dog breeding. 

Mr. Smith did not commit these estimates to writing. Petitioners

did not consult with economic advisers or accountants prior to

beginning their dog-breeding activity.

Petitioners placed their names on a waiting list and

eventually received two Portuguese water dogs. Petitioners were
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able to begin breeding their dogs in 1990. They named their

activity Dacher Kennel and began advertising in national dogbreeding magazines. Petitioners paid thousands of dollars

promoting the name of Dacher Kennel. In addition, they hired

professional handlers to show their dogs and to help establish

their kennel's reputation. 

During the taxable years 1990, 1991, and 1992, petitioners

maintained approximately three adult dogs at their Los Gatos

residence and 15 to 30 additional dogs at outside kennels. Mr.

Smith typically spent 8 to 10 hours per week performing various

activities in keeping and caring for the dogs, including

performing basic veterinary procedures. Mrs. Smith typically

spent approximately 12 hours per week caring for the dogs and

spent an additional 12 hours per month in promotional activities

related to dog breeding and showing. For the first 

3 weeks after puppies were born, petitioners had to be "on call"

to care for the puppies 24 hours a day.

Mr. Smith kept track of expenses and revenues of the dogbreeding activity on his computer. Petitioners, however, did not

keep track of which of their dogs were profitable. Although Mr.

Smith maintained a separate checking account for Dacher Kennels,

occasionally he used personal checks to pay for dog-breeding and

showing activity expenses.
- 6 -

Petitioners achieved their goal of breeding high-quality

dogs. One of petitioners' dogs, Dacher Gotta Get a Gun, won 21

best-of-breed competitions in 1992 and was also the 10th-ranked

Portuguese water dog in the country that year. Unfortunately,

petitioners' success at the shows did not translate into a

profit-making activity.

Progressive retinal atrophy (PRA), a degenerative disease of

the retina that causes blindness, began appearing in Portuguese

water dogs in September of 1990. Within a year, the number of

Portuguese water dogs diagnosed with PRA went from 2 to 42. 

However, Mr. Smith did not know that any of his dogs were

afflicted with PRA until 1994.

Petitioners reported net losses from their kennel in the

amount of $38,724, $69,629, and $109,795 for the taxable years

1990, 1991, and 1992, respectively. During that same period,

petitioners reported gross receipts of only $5,055, $4,650, and

$5,950, primarily from the sale of puppies and from stud fees.

Petitioners' losses were due primarily to the high cost of

dog boarding and handling. In 1992, petitioners reported $88,700

in dog boarding and handling expenses. That amount constituted

nearly 90 percent of the expenses associated with the dogbreeding and showing activity for 1992. In the notice of
- 7 -

deficiency, respondent disallowed the losses associated with the

dog-breeding activity as not engaged in for profit.

OPINION

Issue 1. Section 183

Initially we must decide whether petitioners’ dog-breeding

activity was not engaged in for profit. Section 183(a) provides

that individual taxpayers will not be allowed deductions which

are attributable to an "activity * * * not engaged in for

profit". This term of art is defined in section 183(c) as "any

activity other than one with respect to which deductions are

allowable for the taxable year under section 162 [trade or

business] or under paragraph (1) or (2) of section 212 [expenses

incurred for the production of income]." Section 183(b) permits

deductions which would be allowable only if the activity were

engaged in for profit, but such deductions may be taken only to

the extent that any gross income generated from the activity

exceeds deductions which are not dependent upon a profit

objective (e.g., State and local taxes under section 164). 

Although a reasonable expectation of profit is not required,

the facts and circumstances must indicate that the taxpayer

entered into the activity, or continued the activity, with the

actual and honest objective of making a profit. Keanini v.

Commissioner, 94 T.C. 41, 46 (1990); Dreicer v. Commissioner, 78
- 8 -

T.C. 642, 645 (1982), affd. without published opinion 702 F.2d

1205 (D.C. Cir. 1983); sec. 1.183-2(a), Income Tax Regs. In

making this determination, more weight is accorded to objective

facts than to the taxpayer's statement of intent. Engdahl v.

Commissioner, 72 T.C. 659, 666 (1979); sec. 1.183-2(a), Income

Tax Regs. Petitioners bear the burden of proving that they

possessed the required profit objective. Rule 142(a); Dreicer v.

Commissioner, supra; Golanty v. Commissioner, 72 T.C. 411, 426

(1979), affd. without published opinion 647 F.2d 170 (9th Cir.

1981).

In determining whether an activity is engaged in for profit,

reference is made to objective standards, taking into account all

of the facts and circumstances of each case. Sec. 1.183-2(a),

Income Tax Regs. The regulations set forth nine criteria

normally considered for this purpose. The factors are: (1) The

manner in which the taxpayer carries on the activity; (2) the

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

effort expended by the taxpayer in carrying on the activity; (4)

the expectation that assets used in the activity may appreciate

in value; (5) the success of the taxpayer in carrying on other

similar or dissimilar activities; (6) the taxpayer's history of

income or losses with respect to the activity; (7) the amount of

occasional profits, if any, which are earned; (8) the financial
- 9 -

status of the taxpayer; and (9) the presence of elements of

personal pleasure or recreation. Sec. 1.183-2(b), Income Tax

Regs. None of these factors is determinative, nor is the

decision to be made by comparing the number of factors that weigh

in the taxpayer's favor with the number that support the

Commissioner. Id.

Petitioners argue that they had the requisite profit

objective with respect to their dog-breeding activity. 

Conversely, respondent asserts that the activity was not engaged

in for profit. We agree with respondent. Because the parties

argued their respective cases by addressing each of the nine

criteria enumerated in the regulations, we follow the same

approach in our discussion.

1. Manner in Which the Activity Is Conducted

We begin by examining the manner in which petitioners

carried on their dog-breeding activity. The fact that a taxpayer

carries on the activity in a businesslike manner and maintains

complete and accurate books and records may indicate a profit

objective. Sec. 1.183-2(b)(1), Income Tax Regs. In deciding

whether the taxpayer has conducted the activity in a businesslike

manner this Court has considered, "whether accurate books are

kept, whether the activity is conducted in a manner similar to

other comparable businesses and whether changes have been
- 10 -

attempted in order to make a profit." Ballich v. Commissioner,

T.C. Memo. 1978-497.

Petitioners assert that the fact that they utilized a

software program in order to keep track of expenses is evidence

that they carried on their dog-breeding activity in a

businesslike manner. At trial, however, Mr. Smith admitted that

there were no records kept on which, if any, of his dogs in the

kennel were profitable. Without such knowledge petitioners would

have no way of determining which dog or breed of dogs was

earning, or had the potential to earn, a profit. The lack of

detailed records as to which dogs were or were not profitable is

an indication that the dog-breeding activity was not carried on

for profit. Id.

Petitioners assert that their use of targeted advertising in

numerous trade magazines demonstrates that they conducted their

kennel in a businesslike manner. However, petitioners did not

advertise in any local medium of general circulation. 

Perhaps the most important indication of whether or not an

activity is being performed in a businesslike manner is whether

or not the taxpayer implements some method for controlling

losses. Burger v. Commissioner, 809 F.2d 355, 359 (7th Cir.

1987), affg. T.C. Memo. 1985-523. Mr. Smith asserts that he

attended veterinary seminars and performed basic veterinary
- 11 -

procedures in an effort to help keep down costs. However,

veterinary bills did not represent a significant portion of the

activity's expenses. The vast majority of expenses in connection

with the dog-breeding and showing activity was for boarding and

handling. Petitioners made no attempt to reduce this expense. 

To the contrary, the cost of dog boarding and handling increased

precipitously from $19,102 to $88,700 from 1990 to 1992. We

conclude that petitioners did not operate their dog-breeding

activity in a businesslike manner.

2. Expertise of Petitioners

We next consider the expertise of petitioners with respect

to their dog-breeding activity. Sec. 1.183-2(b)(2), Income Tax

Regs. A taxpayer's expertise, research, and study of an

activity, as well as his or her consultation with experts, may be

indicative of a profit intent. Id.

Mr. Smith met with breeders, attended seminars and read

books on the subject of dog breeding. In addition, his medical

background, combined with his attending veterinary seminars,

provided Mr. Smith with some knowledge of basic dog anatomy and

medicine. Nevertheless, the fact that Mr. Smith was "skilled in

the art of dog breeding does not mean that petitioners began or

continued their dog breeding activity for profit." Glenn v.

Commissioner, T.C. Memo. 1995-399, affd. without published
- 12 -

opinion 103 F.3d 129 (6th Cir. 1996). Significantly, petitioners

did not seek professional economic or accounting advice on the

economic aspects of breeding dogs. Other than Mr. Smith's rough

estimation of potential gross receipts, they made no analysis or

plan for earning a profit from breeding dogs, or even considered

potential costs. Most important, they did not analyze or consult

about the amount of expenses that they were likely to incur. The

failure to seek professional advice is another factor that

indicates a lack of profit motive. Burger v. Commissioner,

supra.

3. Time and Effort Spent in Conducting the Activity

We next consider the time and effort spent by petitioners in

conducting their dog-breeding activity. Sec. 1.183-2(b)(3),

Income Tax Regs. The fact that the taxpayer devotes much of his

personal time and effort to carrying on an activity, particularly

if the activity does not have substantial personal or

recreational aspects, may indicate an intention to derive a

profit. Id.

The record indicates that Mr. Smith spent approximately 8 to

10 hours per week, and Mrs. Smith spent approximately 12 hours

per week in keeping and caring for the dogs. Accordingly, we

find that significant time and effort were spent by the couple in

carrying on the activity. However, we also discern that
- 13 -

petitioners derived substantial recreational benefit from the

time they spent with their dogs; therefore, this factor is

generally neutralized.

4. Expectation That the Assets Will Appreciate in Value

Another factor is the taxpayers' expectation that the assets

used in their breeding activity would increase in value. Sec.

1.183-2(b)(4), Income Tax Regs. Mr. Smith testified that in 1992

one of petitioners' dogs, Dacher Gotta Get a Gun, was the 10thranked Portuguese water dog in the country. In addition,

petitioners, at the time of trial, owned the first- and secondranked Portuguese water dogs in the country. Therefore, there is

evidence that the value of some of the dogs in the kennel has

appreciated. However, petitioners have failed to offer into

evidence any records on the value of any of their dogs, or on the

appreciation in value of their inventory of dogs during the years

in issue. This paucity of evidence makes it difficult for us to

determine whether petitioners had an expectation that the assets

used in their activity would increase, or if they did increase,

in value. See Carson v. Commissioner, T.C. Memo. 1990-508. 

5. Taxpayer's Success in Similar or Dissimilar Activities

We next consider petitioners' prior experience in similar or

dissimilar activities. Sec. 1.183-2(b)(5), Income Tax Regs. 

Although an activity is unprofitable, the fact that a taxpayer
- 14 -

has previously converted similar activities from unprofitable to

profitable enterprises may be an indication of a profit motive

with respect to the current activity. Id.

Mr. Smith operated a successful medical practice, and

although petitioners' farm showed losses during the first 3

years, it has since been profitable. Petitioners had little

prior experience in dog breeding and showing. However, while

prior experience may indicate that a taxpayer is engaged in an

activity for profit, the lack of such experience does not

necessarily indicate that the activity was not engaged in with

the objective of making a profit. Pirnia v. Commissioner, T.C.

Memo. 1989-627; sec. 1.183-2(b)(5), Income Tax Regs. 

Accordingly, we find that this factor weighs in favor of

petitioners.

6. The Activity's History of Income and/or Losses

An important consideration is petitioners' history of income

and/or losses with respect to their dog-breeding activity. Sec.

1.183-2(b)(6), Income Tax Regs. Losses continuing beyond the

period customarily required to make an activity profitable, if

not explainable, may indicate that the activity is not engaged in

for profit. Id.

By the end of the 1992 taxable year, petitioners had

incurred more than $218,000 in losses from the dog-breeding
- 15 -

activity. They used these losses to offset their substantial

income from other sources. Petitioners reported static gross

receipts of $5,055, $4,650, and $4,950 for the taxable years

1990, 1991, and 1992, respectively. The magnitude of the

activity's losses in comparison with its revenues is an

indication that petitioners did not have a profit motive with

respect to the dog-breeding activity. Burger v. Commissioner,

809 F.2d at 360. In fact, petitioners' reported expenses for

1991 and 1992 were far greater than even petitioner Mr. Smith's

estimates of the potential for gross revenues from dog breeding.

Petitioners assert that the reported losses were typical for

the startup stage of any profit-making activity. The record

reveals, however, that the massive losses were not the result of

expenses associated with the startup stage of a dog-breeding

enterprise. The losses during the first 3 years were not the

result of purchasing breeding stock, or from building a kennel. 

Petitioners had a kennel built on their property in 1987, 2 years

before they became interested in the dog-breeding business. The

losses during the 3 years in issue were primarily the result of

the cost of dog boarding and handling. Dog boarding and handling

expenses are not associated with the startup stage of a dogbreeding enterprise; in fact, these expenses are likely to grow

as the size of petitioners' dog stock grows. We therefore find
- 16 -

petitioners' argument that the losses were the result of startup

expenses to be without merit.

In addition, petitioners assert that their losses were the

result of "unforeseen or fortuitous circumstances * * * beyond 

* * * [their] control". Sec. 1.183-2(b)(6), Income Tax Regs. 

Petitioners assert that the disease PRA caused an unanticipated

increase in expenses in 1992 because they were required to

purchase new stock for breeding. This argument fails for two

reasons. First, PRA did not have a significant impact on

petitioners' dog-breeding activity during the taxable years in

question. Petitioners did not know that any of their dogs even

had PRA until 1994. Second, as already noted, petitioners'

losses were largely the result of the high cost of dog boarding

and handling, and not from the purchase of breeding stock. 

7. Amount of Occasional Profits

The amount and frequency of occasional profits earned from

the activity may also be indicative of a profit objective. Sec.

1.183-2(b)(7), Income Tax Regs. Given that petitioners have

never reported a profit on their dog-breeding activity, we find

that this factor supports a finding that the dog-breeding

activity was not carried on for profit. Glenn v. Commissioner,

T.C. Memo. 1995-399.

8. Financial Status of the Taxpayer

We next consider petitioners' financial status. Sec. 1.183-

2(b)(8), Income Tax Regs. Substantial income from sources other
- 17 -

than the activity, particularly if the activity's losses

generated substantial tax benefits, may indicate that the

activity is not engaged in for profit. This is especially true

where there are personal or recreational elements involved. Id.

Petitioners concede that their other business activities

were successful and that this factor does not weigh in their

favor. The income of petitioners was substantial and was

sufficient to enable them to maintain a comfortable standard of

living notwithstanding the losses from the dog-breeding activity. 

In addition, petitioners were able to receive a substantial tax

benefit from the deduction of these losses. Therefore, the fact

that petitioners had substantial income from outside sources,

showing the lack of need to make a profit from the activity,

supports a finding that petitioners did not carry on their dogbreeding activity for profit. Golanty v. Commissioner, supra at

428-429.

9. Elements of Personal Pleasure

The final factor is the personal pleasure derived by

petitioners in conducting their activity. Sec. 1.183-2(b)(9),

Income Tax Regs. Although the mere fact that a taxpayer derives

personal pleasure from a particular activity does not mean that

he or she lacks a profit intent with respect thereto, the

presence of personal motives may indicate that the activity is

not engaged in for profit. This is especially true when there

are recreational elements involved. Id.
- 18 -

Petitioners concede that they derived personal pleasure from

working with and showing their dogs. As this Court has stated,

with respect to this factor:

Unquestionably, an enterprise is no less a

"business" because the entrepreneur gets

satisfaction from his work; however, where

the possibility for profit is small (given

all the other factors) and the possibility

for gratification is substantial, it is clear

that the latter possibility constitutes the

primary motivation for the activity. * * *

[Burger v. Commissioner, T.C. Memo. 1985-523;

fn. ref. omitted.]

Therefore, the fact that petitioners derived substantial personal

pleasure from their dog-breeding activity supports a finding that

the activity was not carried on for profit.

Considering all of the facts and circumstances, we find that

petitioners have failed to prove that their dog-breeding and

showing activity was engaged in for profit. Rule 142(a). 

Accordingly, respondent's determination in that regard is

sustained.

Issue 2. Accuracy-Related Penalty Under Section 6662(a)

Respondent also determined that petitioners were liable for

penalties under section 6662(a) and (b)(1) for each of the years

in issue because petitioners were negligent for claiming

deductions from their dog-breeding and showing activity. Section

6662(a) and (b)(1) imposes an accuracy-related penalty equal to

20 percent of the portion of an underpayment that is attributable

to negligence or disregard of rules or regulations.
- 19 -

Negligence has been defined as "a lack of due care or a

failure to do what a reasonable person would do under the

circumstances." Leuhsler v. Commissioner, 963 F.2d 907, 910 (6th

Cir. 1992), affg. T.C. Memo. 1991-179. Respondent's

determination of negligence is presumed to be correct, and the

taxpayer has the burden of proving that the determination is

erroneous. Rule 142(a). Therefore, petitioners must prove that

they were not negligent, i.e., that they made a reasonable

attempt to comply with the provisions of the Internal Revenue

Code, and that they were not careless, reckless, or in

intentional disregard of rules or regulations. Sec. 6662(c);

sec. 1.6662-3(b), Income Tax Regs.

We sustain respondent's determination. In determining

whether petitioners were negligent in the preparation of their

returns, we take into account petitioner Mr. Smith's business

experience. Glenn v. Commissioner, supra. Additionally, the

size of the tax losses claimed by petitioners in relation to the

revenue earned from the dog-breeding and showing activity

combined with the substantial enjoyment that petitioners derived

from the activity created a situation that was "too good to be

true" within the meaning of section 1.6662-3(b)(1)(ii), Income

Tax Regs. Accordingly, petitioners are liable for the section

6662(a) penalties.

A different result must be reached with respect to the

section 6662(a) penalties that respondent sought by way of an
- 20 -

increase in deficiency. Respondent bears the burden of proving

the increases in deficiency and penalties asserted in his

Amendment to Answer. Rule 142(a); Sproul v. Commissioner, T.C.

Memo. 1995-207. Although petitioners have conceded that they are

liable for the increase in deficiency, petitioners have not

conceded that they are liable for the accuracy-related penalties

asserted in respondent's Amendment to Answer.

Respondent has failed to sustain the burden of proving the

penalties asserted in the Amendment to Answer. Respondent

erroneously assumed on brief that petitioners had the burden of

proof with respect to this issue, and therefore respondent 

presented no proof that petitioners acted negligently or

intentionally disregarded the rules or regulations by failing to

report taxable distributions from petitioner husband’s pension

plan. Accordingly, we hold that petitioners are liable for the

accuracy-related penalties reflected in respondent's notice of

deficiency, but not for the accuracy-related penalties resulting

from the increases in the deficiencies.

To reflect the foregoing,

Decision will be entered

under Rule 155.