T.C. Memo. 2021-104

UNITED STATES TAX COURT

ESTATE OF CHARLES P. MORGAN, DECEASED, ROXANNA L. MORGAN, 

PERSONAL REPRESENTATIVE AND ROXANNA L. MORGAN, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 592-18. Filed August 23, 2021.

Ljubomir Nacev and Simon Y. Svirnovskiy, for petitioners.

Richard J. Hassebrock and Richard L. Wooldridge, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

PUGH, Judge: In a notice of deficiency dated October 13, 2017, respondent 

determined the following deficiency and accuracy-related penalty:1

1 Unless otherwise indicated, all section references are to the Internal 

Revenue Code (Code) in effect at all relevant times, and all Rule references are to 

the Tax Court Rules of Practice and Procedure. All monetary amounts are rounded 

to the nearest dollar.

Served 08/23/21
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Year Deficiency

Penalty 

sec. 6662(a)

2012 $368,659 $73,732

The issues for decision are whether petitioners: (1) were carrying on a trade 

or business during the year in issue and are therefore entitled to deductions claimed 

on Schedule C, Profit or Loss From Business, and Schedule E, Supplemental 

Income and Loss, for expenses incurred by Falcon, LLC (Falcon), and Falcon 

Legacy, LLC (Legacy); (2) are entitled to a net operating loss (NOL) deduction 

attributable to an alleged NOL carryover from tax years 2010 and 2011; and (3) are 

liable for an accuracy-related penalty under section 6662(a).

FINDINGS OF FACT

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

are incorporated in our findings by this reference. Charles Morgan and Roxanna 

Morgan were married residents of Indiana when they timely filed their petition.2

2 Mr. Morgan died in April 2019, and Mrs. Morgan was appointed the 

personal representative of the Estate of Charles P. Morgan. We granted 

petitioners’ subsequent motion to substitute parties and change caption pursuant to 

Rule 63(a).

[*2]
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[*3] I. Background

A. Homebuilding Business and Receivership

Mr. Morgan was a residential real estate developer. He earned an M.B.A. 

degree in 1969 and then worked in the real estate industry for other firms for over a 

decade. In 1983 he began his own home building company, which came to 

comprise a variety of entities, including: C.P. Morgan Communities, L.P. 

(CPMC); C.P. Morgan Communities of Charlotte, LLC; C.P. Morgan 

Communities of the Triad, LLC; the C.P. Morgan Co., Inc.; and C.P. Morgan 

Investment Co., Inc. (collectively, Morgan entities). Over 26 years--from 1983 to 

2009--the Morgan entities built over 26,000 homes in Indiana and North Carolina. 

Throughout that period Mr. Morgan owned them directly or indirectly and was 

involved in their operations and management. 

In the years leading up to 2009 the real estate and financial markets began to 

decline. So did the Morgan entities’ homebuilding business. In 2008 their 

creditors began to rescind credit. By February 2009 the Morgan entities had 

outstanding obligations of approximately $75 million in default and unpaid 

notwithstanding a demand for payment from those creditors. Consequently, the 

creditors filed a “Complaint on Unpaid Indebtedness and for the Appointment of 

Receiver” in Indiana superior court. It alleged that the Morgan entities were 

hopelessly insolvent. In March 2009 the Indiana superior court entered an order 
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[*4] appointing LS Associates, LLC (LS Associates or receiver), as receiver for all 

five Morgan entities. 

Appointed to manage all the affairs of the Morgan entities, LS Associates’ 

task was to identify, take possession of, and liquidate the Morgan entities’ assets. 

During the pendency of the receivership proceedings--which included tax years 

2010 through 2012--LS Associates was in sole control of the Morgan entities, 

under the supervision and subject to the approval of the Indiana superior court. It 

immediately exercised that exclusive control and did not relinquish it until the 

receivership concluded in 2013.3

 Given the depressed market and the lenders’ 

unwillingness to fund the Morgan entities’ operations going forward, LS 

Associates did not consider using the receivership to retool and find a new buyer.4

 

3 Having liquidated the receivership estates of the Morgan entities, 

distributed funds and property, and filed the final tax returns for the Morgan 

entities, LS Associates filed (and was granted) a motion to terminate receivership 

proceedings and release receiver with the Indiana superior court in May 2013.

4 The order appointing LS Associates as receiver noted that the current value 

of the collateral securing the Morgan entities’ obligations was insufficient to 

discharge the debts owed to the creditors. The creditors believed the remaining 

deficiency loan balance after liquidation and sale of the collateral might be as 

much as $50 million. The Morgan entities “acknowledged that, in light of the 

* * * [creditors’ revocation of the Morgan entities’] authority to use cash collateral 

in the operation of their businesses, * * * [the Morgan entities] do not have 

sufficient means to carry on their respective business activities and operations.”
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[*5] Mr. Morgan was prohibited from infringing on LS Associates’ authority or 

incurring expenses on behalf of the Morgan entities, and he never sought 

permission to incur any expenses. Following the appointment of the LS 

Associates, Mr. Morgan spent about six months relaxing and spending time with 

his family. But Mr. Morgan was a hard worker who was not interested in 

retirement or remaining idle. In September 2009 he wrote: 

I am really focused on what my next career is. I[t] has been six 

months since I shut the Company down and it has been a great 

summer of rest and time with my family. Career 2 will almost 

certainly involve acquiring a company * * * or starting another 

company probably in the real estate building field but approaching it 

differently than I did in my first career.

B. Postreceivership Activity: Legacy

Mr. Morgan conducted a search for a trade or business through Legacy, a 

single-member limited liability company (LLC) he had formed in December 2008 

and which was taxed as a disregarded entity for 2010 through 2012. He was 

looking for businesses that met certain financial and logistical parameters, and he 

did not confine his search to any one industry. 

Legacy employed certain former CPMC employees, including Kristen Coyer

as director of finance. Legacy employees kept timesheets, allocating time not just 

to Legacy’s business search but also to the Morgans personally and to Falcon. For 
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[*6] 2011 and 2012 Mr. Morgan recorded 100% of his time spent working for 

Legacy as “business search/forward looking”.

In addition to hiring former CPMC employees, Legacy hired various outside 

consultants to assist in its search for new business opportunities. Generally, the 

consultants would contact Mr. Morgan with business opportunities; and if he was 

interested, he would enter into a nondisclosure agreement with the selling entity to 

discuss the specific opportunity further. Despite these efforts Mr. Morgan did not 

make an offer to purchase--nor did he acquire or otherwise form--a new business

as a result of Legacy’s search before the end of 2012.5

Apart from Legacy, Mr. Morgan indirectly maintained contact with the 

homebuilding industry. In 2009 Mr. Pyatt, the former vice president of CPMC and 

a close friend and business partner of Mr. Morgan, became aware that a number of 

partially developed properties owned by the Morgan entities were available for 

5 The parties introduced evidence that in 2015 Mr. Morgan formed PM 

Development Holdings, LLC, with Todd Pyatt and Pyatt Builders, LLC (Pyatt 

Builders), and that in 2017 he acquired Southeastern Aluminum Products, Inc., a 

manufacturer and distributor of bath enclosures and shower doors for residential 

and commercial buildings. We do not find these facts from later years relevant to 

our redetermination of the amount of petitioners’ income tax deficiency for 2012. 

See sec. 6214(b); cf. Capitol Fed. Sav. & Loan Ass’n & Sub. v. Commissioner, 96 

T.C. 204, 215 (1991). We also note that tax years 2013, 2014, and 2015 are before 

the Court at docket No. 16442-19. 
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[*7] purchase from the receiver. He approached Mr. Morgan about partnering to 

purchase and develop the properties. Mr. Morgan instead lent Pyatt Builders

$180,000 so it could purchase the property from the receiver, using a singlemember LLC he owned and used as a vehicle for lending money. Mr. Morgan did 

not hold an ownership interest in Pyatt Builders and was not involved in the daily 

activities of the business. The loan was repaid, timely and with interest, in July 

2010. Mr. Morgan’s close relationship with Mr. Pyatt influenced his willingness to 

extend the loan. 

C. Aircraft: Falcon

Finally, throughout this time Mr. Morgan continued to fly aircraft owned by 

Falcon, an entity he had formed in 1996 to hold, operate, and maintain aircraft. 

Before the receivership proceedings, Mr. Morgan used Falcon’s aircraft to 

further the Morgan entities’ real estate development business; he visited potential 

building sites, researched development strategies, and checked on current 

developments. CPMC had an aviation department that employed the pilots, 

mechanics, and recordkeepers that flew, serviced, and kept track of the books and 

records for the aircraft held by Falcon.

During the receivership proceedings Mr. Morgan continued to use Falcon’s 

aircraft in his search (through Legacy) for new business opportunities. Falcon did 
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[*8] not lease its aircraft or provide services to any unrelated third parties at any 

time. Mr. Morgan had a passion for aviation and both before and during the 

receivership proceedings often would pilot the aircraft himself.

For 2010 and 2011 Falcon was taxed as a partnership, and its partners 

included Mr. Morgan and an S corporation. For 2012 Mr. Morgan was Falcon’s 

sole owner, resulting in the partnership’s termination and Falcon’s taxation as a 

disregarded entity. Falcon’s principal business activity was listed as “Consulting” 

on its 2010 and 2011 Forms 1065, U.S. Return of Partnership Income, and on 

petitioners’ 2012 Schedule C. 

II. Petitioners’ Tax Return

Petitioners filed a joint Form 1040, U.S. Individual Income Tax Return, for

2012. It was prepared by Roy Rice of Somerset CPAs (Somerset), a firm in 

Indianapolis, Indiana.6

 Mr. Rice was petitioners’ return preparer for over three 

decades and had been at Somerset since 1999. Following the recession, Mr. Rice 

and Ms. Coyer discussed how Falcon’s expenses would be paid and deducted, and 

Mr. Morgan subsequently signed an “expense reimbursement policy” as both the 

Chairman of CPMC and a member of Falcon. Legacy’s monthly meeting agenda 

6 Mr. Rice and Somerset also prepared petitioners’ individual returns for 

2010 and 2011 as well as the Morgan entities’ returns for 2010 through 2012.
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[*9] from January 2011, prepared by Ms. Coyer and distributed to petitioners,

indicates that Mr. Rice joined to “review entities” and “discuss business expense/

deductions”. For 2012 Ms. Coyer provided Mr. Rice and Somerset information 

used to prepare the returns; Ms. Coyer and Mr. Rice would communicate through 

the year and Mr. Rice could ask Ms. Coyer for clarification and additional input as 

needed. Both Mr. Rice and Ms. Coyer were licensed certified public accountants 

at all relevant times.

A. Falcon Expenses

Petitioners attached Schedule C for Falcon to their 2012 Form 1040. Falcon 

reported a loss of $303,302. Gross income totaled $516,654 and comprised a 

$315,000 fee Legacy paid for consulting and $201,654 petitioners paid for the 

personal use of Falcon aircraft. Total expenses were $819,956, all related to the 

use and maintenance of Falcon’s aircraft. 

For 2010 and 2011 Falcon’s Forms 1065 show each partner’s capital account 

but do not show each partner’s outside basis. Mr. Rice used the partner’s capital 

account on the Forms 1065 to report Mr. Morgan’s outside basis on Schedule K-1, 

Partner’s Share of Income, Deductions, Credits, etc. Falcon is the sole member of 

Falcon II, LLC, which either owned or merged with other “Falcon” entities
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[*10] (including Falcon VII, LLC), which contracted for the purchase of a 

helicopter in 2008. 

B. Legacy Expenses

Petitioners also attached Schedule E to their 2012 Form 1040, on which they 

reported expenses related to Legacy.7

 Legacy reported no gross receipts. It 

reported total expenses of $648,118, which included the consulting fee paid to 

Falcon, “[b]usiness [i]nvestigations [e]xpenses” of $121,715, and other expenses 

related to the former CPMC employees’ tasks of searching for business 

opportunities, providing personal services to the Morgans, and managing Falcon. 

C. NOL Deduction

Petitioners claimed an NOL deduction of $966,121 on their 2012 Form 

1040, attributable to NOL carryforwards of $35,083 and $931,038 from tax years 

2010 and 2011, respectively.

7 Petitioners reported Schedule E expenses paid or incurred by Legacy on a 

“Statement SBE, Supplemental Business Expense” attached to their Form 1040 

and listed Legacy’s business as “construction”. The Statement SBE is not an 

Internal Revenue Service (IRS) form. Respondent questions why petitioners 

reported Legacy’s expenses on this non-IRS form and on Schedule E rather than a 

separate Schedule C. But the manner of reporting is not dispositive of any issue in 

this case. Respondent concedes as much in his posttrial answering brief, stating 

that “[r]egardless of how or why petitioners reported and claimed these deductions, 

the bottom line is petitioners were not involved in an active trade or business and 

thus, * * * [the deductions] were properly disallowed by respondent.”
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[*11] Falcon and Legacy expenses contributed to these NOL carryforwards. For 

Falcon, petitioners reported Schedule E losses of $194,304 for 2010 and $101,794 

for 2011, as well as unreimbursed expenses of $164,996 for 2011. For Legacy, 

petitioners reported negative other income related to business investigation 

expenses of $319,182 for 2010 and Schedule E expenses of $663,662 for 2011. 

When combined with other items of income and loss reported on petitioners’ 2010 

and 2011 Forms 1040, these Falcon and Legacy expenses generated the claimed 

NOL carryforwards from 2010 and 2011. 

III. Respondent’s Determinations 

In the notice of deficiency respondent disallowed the $819,956 Schedule C 

deduction for Falcon’s expenses, the $648,118 Schedule E deduction for Legacy’s 

loss due to unreimbursed expenses, and the $966,121 NOL deduction. As a result 

of these adjustments respondent determined that the correct amount of tax due 

from petitioners for 2012 is $407,214. Petitioners reported $38,555 of tax on their 

2012 Form 1040, leaving the $368,659 deficiency.

Respondent further determined that petitioners are liable for an accuracyrelated penalty under section 6662 for an underpayment due to negligence and/or a 

substantial understatement of income tax. On June 15, 2016, Revenue Agent 

Christian Donovici (RA Donovici), the revenue agent who performed the 
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[*12] examination of petitioners’ 2012 Form 1040, requested permission to assert 

the penalty under section 6662 from his immediate supervisor, Supervisory 

Revenue Agent Jill Sullivan (Supervisory RA Sullivan). Supervisory RA Sullivan 

approved the penalty that same day. On June 17, 2016, RA Donovici mailed to 

petitioners a Letter 950-Z (30-day letter), which asserted the section 6662 penalty. 

The 30-day letter included Form 4549-A, Income Tax Discrepancy Adjustments, 

which had been generated by an IRS computation specialist on June 8, 2016, at RA 

Donovici’s request. 

OPINION

I. Burden of Proof

Generally, the taxpayer bears the burden of proving that the Commissioner’s 

determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 

(1933). Under section 7491(a)(1), “[i]f, in any court proceeding, a taxpayer 

introduces credible evidence with respect to any factual issue relevant to 

ascertaining the liability of the taxpayer for any tax imposed by subtitle A or B, the 

Secretary shall have the burden of proof with respect to such issue.” See Higbee v. 

Commissioner, 116 T.C. 438, 442 (2001). Petitioners have not introduced credible 

evidence sufficient to shift the burden of proof to respondent under section 7491(a) 

as to any relevant factual issue. Therefore, petitioners generally bear the burden of 

proof. 
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[*13] II. Business Expense Deductions

Whether petitioners are entitled to the Falcon Schedule C and the Legacy 

Schedule E deductions for 2012 is resolved by answering one question: Were they

carrying on a trade or business in that year?8

 

A. Legal Background: Carrying on a Trade or Business 

A taxpayer must prove entitlement to any deductions and credits claimed. 

INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. 

v. Helvering, 292 U.S. 435, 440 (1934). 

Section 162(a) “allow[s] as a deduction all the ordinary and necessary 

expenses paid or incurred during the taxable year in carrying on any trade or 

business”. Neither the Code nor the regulations provide a generally applicable 

definition of the term “trade or business”. Commissioner v. Groetzinger, 480 U.S. 

23, 27 (1987); McManus v. Commissioner, T.C. Memo. 1987-457, 1987 Tax Ct. 

Memo LEXIS 454, at *19, aff’d without published opinion, 865 F.2d 255 (4th Cir. 

1988). Determining the existence of a trade or business “requires an examination 

8 We also answer this question for 2010 and 2011. Whether petitioners were 

carrying on a trade or business in those years is partially determinative of the 

second issue in this case: petitioners’ entitlement to NOL carryforwards

attributable to those years. See infra pp. 31-33.
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[*14] of the facts in each case.” Commissioner v. Groetzinger, 480 U.S. at 36

(quoting Higgins v. Commissioner, 312 U.S. 212, 217 (1941)).

In examining the facts of each case to determine the existence of a trade or 

business we have focused on three factors: (1) whether the taxpayer undertook the 

activity intending to earn a profit; (2) whether the taxpayer is regularly and actively 

involved in the activity; and (3) whether the taxpayer’s activity has actually 

commenced. E.g., Weaver v. Commissioner, T.C. Memo. 2004-108, 2004 WL 

938293, at *6; McManus v. Commissioner, 1987 Tax Ct. Memo LEXIS 454, 

at *20. The third factor addresses timing, and the following oft-quoted test offers 

guidance:

[E]ven though a taxpayer has made a firm decision to enter into 

business and over a considerable period of time spent money in 

preparation for entering that business, he still has not “engaged in 

carrying on any trade or business” within the intendment of section 

162(a) until such time as the business has begun to function as a going 

concern and performed those activities for which it was organized.

Richmond Television Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965) 

(fn. ref. omitted), vacated and remanded on other grounds, 382 U.S. 68 (1965).

Stated otherwise, a taxpayer must show “more than initial research into or 

investigation of business potential” to cross the threshold into “carrying on a trade 

or business”. Glotov v. Commissioner, T.C. Memo. 2007-147, 2007 WL 1702618, 

at *2 (citing Dean v. Commissioner, 56 T.C. 895, 902 (1971), and McKelvey v. 
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[*15] Commissioner, T.C. Memo. 2002-63, 2002 WL 341044, aff’d, 76 F. App’x 

806 (9th Cir. 2003)). Crossing that threshold does not require that the business 

succeed, but it must engage in business. Cabintaxi Corp. v. Commissioner, 63 

F.3d 614, 620-621 (7th Cir. 1995), aff’g in part, rev’g in part, and remanding T.C. 

Memo. 1994-316.

Before crossing the threshold of carrying on a trade or business, the taxpayer 

is in the province of section 195. See Weaver v. Commissioner, at *5 (“Implicit in 

the foregoing definitions is the concept that a taxpayer must in fact be ‘carrying 

on’ a trade or business for expenditures to be deductible under section 162. This 

limitation is made explicit in section 195[.]”). 

Section 195(a) provides the general rule that no current deduction is allowed 

for start-up expenditures. See Yapp v. Commissioner, T.C. Memo. 2018-147, 

at *13, aff’d, 818 F. App’x 743 (9th Cir. 2020); see also Fishman v. 

Commissioner, 837 F.2d 309, 312 (7th Cir. 1988) (citing cases) (“In a long line of 

decisions under section 162, the courts (including the Tax Court) have held that 

‘pre-opening’ expenses, that is, expenses incurred before the taxpayer’s trade or 

business begins to operate (what we are calling ‘start-up-costs’), are not 

deductible.”), rev’g T.C. Memo. 1986-127. Although not deductible “before the 

day on which the active trade or business begins”, sec. 195(c)(1)(A)(iii), start-up 
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[*16] expenditures may be deducted, or capitalized and deducted over time, upon a 

taxpayer’s becoming actively engaged in a trade or business, sec. 195(b); sec. 

1.195-1, Income Tax Regs.; see also Cabintaxi Corp. v. Commissioner, 63 F.3d 

at 619; Yapp v. Commissioner, at *13.

Section 195(c)(1) defines “start-up expenditure” to include any amount: 

(A) paid or incurred in connection with--

(i) investigating the creation or acquisition of an active 

trade or business, or

(ii) creating an active trade or business, or 

(iii) any activity engaged in for profit and for the 

production of income before the day on which the active trade 

or business begins, in anticipation of such activity becoming an 

active trade or business, and 

(B) which, if paid or incurred in connection with the operation 

of an existing active trade or business (in the same field as the trade or 

business referred to in subparagraph (A)), would be allowable as a 

deduction for the taxable year in which paid or incurred. 

The legislative history of section 195 states that start-up expenditures are 

those incurred to study and choose a potential business, and, once a business is 

chosen, to prepare to begin that business by compensating employees and 

consultants and traveling as needed. See H. Rept. 96-1278, at 10-11 (1980), 

1980-2 C.B. 709, 712; S. Rept. 96-1036, at 11-12 (1980), 1980 U.S.C.C.A.N. 

7293, 7301 (containing identical text).
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[*17] The taxpayer must make the preliminary choices of whether to enter into 

business and which business to enter. If the taxpayer has not made these choices, 

at the most he is still incurring investigatory costs. See sec. 195(c)(1)(A)(i); Rev. 

Rul. 99-23, 1999-1 C.B. 998, 1000 (concluding that amounts spent hiring an 

investment banker to conduct research on several industries and evaluate publicly

available financial information related to several businesses are “typical of the 

costs related to a general investigation” because they are “expenditures paid or 

incurred in order to determine whether to enter a new business and which new 

business to enter” and are therefore start-up expenditures under section 195). 

If the taxpayer has made these choices, the next step is getting that business 

to “function as a going concern and perform[] those activities for which it was 

organized.” Richmond Television Corp., 345 F.2d at 907. This is the step that 

allows the taxpayer to deduct expenses under section 162. The taxpayer “d[oes] 

not have to succeed, even so far as to have a single penny of income, in order to be 

engaged in a trade or business.” Cabintaxi Corp. v. Commissioner, 63 F.3d at 620. 

But it must intend to engage in a business (make the “whether” and “which” 

choices) and perform activities for which it was organized. 

For instance, in Cabintaxi the taxpayer had organized a corporation with the 

purpose of selling, installing, and maintaining automated transportation systems; 
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[*18] received formal authorization from a German company which had developed 

such a system (named “Cabintaxi”) to market the systems in the United States and 

Canada; and incurred expenses in an effort to sell the German system to 

Indianapolis and other North American cities. Id. The Court of Appeals for the 

Seventh Circuit, to which an appeal of this case would ordinarily lie under section 

7482, found that Cabintaxi was engaged in the business of being a U.S. and 

Canadian distributor of the German company’s automated transit system and that 

the selling expenses--which were “an integral part of being in the business of 

selling automated transit systems”--were deductible under section 162. Id.

at 620-621 (“The business of being a distributor commences with the agreement to 

distribute the supplier’s product, provided that the agreement is followed with 

reasonable promptitude by bona fide efforts to sell the product[.]” (citing 

McManus v. Commissioner, 1987 Tax Ct. Memo LEXIS 454, at *22-*23)). 

Short of taking that step and performing the functions for which a business 

was organized, the taxpayer cannot deduct expenses. Cabintaxi Corp. v. 

Commissioner, 63 F.3d at 620, directs us to compare Jackson v. Commissioner, 

864 F.2d 1521, 1526 n.7 (10th Cir. 1989), aff’g on this issue 86 T.C. 492 (1986). 

In Jackson v. Commissioner, 864 F.2d at 1523, the taxpayers organized a business 

to sell audio players/recorders and obtained a license to do so. But the taxpayers 
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[*19] “made [no] legitimate efforts to locate potential buyers for the [players/

recorders]”, a finding which was “fatal to * * * [their] case”. Id. at 1526 (first and 

second alteration in original) (“Merely possessing the legal capability to sell 

player/recorders by obtaining a license from the inventor, without actual efforts to 

sell the products, is insufficient to constitute carrying on a trade or business for 

purposes of section 162.”). And in Richmond Television Corp., 345 F.2d at 907--

the case that gave us the oft-quoted “function[ing] as a going concern” test--the 

taxpayer could not currently deduct training costs incurred before and after 

issuance of a construction permit for a television station because the television 

station was not in business until it obtained its license and began broadcasting. See 

also Provitola v. Commissioner, ___ F. App’x ___, 2021 WL 2390370, at *4 (11th 

Cir. June 11, 2021) (holding that a company still engaged in the process of creating 

a manufacturable item had not begun to operate as a going concern because “it had 

not yet manufactured or sold any of the devices, the purpose for which it was 

organized”); Madison Gas & Elec. Co. v. Commissioner, 72 T.C. 521, 566-567 

(1979) (rejecting the taxpayer’s argument that the date of issuance of a provisional 

construction permit should be considered the date of commencement of the 

partnership business and holding that the expenses the taxpayer sought to deduct 

were preoperational costs of the partnership’s initial activity and therefore must be 
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[*20] capitalized), aff’d, 633 F.2d 512 (7th Cir. 1980); McKelvey v. 

Commissioner, 2002 WL 341044, at *3 (citing Reems v. Commissioner, T.C. 

Memo. 1994-253) (finding that a taxpayer with a background in forestry who had 

taken steps to start a tree-farming business was nonetheless not carrying on a trade 

or business because “in neither of the years at issue did * * * [the taxpayer] 

commercially harvest any trees or even decide which species of tree to plant”). In 

each of these cases the taxpayer was still investigating or creating a trade or 

business, or the business had not yet begun. See sec. 195(c)(1)(A). 

Acquisition can be the means of beginning a trade or business: If a trade or 

business is acquired, it is deemed to begin when the taxpayer acquires it. Sec. 

195(c)(2)(B). And if a prior trade or business never ceased, the taxpayer need not 

begin a new trade or business; business investigation expenses are deductible if 

they are incident to an existing trade or business. See O’Donnell v. Commissioner, 

62 T.C. 781, 785 (1974), aff’d without published opinion, 519 F.2d 1406 (7th Cir. 

1975); Frank v. Commissioner, 20 T.C. 511, 513 (1953). 

B. Analysis: Petitioners’ Postreceivership Activities

Respondent argues that petitioners were no longer carrying on a trade or 

business once the Morgan entities were placed into receivership in 2009, and 

therefore the disallowed expenses (which were incurred after that time) are not 
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[*21] deductible under section 162. He argues instead that the expenses are either 

personal expenses or expenses incurred in the search for a new trade or business. 

If they are personal, then their deduction is barred by section 262(a), which 

disallows a deduction for “personal, living, or family expenses” unless the Code 

expressly provides otherwise. If they were incurred in a search for a new trade or 

business, then they are start-up expenditures, and their deduction is barred by 

section 195 until petitioners begin a business. Respondent does not dispute that the 

expenses at issue were paid or incurred. 

Petitioners counter that they were carrying on a trade or business in 2012 

and therefore Falcon’s Schedule C aircraft-related expenses and Legacy’s Schedule 

E business-search-related expenses are deductible under section 162 for that year.9

 

9 Petitioners argue in the alternative that if the Falcon and the Legacy

expenses are not deductible pursuant to sec. 162, then they are nonetheless 

deductible under sec. 165(c)(1) as losses incurred in a trade or business. Sec. 

165(c)(1) allows an individual a deduction for a loss that was incurred in a trade or 

business. But if petitioners were not carrying on a trade or business in 2012, the 

expenses are not deductible under either section. See O’Donnell v. Commissioner, 

62 T.C. 781, 786 (1974) (“Nor can * * *[the taxpayer] draw any sustenance 

from section 165 in order to sustain an abandonment loss. Our earlier rationale 

precludes a holding that * * * [the taxpayer’s] loss was ‘incurred in a trade or 

business’ under section 165(c)(1) and the fact that * * * [the taxpayer] did no more 

than make a preliminary investigation without committing any funds to the Miami 

acquisition precludes any deduction for any loss ‘incurred in any transaction 

entered into for profit’ within the meaning of section 165(c)(2).”), aff’d without 

published opinion, 519 F.2d 1406 (7th Cir. 1975).
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[*22] They present two narratives in support of this counterargument: first, Mr. 

Morgan’s continued engagement with the homebuilding industry after the receiver 

was appointed; and second, Mr. Morgan’s search for a new business to acquire. 

We consider each in turn. 

1. Continuation of Homebuilding Business

Petitioners argue that Mr. Morgan need not begin a new trade or business 

because the last one--homebuilding--never ceased. They point to his continued 

engagement with the Morgan entities and his new activities, such as the loan to Mr. 

Pyatt. 

As for Mr. Morgan’s continued engagement with the Morgan entities, the

on-the-ground cessation of homebuilding activity and the order appointing LS 

Associates as receiver indicate that his prior homebuilding trade or business ceased 

in 2009. All CPMC employees were terminated in February 2009, and CPMC did 

not build additional homes after that point. This practical shutdown is consistent 

with the Morgan entities’ financial situation and the Indiana superior court’s March 

2009 order appointing LS Associates as receiver, which gave it broad and 

exclusive powers to manage and liquidate assets. 

And as for petitioners’ argument that Mr. Morgan’s lending activity was a 

continuation of his homebuilding business, his $180,000 loan to Mr. Pyatt in 2009 
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[*23] did not demonstrate regular and continuous activity in a homebuilding trade 

or business but rather a one-time loan to a friend so the friend could pursue a 

development opportunity and then repay the loan with interest. If anything, the 

loan would be part of a lending trade or business, but isolated and irregular loans to 

trusted individuals do not support that conclusion either. See Imel v. 

Commissioner, 61 T.C. 318, 323 (1973) (holding that a taxpayer’s eight or nine

loans over a four-year period was not a lending trade or business); Heinbockel v. 

Commissioner, T.C. Memo. 2013-125, at *31-*32 (holding that a taxpayer’s 

occasional loans to her brother was not a lending trade or business).

Mr. Morgan’s actions and words support our conclusion that he was no 

longer carrying on a homebuilding trade or business. From his perspective in 

September 2009, the receivership proceedings “shut the company down” and 

began a period of transition in his life. And his focus shifted to starting or 

acquiring a new trade or business. After decades, Mr. Morgan’s homebuilding 

business had ceased.

Petitioners rely on Furner v. Commissioner, 393 F.2d 292 (7th Cir. 1968), 

rev’g 47 T.C. 165 (1966), to argue that “the intent to continue in a trade or business 

is the critical element in finding that efforts to do so are deductible” and “a 

taxpayer is able to retain his status of carrying on his * * * own trade or business 
- 24 -

[*24] independent of receiving compensation from a particular employer.” But 

Furner is readily distinguishable on its facts.

In Furner a junior high school history teacher “believed that her teaching 

required greater depth of subject matter than she possessed”, wanted to take 

courses that were difficult to pursue part time, and therefore devoted one school 

year to full-time graduate study. Id. at 293. The school system in which she 

worked did not customarily grant leaves of absence, requiring her to resign to 

pursue her year of study. Id. She returned to teaching the following year. Id. The 

court found that her period of study was a “normal incident of carrying on the 

business of teaching”. Id. at 294. It focused on “the broader question [of] whether 

the relationship of the course of study to intended future performance as a teacher 

is such that the expenses thereof can reasonably be considered ordinary and 

necessary in carrying on the business of teaching”, noting the teacher’s strategic 

choice to pursue a single-year course of study rather than spreading it out over 

many years. Id. at 294-295 (repeating the importance of “consideration of the 

relationship of the education with intended future resumption of business 

activity”).

It is difficult to consider this relationship--purposeful break from activity to 

future resumption of activity--for Mr. Morgan because his “break” was 
- 25 -

[*25] necessitated by the receivership; he used it to take time with family after 

decades of work; and while he eventually formed the intent to resume some 

business activity, he expressed uncertainty as to what that activity would be. The 

basic recognition in Furner that a brief, purposeful period studying an activity 

before returning to regular involvement in that activity does not end a trade or 

business cannot be stretched to fit the facts before us. Petitioners’ argument that 

Mr. Morgan was in the homebuilding trade or business because he was “a partner 

in his home construction partnership [CPMC]”, he “made efforts during 2009-2012 

to continue” in that business, and “[his] intent was genuine” cannot overcome the

evidence that he neither built nor sold homes in that period and was unsure 

whether he would return to the homebuilding industry.

We therefore find that Mr. Morgan was no longer carrying on a 

homebuilding trade or business following the appointment of LS Associates as 

receiver for the Morgan entities. After that time Mr. Morgan was no longer 

regularly and actively undertaking homebuilding activity with the intent to earn a 

profit. Appointment of a receiver does not always spell the end of a taxpayer’s 

trade or business. But here it did. Petitioners recognize this reality, noting that 

CPMC “did cease its operations”. Their argument that “Mr. Morgan did not 

likewise cease or abandon his interest in continuing to stay in business, but rather 
- 26 -

[*26] uninterruptedly attempted to continue in business” is unavailing given our 

finding that petitioners did not commence another homebuilding trade or business 

before the end of 2012. We therefore reject petitioners’ first theory for an active 

trade or business to which to attribute Falcon’s aircraft maintenance expenses and 

Legacy’s business search expenses. 

2. General Search for a New Trade or Business 

We next consider Mr. Morgan’s activities related to Legacy and Falcon. 

Petitioners argue that Mr. Morgan’s search for a new trade or business to acquire 

was itself an active trade or business in 2012. They point to the formation and use 

of Legacy, noting that it hired employees and engaged outside consultants. And 

they point to the support that Falcon provided Legacy in conducting that search, 

noting that it facilitated Legacy’s business search as it once facilitated the Morgan

entities’ homebuilding--that “Falcon * * * [did] for Legacy what Falcon once did 

for CPMC.” Respondent characterizes petitioners’ argument as one that Mr. 

Morgan was “simply in the business of being in business” in an attempt to avoid 

section 195 by using Legacy and Falcon as “vehicle[s] to deduct all business 

investigation expenses.” 

Beginning with Legacy, we conclude that its general business search does 

not meet the “carrying on any trade or business” requirement of section 162. The 
- 27 -

[*27] “business investigation expenses” that petitioners claimed and attributed to 

Legacy for the 2012 taxable year fit the definition of start-up expenditures in 

section 195(c)(1)(A)(i) as “amount[s] * * * paid or incurred in connection with

* * * investigating the creation or acquisition of an active trade or business”. 

Legacy paid employees and outside consultants to research a variety of industries 

and Mr. Morgan listed his time on his Legacy timesheets as 100% “business 

investigation/looking forward”, both of which indicate that Legacy’s activities 

were carried out in anticipation of beginning a trade or business. And because Mr. 

Morgan did not acquire a new business by the end of 2012, no business is deemed 

to have begun in that year under section 195(c)(2)(B). 

Petitioners rely on Roberts v. Commissioner, 820 F.3d 247 (7th Cir. 2016), 

rev’g T.C. Memo. 2014-74, to argue that “a transition from one career to another is 

a business activity” and repeatedly state that “a career is not a personal activity.” 

But Roberts focuses on section 183 and the existence of a profit motive in the 

taxpayer’s horse-racing business. Id. at 254. As petitioners note in their posttrial 

brief, respondent “does not invoke section 183”. In Roberts the taxpayer had 

chosen and was carrying on an identifiable activity (horseracing), and the Court of 

Appeals for the Seventh Circuit allowed a deduction for an improvement to that 
- 28 -

[*28] activity because the taxpayer had a profit motive. Id. But in this case petitioners had not chosen an activity and were generally searching for a new business. 

Petitioners also repeat two quotations in their briefs that, when examined in 

context, are demonstrably inapplicable to this case. First, from Primuth v. 

Commissioner, 54 T.C. 374, 379 (1970), they highlight the following proposition: 

“[F]or it is difficult to think of a purer business expense than one incurred to permit 

such an individual to continue to carry on that very trade or business”. But the 

immediately preceding clause states that “[o]nce we have made our decision that 

the * * * [taxpayer] was carrying on a trade or business of being a corporate 

executive, the problem presented here virtually dissolves”. Id. Not only have we 

not made the decision that petitioners were carrying on a trade or business, but the 

business expense in Primuth--a job-placement fee that resulted in the corporate 

executive’s transitioning from one company on Friday to another company on the 

following Monday--is a far cry from petitioners’ general business search expenses. 

Second, from T.J. Enters., Inc. v. Commissioner, 101 T.C. 581, 589 (1993), 

aff’d, 67 F.3d 1445 (9th Cir. 1995), they highlight the Court’s conclusion that “[i]t 

is well established that expenses incurred to protect, maintain, or preserve a 

taxpayer’s business, even though not in the normal course of such business, may be 

deductible as ordinary and necessary business expenses.” In T.J. Enterprises, Inc.,
- 29 -

[*29] the Court allowed a deduction for a fee paid to prevent an event of increase 

in a franchise agreement’s royalty payment because it found that if the taxpayer 

had not paid the fee the business might not have survived. Id. at 592-593. 

Petitioners’ position is that the economic recession created an event outside the 

normal course of business, entitling them to deduct expenses for 2010 through 

2012 because they were simply trying to “protect, maintain, or preserve” their 

business. Their reading would widen the scope of section 162 beyond its statutory 

bounds by effectively eliminating the “carrying on” requirement.

In sum, Mr. Morgan was not carrying on a trade or business through his 

search for a new trade or business to acquire. We agree with respondent that 

petitioners cannot squeeze into section 162 and avoid section 195 by claiming that 

Mr. Morgan’s trade or business was searching for a trade or business.

Nor can they squeeze into section 162 by arguing Falcon was in the 

consulting business during the year in issue; its activities by themselves did not 

constitute an active trade or business independent of the Morgan entities. Before 

2009 Falcon aircraft were used by Mr. Morgan to further the Morgan entities’ real 

estate development business. He would fly to various locations to view potential 

building sites, research development strategies, and check on current 

developments. Falcon serviced a broader homebuilding trade or business. 
- 30 -

[*30] Petitioners attached Schedule C for Falcon to their 2012 Form 1040 and 

listed its principal business as “consulting”, but they never established that the term 

encompasses anything other than transporting them and related individuals; Falcon

did not lease its aircraft or provide services to any unrelated third parties at any 

time, and its only gross receipts came from petitioners and Legacy. 

C. Trade or Business Conclusion

We conclude that Mr. Morgan was no longer carrying on a trade or business 

within the meaning of section 162 after the Morgan entities were placed in 

receivership in 2009 and therefore sustain respondent’s disallowance of the 

Schedule C and Schedule E deductions in issue.10

The absence of an active trade or business under the Code does not mean 

Mr. Morgan was not active in a colloquial sense--we have noted that his history of 

hard work continued in the postreceivership period. But receivership spelled the 

end of Mr. Morgan’s homebuilding trade or business. And Mr. Morgan’s 

continued activities in the aftermath of the recession and receivership--namely, the 

10 Respondent’s determination that Falcon’s “consulting” activity “does not 

meet the guidelines of carrying on a trade or business” under sec. 162 necessitated 

two corresponding adjustments on its Schedule C: a $201,654 reduction in other 

income (the amount petitioners paid for personal use of the plane) and a $315,000 

reduction in gross receipts (the amount Legacy paid Falcon as a “consulting fee”). 

Consistent with our finding that Falcon did not constitute a trade or business, we 

sustain these corresponding adjustments.
- 31 -

[*31] use of Legacy to search for a new trade or business and the continued 

existence of Falcon--did not constitute an active trade or business in 2010, 2011, or 

2012.

III. NOL Deduction

The second issue in this case is whether petitioners are entitled to an NOL 

deduction for 2012 attributable to NOL carryovers from 2010 and 2011. 

A. NOL Carryovers

Section 172 allows a taxpayer to deduct NOLs for a taxable year. The 

amount of the NOL deduction equals the aggregate of the NOL carryforwards and 

NOL carrybacks to the taxable year. Sec. 172(a). Section 172(c) defines an NOL 

as the excess of deductions over gross income, computed with certain 

modifications specified in section 172(d). Absent an election under section 

172(b)(3), an NOL for any taxable year first must be carried back 2 years and then 

carried forward 20 years. Sec. 172(b)(1)(A). The NOL deduction is not an 

automatic right. See Power v. Commissioner, T.C. Memo. 2016-157, at *13 

(citing United States v. Olympic Radio & Television, Inc., 349 U.S. 232, 235 

(1955)). Taxpayers bear the burden of establishing both the existence of NOLs 

and the amounts that may be carried over to taxable years in issue. See Rule 

142(a); Keith v. Commissioner, 115 T.C. 605, 621 (2000). 
- 32 -

[*32] While 2010 and 2011 are not before us, we may determine the correct 

amount of NOL for those years as a preliminary step in determining the correct 

amount of an NOL carryover to 2012, the year in issue. See sec. 6214(b); Calumet 

Indus., Inc. v. Commissioner, 95 T.C. 257, 274-275 (1990). NOLs may carry over 

under section 172 from the year in which they were incurred to another year only if 

the losses were the result of operating a trade or business within the meaning of 

section 162. See Lender Mgmt., LLC v. Commissioner, T.C. Memo. 2017-246, 

at *24 (citing Todd v. Commissioner, 77 T.C. 246, 248 (1981), aff’d, 682 F.2d 207 

(9th Cir. 1982)). 

Respondent argues that petitioners’ 2010 and 2011 expenses cannot give rise 

to an NOL deduction because they are the same type as the expenses underlying 

the claimed Schedule C and Schedule E deductions for 2012--that is, Falcon and 

Legacy expenses--and petitioners were not carrying on a trade or business in any 

postreceivership year.

Legacy’s expenses for 2010 and 2011 cannot carry over under section 172 

because they were not the result of operating a trade or business within the 

meaning of section 162 during those years. See supra pp. 30-31. The same would 

be true for Falcon’s expenses in those years, but petitioners claim that the Tax 
- 33 -

[*33] Equity and Fiscal Responsibility Act of 1982 (TEFRA) precludes respondent 

from disallowing any claimed deduction with respect to Falcon.11

B. TEFRA-Affected Item

TEFRA partnerships are subject to special tax and audit rules. See secs. 

6221-6234. Falcon is subject to the TEFRA audit procedures for 2010 and 2011.12 

TEFRA requires the uniform treatment of all “partnership item[s]”. A partnership 

item is an item that is most appropriately determined solely at the partnership level. 

Sec. 6231(a)(3). If the IRS decides to adjust any partnership items on a partnership 

return, it must notify the individual partners of the adjustment by issuing a Final 

Partnership Administrative Adjustment (FPAA). Sec. 6223(a); see also Greenberg 

v. Commissioner, T.C. Memo. 2018-74, at *21 n.16.

Where no TEFRA audit is commenced and no FPAA is issued, “the tax 

treatment of all partnership items with respect to the[] partnership[] is final in 

11 Before its repeal, see Bipartisan Budget Act of 2015, Pub. L. No. 114-74, 

sec. 1101(a), 129 Stat. at 625, part of TEFRA governed the tax treatment and audit 

procedures for many partnerships.

12 For those years, Falcon elected to be treated as a partnership and Falcon’s 

partners included Mr. Morgan and an S corporation. Because one of its partners is 

a pass-thru entity, Falcon is not subject to the small partnership exception. See

sec. 6231(a)(1)(B)(i), (9); sec. 301.6231(a)(1)-1(a)(2), Proced. & Admin. Regs. 

TEFRA did not apply to Falcon for 2012 because in that year Falcon was taxed as 

a disregarded entity.
- 34 -

[*34] accordance with the tax return[] filed by the[] partnership[].” Roberts v. 

Commissioner, 94 T.C. 853, 857 (1990); see also Harris v. Commissioner, 99 T.C. 

121, 124-125 (1992), supplementing T.C. Memo. 1990-80. Respondent did not

commence a TEFRA audit of Falcon for 2010 and 2011 and acknowledges that the 

time for doing so under section 6229(a) has expired. Therefore, respondent must 

accept Falcon’s 2010 and 2011 Forms 1065 as filed.

Items that are not treated as partnership items are nonpartnership items and 

are not resolved under the TEFRA rules. Sec. 6231(a)(4). Nonpartnership items 

that are dependent on determinations made at the partnership level are “affected 

item[s]”. Sec. 6231(a)(5). The need for partner-level factual development is 

enough to except an item from the definition of a partnership item. Greenwald v. 

Commissioner, 142 T.C. 308, 316-317 (2014). There is no requirement that a 

partner-level determination actually result in a change to the determination made at 

the partnership level. Domulewicz v. Commissioner, 129 T.C. 11, 20 (2007), aff’d 

in part, remanded in part sub nom. Desmet v. Commissioner, 581 F.3d 297 (6th 

Cir. 2009).
- 35 -

[*35] At least one affected item remains at issue and precludes the deductibility of 

the 2010 and 2011 Falcon losses: petitioners’ outside basis in Falcon.13 See

Greenwald v. Commissioner, 142 T.C. at 317 (holding that outside basis is an 

affected item requiring partner-level determination); sec. 301.6231(a)(5)-1(b), 

Proced. & Admin. Regs.

Outside basis is a partner’s adjusted basis in the partnership interest. 

William S. McKee, et al., Federal Taxation of Partnerships and Partners, para. 6.01 

(4th ed. 2007). Partnerships generally do not report a partner’s outside basis. A 

deduction for a partner’s distributive share of partnership losses is allowed only to 

the extent of the adjusted basis of the partner’s interest in the partnership at the end 

of the partnership year in which the losses occurred, and the losses cannot reduce 

the partner’s basis below zero. Secs. 704(d), 705(a)(2). If the partner cannot 

establish his adjusted basis in his interest, then he cannot deduct any partnership 

13 Another nonpartnership item in issue is whether the passive loss limitation 

of sec. 469 applies because petitioners did not materially participate in Falcon. See

Sellers v. Commissioner, T.C. Memo. 2020-84, at *9 n.4 (“It is well established 

that whether a partner’s involvement in an entity was active or passive is a partnerlevel determination.” (citing Estate of Quick v. Commissioner, 110 T.C. 172, 187 

(1998), supplemented by 110 T.C. 440 (1998))). Respondent argues that in the 

postreceivership years Falcon’s activities were limited to holding airplanes and 

aviation-related assets, and it therefore did not engage in any activity in which Mr. 

Morgan could materially participate. We do not reach the issue because we find 

that petitioners did not substantiate their outside basis in Falcon.
- 36 -

[*36] losses. See sec. 704(d); Sennett v. Commissioner, 80 T.C. 825, 829 (1983), 

aff’d, 752 F.2d 428 (9th Cir. 1985). “Proof of basis is a specific fact which the 

taxpayer has the burden of proving.” O’Neill v. Commissioner, 271 F.2d 44, 50 

(9th Cir. 1959), aff’g T.C. Memo. 1957-193; see also Powers v. Commissioner, 

T.C. Memo. 2013-134, at *28-*30. Further, taxpayers cannot rely solely on their 

own income tax returns to establish the losses they sustained. Wilkinson v. 

Commissioner, 71 T.C. 633, 639 (1979) (citing Roberts v. Commissioner, 62 T.C. 

834, 837, 839 (1974)).

Petitioners rely on the partners’ capital accounts reported on Falcon’s 2010 

and 2011 Forms 1065, which do not reflect Mr. Morgan’s outside basis. Mr. Rice 

testified that he and Somerset did not keep a separate schedule that showed outside 

basis because there were no differences between the capital account and outside 

basis. But we must consider whether Mr. Morgan, as a partner, incurred costs that 

increased his outside basis or otherwise engaged in transactions that reduced his 

outside basis in Falcon. In their posttrial brief petitioners argue that they

substantiated Mr. Morgan’s outside basis in Falcon by pointing to the purchase of a 

helicopter by other entities related to Falcon, but it is unclear from the record 

whether Mr. Morgan contributed property in the transaction. Petitioners have not 

introduced their 2008 or 2009 Form 1040, and we therefore do not know whether 
- 37 -

[*37] they deducted basis-reducing losses related to these other entities before 

2010 and 2011. Petitioners have not introduced sufficient evidence supporting 

their outside basis in Falcon. They therefore failed to prove entitlement to deduct 

the NOLs, and we sustain respondent’s determination. 

In sum, we find that petitioners are not entitled to the NOL carryforward 

deduction because Legacy’s 2010 and 2011 expenses were not deductible under 

section 162 and Falcon’s distributive losses were limited by petitioners’ failure to 

substantiate their outside basis.14 Accordingly, we sustain respondent’s 

disallowance of the NOL deduction for 2012. 

IV. Section 6662(a) Penalty

Finally, we must determine whether petitioners are liable for the section 

6662(a) accuracy-related penalty.

Section 6662(a) and (b)(1) and (2) imposes a penalty equal to 20% of the 

portion of an underpayment of tax required to be shown on the return that is 

attributable to “[n]egligence or disregard of rules or regulations” and/or a 

“substantial understatement of income tax.” Negligence includes “any failure to 

14 Respondent makes an alternative argument for disallowing the 2012 NOL 

deduction: Petitioners failed to report discharge of indebtedness income for 2011 

that would have absorbed their claimed NOL carryforward from that year. We do 

not reach the issue because we find that petitioners otherwise are not otherwise 

entitled to the 2012 NOL deduction.
- 38 -

[*38] make a reasonable attempt to comply with the provisions of this title”. Sec. 

6662(c). An understatement of income tax is a “substantial understatement” if it 

exceeds the greater of 10% of the tax required to be shown on the return or $5,000. 

Sec. 6662(d)(1)(A).

The Commissioner bears the initial burden of production to show an 

individual taxpayer’s liability for a penalty and is required to present sufficient 

evidence showing that the penalty is appropriate. Sec. 7491(c); Higbee v. 

Commissioner, 116 T.C. at 446-447. To meet this burden, in certain cases, the 

Commissioner also must show that he complied with the procedural requirements 

of section 6751(b)(1). See sec. 7491(c); Graev v. Commissioner, 149 T.C. 485, 

492-493 (2017), supplementing and overruling in part 147 T.C. 460 (2016).

Once the Commissioner satisfies his burden of production, the taxpayer 

bears the burden of proving that the Commissioner’s penalty determination is 

incorrect or that the taxpayer has an affirmative defense such as reasonable cause. 

See Rule 142(a); Higbee v. Commissioner, 116 T.C. at 446-447.

A. Respondent’s Burden of Production

1. Section 7491(c) Negligence and/or Substantial Understatement

We find that respondent initially presented sufficient evidence showing that 

the negligence and substantial understatement penalties are appropriate. 

Petitioners reported expenses incurred from the operation of consulting and 
- 39 -

[*39] construction businesses in 2012 and failed to present evidence that they were 

carrying on such businesses in that year. See Glotov v. Commissioner, at *3 

(finding that the Commissioner met the burden of production for a negligence 

penalty where evidence showed that the taxpayer was not carrying on a computer 

software business, contrary to the taxpayer’s reporting position). And the 

understatement of income tax in this case is $368,659. This exceeds the greater of 

10% of the tax required to be shown on the return ($40,721) or $5,000, and is 

therefore a substantial understatement under section 6662(d).

2. Section 6751 Written Supervisory Approval

We also must decide whether the Commissioner complied with section 

6751(b)(1), which provides that no penalty is allowed unless the “initial 

determination of such assessment is personally approved (in writing) by the 

immediate supervisor of the individual making such determination”. He must 

show that written supervisory approval for any penalty was obtained before the 

first formal communication to the taxpayer of the initial determination to assess 

penalties, which includes a 30-day letter. Clay v. Commissioner, 152 T.C. 223, 

249 (2019), aff’d, 990 F.3d 1296 (11th Cir. 2021).
- 40 -

[*40] Petitioners argue that respondent failed to comply with section 6751(b) 

because supervisory approval of the accuracy-related penalty was not secured 

timely and because supervisory review of the penalty was not meaningful.

Petitioners’ first argument fails. RA Donovici made a determination to 

assert the section 6662 accuracy-related penalty for both negligence and a 

substantial understatement of tax. On June 15, 2016, RA Donovici sent 

Supervisory RA Sullivan a memorandum requesting permission to assert a penalty. 

On that date, Supervisory RA Sullivan was RA Donovici’s immediate supervisor. 

And on that date, Supervisory RA Sullivan approved the penalty by digitally 

signing the memorandum. Two days after receiving this approval, on June 17, 

2016, RA Donovici mailed the 30-day letter to petitioners. Petitioners point out 

that Form 4549-A was produced on June 8, 2016, before supervisory approval was 

secured. But Form 4549-A was not mailed to petitioners before the date the 

penalty was approved. It was part of the 30-day letter mailed to petitioners two 

days after approval. We therefore find that respondent secured supervisory

approval in a timely fashion. 

Petitioner’s second argument--that the supervisory review of the penalty 

determination was not meaningful because Supervisory RA Sullivan responded 

promptly to RA Donovici’s request for permission to assert the penalty--also fails. 
- 41 -

[*41] As we have explained, “‘[w]e decline to read into section 6751(b)(1) the 

subtextual requirement’ that respondent demonstrate the depth or 

comprehensiveness of the supervisor’s review.” Belair Woods, LLC v. 

Commissioner, 154 T.C. 1, 17 (2020) (“[T]he written supervisory approval 

requirement * * * requires just that: written supervisory approval.” (quoting 

Raifman v. Commissioner, T.C. Memo. 2018-101, at *61)); see also Larkin v. 

Commissioner, T.C. Memo. 2020-70, at *69 (“[T]he question under section 

6751(b)(1) is simply whether the supervisor in fact approved the penalty[.]”). 

Supervisory RA Sullivan approved the penalty by signing it “approved”. We 

therefore find that respondent has established compliance with section 6751(b)(1).

Petitioners now bear the burden of proving reasonable cause and good faith

for any portion of the underpayment. See sec. 6664(c)(1); Higbee v. 

Commissioner, 116 T.C. at 448-449.

B. Reasonable Cause and Good Faith

A taxpayer may avoid a section 6662(a) penalty by showing that there was 

reasonable cause for any portion of the underpayment and the taxpayer acted in 

good faith. Sec. 6664(c)(1). The determination of whether a taxpayer acted with 

reasonable cause and in good faith is made on a case-by-case basis, taking into 

account all the pertinent facts and circumstances, including the taxpayer’s efforts 
- 42 -

[*42] to assess the proper tax liability and the taxpayer’s knowledge, experience, 

and education. Sec. 1.6664-4(b)(1), Income Tax Regs.

Petitioners contend that they had reasonable cause for the position they took 

on their Form 1040 because they reasonably relied on Mr. Rice and Somerset when 

reporting Falcon and Legacy expenses. Reasonable reliance on professional advice 

may constitute reasonable cause and good faith if the taxpayer proves, by a 

preponderance of the evidence, that (1) the adviser was a competent professional

with sufficient expertise to justify reliance, (2) the taxpayer provided necessary and 

accurate information to the adviser, and (3) the taxpayer actually relied in good 

faith on the adviser’s judgment. See Alt. Health Care Advocates v. Commissioner, 

151 T.C. 225, 246 (2018); Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 

43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002).

1. Competent Tax Adviser

There is no precise threshold of competence that a tax adviser must have to 

justify reliance. Our practical test looks for expertise in the context of the facts of 

each case. CNT Inv’rs, LLC v. Commissioner, 144 T.C. 161, 224 (2015); see also

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. at 99 (holding that an 

insurance agent who did not claim to be a tax professional and had a direct 

financial interest in the transaction at issue lacked sufficient expertise to advise on 
- 43 -

[*43] complex life insurance); Pankratz v. Commissioner, T.C. Memo. 2021-26, 

at *24 (holding that a longtime employee who provided financial-related support to 

taxpayer and had a bachelor’s degree in accounting lacked sufficient expertise to 

prepare a large and complex tax return); Thousand Oaks Residential Care Home I, 

Inc. v. Commissioner, T.C. Memo. 2013-10, at *41 (holding that an accountant 

with an M.B.A. degree who was a full-time return preparer and enrolled agent was 

competent to advise on employment-plan contributions).

Applying this practical test, we find that Mr. Rice was a competent tax 

adviser with sufficient expertise to justify reliance. He was a professionally 

licensed, experienced tax-return preparer with an accounting firm’s staff at his 

disposal. He knew petitioners’ personal and business affairs from his decades-long 

relationship with them. While he had not prepared a return for an entity in 

receivership, there is no indication that he was unfamiliar with how to deal with 

asset sales. Nor is there any indication that petitioners had reason to doubt his 

competence.

2. Provision of Information

To meet the second requirement of reasonable reliance, the taxpayer cannot 

“fail[] to disclose a fact that it knows, or reasonably should know, to be relevant to 

the proper tax treatment of an item.” Sec. 1.6664-4(c)(1)(i), Income Tax Regs. A 
- 44 -

[*44] taxpayer is not obligated to share details that a reasonably prudent taxpayer 

would not know, or that he would neither know nor reasonably should know are 

relevant. CNT Inv’rs, LLC v. Commissioner, 144 T.C. at 228. 

We find that petitioners provided necessary and accurate information to Mr. 

Rice and Somerset through Ms. Coyer, who would summarize all data necessary 

for their return and provide supporting documents. Mr. Rice would interact with 

Ms. Coyer throughout the year, and he had the opportunity to ask Ms. Coyer for 

clarification and additional input. Respondent argues that petitioners did not 

provide Mr. Rice with the documentation underlying the Legacy employee time 

breakdown, which Ms. Coyer prepared. But while it may have been a summary, 

there is no indication it was inaccurate, and Mr. Rice had the opportunity to request 

additional input from petitioners and Ms. Coyer. Cf. Babu v. Commissioner, T.C. 

Memo. 2020-121, at *12-*13 (holding that the taxpayer failed to meet this 

requirement by not mentioning engaging in 30,000 transactions and withdrawing 

over $3 million from a bank account during the tax year in issue).

3. Good Faith Reliance on Advice

The last requirement is that a taxpayer must have actually received advice 

and relied upon it in good faith. Neonatology Assocs., P.A. v. Commissioner, 115 

T.C. at 99. Advice is “any communication, including the opinion of a professional 
- 45 -

[*45] tax advisor, setting forth the analysis or conclusion of a person, other than 

the taxpayer, provided to (or for the benefit of) the taxpayer and on which the 

taxpayer relies, directly or indirectly”. Sec. 1.6664-4(c)(2), Income Tax Regs.

Mr. Rice credibly testified that he worked with Ms. Coyer and Mr. Morgan 

in the years before 2012 to determine how to report unreimbursed partnership

expenses related to Falcon, and that he reviewed documents provided to him by 

Ms. Coyer before entering information on petitioners’ return. While petitioners did 

not review their 2012 Form 1040 with Mr. Rice before filing, evidence from prior 

years such as Falcon’s modified expense reimbursement agreement (signed by Mr. 

Morgan) and Legacy’s monthly meeting agenda from January 2011 (distributed to 

petitioners) indicate petitioners’ awareness of and engagement with the issues in 

this case. 

We find equally credible petitioners’ reliance upon that advice because Mr. 

Rice and Somerset had been preparing petitioners’ individual returns, the Morgan 

entities’ returns, and Falcon’s returns for over a decade. See Watts v. 

Commissioner, T.C. Memo. 2017-114, at *33-*34 (holding that the taxpayers’ 

return position was taken with reasonable cause and in good faith because, 

although their long-term accountant’s determination was incorrect, it was 

reasonable and prudent for the taxpayers to rely on his advice and direction as to 
- 46 -

[*46] the intricate subject matter at hand, the sale of a partnership interest), vacated 

and remanded on other grounds, 747 F. App’x 837 (11th Cir. 2019). That Mr. 

Morgan was a well-educated, sophisticated businessman does not foreclose his 

relying on his long-time tax adviser to prepare his return. We therefore hold that 

petitioners are not liable for the section 6662 accuracy-related penalty.

Any contentions we have not addressed we deem irrelevant, moot, or 

meritless. 

To reflect the foregoing,

An appropriate decision will be

entered.