T.C. Mem o. 2 01 3- 15 1

UNITED STAT ES TAX COURT
PATRICK D. MONTGOMERY AND PATRICIA A. MONTGOMERY, Pet it io ne rs v. COMM ISSI ONER OF INTERNAL REVENUE, Resp on de nt

Doc ke t No . 25 08 9- 10
. Fi le d J un e 1 7, 2 01 3.

Patric k D. Mo nt go m ery an d P atric iaA. Mon tg om ery, pro ses e. Ch ris to ph er A. Pav il on is , forres po nd en t.

MEMORANDUM FINDINGS OF FACT AND OPINION
MORR ISON, Ju dg e: The re sp on de ntinth is cas e (the IRS) i ss ue d ano ti ce of de fic ie nc y

to pe ti ti on ers Patric k D. Mo nt go m ery an d P atric iaA. Mon tg om ery. Inth e n ot ic e th e IRS de te rm in eda de fic ie nc y of $ 7,1 74 fortax y ear 2 00 5, a de fic ie nc y

of $ 16 4,6 12 for20 06 , andanad di ti on to tax un de r se ct io n 6 65 1( a)(1 )- 2 -

[* 2] of $3 ,83 6.6 6 fo r 20 06 . Som e ad jus tm en ts inth e n ot ic e o f de fic ie nc y ha ve be enset tl ed . The i ss ue s re m ai ni ng for de ci si on are: (1 ) DidPatric iaMo nt go m ery m at eri al ly part ic ip at e in UDI Und erg ro un d, LLC, in20 07 ? W e h ol d t ha t s he di d m at eri al ly part ic ip at e. (2 ) Wha t ar e th e se ct io n 1 36 6( d) (1 ) li m it s o n P atric k a ndPatric ia Mo nt go m ery’ s s ha res of l os se s o f Uti li ty D es ig n, In c., fo r th e ta x year 20 07 ? W e h ol d tha t the li m itforPatric k M on tg om ery is $9 5,5 91 an d th e li m itforPatric iaMo nt go m ery is $1 ,78 1. (3 ) Are the Mo nt go m erys li ab le foranad di ti onto tax un de r se ct io n 6 65 1( a)(1 )? W e h ol d tha t the y are l iabl e. All sec ti on refe ren ces are t o t he Int ern al Rev enue Co de as i n e ffec t i n t he y ears at i ss ue , andall Ru le refe ren ces are t o t he Tax C ou rt R ul es of P ract ic e an d Pro cedur e. FINDINGS OF FACT At the ti m e o f fi li ng th ei r pe ti ti on , andat a ll ot he r rel ev an t t im es , th e Mo nt go m erys were a m arri edco up le res id in g i n F lo rid a. Befo re 2 00 5 the Mo nt go m erys m ov edfro m Ohi o t o F lo rid a to tak e o ve r th e op erat io ns of Ut il ity

Desi gn , Inc ., from

Patric k’s fa th er. Dur in g 2 00 7 Ut il ity- 3 -

[* 3] Desi gn , Inc ., was an S co rp or at io n i n wh ic h b ot h P atric k M on tg om ery an d Patric iaMo nt go m ery were s ha reh ol de rs . Uti li ty D es ig n, In c., pe rfo rm eden gi ne eri ng workon tel ep ho ne -rel at ed in fras tru ctur e. Becaus e o f co nf li ct -o f-i nt eres t ru le s, i t co ul d n otpe rfo rm co ns tru ct io n wo rkon th e sam e p ro jects forwhi chitpe rfo rm eden gi ne eri ng work
. Patric k M on tg om ery de ci de d t o fo rm a se pa rat e en ti ty to p erfo rm co ns tru ct io n work o n t el ep ho ne -rel at edin fras tru ctur e. The n ew en ti ty, UDI Und erg ro un d LLC, be ga n o pe rat io ns on Apri l 2 , 20 07
. Fo r th e 2 00 7 t ax ab le y ear UDI Un de rg ro un d, LLC, was a li m it edli ab il ity co rp or at io n tha t was tre at edas apa rtn ers hi p fo r fed eral in co m e ta x p ur po se s. It fil eda Fo rm

10 65 , U.S. Retu rnof P artne rs hi p In co m e. The F orm 10 65 st at edth at th e m em be rs of UDI Un de rg ro un d, LLC, were: Nam e Ty

pe of m em

be r Owner sh ip in te res t ZachDura nt LLC m em be r-m an ag er 10 % Patric iaMo nt go m ery Oth er LLC m em be r 40 % And er Ro th Oth er LLC m em be r 15 % Ch arl es Ro th Oth er LLC m em be r 15 % Cu rry Mea do ws Pro pe rti es , LLC Oth er LLC m em be r 20 %- 4 -

[* 4] Co ns is te ntwith the Fo rm 10 65 , th e IRS co nt en ds th atPatric iaMo nt go m ery
was a 40 % m em

be r of UDI Und erg ro un d, LLC, an d P atric k M on tg om ery was no t
a m em be r. The M on tg om erys’ li ti ga ti on po si ti on reg ard in g t he ir r es pe ct iv e
m em be rs hi p i nt eres ts inUDI Und erg ro un d, LLC, is un cl ear. We fin d t ha t Pa tri ci a Mo nt go m ery was a 40 % m em be r an d P atric k M on tg om ery was no t a m em be r. W e al so fin d tha t Zac h Duran t was th e m em be r-m an ag er o f UDI Und erg ro un d, LLC, du rin g 2 00 7. Uti li ty D es ig n, In c., bo rro wedth e fo ll owi ng am ou nt s i n 2 00 6 a nd20 07 : (1 ) $1 m il li on fro m

SunTru stBan k o n Au gu st25 , 20 06 , (2) $6 0,0 00 fro m Patric k Mo nt go m ery on Sep te m

be r 26 , 20 07 , (3) $3 0,0 00 fro m Patric k M on tg om ery on Octo be r 5, 2 00 7, an d (4 ) $1 5,0 00 fro m Patric k M on tg om ery on Nov em be r 13 , 20 07 . The Mo nt go m erys per so na ll y gu aran te edth e $ 1 m il li on lo anfro m SunTru st Ban k. Patric iaMo nt go m ery act edas a n o ffi ce m an ag er fo r UDI Und erg ro un d, LLC, in20 07 . Patr ic k M on tg om ery m an ag edth e co m pa ny’ s o pe rat io ns an d
worke d t o s ecu re a co nt ractwith AT&T. The Mo nt go m erys fil edth ei r 20 06 in co m e-t ax return o n No ve m be r 2, 2 00 7. The y reque st edan d re cei ve d a n e xt en si on of the ti m e to fil e, so th e return was du e on Octo be r 15 , 20 07
.- 5 -

[* 5] Patric k M on tg om ery an d P atric iaMo nt go m ery bo th rece iv edFo rm s W-2, W ag e an d Tax Sta te m en t, fro m Uti li ty D es ig n, In c., fo r th e 2 00 7 t ax y ear. Th ey rep orte d the Fo rm

W -2 am ount s o n t he ir jo in t Fo rm 10 40 , U.S. Ind iv idua l In co m e Tax Return, fo r 20 07 . Neithe r rec ei ve d F orm s W-2 fro m UDI Und erg ro un d, LLC, fo r 20 07 . They di d n otrep ort re cei vi ng sal ary orwage in co m e fro m UDI Und erg ro un d, LLC, o n the ir jo in t fe de ral in co m e-t ax return. Aro un d Dec em

be r 20 08 Uti li ty D es ig n, In c., de fau lt edon th e $ 1 m il li on lo anfro m SunTru stBan k. Th e Mo nt go m erys thus be cam e li ab le forth atde bt th ro ug h the ir p ers on al gu aran te es of t he lo an . The Mo nt go m erys def au lt edon th e de bt , andinNov em

be r 20 09 a jud gm en t was is su edag ai ns t the m for$4 25 ,16 9.5 4. OPINION A netop erat in g l os s fo r a t ax y ear i s d efi ne d a s the ex ces s o f a t ax pa y er’s de du ct io ns forth e y ear o ve r gr os s i nc om e. Sec. 1 72 (c). A ne t o pe rat in g l os s fo r a ta x year is carr ie d b ackto th e two tax y ears pre ced in g t he tax y ear. Se c. 17 2( b) (1 )(A)(i ). Net o pe rat in g l os s ca rry ba ck s ar e d educ ti on s fo r th e p rece di ng two tax y ears . Sec. 1 72 (a). Th e Mo nt go m erys cla im th atth ey ha d ajoi ntne t op erat in g l os s i n 2 00 7 a ndth atth e lo ss is carr ie d b ackto 20 05 an d 2 00 6. Inth ei r cal cu la ti on of t he ir jo in t n etop erat in g l os s fo r 20 07 th ey in cl ud ed : (1 ) lo ss es UDI Und erg ro un d, LLC, in cu rredin20 07 th atwere al le ge dl y pa ss edth ro ug h t o- 6 -

[* 6] Patric iaMo nt go m ery as a 40 % m em be r of UDI Und erg ro un d, LLC, an d (2 ) lo ss es Uti li ty D es ig n, In c., in cu rredin20 07 th atwere al le ge dl y pa ss edth ro ug h t o Patric k M on tg om ery an d P atric iaMo nt go m ery, who were b ot h s ha reh ol de rs in Uti li ty D es ig n, In c. The IR S ch al le ng es th e am ou ntof t he ne t o pe rat in g l os s fo r 20 07 on two gro un ds : (1 ) th atPatric iaMo nt go m ery di d n otm at eri al ly part ic ip at e in UDI Und erg ro un d, LLC, dur in g 2 00 7, an d (2 ) th atpo rti on s o f Patric k and Patric iaMo nt go m ery’ s p as st hr ou gh lo ss es fro m Uti li ty D es ig n, In c., are di sa ll owe d u nd er s ect io n 1 36 6( d) (1 ). The tax pa y er g en eral ly bears th e b ur de n o f pr oo f un le ss th e co nd it io ns in
se ct io n 7 49 1( a) ar e sa ti sf ie d. Ru le 14 2( a); W el chv. Hel ve rin g, 2 90 U.S. 11 1, 1 15 (1 93 3) . Our h ol di ng th atPatric iaMo nt go m ery m at eri al ly part ic ip at edinUDI Und erg ro un d, LLC, dur in g 2 00 7, i s s up po rte d b y th e p rep on de ran ce o f ev id en ce. See M art in Ice Cr eam

Co . v. Co m

m is si on er, 1 10 T.C. 18 9, 2 10 n.1 6 (1 99 8) . Thu s, itis un ne ces sa ry

to de te rm in e whi chpa rty (i.e., th e Mo nt go m erys or the IRS) h as th e b ur de n o f pr oo f reg ard in g the factua l i ss ue s u nd erl y in g t he qu es ti on of wh ethe r Patric iaMo nt go m ery m at eri al ly part ic ip at edinUDI Und erg ro un d, LLC, dur in g 20 07 . The Mo nt go m erys hav e n otco nv in cedus th atth ey m etth e co nd it io ns in
se ct io n 7 49 1( a) wi th res pe ctto an y di sp ut edfactua l i ss ue s u nd erl y in g t he am ou nt s- 7 -

[* 7] di sa ll owe d und er s ect io n 1 36 6( d) (1 ). Ther efo re, the Mo nt go m erys hav e th e bu rd enof p ro of

with re sp ectto all di sp ut edfactua l i ss ue s u nd erl y in g t ha t i ss ue . 1. DidPatric iaMo nt go m ery m at eri al ly part ic ip at e in UDI Und erg ro un d, LLC, in 20 07 ? A po rti on of t he Mo nt go m erys’ cla im edjoi ntne t o pe rat in g l os s fo r 20 07 st em s fr om

lo ss es UDI Und erg ro un d, LLC, in cu rredth atwere al le ge dl y pa ss ed th ro ug h t o P atric iaMo nt go m ery as a 40 % m em be r of UDI Und erg ro un d, LLC. The IRS co nt en ds th atso m e o r al l o f he r sh are o f th es e lo ss es is di sa ll owe d u nd er se ct io n 4 69 (a), wh ic h d is al lo ws a t ax pa y er’s p as si ve -act iv ity lo ss forth e y ear. A pa ss iv e-ac ti vi ty los s i s equa l t o the ag gr eg at e in co m e fro m all th e ta xp ay er’s pa ss iv e act iv it ie s m in us th e ag gr eg at e lo ss es fro m all th e ta xp ay er’s p as si ve act iv it ie s. Sec . 46 9( d) (1 ). In t he IRS’s v ie w, Patr ic iaMo nt go m ery’ s ac ti vi ti es with re sp ectto UDI Und erg ro un d, LLC, are a pa ss iv e act iv ity withi n t he m ean in g of sec ti on 46 9( c)(1 ). The p et it io ne rs co nt en d t ha t Pa tri ci a Mo nt go m ery’ s act iv it ie s wi th res pe ctto UDI Und erg ro un d, LLC, are no t a p as si ve act iv ity . A pas si ve act iv ity

is de fin edas a ny acti vi ty whi chin vo lv es th e co nduc t o f
an y tra de or b us in es s i n wh ic h the tax pa y er d oe s n otm at eri al ly part ic ip at e. Sec. 46 9( c)(1 ). “ Part ic ip at io n” ge ne ral ly m ean s al l wo rkdo ne inco nn ect io n wi th an act iv ity by the tax pa y er. Sec . 1.4 69 -5 (f), In co m e Tax Reg s. Anin di vi du al- 8 -

[* 8] ta xp ay er’s p art ic ip at io n i n a n a ct iv ity is m at eri al if h e o r sh e is in vo lv edon a reg ul ar, co nt in uo us , andsubs tant ia l b as is . Sec. 4 69 (h )(1 ). An i nd iv idua l t ax pa y er is co ns id eredto have m at eri al ly part ic ip at edinanact iv ity if andon ly if any

on e o f
se ve n t es ts setforthinth e reg ul at io ns is m et . Sec. 1 .46 9- 5T(a ), Tem po rary In co m e Tax Reg s., 5 3 F ed . Reg . 57 25 -5 72 6 (F eb . 25 , 19 88 ); Garn et t v . Co m m is si on er, 1 32 T.C. 36 8, 3 72 n.1 0 (2 00 9) . W e h ol d t ha t Pa tri ci a Mo nt go m ery’ s ac ti vi ti es with re sp ectto UDI Und erg ro un d, LLC, m eetth e fi rs t
an d s ev en th tes ts , whi chare: (1) th e in di vi du al pa rti ci pa te s i n the act iv ity for 1
m or e th an50 0 h ours du rin g s uc h year; a nd(7) onth e b as is of a ll of t he fact s an d ci rcu m st an ces , th e in di vi du al ’s parti ci pa ti on was re gu lar, co nt inuo us , and
subs tant ia l dur in g s uc h year. Sec. 1 .46 9- 5T(a ), Tem po rary Inco m e Tax Reg s., supr a. 2 Inde te rm in in g wh ethe r an y of t he sev entes ts are s at is fie d, the parti ci pa ti on of th e in di vi du al ’s sp ou se is tak enin to acco un t. Sec . 46 9( h) (5 ); s ee 1 .46 9- Si nc e th e fi rs t an d s ev en th tes ts are m et , itis un ne ces sa ry to co ns id er 1 whe th er an y

of t he othe r fi ve tes ts are m et . Furt he rm or e, th e Mo nt go m erys do no t co nt en d tha t an y

of t he othe r fi ve tes ts are m et . Und er the sev en th tes t, wh ic h i s wo rd edsi m il arl y to th e st atut e it se lf, an 2 in di vi du al is tre at edas m at eri al ly part ic ip at in g i n an a ct iv ity if “ [b ]asedon all th e fact s an d c irc um st an ces * * *, the in di vi du al parti ci pa te s i n t he act iv ity on a reg ul ar, co nt in uo us , andsubs tant ia l b as is ”. Sec. 1 .46 9- 5T(a )(7 ), Tem po rary In co m e Tax Reg s., 5 3 F ed . Reg . 57 26 (Feb . 25 , 19 88 ).- 9 -

[* 9] 5T(f )(3 ), Tem po rary Inco m e Tax Reg s., 5 3 F ed . Reg . 57 27 (Feb . 25 , 19 88 ). The refo re, Pat ric k M on tg om ery’ s p art ic ip at io n i n UDI Un de rg ro un d, LLC, is
co un te d i n d et erm in in g wh ethe r Patric iaMo nt go m ery m at eri al ly part ic ip at ed
. Sect io n 1 .46 9- 5T(f

)(4 ), Tem po rary Inco m e Tax Reg s., 5 3 F ed . Reg . 57 27 (Feb . 25 , 19 88 ), se ts forth rul es forth e type o f pr oo f to be co ns id eredin de te rm in in g the ex te ntof a n i nd iv idua l’s p art ic ip at io n i n an a ct iv ity . It s ta te s: The ex te ntof a n i nd iv idua l’s p art ic ip at io n i n a n a ct iv ity m ay be es tabl is he d b y

any reas on ab le m ean s. Co nt em po ran eo us da il y

ti m e rep orts , lo gs , or s im il ar d oc um en ts are n otrequi redif the ex te ntof su chpa rti ci pa ti on m ay

be est ab li sh edby oth er re as on ab le m ean s. Rea so nabl e m ean s fo r pu rp os es of t hi s p arag rap h m ay in cl ud e b utare no t l im it edto th e id en ti fic at io n o f se rv ic es pe rfo rm edov er a p eri odof ti m e an d the ap pr ox im at e num be r of ho ur s s pe ntpe rfo rm in g s uc h se rv ic es du rin g s uc h p eri od , bas edon ap po in tm en t b oo ks , cal en da rs , orna rrat iv e su m

m ari es . Fo r 20 07 th e Mo nt go m erys cred ib ly test ifi edth atPatric iaMo nt go m ery ha nd le d a ll of t he off

ic e fu nc ti on s, m an ag edpa yro ll , pre pa reddo cu m en ts , m et with m em

be rs of the co m

pa ny andatt en de d b us in es s m eet in gs . Add it io na ll y , Patric k M on tg om ery cred ib ly test ifi edth atPatric iaMo nt go m ery worke d o n co m pa ny m at te rs da il y

an d d is cu ss edth e co m

pa ny’ s b us in es s wi th hi m da il y . Patric k M on tg om ery st art edth e co m pany in 2 00 7 a ndbro ug htinot he r in di vi du al s as in ve st or s. He s ecu reda co nt ractwith AT&T. He h an dl edva rio us- 10 -

[* 10 ] op erat io na l as pe ct s o f th e b us in es s i nc lu di ng arrang in g t he co ns tru ct io n
work, b uyin g e qu ip m en t, an d h iri ng an d fi rin g e m pl oyees. Bo th Patric iaMo nt go m ery an d P atric k M on tg om ery were i nt eg ral inth e pr oc es s o f se tt in g up a ndest ab li sh in g UDI Un de rg ro un d, LLC. The co m pa ny be ga n i n Ap ril 20 07 with n o e m pl oyees. Th e Mo nt go m erys hi red25 0 e m pl oyees on be ha lf o f UDI Und erg ro un d, LLC, b y th e en d o f 20 07 . Alth ou gh th e Mo nt go m erys per fo rm edso m e se rv ic es forUti li ty D es ig n, In c., du rin g 2 00 7, thi s ol de r co m

pa ny alrea dy hadest ab li sh edit s b us in es s o pe rat io ns . The Mo nt go m erys sp en t m or e o f th ei r work t im e o n UDI Un de rg ro un d, LLC, th anon Uti li ty D es ig n, In c. They didno t h ol d a ny j ob s o ut si de th e two co m pa ni es . They cred ib ly te st ifi edth atth ey

work edth ou sa nd s o f ho ur s fo r UDI Und erg ro un d, LLC, dur in g 20 07 . W e fi ndth atth e Mo nt go m erys parti ci pa te d i n UDI Un de rg ro un d, LLC, fo r
m or e th an50 0 h ours du rin g 2 00 7. Onth e b as is of a ll th e fac ts an d c irc um st an ces we al so fin d tha t the Mo nt go m erys parti ci pa te d i n UDI Un de rg ro un d, LLC, o n a reg ul ar, co nt in uo us , andsubs tant ia l b as is du rin g 2 00 7. The IRS ar gu es th atth e types of p ro of th e Mo nt go m erys pre se nt eddo no t
sa ti sf y sec ti on 1.4 69 -5 T(f)(4 ), Tem po rary Inco m e Tax Reg s., s up ra. The Mo nt go m erys read il y

adm itth atth ey

di d n otm ai nt ai n re po rts or l og s o f th ei r ho ur s. Ho wev er, und er the reg ul at io n, “ da il y ti m e rep orts , lo gs , or s im il ar- 11 -

[* 11 ] do cu m en ts are n otrequi redif * * * pa rti ci pa ti on m ay be est ab li sh edby oth er
reas on ab le m ean s.” Id . The Mo nt go m erys pro vi de d d et ai ls of t he na tu re o f th e act iv it ie s the y

co nduc te d i n s tarti ng an d m an ag in g UDI Un de rg ro un d, LLC. The ta sk s the y de sc rib edin cl ud edfou nd in g t he co m pany, neg ot ia ti ng co nt ract s wi th AT&T, hi rin g 2 50 em

pl oyees, an d c on du ct in g d ai ly bus in es s. Th ey cred ib ly te st ifi edth ey

work edon th e b us in es s “ da y inan d d ay

ou t.” Th ey

were cr ed ib le witne ss es an d wer e fo rth co m in g wi th in fo rm at io n abo utth ei r act iv it ie s re ga rd in g UDI Und erg ro un d, LLC. W e fi ndth atth e p ro of th e Mo nt go m erys pro vi de d m eet s th e requi rem en ts of s ect io n 1 .46 9- 5T(f )(4 ), Tem po rary Inco m e Tax Reg s., s up ra. W e h ol d tha t Pa tri ci a Mo nt go m ery m at eri al ly part ic ip at edinth e act iv it ie s o f UDI Und erg ro un d, LLC, dur in g 2 00 7. 2. Wha t ar e th e se ct io n 1 36 6( d) (1 ) li m it s o n t he am ou nt s o f lo ss es tak enin to acco un t wi th res pe ctto Patric k M on tg om ery’ s an d P atric iaMo nt go m ery’ s sh ares of t he S Co rp or at io n Ut il ity Desi gn , Inc .? A po rti on of t he Mo nt go m erys’ cla im edjoi ntne t o pe rat in g l os s fo r 20 07 st em s fr om

lo ss es Uti li ty D es ig n, In c., in cu rredforit s 2 00 7 t ax y ear a ndth atwere al le ge dl y pa ss edth ro ug h t o P atric k M on tg om ery an d P atric iaMo nt go m ery as sh areh ol de rs of Ut il ity

Desi gn , Inc ., for t he ir 2 00 7 t ax y ear. Th e p art ie s d is pu te th e am ou nt s b y

whi chth e lo ss es are l im it edby sect io n 1 36 6( d) (1 ).- 12 -

[* 12 ] Sect io n 1 36 6( a) re qu ire s S c or po rat io n s ha reh ol de rs , when cal cu la ti ng th ei r ta xabl e in co m e fo r th e y ear, t o t ak e in to acco un t the ir p ro rat a sh are o f th e S
co rp or at io n’s i te m s o f in co m e, lo ss , deduc ti on , or c red itfor th e S co rp or at io n’s t ax y ear t ha t en ds inth e ta x year of th e sh areh ol de r. Sec. 1 .13 66 -1 (a), In co m e Tax Reg s. Ho wev er, the S co rp or at io n’s l os s t ak enin to acco un t b y a sh areh ol de r can no t ex ceedth e am ou ntcal cu la te d u nd er s ect io n 1 36 6( d) (1 ) fo r th e sh areh ol de r fo r th e ta x year of

th e co rp or at io n. The 20 07 tax y ear o f Uti li ty D es ig n, In c., en de d o n Dec em be r 31 , 20 07
. The 20 07 tax y ear o f th e Mo nt go m erys als o e nd edon Decem be r 31 , 20 07
. The refo re, Uti li ty D es ig n, In c.’s lo ss es for20 07 pa ss th ro ug h t o the Mo nt go m erys fo r th ei r 20 07 tax y ear. Ho wev er, Pat ric k a ndPatric iaMo nt go m ery each ha s a se ct io n 1 36 6( d) (1 ) li m it at io n fo r th e res pe ct iv e lo ss es pa ss edth ro ug h fr om Uti li ty Des ig n, In c.,’s 20 07 tax y ear. The sec ti on13 66 (d )(1 ) li m it at io n i s equa l t o t he sh areh ol de r’s ad jus te d ba si s o f st oc k a t the en d o f th e co rp or at io n’s t ax y ear o f th e lo ss , pl us th e sh areh ol de r’s ad

jus te d b as is of a ny deb t o f th e S co rp or at io n t o the sh areh ol de r at th e en d o f th e co rp or at io n’s year of th e lo ss . Sec. 1 36 6( d) (1 )(A) an d (B ); s ee s ecs . 1.1 36 6- 2( a)(3 ), 1.1 36 7- 1( d) (1 ), 1.1 36 7- 2( d) , Inc om e Tax Reg s.- 13 -

[* 13 ] Thu s, the sec ti on 13 66 (d )(1 ) li m it at io n h as two co m po ne nt s: (1) a st oc k po rti on , i.e., th e sh areh ol de r’s ad jus te d b as is of s to ckof t he S co rp or at io n at the
en d o f th e y ear o f lo ss , and(2) a de btpo rti on , i.e., th e sh areh ol de r’s ad jus te d b as is of de btof t he S co rp or at io n t o the sh areh ol de r atth e en d o f th e y ear o f lo ss . See
se c. 1.1 36 6- 2( a), In co m e Tax Reg s. Lik e th e ad

jus te d b as is of a ny pro pe rty, the ad jus te d b as es of s to ckan d d eb t of anS co rp or at io n a re d et erm in edun de r ge ne ral rul es setforth un de r se ct io n 10 11 . See s ec. 1 .13 67 -1 (a)( 2) , Inc om e Tax Reg s. (b es id es ad jus tm en ts to ba si s requi redby sect io n 1 36 7, o th er ad jus tm en ts to ba si s o f st oc k a re d et erm in edun de r ot he r ap pl ic ab le pro vi si on s o f th e In te rn al Rev enue Co de ). The ad jus te d b as is of 3 Sec. 1 .13 67 -1 (a)( 2) , Inc om e Tax Reg s., d is cu ss es ad jus tm en ts to ba si s o f S 3 co rp or at io n s to ck , no t d eb t. Sec . 1.1 36 7- 2, In co m e Tax Reg s., i ts co un te rp artfor S co rp or at io n d eb t, m ak es no ex pl ic itst at em en t tha t b as is rul es fro m othe r pa rts of th e Co de ap pl y

to S co rp or at io n d eb t as sec . 1.1 36 7- 1( a)(2 ), In co m e Tax Reg s., do es for st oc k. Ho wev er, a l ead in g t reat is e o pi ne s tha t the ge ne ral ba si s ru le s go ve rnde btof S co rp or at io ns to th ei r sh areh ol de rs : The Co de co nt ai ns m an y

rul es th atm ay

affe ctth e b as is of s to ckor de btinth e h an ds of ash areh ol de r. In g en eral , th os e ru le s m ay ap pl y to th e st oc k o r de btof a n S co rp or at io n. 2 0 Treas . Reg . § 1 .13 67 -1 (a)( 2) pro vi de s tha t o th er ru le s i n t he 2 0 Co de m ay

affe ctth e b as is of a n S co rp or at io n’s s to ck . Treas . Reg . § 1.1 36 7- 2 d oe s n otm ak e th e sa m e st at em en t re gard in g a n S co rp or at io n’s d eb t, b utth e sa m e p rin ci pl e sh ou ldap pl y . (co nt in ue d...)- 14 -

[* 14 ] pro pe rty is e qu al to it s i ni ti al ba si s s up pl em en te d wi th ad jus tm en ts . Sec. 10 11 (a). Th e in it ia l b as is of p ro pe rty gen eral ly is the co stof t he pro pe rty. Sec. 10 12 (a); sec . 1.1 01 2- 1( a), In co m e Tax Reg s. Th e in it ia l b as is of s to ckge ne ral ly is th e co stof t he st oc k. Es ta te of Leavi ttv. Co m m is si on er, 9 0 T.C. 2 06 , 21 2 (1 98 8) , aff’d, 8 75 F.2d42 0 (4 th Cir . 19 89 ). The i ni ti al ba si s o f de btis th e co stof t he de bt to th e le nd er; i.e., the am ountof p rin ci pa l ad va nc edby the len de r. See Ti ge rs Ey e Trad in g, LLC v . Comm is si on er, 1 38 T.C. 67 , 12 2 (2 01 1) (“ [A] shareh ol de r in anS
co rp or at io n h as a se pa rat e ta x b as is inlo an s the sh areh ol de r m ak es to th e S
co rp or at io n e qu al to th e am ou ntof t he lo an s.” ( Em ph as is ad de d.)) ; s ee al so Deb or ahH. Sche nk , Fed eral Taxa ti on of S Co rp or at io ns , sec . 7.0 6[ 3] (20 13 ) (LEXIS) (“ The sh areh ol de r’s ba si s i n c or po rat e d eb t o rd in ari ly is the am ountof
m on ey lo an edto th e co rp or at io n.” ). Inad di ti on to th e g en eral rul es forde te rm in in g b as is (i.e ., th os e fo un d i n se ct io n 1 01 1) , th ere a re s pe ci al rul es th atrequi re an nu al ad jus tm en ts to th e (...co nt inue d) 3
* * * * * * * A cor po rat e d eb t o bl ig at io n s ho ul d b e “pr op erty ” fo r th e 3 0 pu rp os es of I RC § 10 12
. Ja m es S. Eus ti ce & J oe l D. Kun tz , Fed eral Inc om e Tax at io n o f S Co rp or at io ns , pa r. 9.0 2 & n.2 0, 9 .02 [1 ][b] n.30 (4t h e d. 2 00 1)
.- 15 -

[* 15 ] sh areh ol de r’s ad

jus te d b as is of s to ckof a n S co rp or at io n a ndto th e sh areh ol de r’s ad

jus te d b as is of d eb t o f th e S co rp or at io n t o the sh areh ol de r. Thes e ru le s ar e fo un d i n s ect io n 1 36 7( a) an d 1 36 7( b) (2 ), res pe ct iv el y . See al so sec s. 1.1 36 7- 1( a)(1 ), (b ), (c), 1 .13 67 -2 , Inc om e Tax Reg s. Acco rd in g t o re gu lati on s, the ad jus tm en ts are “ de te rm in edas o f th e cl os e o f th e co rp or at io n’s t ax ab le y ear, an d th e ad jus tm en ts ge ne ral ly are effec ti ve as o f th atda te .” Secs . 1.1 36 7- 1( d) (1 ) (s to ck ), 1.1 36 7- 2( d) (1 ) (d eb t), In co m e Tax Reg s. Fo r th e p ur po se s o f cal cu la ti ng th e co m po ne nt s o f th e se ct io n 1 36 6( d) (1 ) li m it at io n fo r a p art ic ul ar y ear, o nl y cert ai n o f th e sp eci al ad

jus tm en ts forth e y ear a re t ak enin to acco un t. The se are s et fo rth insec ti on 13 66 (d )(1 ). See al so sec . 1.1 36 6- 2( a)(3 )(I) a nd(ii ), In co m e Tax Reg s. The fir stco m

po ne ntof t he sec ti on 13 66 (d )(1 ) li m it at io n fo r Uti li ty D es ig n, In c.’s 20 07 y ear, i .e., th e st oc k c om po ne nt , is equa l t o:

• th e ad

jus te d b as is of t he st oc k a t the be gi nn in g o f 20 07 ,

• supp le m en te d b y

th e g en eral ba si s ad

jus tm en ts du rin g 2 00 7,

• an d the n a dju st edby the ap pr op ria te sp eci al ad jus tm en ts for20 07
. The sec on d c om

po ne ntof t he sec ti on 13 66 (d )(1 ) li m it at io n fo r Uti li ty D es ig n, In c.’s 20 07 y ear, i .e., th e d eb t co m po ne nt , is equa l t o:

• th e ad

jus te d b as is of d eb t atth e b eg in ni ng of 2 00 7 year,- 16 -

[* 16 ] • supp le m en te d b y th e g en eral ba si s ad

jus tm en ts du rin g 2 00 7,

• an d the n a dju st edby the ap pr op ria te sp eci al ad jus tm en ts for20 07
. Inde te rm in in g the sec ti on 13 66 (d )(1 ) li m it at io n a m ou nt s, we b eg in with the ad jus te d b as es of s to ckan d d eb t atth e b eg in ni ng of Ut il ity Desi gn , Inc .’ s 2 00 7 y ear. Th e IRS co nt en ds th atth e ad jus te d b as es of s to ckan d d eb t wer e zer o fo r Patric k M on tg om ery an d z ero for Patric iaMo nt go m ery. The M on tg om erys co nt en d tha t the ad

jus te d b as es were $ 42 4 fo r Patric k M on tg om ery an d $ 20 0 fo r Patric iaMo nt go m ery. The M on tg om erys hav e ad du cedno ev id en ce t o s up po rt th ei r cl ai m

th atth e b as es were $ 42 4 a nd$2 00 at t he be gi nn in g o f 20 07 . They ci te

“ IRS Workpape r #: 50 4- 1.2 ” to supp ort the ir c la im . They as se rt i n the ir b rie f th at th is workpape r subs tant ia te s the fol lo win g p ro po si ti on s: “ Patric k M on tg om ery’ s ba si s i n h is UDI [anab br ev ia ti on forUti li ty D es ig n, In c.] sto ckwas $ 80 0 a s o f 1- 1- 07 . If th is is all oc at edbe twee n P atric k a ndPatric ia , he wo ul d g et53 %, or $ 42 4,
an d P atric iawou ldge t 2 5%, o r $2 00 .” Butth e workp ap er i s n otinth e rec or d. 4 The refo re, we can no t re ly on i t. The Mo nt go m erys als o c la im th atth ei r 20 07
am en de d re tu rn(an d the Sch edul e E, Sup pl em en ta l In co m e an d Lo ss , att ach edto The Mo nt go m erys ass ertth at“ IRS Workpape r #: 50 4- 1.2 ” st at es th at 4 Patric k M on tg om ery own ed53 % of t he sh ares of Ut il ity Desi gn , Inc ., andPatric ia Mo nt go m ery own ed25 % of t he sh ares . Howev er, i t i s u nc le ar wh y , if Pa tri ck Mo nt go m ery’ s b as is alo ne was $ 80 0, the Mo nt go m erys wou ldwantto tak e furth er st ep s t o a ll oc at e th atba si s b etweenth em .- 17 -

[* 17 ] it ) supp ort the ir b eg in ni ng -o f-the -y ear a dju st edba si s fi gu res of $ 42 4 and $2 00 . They do no t ex pl ai n h ow the return s up po rts th ei r co nt en ti on , andno th in g on th e return app ears to sh ow ei th er a t ot al ba si s o f $8 00 inUti li ty D es ig n, In c.’s st oc k o n J anua ry

1, 2 00 7, o r ba se s o f $4 24 an d $ 20 0 i n P atric k a ndPatric ia Mo ng to m ery’ s re sp ect iv e sh ares . There fo re, we h ol d t ha t the ad jus te d b as es of st oc k a ndde btwere ze ro forbo th Patric k M on tg om ery an d P atric iaMo nt go m ery atth e b eg in ni ng of 2 00 7. W e n ow co ns id er the effe ctof year-o f-l os s s pe ci al ad jus tm en ts on ba se s o f st oc k a ndde bt . Neithe r pa rty con te nd s tha t an y sp eci al ad

jus tm en ts for20 07 sh ou ldbe m ad e. W e co nc lu de th atno sp eci al ad jus tm en ts for20 07 sh ou ldbe
m ad e to th e ad

jus te d b as is of t he st oc k o r de btco m po ne nt s. W e n ow co ns id er the effe ctof g en eral ba si s ad jus tm en ts to st oc k a ndde bt fo r ev en ts oc cu rri ng in20 07 . In i ts bri ef the IRS co nt en ds th atth e g en eral ba si s ad jus tm en ts to st oc k a ndde btres ul t i n a n e nd -o f-y ear l im it at io n fo r bo thst oc k a nd de btof $ 95 ,59 1. (Th es e ad jus tm en ts in cl ud e in crea se s o f $1 05 ,00 0 i n P atric k Mo nt go m ery’ s l im it at io n am ou ntforlo an s h e m ad e to Uti li ty D es ig n, In c., in 20 07 , i.e., th e Sep te m

be r 26 , 20 07 lo anof $ 60 ,00 0, the Octo be r 5, 2 00 7 l oa n o f $3 0,0 00 , andth e Nov em

be r 13 , 20 07 lo anof $ 15 ,00 0.) Th e Mo nt go m erys do no t ch al le ng e th es e g en eral 20 07 ba si s ad jus tm en ts ex cep t tha t the y ass ertth atPatric k- 18 -

[* 18 ] Mo nt go m ery’ s ad

jus te d b as is inde btof Ut il ity Desi gn , Inc ., to hi m

sh ou ld be in crea se d b y

$4 25 ,16 9,5 4 t o re fle ctth atin20 09 a jud gm en t was im po se d o n the Mo nt go m erys as ares ul t o f th ei r gu aran te e o f th e $ 1 m il li on lo anSunTru stBan k
m ad e to Uti li ty D es ig n, In c., in20 06
. Thu s, the on ly rem ai ni ng is su e to res ol ve 5 reg ard in g the sec ti on 13 66 (d ) li m itis to de te rm in e th e eff ectof t hi s ju dg m en t o n th e b as is of d eb t o wedby Uti li ty D es ig n, In c., to Patric k M on tg om ery. Whe n a n S co rp or at io n s ha reh ol de r gu aran te es a lo anby a ban k t o t he S
co rp or at io n, n o d eb t h as be encrea te d b etweenth e S co rp or at io n a ndth e sh areh ol de r. See Un de rwo odv. Co m m is si on er, 6 3 T.C. 4 68 , 47 5- 47 6 (1 97 5) , aff’d, 5 35 F.2d30 9, 3 11 -3 12 (5t h C ir. 1 97 6) ; Pe rry v. Co m mis si on er, 4 7 T.C. 1 59 , 16 3 (1 96 6) , aff’d, 3 92 F.2d45 8 (8 th Cir . 19 68 ). Howev er, o nc e th e S co rp or at io n sh areh ol de r pa y s the ba nkpu rs ua ntto a gu aran te e, th e S co rp or at io n b eco m es in de bt edto th e sh areh ol de r. As we h el d i n Un de rwo odv. Co m mis si on er, 6 3 T.C. at47 6, “ itis th e p aym en t b y th e g ua ran to r of

th e g ua ran te edob li ga ti on th atgi ve s ris e to in de bt edne ss on th e p artof t he de bt or to th e g ua ran to r. The m ere f actth at th e d eb to r de fau lt s an d the reb y ren de rs th e g ua ran to r li ab le is no t s uf fic ie nt .” Patric k M on tg om ery di d n otm ak e an y pa ym en ts on th e Su nTru stBan k l oan The jud gm en t was ag ai ns t b ot h M on tg om erys. It i s u nc le ar wh y th ey 5 co nt en d P atric k M on tg om ery’ s b as is inde btsh ou ldbe in crea se d b utPatric ia Mo nt go m ery’ s b as is inde btsh ou ldno t.- 19 -

[* 19 ] du rin g 2 00 7. Th eref or e h is gu aran te e o f th e Su nTru stBan k l oa n d idno t gi ve ris e to a de btto hi m

fro m Uti li ty D es ig n, In c., du rin g 2 00 7. 6 Inco nc lu si on , we ho ldth atth e b as is li m it at io n fo r Patric k M on tg om ery’ s sh are o f Uti li ty D es ig n, In c., was $ 95 ,59 1 fo r 20 07 . Patr ic iaMo nt go m ery’ s li mit at io n was $1 ,78 1. 3. Are the Mo nt go m erys Liab le Fo r anAdd it io n t o Tax Und er Se ct io n 66 51 (a)( 1) ? Sect io n 6 65 1( a)(1 ) im

po se s an ad di ti on to tax of 5 % of t he “ am ou nt requi redto be sh own as t ax on * * * [a ] return” forfai lu re t o fi le if “ th e fai lu re i s fo r no t m or e th an1 m on th ”. The a dd it io n t o t ax is im po se d unl es s a t ax pa y er h as The Mo nt go m erys rel y

on Gil da y

v. Co m m is si on er, T.C. Mem o. 1 98 2- 24 2, 6 19 82 Tax C t. Me m o LEXIS 5 12 . In Gi ld ay , sh areh ol de rs of a n S co rp or at io n tha t owe d ade btto a ba nkgave th e b an k ape rs on al no te forth e am ou ntof t he S co rp or at io n’s d eb t. Inex ch an ge , th e b an k c an cel edth e d eb t o f th e S co rp or at io n. The sh areh ol de rs th us “ m ov edfro m po si ti on s as gu aran to rs of c or po rat e d eb t t o po si ti on s as pri m ary ob li go rs .” Id ., 19 82 Tax C t. Me m o LEXIS 5 12 , at * 6. Patric k M on tg om ery di d n otm ov e to th e p os it io n a s p rimary ob li go r in20 07
. W e al so no te forth e sa ke of c om pl et en es s tha t the U.S. Cou rt o f App eal s fo r th e Ele ve nt h C irc ui t, the co urt t o wh ic h t hi s ca se co ul d b e ap pe al ed , hel d i n S el fe v. Un it edSta te s, 7 78 F.2d76 9 (1 1t h C ir. 1 98 5) , th atth ere i s anex cep ti on to th e ru le th atgu aran te ei ng a de btof an S co rp or at io n i s i ns uf fic ie ntto in crea se ba si s. The Mo nt go m erys do no t at te m ptto rel y onSel fe, an d the reco rddo es no t de m on st rat e th atth e lo anfro m SunTru stBan k fa ll s wi th in th is li m it edex cep ti on . Unl ik e th e Mo nt go m erys, th e ta xp ay er i n S el fe h adun de rta ke n alo anpe rs on al ly whi chwas the n a ss um edby an S co rp or at io n (wi th th e ta xp ay er g ua ran te ei ng th e lo an ). Test im on y

fro m a ba nkoff

ic er s ho wedth atth e b an k s ti ll “ lo ok [ed ] [p rimaril y ] to th e sh areh ol de r as th e p rimary ob li go r.” Id . at 7 74 . No su ch ev id en ce fr om

th e le nd er i s i n the reco rdbe fo re u s.- 20 -

[* 20 ] reas on ab le cau se forfil in g l at e. Id . Taxp ay ers be ar the bu rd enof p ro vi ng

“ reas on ab le cau se ” und er s ect io n 6 65 1( a). See Hig be e v . Comm is si on er, 1 16 T.C. 43 8, 4 46 -4 47 (20 01 ). The M on tg om erys fil edth ei r in co m e ta x re turnon Nov em be r 2, 2 00 7. Th ey

ha d fi le d fo r anex te ns io n o f th e due date ; the ir t ax return was du e o n Oct ob er 1 5, 2 00 7. Be cau se th e Mo nt go m erys fil edth ei r return la te an d d o n otcla im

th atth ey ha d re as on ab le cau se fordo in g s o, we h ol d t ha t th ey are re sp on si bl e fo r a 5 % ad di ti on to tax forth e 2 00 6 t ax y ear. W e h av e co ns id eredall of t he arg um en ts th e p art ie s h av e m ad e, an d t o the
ex te ntth atwe ha ve no t d is cu ss edth em , we fin d t he m to be irr el ev an t, m oo t, o r witho utm eri t. To re fle ctth e fo reg oi ng , Deci si on wil l b e en te red
un de r Ru le 15 5.