TAX COURT OPINION

Case: Larry G. & Mary L. Bangs
Docket Number: 17415-04
Judge: Kroupa
Opinion Type: memo
Filed: 04/24/2006
Pages: 12

T.C. Memo. 2006-83 UNITED STATES TAX COURT LARRY G. BANGS AND MARY L. BANGS, Petitioners X. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket No. 17415-04. Filed April 24, 2006. W. Alan Lautanen, for petitioners. Erin K. Huss, for respondent. MEMORANDUM FINDINGS OF FACT AND OPINION KROUPA, Judge: Respondent determined deficiencies in petitioners' Federal income taxes and accuracy-related penalties under section 6662(a)¹ for 1999, 2000, 2001, and 2002 (the years at issue). For 1999, respondent determined a $14,335 deficiency and determined that petitioners were liable for a $2,867 ¹All section references are to the Internal Revenue Code for issue, and all Rule references are to the Tax Court the years at Rules of Practice and Procedure, unless otherwise indicated. 4 -3- FINDINGS OF FACT Some of the facts have been stipulated and are so found. The stipulation of facts, the supplemental stipulation of facts, . and the accompanying exhibits are incorporated by this reference. Petitioners resided in California at the time they filed the petition in this case. Petitioners Petitioner Larry Bangs (Mr. Bangs) was raised and met his future wife in a small farming town in Kansas. Mr. Bangs and his future wife decided to move to California in 1964 to seek warmer weather after Mr. Bangs spent some time in college and worked in the salt mines. They were then married.3 Mr. Bangs accepted a job at Standard Oil in California. He started in a plant and then moved to the sales department, where he sold polyester resin for 6 years. His sales experience.and entrepreneurial drive convinced him to start a new business with his wife. They began their own business distributing fiberglass products. The business was successful and grew into fiberglass manufacturing as well. Petitioners explored several different business opportunities, some of which were successful. Petitioners found.success in manufacturing plastic lettering, manufacturing chemical tanks, and designing the curled tail on the back of skateboards. Petitioners lost money in jet ski manufacturing, however, and they discontinued it when it was not 3 We refer to petitioner Mary Bangs as Mrs. Bangs. -5- property. They built a warehouse, a ripening room, and added water pumps. Petitioners also had a large well on the property that was producing more water than necessary for the lemon trees, so petitioners also decided to raise catfish. They watered the lemon trees with refuse or runoff water from the catfish tanks, but when the catfish venture was unsuccessful, petitioners abandoned it. Mr. Bangs decided in 1994 to harvest some lemons. He decided to harvest less than 4 years after planting the trees even though he was aware that it would take 10 years before the trees would fully produce. He also knew that it might stunt the growth of the trees but he was anxious to see how the lemon market worked. Petitioners sold these lemons to a packing house in Rancho Santa Fe and reported $469 of income from lemon sales in 1994. Mr. Bangs claimed that he spent 60 to 80 hours per week on the lemon farming activity, and claimed that petitioners together spent between 80 to·90 hours per week on the activity. Mr. Bangs pruned and weeded the tree area, re.paired equipment, and did other activities. Mrs. Bangs did both physical. work and kept the financial records. Petitioners did not employ any outside employees. Mrs. Bangs was responsible for the financial records of the farming activity. The only financial records for the activity, however, consisted of stacks of receipts. Petitioners did not -7- Respondent audited petitioners' return for 1995. In that audit,. respondent did not disall.ow the deductions petitioners claimed in connection with their farming activity for that year. Several natural events occurred during the years at issue that impacted the lemon farming activity. A 1993 wildfire destroyed some of the lemon trees. Poor soil conditions led petitioners to consult a supervising plant pathologist in 1997 out of concern for their trees' health. The pathologist examined the trees and.noted that they looked unhealthy and had curled yellow leaves. The pathologist reported that these problems could be due to the soil staying wet too long or to a mineral deficiency. Petitioners also claim they experienced a water shortage during the years at issue. Petitioners drilled additional wells in 2000 and 2002, but their efforts did not produce any additional water. Mr. Bangs indicated at trial that (cid:16)042he would await the outcome of this case before he decided whether to drill more wells on the property. The Trust Scheme Petitioners became involved in a trust scheme in 1999. They did not consult an attorney or CPA before they bought into the scheme. Petitioners transferred title to most of their assets to trusts to avoid paying taxes on the income from these assets. Petitioners, in contrast to the lack of records for lemon farming, kept detailed books and records relating to their trusts. The trust-related financial records included balance sheets, capital gain reports, and transaction reports by _9_ Respondent's revenue agent sent petitioners a number of documents in September 2003 to resolve all non-farming activity issues after she reviewed petitioners' pro forma returns. These documents included Form 4549A, Form 870, Waiver of Restrictions on Assessment, Form 906, Closing Agreement Covering Specific Matters (the closing agreement), and Form 872, Consent to Extend (cid:16)042the Time to Assess Tax. Petitioners needed to extend the period of limitations because the period for 1999 would soon expire. The closing agreement resolved the dispute relating to the proper treatment of the trusts. In it, the parties agreed that the trusts would be disregarded and the trusts were petitioners' alter egos. Petitioners also agreed that they would report on individual returns for 1999 and subsequent years all income, expenses, and deductions, as allowed by the Code.. In addition, the parties agreed that petitioners would be liable for additional taxes, penalties, and interest on their individual returns due to collapsing the trusts. Petitioners signed each document and returned them to the revenue agent. Respondent also executed the closing agreement. Shortly after petitioners signed these documents, the revenue agent discovered that she had made errors in the Form 4549A petitioners signed. The revenue agent had inadvertently omitted interest income that petitioners had shown on their pro forma returns, and she miscalculated the amount of capit'al gains. Petitioners apparently did not notice these mistakes when they -11- OPINION There are several issues for decision. We are asked to decide, first, whether petitioners engaged in their lemon farming activity for profit. We are also asked to decide whether petitioners are liable for taxes on interest income and capital gains that petitioners admit they earned for the years at issue, but were excluded from the initial Form 4549A petitioners signed. Finally, we must decide whether petitioners are liable for the accuracy-related penalty for each of the years at issue. We address each of these issues in turn, after first considering the burden of proof. I. Burden of Proof In general, the Commissioner's determinations in the deficiency notice are presumed correct, and the taxpayer bears the burden of proving that the Commissioner's determinations are in error. See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Section 7491(a) shifts the burden of proof to the Commissioner with respect to a factual issue relevant to a taxpayer's liability for tax, however, under certain circumstances. The burden shifts to the Commissioner if the taxpayer introduces credible evidence with respect to the issue, complies with substantiation requirements, maintains all required records, and cooperates with the Commissioner's reasonable -13- gross income from the activity exceeds the deductions allowable under section 183(b)(1). We follow the Court of·Appeals opinion squarely in point when appeal from our decision would lie to that court absent stipulation by the parties to the contrary. Golsen v. Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir. 1971). Taxpayers residing in the Ninth Circuit, such as petitioners, must prove they conducted their activities with the primary, predominant, or principal purpose of realizing an economic profit independent of tax savings. See Wolf v. Commissioner, 4 F.3d 709, 713 (9th Cir. 1993), affg T.C. Memo. 1991-212; Polakof v. Commissioner, 820 F.2d 321, 323 (9th Cir. 1987), affg. T.C. Memo. 1985-197; Indep. Elec. Supply, Inc. v. Commissioner, 781 F.2d 724, 726 (9th Cir. 1986), affg. Lahr v. Commissioner, T.C. Memo. 1984-472. Whether a taxpayer has the primary, predominant, or principal purpose of realizing an economic profit independent of tax savings is determined on the basis of all surrounding facts and circumstances. Polakof v. Commissioner, supra at 324; Indep. Elec. Supply, Inc. v. Commissioner, supra at 727; Dreicer v. Commissioner, 78 T.C. 642, 645 (1982), affd. without published opinion 702 F.2d 1205 (D.C. Cir. 1.983); sec. 1.183-2(b), Income . . Tax Regs. While a taxpayer's expectation of profit need not be reasonable, there must be a good faith objective of making a profit. Allen v. Commissioner, 72 T.C. 28, 33 (1979); sec. 1.183-2(a), Income Tax Regs. C. Applying Factors to Facts -15- Nearly all of the factors in this case indicate that petitioners did not engage in their lemon farming activity for profit. Petitioners did not conduct their activity in a businesslike manner. Engdahl v. Commissioner, 72 T.C. 659, 666-667 (1979); sec. 1.183-2(b)(1), Income Tax Regs. For example, they did not have a written business plan, any financial statements, or any financial data pertaining to their lemon farming activity other than a stack of receipts. This dearth of financial records is in stark contrast to their financial records for their abusive trusts. Petitioners had copious records for the trusts including transaction reports by category, balance sheets, and capital gain reports. Moreover, petitioners were unable to articulate how they intended to earn a profit, and it is unclear from the record how many trees they had on the property at any given time. Petitioners also claim that they attempted changes to their lemon farming activity when they experienced a water shortage. While they introduced evidence that they drilled additional wells, petitioners did not indicate any other methods they attempted to supply water to their land. Petitioners also have not shown that they studied the accepted business, economic, and scientific practices involved in lemon farming. See sec. 1.183-2(b)(2), Income Tax Regs. While Mr. Bangs likely had some general farming experience from his youth and he consulted an adviser regarding which crop to raise, -17- years at issue, petitioners failed to document the activity in their trust-related financial records. Petitioners do not contend that they were relying upon the property's value increasing for them to generate profit from the lemon farming activity. See Bessenvey v. Commissioner, 45 T.C. 261, 274 (1965), affd. 379 F.2d 252 (2d Cir. 1967); sec. 1.183- 2(b) (4), Income Tax Regs. They do assert, however, that they expected the lemon trees to·appreciate as fruit 'production increased. Selling the trees to realize this appreciation is counter to their argument that they were selling lemons for profit. Petitioners succeeded in other pursuits. None was similar to the lemon farming activity. See Haladay v. Commissioner, T.C. Memo. 1990-45; Daugherty v. Commissioner, T.C. Memo. 1983-188. Petitioners grew their fiberglass business into a successful enterprise that they sold for several million dollars. Petitioners also have a successful rental real estate and investment operation. These activities, however, are quite dissimilar to lemon farming. Petitioners' success in these dissimilar activities does not lead us to conclude that the lemon farming activity will eventually become profitable as well. See Haladay v. Commissioner, supra. We find just as telling that petitioners were involved in unprofitable businesses, all of which they abandoned. These included jet ski manufacturing and catfish farming. Yet, unlike the other unprofitable enterprises, petitioners have not -19- Moreover, the trees on the prop.erty across from petitioners' land looked healthy. Petitioners sold their fiberglass business in the early 1980s for several million dollars and currently have a profitable rental real estate activity. Petitioners consider themselves retired. The large losses they claim from their lemon farming activity partially offset petitioners' substantial income from their non-farming activities. Petitioners therefore had an incentive to incur losses in the farming activity. See Jackson v. Commissioner, 59 T.C. 312, 317 (1972). Petitioners have a 6,000 square foot home on the Valley Center property where they conduct their farming activity. Mr. Bangs wanted to have something to do in his backyard when he retired. Petitioners have fond memories of farming from their youth and had always hoped to get back to farming. They were pleased that they could do so raising citrus trees in California, a warm climate. See id.; sec. 1.183-2(b)(9), Income Tax Regs. We find that petitioners derived personal pleasure from their farming activity, which is an indication that petitioners did not engage in the activity for profit. Based on all of the facts and circumstances, we find that . petitioners have not shown they conducted their lemon farming activity with the primary, predominant, or principal purpose of . realizing an economic profit independent of .tax savings. See Wolf v. Commissioner, 4 F.3d at 713; Polakof v. Commissioner, 820 -21- covers only specific matters; in this case, the treatment of the trusts. The closing agreement does not cover other issues or determine petitioners' tax liability for the years at issue. Urbano v. Commissioner, supra. Accordingly, the closing agreement does not.prevent respondent from determining deficiencies or penalties for the years at issue. In fact, the parties agreed in the closing agreement that petitioners would report all income, expenses, and deductions on their individual returns for the years at issue. The closing agreement also provides that petitioners will be liable for additional taxes, penalties, and interest that may arise on their individual returns by collapsing the trusts. Accordingly, the terms of the closing agreement provide that petitioners shall be liable for taxes on their income for the years at issue. Respondent was therefore not prevented from determining that petitioners owe taxes on interest income and capital gains they admitted they received during the years at issue. We find that petitioners are liable for these taxes. IV. Whether Petitioners Are Liable for the Accuracy-Related Penalty The next issue is whether petitioners are liable for the accuracy-related penalty under section 6662(a). Respondent determined that petitioners.were negligent and therefore liable for the penalty.7 7Respondent also asserts that petitioners substantially understated their tax and are therefore liable. that petitioners were negligent, we need not consider whether Because we find (continued...) -23- 6664(c)(1); sec. 1.6664-4(b), Income Tax Regs. Petitioners have the burden of proving that the accuracy-related penalty does not apply. See Higbee v. Commissioner, supra at 446. The determination of whether the taxpayers acted with reasonable cause and in good faith depends on the pertinent facts and circumstances, including the taxpayer's efforts to assess his or her proper tax liability, the knowledge and experience of the taxpayers, and the reliance on the advice of a professional. Sec. 1.6664-4(b)(1), Income Tax Regs. Petitioners argue that they acted with reasonable cause regarding the lemon farming activity. Petitioners deducted the same expenses on previous returns, and the Commissioner did not disallow those deductions in an earlier audit. Sheehy v. Commissioner, T.C. Memo. 1996-334. A similar deduction allowed on audit for an earlier year may be one factor to be considered in determining whether the accuracy-related penalty applies. See Stewart v. Commissioner, T.C. Memo. 2002-199; sheehy v. Commissioner, supra. We note that the inquiry into whether an activity was engaged in for profit is a facts and circumstances test. We find it was reasonable for petitioners to believe the deductions were permitted when a previous audit did not require changes. See Sheehy v. Commissioner, supra. Based on all of the facts and circumstances of this case, we find that petitioners had reasonable cause for and acted in good faith with respect to the treatment of their lemon farming activity. We accordingly find