department of the treasury internal_revenue_service washington d c contact person id number op telephone number date uil act legend foundation a foundation b foundation c dear taxpayer this is in response to your letter dated date as supplemented by subsequent correspondence wherein you requested certain rulings concerning the federal tax consequences of the proposed transaction described below you are a non-profit non-stock corporation and your purpose is to carry out charitable activities as described in sec_501 of the internal_revenue_code ‘code’ you are exempt from federal_income_tax under sec_501 of the code and are classified as a private_foundation within the meaning of sec_509 a ten- member board_of directors governs you to accomplish your charitable purposes you are involved in agricultural research and applied biotechnology and assist other non- profit organizations through grants and employee involvement you represent that you have no outstanding grants with respect to which you are required to exercise expenditure_responsibility under sec_4945 _ foundation a is a non-profit corporation and is organized and operated exclusively for religious charitable scientific literary and or educational_purposes it is exempt from federal_income_tax as an organization described in sec_501 of the code and is classified as a private_foundation within the meaning of sec_509 two members of its three-member board_of directors serve on your board_of directors foundation b is a non-profit corporation and is organized and operated exclusively for religious charitable scientific literary and or educational_purposes it is exempt from federal_income_tax as an organization described in sec_501 of the code and is classified as a private_foundation within the meaning of sec_509 two s 7s members of its five-member board_of directors serve on your board_of directors foundation c is a non-profit corporation and is organized and operated exclusively for religious charitable scientific literary and or educational_purposes it is exempt from federal_income_tax as an organization described in sec_501 of the code and is classified as a private_foundation within the meaning of sec_509 two members of its four-member board_of directors serve on your board_of directors you propose to provide grants to foundation a foundation b and foundation c each grant will consist of cash and securities the total amount of all three grants combined is less than percent of the fair_market_value of your net assets the president of each recipient foundation is required to sign a written_agreement wherein the foundation agrees to comply with certain terms the written_agreement is in the form of a bill of sale and the terms therein include the following the grant is to be used for endowment or other capital purposes to enable the foundation to carry out its religious charitable scientific literary and or educational_purposes as described in sec_170 and sec_501 of the code the recipient foundation must return any portion of the grant not used for such purposes it must submit full and complete annual reports with respect to its use of the grant maintain financial records of receipts and expenditures with respect to the grant and make such records available for your inspection the recipient foundation must comply with all other expenditure_responsibility requirements of sec_4945 finally it must not use the grant for any purposes prohibited under sec_4945 you have incurred legal accounting and other expenses and costs in connection with providing these grants to the recipient foundations you represent that these expenses and costs are reasonable and necessary concerning a prior transaction in a letter dated date we issued nine rulings approving the proposed merger between you and a private_foundation which had the same name as foundation a on date you and that private_foundation merged with you as the surviving foundation at the time of that requested rulings none of the parties involved contemplated the transactions that are the subject of this ruling law sec_501 of the code provides for the exemption from federal_income_tax of non-profit organizations organized and operated exclusively for religious charitable educational and other exempt purposes sec_507 of the code provides that except as provided in sec_507 the status of any organization as a private_foundation shall be terminated only if it notifies the secretary of its intent to terminate or with respect to such organization there have cw been either willful repeated acts or failures to act or a willful and flagrant act or failure to act giving rise to liability for tax under chapter and the secretary notifies such organization that it is liable for tax imposed by sec_507 sec_507 of the code provides that in the case of a transfer of assets of any private_foundation to another private_foundation pursuant to any liquidation merger redemption recapitalization or other adjustment organization or reorganization the transferee foundation shall not be treated as a newly created organization sec_1_507-3 of the income_tax regulations regulations provides that a transfer under sec_507 of the code includes a transfer of assets from one private_foundation to one or more private_foundations pursuant to any reorganization partial_liquidation or any other significant disposition of assets the term significant disposition includes any disposition of percent or more of the transferor private foundation's assets sec_4941 of the code imposes a tax on each act of self-dealing between a disqualified_person and a private_foundation sec_4942 of the code imposes a tax on the undistributed_income_of_a_private_foundation sec_4942 of the code provides that the term undistributed_income means with respect to any private_foundation for any taxable_year as of any time the amount by which the distributable_amount for such taxable_year exceeds the qualifying distributions made before such time out of such distributable_amount sec_53_4942_a_-3 of the regulations provides in pertinent part that the term qualifying_distribution means any amount including program-related investments as defined in sec_4944 and reasonable and necessary administrative expenses paid to accomplish one or more purposes described in sec_170 or b other than any contribution to a private_foundation which is not an operating_foundation as defined in sec_4942 - sec_4942 of the code provides in pertinent part that the term qualifying_distribution means any amount including that portion of reasonable and necessary administrative expenses paid to accomplish one or more purposes described in sec_170 other than any contribution to i an organization controlled directly or indirectly by the foundation or one or more disqualified persons with respect to the foundation except as provided in paragraph or ii a private_foundation which is not an operating_foundation except as provided in paragraph sec_4942 of the code provides in pertinent part that the term qualifying_distribution includes a contribution to a sec_501 organization described in ot a sec_4942 or ii if a not later than the close of the first taxable_year after its taxable_year in which such contribution is received such organization makes a distribution equal to the amount of such contribution and such distribution is a qualifying_distribution which is treated under sec_4945 as a distribution out of corpus and b the private_foundation making the contribution obtains adequate_records or other_sufficient_evidence from such organization showing that the qualifying_distribution described in subparagraph a has been made by such organization sec_4944 of the code imposes a tax on any amount invested by a private_foundation in a manner that jeopardizes the carrying out of any of its exempt purposes sec_4945 of the code imposes a tax on any taxable_expenditure made by a private_foundation as defined in pertinent part by sec_4945 sec_4945 of the code provides that the term taxable_expenditure means any amount_paid or incurred by a private_foundation as a grant to another organization unless - a such organization is described in paragraph or of sec_509 or is an exempt_operating_foundation as defined in sec_4940 or b the private_foundation exercises expenditure_responsibility with respect to such grant in accordance with sec_4945 sec_53_4945-5 of the regulations provides in pertinent part that the term taxable_expenditure includes any amount_paid or incurred by a private_foundation as a grant to an organization other than an organization described in sec_509 or unless the private_foundation exercises expenditure_responsibility with respect to such grant in accordance with sec_4945 sec_53_4945-5 of the regulations concerns the terms of grants the regulation provides that in order to exercise expenditure_responsibility the grantor private_foundation must require that the grant be subject_to a written commitment signed by an appropriate officer director or trustee of the grantee including the grantee’s agreement to repay any portion of the grant which is not used for the purposes of the grant to submit full and complete annual reports on the manner in which the grant funds are spent and the progress made in accomplishing the purposes of the grant to maintain records of receipts and expenditures to make its books_and_records available to the grantor at reasonable times and not to use any of the funds to carry on propaganda or otherwise attempt to influence legislation within the meaning of one a code sec_4945 or to influence the outcome of any specific public election or to carry on directly or indirectly any voter registration drive within the meaning of code sec_4945 or to make any grant which does not comply with the requirements of code sec_4945 or sec_4945 or to undertake any activity for any purpose other than one specified in code sec_170 the agreement must also clearly specify the purposes of the grant such purposes may include contributing for capital endowment provided that neither the grants nor the income therefrom may be used for purposes other than those described in code sec_170 sec_53_4945-5 of the regulations concerns capital endowment grants to exempt private_foundations the regulation provides that if a private_foundation makes a grant to another private_foundation for endowment or for other capital purposes the grantor private_foundation must require reports from the grantee private_foundation on the uses of the principal and the income if any from the grant funds the grantee must make such reports annually for its tax_year in which the grant was made and for its immediately succeeding two tax years only if it is reasonably apparent to the grantor that before the end of such grantee’s second succeeding tax_year neither the principal nor the income from the grant funds has been used for any purpose which would result in liability for tax under sec_4945 may the grantor then allow the grantee’s reports to be discontinued sec_53_4945-5 of the regulations provides in pertinent part that to satisfy the report making requirements of sec_4945 of the code a granting foundation must provide the required information on its annual information_return required to be filed by sec_6033 for each taxable_year with respect to each grant made during the taxable_year which is subject_to the expenditure_responsibility requirements of sec_4945 such information must also be provided on such return with respect to each grant subject_to such requirements upon which any amount or any report is outstanding at any time during the taxable_year however with respect to any grant made for endowment or other capital purposes the grantor must provide the required information only for any taxable_year for which the grantor must require a report from the grantee under sec_53_4945-5 the requirements of this subparagraph with respect to any grant may be satisfied by submission with the foundation's information_return of a report received from the grantee if the information required by section d is contained in such report sec_53_4945-5 of the regulations provides that the report required by this paragraph shall include the following information i the name and address of the grantee ii the date and amount of the grant iii the purpose of the grant iv the amounts expended by the grantee based upon the most recent report received from the grantee v whether the grantee has diverted any portion of the funds or the income therefrom in the case of an endowment grant from the purpose of the grant to the knowledge of the grantor vi the dates of any reports received from the grantee vii the date and results of any verification of the grantee’s reports undertaken sec_79 pursuant to and to the extent required under paragraph c of this section by the grantor or by others at the direction of the grantor sec_53_4945-6 of the regulations provides that any payment which constitutes a qualifying_distribution under sec_4942 or an allowable deduction under sec_4940 will not be treated as a taxable_expenditure under sec_4945 sec_53_4946-1 of the regulations provides that for purposes of sec_4941 only the term disqualified_person shall not include any organization which is described in sec_501 other than an organization described in sec_509 discussion a private_foundation described in sec_501 of the code may make grants to another private_foundation such grants will not be taxable_expenditures provided the grantor private_foundation exercises expenditure_responsibility with respect to those grants see sec_4945 of the code and sec_53_4945-5 of the regulations in exercising expenditure_responsibility the grantor private_foundation must require the grant recipient to comply with the requirements described in sec_53_4945-5 of the regulations where a grant is a capital endowment grant the requirements of sec_53_4945-5 also must be satisfied by the grantor private_foundation you propose to make an endowment grant to each of the aforementioned foundations the terms of these grants as described above satisfy the expenditure requirements of sec_4945 and the regulations thereunder hence making these grants to the foundations will not constitute taxable_expenditures you have provided sufficient information as described above to show that these grants will further charitable purposes described in sec_170 and sec_501 of the code hence your exempt status under sec_501 will not be adversely affected these grants will not constitute a sec_507 transfer since the total amount of all three grants does not comprise percent or more of your assets see sec_1_507-3 of the regulations the definition of a disqualified_person does not include any organization that is described in sec_501 see sec_53_4946-1 of the regulations hence providing the endowment grants to the recipient foundations will not constitute self- dealing within the meaning of sec_4941 the grant you will make to each foundation for endowment purposes is not an investment for the production_of_income rather such amounts constitute endowment grants that further purposes described in sec_501 and sec_170 of the sg code thus the grants will not constitute investments that jeopardize the carrying out of your exempt purposes under sec_4944 the reasonable and necessary expenses and costs were incurred in connection with providing these endowment grants and to accomplish purposes described in sec_170 of the code hence they may be treated as qualifying distributions for purposes of sec_53_4942_a_-3 of the regulations and are not taxable_expenditures for purposes of sec_4945 see sec_53_4945-6 of the regulations finally making the grants to the foundations will not call into question the representations made by you in our date ruling letter request for rulings neither you nor that private_foundation contemplated the current proposed transaction described herein therefore the proposed grants to the foundations will not adversely affect the rulings we made in our date ruling letter at the time of your based upon the foregoing we rule as follows the grant you will provide to each recipient foundation will not adversely affect your exempt status under sec_501 of the code the grant you will provide to each recipient foundation will not constitute a transfer described in sec_507 of the code also providing the grants will not have the effect of dispossessing you of any of the attributes or characteristics described in sec_1_507-3 of the regulations the grant you will provide to each recipient foundation will constitute capital or endowment grants since you will exercise expenditure requirements pursuant to sec_53_4945-5 and sec_53_4945-5 of the regulations these grants will not constitute taxable_expenditures within the meaning of sec_4945 of the code the grant agreement that you and each recipient foundation will execute meets the requirements of sec_53_4945-5 of the regulations the reasonable and necessary legal accounting and other expenses you incur in connection with providing these grants to each recipient foundation will constitute qualifying_distribution within the meaning of sec_4942 of the code and will not constitute taxable_expenditures within the meaning of sec_4945 the grant you will provide to each recipient foundation will not constitute an act of self-dealing within the meaning of sec_4941 of the code the grant you will provide to each recipient foundation will not constitute a cy ao jeopardizing investment within the meaning of sec_4944 of the code the grants you will provide to the recipient foundations will not affect the rulings we issued in our date ruling letter this ruling is conditioned on the understanding that there will be no material_change in the facts upon which it is based this ruling does not address the applicability of any section of the code or regulations to the facts submitted other than with respect to the sections described above you should keep a copy for your permanent records the ruling is directed only to the organization that requested it sec_61 k of the internal_revenue_code provides that it may not be used or cited by others as precedent sincerely signed robert c harper ur robert c harper jr id chief exempt_organizations technical branch sy


t c memo united_states tax_court lee w yates and wendy s yates petitioners v commissioner of internal revenue respondent docket no filed date bruce j berger for petitioner andrew p crousore for respondent memorandum findings_of_fact and opinion panuthos chief special_trial_judge this case was heard pursuant to the provisions of sec_7443a and rule sec_180 sec_181 and sec_182 respondent determined deficiencies in all section references are to the internal_revenue_code as amended unless otherwise indicated all rule references are to the tax_court rules_of_practice and procedure petitioners' federal income taxes as well as accuracy-related_penalties in the following amounts accuracy-related_penalty year deficiency sec_6662 dollar_figure dollar_figure big_number big_number the issues for decision are whether petitioners' horse-breeding activities constitute an activity engaged in for profit for the purposes of sec_162 and sec_183 and whether petitioners are liable for the accuracy-related_penalty under sec_6662 findings_of_fact some of the facts have been stipulated and they are so found the stipulation of facts and the attached exhibits are incorporated herein by this reference at the time of filing the petition petitioners resided in clovis california during the years in issue petitioners were each employed full time as registered nurse supervisors since petitioners also operated a medical legal consulting firm the firm reviewed medical charts upon request petitioners reported combined gross_income from this employment during the period through in the following amounts year amount dollar_figure big_number big_number big_number petitioners also reported consulting income on line of form sec_1040 for and in the amounts of dollar_figure and dollar_figure in petitioners bought a horse as a gift_for their daughter prior to purchasing the horse petitioners attended a to 8-week course on equine care and maintenance while attending the class they met dr keith lane who introduced petitioners to the paso fino a breed of horse possessing a smooth gait and agreeable disposition in petitioners decided to breed paso fino horses and commenced operating the silk oak paso fino ranch silk oak petitioners established silk oak on dollar_figure acres of property where their personal_residence was located petitioners had acquired the land for dollar_figure in and constructed a residence at a cost of dollar_figure in the same year the parties agree that at the time of trial the fair_market_value of the property was dollar_figure before beginning the operation of silk oak petitioners met with several successful breeders of paso fino horses who convinced petitioners that they could profitably run a paso fino ranch petitioners were advised on such topics as basic horse care showing advertising cost control and breeding cliff hathaway an appraiser hired by petitioners determined the value of the property by comparing the sale prices of similar personal residences recently sold in the area petitioners also met with an accountant who assisted petitioners in setting up a bookkeeping system and separate checking accounts petitioners however did not draft a detailed business plan and did not compute any written financial projections by early petitioners owned purebred paso fino horses and had owned a maximum of petitioners have also sold five horses since establishing silk oak the horses owned by silk oak at the date of trial their acquisition costs and their estimated values are as follows name acquisition_cost estimated f m v mancebo de coral dollar_figure dollar_figure--big_number la hija del centaur big_number big_number vitrina del dulce big_number big_number -big_number reya de seda foaled big_number --big_number el coete de seda foaled big_number --big_number alas de seda foaled big_number --big_number elegancia de seda foaled big_number --big_number latina de seda foaled big_number --big_number total big_number big_number -big_number the five horses sold by petitioners including original acquisition costs and selling prices are as follows name acquisition_cost sale price gain cobre de seda foaled dollar_figure dollar_figure noche caliente -0- fernando bravo dollar_figure big_number big_number tuaca del centaur big_number big_number big_number sombra de seda foaled -0- -0- total big_number big_number big_number from to petitioners reported income and expenses relating to the operation of silk oak on schedule c in the following amounts year ranch expense sec_1 gross_income ranch losses --- --- dollar_figure --- --- big_number --- --- big_number dollar_figure dollar_figure big_number big_number big_number big_number big_number big_number big_number big_number big_number total big_number the record does not include information regarding petitioners' income and expenses for and the stipulation of facts miscalculated total losses as dollar_figure petitioners deducted the losses resulting from the operation of silk oak respondent disallowed petitioners' deductions for and concluding that petitioners did not engage in the running of silk oak with the requisite profit_motive petitioners have hired professional trainers to work with their horses averaging to months per horse to increase profitability petitioners have improved their own abilities to personally train their horses thereby mitigating the expenses of hiring an outside trainer in addition petitioners have sought to increase profitability by breeding up ie breeding their horses to horses with stronger pedigrees petitioners have advertised their horses for sale in the local newspaper have posted flyers offering their horses for sale or stud services and have participated in various horse shows furthermore in and petitioners were seeking to sell their ranch in california and relocate to texas where purportedly lower costs and a better market for paso fino horses render profitability more likely opinion taxpayers seeking to deduct expenses under sec_162 must establish that the underlying activity was engaged in for an actual and honest profit objective 78_tc_642 affd without published opinion 702_f2d_1205 d c cir if a taxpayer's activity is deemed not to be engaged in for the purposes of earning a profit the deductibility of expenses resulting from the activity is restricted by sec_183 particularly sec_183 provides that expenses which result from an activity_not_engaged_in_for_profit and which would be allowable only if the activity were engaged in for profit are deductible only to the extent of income derived from the activity generally taxpayers bear the burden of proving that the activities in question were entered into for a profit rule a 72_tc_411 affd without published opinion 647_f2d_170 9th cir to determine whether a taxpayer has entered into an activity for a profit we must consider all of the facts and circumstances placing greater weight upon objective facts than upon a taxpayer's mere statements of intent dreicer v commissioner supra pincite nevertheless there is no requirement that the taxpayer reasonably expect profits from the activity in question 90_tc_960 affd without published opinion 899_f2d_18 9th cir sec_1_183-2 income_tax regs provides nine factors to be considered when determining whether an activity is engaged in for profit these are the manner in which the taxpayer carries on the activity the expertise of the taxpayer or his advisors the time and effort expended by the taxpayer in carrying on the activity the expectation that assets used in the activity may appreciate in value the success of the taxpayer in carrying on other similar or dissimilar activities the taxpayer's history of income or losses with respect to the activity the amount of occasional profits if any which are earned the financial status of the taxpayer and the elements of personal pleasure or recreation that may be present no single factor is controlling 86_tc_360 sec_1 b income_tax regs we will separately discuss each factor the manner in which petitioners carried on the horse- breeding activity taxpayers who carry on the activity in question in a businesslike manner and maintain complete and accurate books_and_records are more likely to establish that the activities in question were engaged in for a profit sec_1_183-2 income_tax regs the record indicates that petitioners maintained thorough accounts of revenue and expenditures connected with silk oak's operations using a computer_program recommended by their accountant petitioners also maintained separate_accounts for silk oak's finances respondent concedes that petitioners maintained books_and_records in a businesslike manner petitioners' detailed bookkeeping does not by itself indicate an intent to generate a profit golanty v commissioner supra pincite a lack of profit_motive may exist where a taxpayer fails to abandon unprofitable methods change operations or adopt new techniques in an attempt to improve profitability sec_1_183-2 income_tax regs accordingly the maintenance of detailed books_and_records may reveal the mere trappings of a profit business particularly when a taxpayer fails to produce income statements profit plans or business plans created to alter operations in an attempt to reverse mounting losses osteen v commissioner tcmemo_1993_519 affd in part and revd in part 62_f3d_356 11th cir in this instance petitioners commenced operation of silk oak with neither expertise in running a profitable ranch nor a detailed written plan fashioned to enable them to earn a profit petitioners however contend that before conducting any ranching activities they consulted with individuals who have had some success in breeding paso fino horses petitioners also argue that since commencing operation of silk oak they have attempted to increase profitability by improving their training techniques enhancing the bloodlines of their foals and proposing a move of their ranching activities to texas where expenses are purportedly lower respondent asserts that petitioners' testimony concerning advice received from other paso fino breeders was vague and self-serving and yielded no written business plan likewise respondent contends that petitioners offered no specific evidence to establish that a relocation to texas would enhance profit opportunities furthermore respondent maintains that silk oak's consistent losses indicate that the changes implemented by petitioners were modest and have had little impact the record indicates that expenses and losses have steadily increased over time and petitioners have not presented a detailed written profit plan although petitioners sought advice from several successful paso fino breeders their testimony in this regard was vague and the meetings yielded no concrete plan of operation petitioners decided to commence operation of silk oak with little concept of the expenses involved or of the steps involved to achieve cost efficiency and an eventual profit daley v commissioner tcmemo_1996_259 furthermore in the face of mounting losses petitioners have failed to materially alter their operations or their prospects of generating profits golanty v commissioner supra pincite with respect to their proposed move to texas petitioners have failed to introduce specific evidence to indicate that increased profit potential would result for this reason we regard petitioners' expectations of enhancing profitability by moving to texas as being too speculative to support their position accordingly we find that this factor favors respondent the expertise of petitioners or their advisors preparing to enter into an activity by extensively studying accepted business economic and scientific practices as well as consulting with experts may indicate that the taxpayer has a profit_motive sec_1_183-2 income_tax regs while we have found that petitioners have knowledge of paso fino horses they did not engage in the activity with expertise about running a profitable ranch the record indicates that the to 8-week course in which petitioners enrolled narrowly pertained to horse care and maintenance and did not instruct petitioners in regard to the day-to-day operations of a profitable ranch this factor favors respondent the time and effort expended by petitioners in carrying on the activity taxpayers expending substantial amounts of personal time in conducting an activity particularly where there is no recreational element involved are more likely to be deemed to have engaged in the activity for profit sec_1_183-2 income_tax regs while withdrawal from an occupation to spend more time on the activity suggests a profit_motive taxpayers who spend limited amounts of time on an activity may nevertheless possess the requisite profit_motive if they use the services of qualified persons thus the fact the petitioners were employed full-time as registered nurses does not necessarily preclude a finding that they bred horses with a profit_motive petitioners credibly maintain that they and their daughter have averaged a total of to hours per week on the care and training of their horses as well as on the maintenance of silk oak silk oak is a modest ranch and we believe that petitioners performed much of the necessary and unpleasant labor themselves therefore despite petitioners' full-time employment as registered nurse supervisors during the years in issue we find that this factor favors petitioners the expectation that assets used in the activity may appreciate in value the term profit may contemplate appreciation in the value of assets including land used in the activity sec_1 b income_tax regs petitioners argue that the increased value of the property where silk oak is located should be considered to offset past losses in this instance however the appreciation in value of silk oak must derive from petitioners' ranching activities rather than from independent factors stubblefield v commissioner tcmemo_1988_480 ruben v commissioner tcmemo_1986_260 affd without published opinion 852_f2d_1290 9th cir petitioners purchased and held the property as a personal_residence for years before converting it into a ranch silk oak still serves as petitioners' residence and the valuation in question stipulated by the parties used a market comparison approach to real_estate_valuation the properties used by the appraiser in comparison to petitioners' property were residential properties rather than ranches the appreciation of the real_estate in question therefore is based upon its use_as_a_residence rather than as a horse ranch ruben v commissioner supra consequently we will not consider the real_estate as an appreciated asset held by petitioners to offset silk oak's losses id petitioners also argue that they had hoped that appreciation in the value of their horses would yield a profit in the future petitioners' losses from the operation of silk oak total dollar_figure at the time of trial petitioners owned eight horses and had never generated more than dollar_figure in profit from the sale of any one horse even if their entire stock of horses were liquidated at fair_market_value the maximum profit generated would be dollar_figure it is therefore unlikely that petitioners will generate any profits from the sale of their horses in the near future that would recoup more than a fraction of the past losses this factor favors respondent the success of petitioners in carrying on other similar or dissimilar activities the fact that a taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable may indicate a profit_motive with respect to the activity in question regardless of recent profits sec_1_183-2 income_tax regs before commencing the operation of silk oak petitioners had never run a profitable ranch and had little knowledge of the business we therefore conclude that this factor favors respondent petitioners' history of income and losses with respect to the activity the presence of consistent losses militates against a finding that an activity was engaged in for a profit sec_1_183-2 income_tax regs an activity however may be deemed to be engaged in for profit despite a history of losses in initial or startup stages id therefore if losses continue to be sustained beyond the period which is normally necessary to bring the operation into profitable status we will consider such losses as an indication of a lack of profit_motive golanty v commissioner t c pincite with respect to horse-breeding we stated in golanty v commissioner supra pincite quoting 45_tc_261 affd 379_f2d_252 2d cir the presence of losses in the formative years of a business particularly one involving the breeding of horses is not inconsistent with an intention to achieve a later profitable level of operation bearing in mind however that the goal must be to realize a profit on the entire operation which presupposes not only future net_earnings but also sufficient net_earnings to recoup the losses which have meanwhile been sustained in the intervening years in this instance petitioners sustained substantial losses from their horse-breeding activities for years from to the aggregate net losses over the course of these years was dollar_figure losses grew steadily over the first years of operation petitioners' operating_expenses in each of the years in issue exceeded dollar_figure while they have never realized a profit greater than dollar_figure on the sale of any one horse it is therefore unlikely that petitioners will generate sufficient profits from the activity to make up for past losses despite petitioners' sincere devotion to the operation of silk oak we find this to be highly probative evidence that petitioners do not expect their horse-breeding activity to become profitable see id this factor favors respondent the amount of occasional profits if any which are earned the amount of profits generated in relation to the amount of losses_incurred and in relation to the taxpayer's investment and the value of the assets used in the activity may suggest the taxpayer's intent sec_1_183-2 income_tax regs from to petitioners generated a net gain of dollar_figure from the sale of four horses and two goats and dollar_figure from the use of their land for grazing petitioners' sporadic revenues from the operation of silk oak have been de_minimis when compared to the dollar_figure in expenses_incurred bischoff v commissioner tcmemo_1995_34 accordingly this factor favors respondent the financial status of petitioners the fact that a taxpayer does not have substantial income from sources other than the activity may indicate that the activity is engaged in for profit sec_1_183-2 income_tax regs in this case petitioners' income from their nursing supervisory activities totaled dollar_figure in and dollar_figure in petitioners' income is sufficient to produce a comfortable standard of living even upon consideration of the losses_incurred in the operation of silk oak golanty v commissioner supra we also note that the losses reported from the operation of silk oak provided petitioners with substantial tax benefits id pincite this factor favors respondent the elements of personal pleasure or recreation that may be present the presence of personal motives in carrying on an activity may indicate that the activity is not engaged in for profit especially where there are recreational or personal elements involved sec_1_183-2 income_tax regs the existence of personal pleasure for the taxpayer however does not compel a finding that the activity was not engaged in for profit 59_tc_312 conversely the existence of hard work is not enough to distinguish a profit- seeking activity from a hobby borsody v commissioner tcmemo_1993_534 affd per curiam 92_f3d_1176 4th cir osteen v commissioner tcmemo_1993_519 the care and maintenance of horses demands a large measure of laborious and unpleasant work petitioners were responsible inter alia for mucking and cleaning the stalls grooming the horses and caring for mares which had recently foaled however while we do not reject petitioners' contention that the day to day operation of silk oak demands a great deal of hard work we note that petitioners' introduction into horse breeding was precipitated by their daughter's love of horses we also believe that petitioners were partially motivated by personal reasons in engaging in the horse-breeding activities both enjoying life on a farm and using the horses for recreational pleasure this factor favors neither party given a consideration of all relevant factors we conclude that petitioners did not engage in the operation of silk oak with the intent of generating a profit we therefore sustain respondent on this issue accuracy-related_penalty under sec_6662 respondent determined that petitioners are liable for the accuracy-related_penalty provided under sec_6662 the accuracy-related_penalty is equal to percent of any portion of an underpayment attributable to a taxpayer's negligence or disregard of rules and regulations sec_6662 and b the term negligence includes any failure to do what a reasonable and ordinarily prudent person would do under the same circumstances 85_tc_934 the penalty does not apply to any portion of an underpayment for which there was reasonable_cause and with respect to which the taxpayer acted in good_faith sec_6664 respondent's determination imposing the accuracy-related_penalty is presumed correct and petitioners bear the burden of proving that they are not liable for the accuracy-related_penalty imposed by sec_6662 rule a 92_tc_501 although we have sustained respondent's determination that petitioners did not have the requisite profit objective we find that petitioners were not negligent petitioners claimed the deductions relating to silk oak with a reasonable and good_faith application of the law accordingly we do not sustain respondent's determination that petitioners are liable for the accuracy-related_penalty under sec_6662 connolly v commissioner tcmemo_1994_218 affd without published opinion 58_f3d_637 5th cir to reflect the foregoing decision will be entered for respondent as to the deficiencies and for petitioners as to the penalties


department of the treasury internal_revenue_service washington d c date uilc dollar_figure internal_revenue_service national_office field_service_advice number release date memorandum for from subject nancy romano senior technician reviewer cc dom fs proc internal_revenue_service national_office field_service_advice this field_service_advice responds to your memorandum dated date field_service_advice is not binding on examination or appeals and is not a final case determination this document is not to be cited as precedent legend x y tax_year year date date date date date date date date date date -2- date a b c state issue s under what theory or policy if any may the service refund a gift_tax payment made by an estate on behalf of the decedent’s incompetent surviving_spouse based upon an erroneous second gift_tax_return when the estate but not the surviving_spouse filed a timely refund claim and the service did not timely notify the estate or the surviving_spouse that the deceased spouse had already filed a gift_tax_return accounting for the gift_tax obligation what action should the service take to protect itself from a whipsaw claim by the surviving_spouse conclusions when spouses file two gift_tax returns pursuant to sec_2513 gift by husband or wife to third party each spouse is jointly and severally liable for the entire amount of both gift_tax returns because x and y are both subject for the full amount_of_the_gift tax x has paid the total gift_tax deficiency x’s estate has standing to file a claim_for_refund for the full gift_tax overpayment sec_6402 provides that the only person who can be paid a refund of an overpayment is the person who made the overpayment y did not make any payment for the gift_tax x’s estate paid the full amount owed for the gift_tax therefore y is precluded from both filing a claim_for_refund and filing a suit for a refund facts x and y were married in tax_year x created a family_trust for the benefit of y and x’s children on date x and y both mailed gift_tax returns for tax_year which included gifts made to the family_trust these gift_tax returns were deemed filed on april of year x and y filed the gift_tax returns and elected to have the gifts treated as if one half was attributable to x and one half was attributable to y pursuant to sec_2513 x elected to treat the trust as a qualified terminable_interest and claimed a marital_deduction under sec_2523 y used the unified_credit under sec_2501 to offset y’s gift_tax therefore no gift_taxes were due for either x or y -3- x died on date shortly after x’s death y was determined to be incompetent and a guardian was appointed for y x’s estate representative erroneously believed that x had not filed the gift_tax returns before x died x’s estate representative did not contact the service to confirm whether gift_tax returns had not been filed for tax_year x’s estate representative and y’s guardian reached an agreement on date whereby x and y would elect to have x’s gift be treated as if half was made by x and y pursuant to sec_2513 x’s estate representative and y’s guardian further agreed that the estate representative of x would be responsible for paying the entire gift_tax liability reported on x and y’s tax_year gift_tax returns on date x’s estate representative and y’s guardian prepared delinquent gift_tax returns these delinquent returns reported that x owed tax and interest in the amount of a and y owed tax and interest in the amount of b for a total gift_tax in the amount of c x’s estate paid the full gift_tax liability of c this payment was posted on date x’s estate representative filed an estate_tax_return on date the estate_tax_return was audited on date with regard to x’s estate y’s guardian elected to take a statutory share rather than take under the will under the law of state the statutory share is reduced by administrative expenses including the estate_taxes on date the guardian for y contested the administrative accounting for x’s estate y’s guardian filed a suit in state alleging that the trust should have paid the federal gift_taxes attributable to the gifts in tax_year not the estate as a result of the litigation in state x’s estate filed a protective claim_for_refund for the full amount of gift_taxes paid in the amount of c on date the protective claim_for_refund was not signed by y and it did not list y as a claimant the two year period of limitations on the refund for the full payment made on date expired on date two days after the expiration date on date the service advised x’s estate representative that gift_tax returns had already been filed for tax_year in year x’s estate filed a second claim_for_refund the next day on date for the full gift_tax paid on behalf of both x and y in the amount of c y has never filed a claim_for_refund for amount b which was paid_by x’s estate law and analysis issue jurisdiction over a suit_for_refund of taxes under u s c sec_1346 is proper only if certain jurisdictional prerequisites are satisfied that is a taxpayer must pay the full amount of the tax and file a timely administrative claim_for_refund prior to filing suit 362_us_145 sec_7422 a sec_7422 a states that no suit or proceeding for a refund shall be maintained in any court until a claim for credit or refund has been duly filed with the secretary sec_6511 a provides a limitation period for a taxpayer to file a claim_for_refund -4- claim for credit or refund of an overpayment of any_tax imposed by this title in respect of which tax the taxpayer is required to file a return shall be filed by the taxpayer within three years from the time the return was filed or two years from the time the tax was paid whichever of such periods expires the later or if no return was filed by the taxpayer within two years from the time the tax was paid in the case at issue the overpayment_of_tax was made by x’s estate on date therefore a claim_for_refund must have been made by the taxpayer within two years from date which is date x’s estate filed a protective claim_for_refund within the two year limitation period on date informal claims for refund have long been recognized as a valid claim which tolls the limitation period from running 32_fedclaims_636 an informal claim_for_refund must have a written component and should adequately apprise the internal_revenue_service that a refund is sought and for certain years 874_f2d_1165 7th cir the specific legal formulations of the claims need not be made 594_f2d_1141 n 7th cir an informal claim is adequate if it furnishes sufficient information to allow the service to make a reasonable and intelligent investigation and evaluation of the taxpayer’s claim id the date protective claim_for_refund was in writing and it advised the service that the estate of x was claiming a refund for tax_year in the amount of c the claim further advised the service that x’s estate was claiming a refund for the gift_tax paid_by the estate although the date protective claim_for_refund stated that the reason for the protective claim was the litigation between the estate of x and y’s guardian it provided the service with sufficient notice that a refund was sought for a certain tax_year which tolls the limitation period for the filing of a proper claim 950_fsupp_1246 s d n y therefore even if the date protective claim_for_refund cannot qualify as a claim_for_refund it is sufficient to qualify as an informal claim_for_refund which tolled the limitation period the estate of x timely filed a claim_for_refund for the amounts erroneously payed for both x and y’s gift_tax clearly the estate of x can file a claim_for_refund for x the question then becomes whether the estate of x can file a claim_for_refund for the amounts erroneously paid for y’s gift_tax generally a person may not file a claim_for_refund unless they are the taxpayer who was assessed with the tax_deficiency 514_us_527 the courts however have allowed third parties to have standing to file a claim_for_refund when that third party has paid the tax under protest in order to remove a tax_lien or a levy -5- against property belonging to that third party 514_us_527 64_f3d_456 9th cir in the case at issue the determination of whether or not the estate of x paid the full gift_tax amount under protest does not need to be made if x was a taxpayer for the full gift_tax amount in the returns prepared by the estate representative of x and y’s guardian the gift_tax liability was equally divided between x and y pursuant to sec_2513 sec_2513 states that a gift made by one spouse to any person other than his spouse shall for the purposes of this chapter be considered as made one-half by him and one-half by his spouse sec_2513 further provides that the liability with respect to the entire tax imposed by this chapter of each spouse shall be joint_and_several therefore each spouse is liable for the entire amount_of_the_gift tax sec_7701 a defines a taxpayer as any person subject_to any internal revenue tax because x and y are both jointly and severally liable for the full amount_of_the_gift tax x and y are both taxpayers for the full amount_of_the_gift tax since x’s estate paid the entire gift_tax liability and was liable under sec_2513 for the full amount_of_the_gift tax the estate of x has standing to file a claim_for_refund for the full gift_tax amount of c and a williams standing determination does not need to be made issue sec_6402 a states that in the case of any overpayment the secretary within the applicable_period of limitations may credit the amounts of such overpayment including any interest allowed thereon against any liability in respect of an internal revenue tax on the part of the person who made the overpayment and shall subject_to subsections c and d refund any balance to such person in 759_f2d_755 9th cir the court held that the taxpayer who had no financial interest in the litigation because his attorney rather than the taxpayer had paid the deficiency and interest did not have standing to obtain a refund sec_6402 a provides that the only person who can be paid a refund of an overpayment is the person who made the payment 852_f2d_153 6th cir 330_fsupp_269 e d mich the language of sec_6402 a is specific in limiting the refund of overpayments to the person who made the overpayment id as stated previously both x and y were liable for the full amount of the paid gift_tax however y did not pay any of the gift_tax the estate of x is the only taxpayer who made the payment in fact the estate of x and y’s guardian have a written_agreement that the estate of x would pay the full gift_tax amount -6- therefore only the estate of x can file a claim_for_refund for the overpayment amount and y lacks standing to file a claim_for_refund y would also be prohibited from filing a claim_for_refund at this time because y failed to file a timely claim_for_refund pursuant to sec_6511 a if you have any further questions please call the branch telephone number


number release date internal_revenue_service index numbers - ---------------------------------------- ------------------------------------------------ ------------------------- ------------------------ --------------------- department of the treasury washington dc person to contact ----------------------------------------------------- -------- telephone number --------------------- refer reply to cc psi - plr-100337-06 date date legend x ------------------------------------------------ -------- ----------- ----- ---------- ------------------ d1 country dear -------------------- this letter responds to a letter dated date and subsequent correspondence submitted on behalf of x requesting an extension of time under sec_301_9100-3 of the procedure and administration regulations for x to file an election to be treated as a disregarded_entity under the laws of country was acquired by a single owner with limited_liability on d1 x intended to be treated as a disregarded_entity for federal tax purposes effective d1 however x did not timely file a form_8832 entity classification election according to the information submitted all of the interest in x an entity formed sec_301_7701-3 provides that a business_entity that is not classified as a corporation under sec_301_7701-2 or an eligible_entity can elect its classification for federal tax purposes as provided in sec_301_7701-3 sec_301_7701-3 provides guidance on the classification of a foreign eligible_entity for federal tax purposes under sec_301_7701-3 except as provided in sec_301 b unless it elects otherwise a foreign eligible_entity is classified as an association if all members have limited_liability sec_301_7701-3 provides that for purposes of sec_301_7701-3 a sec_301_7701-3 provides that an election under sec_301_7701-3 member of a foreign eligible_entity has limited_liability if the member has no personal liability for the debts of or claims against the entity by reason of being a member will be effective on the date specified on form_8832 or on the date filed if no such date is specified on the form the effective date specified on form_8832 cannot be more than days prior to the date the form is filed and cannot be more than months after the date on which the form is filed sec_301_9100-1 provides that the commissioner has discretion to grant a reasonable extension of time under the rules set forth in sec_301_9100-2 and sec_301_9100-3 to make a regulatory election or a statutory election but no more than six months except in the case of a taxpayer who is abroad under all subtitles of the code except subtitles e g h and i sec_301_9100-1 defines a regulatory election to include an election whose due_date is prescribed by a regulation published in the federal_register sec_301_9100-2 provides the rules governing automatic extensions of time for making certain elections sec_301_9100-3 sets forth the standards the commissioner will use to determine whether to grant an extension of time for regulatory elections that do not meet the requirements of sec_301_9100-2 under sec_301_9100-3 a request for relief will be granted when the taxpayer provides evidence to establish to the satisfaction of the commissioner that the taxpayer acted reasonably and in good_faith and granting relief will not prejudice the interests of the government requirements of sec_301_9100-3 have been satisfied as a result x is granted an extension of time of days from the date of this letter to file form_8832 and elect to be treated as a disregarded_entity for federal tax purposes effective d1 a copy of this letter should be attached to the form_8832 based on the facts submitted and representations made we conclude that the except as specifically set forth above no opinion is expressed or implied as to the federal tax consequences of the transaction described above under any other provision of the code sec_6110 provides that it may not be used or cited as precedent this ruling is directed only to the taxpayer on whose behalf it was requested in accordance with the power_of_attorney on file with this office a copy of this sincerely letter is being sent to x’s authorized representative enclosures copy of this letter copy for sec_6110 purposes heather c maloy associate chief_counsel passthroughs and special industries


t c memo united_states tax_court christopher w johnson jr petitioner v commissioner of internal revenue respondent christopher w johnson jr and jill s johnson petitioners v commissioner of internal revenue respondent docket nos filed date a brian phillips and joshua e bills for petitioners randall b childs for respondent memorandum findings_of_fact and opinion paris judge on date respondent issued a notice_of_deficiency for tax_year to petitioner christopher w johnson jr on date respondent issued a notice_of_deficiency for tax years and to petitioners christopher w johnson jr and jill s johnson the notices determined the following deficiencies in petitioners’ federal_income_tax additions to tax under sec_6651 and penalties under sec_6662 petitioner s christopher w johnson jr christopher w johnson jr jill s johnson christopher w johnson jr jill s johnson year addition_to_tax penalty sec_6651 sec_6662 deficiency dollar_figure dollar_figure dollar_figure big_number dollar_figure dollar_figure big_number dollar_figure dollar_figure the issues for decision are whether petitioners engaged in a drag racing venture during tax years and with the expectation of making a profit whether if the activity was engaged in for profit petitioners are entitled to deduct drag racing expenses of dollar_figure dollar_figure and dollar_figure for tax years and respectively whether petitioners are liable for the addition_to_tax for failure to timely file federal_income_tax returns under sec_6651 for tax years and and whether petitioners are 1all section references are to the internal_revenue_code in effect for the tax years at issue and all rule references are to the tax_court rules_of_practice and procedure unless otherwise indicated liable for the accuracy-related_penalty under sec_6662 for tax years and findings_of_fact some of the facts have been stipulated and are so found the stipulation of facts and the exhibits received in evidence are incorporated herein by this reference petitioners resided in florida when the petitions were filed i background between and petitioner christopher w johnson jr mr johnson was employed by lucent technologies and a subsequent spinoff company avaya as a data network remote field engineer mr johnson serviced large corporate and governmental clients’ telecommunications accounts in mr johnson became involved with two other partners david posea and gerald wroblewski in a business venture to develop and market performance computer chips for automobiles mr johnson’s primary role in this venture was to contribute to the development of the intellectual_property that went into the automotive performance products in addition mr johnson contributed by testing and debugging the company’s products and engaging in marketing activities in this venture was officially organized and registered as zoom chips llc zoom chips a florida limited_liability_company mr johnson served as the managing member of zoom chips by the time zoom chips was officially organized the intellectual_property it developed had become very valuable later in a company known as superchips made an offer to purchase the assets of zoom chips which mr johnson and the other members accepted this sale resulted in income to mr johnson of approximately dollar_figure as part of the sale agreement mr johnson mr posea and mr wroblewski formed a new company known as superchips custom tuning llc sct sct was organized as a florida limited_liability_company in late to design manufacture and produce both hardware and software used for the customization of automobiles in this venture mr johnson did not retain his status as the managing member the members of sct continued developing the intellectual_property they had developed previously as zoom chips but they did so in conjunction with superchips zoom chips ceased operations in late and thereafter existed only as an entity through which to distribute the proceeds of the reorganization 2this amount was paid to mr johnson in monthly installments spread out over tax years and sct was owned and operated by mr johnson and the other members until when its assets were sold to a private equity group for a substantial sum ii cj racing as far back as the early 1990s mr johnson regularly engaged in competitive automobile drag racing on a recreational level in outside of his involvement with zoom chips and sct mr johnson began operating an automobile drag racing venture known as chris johnson racing cj racing all of the expenses associated with cj racing were paid out of the private accounts of petitioners mr johnson did not open separate banking or credit accounts for this activity nor did he create a formal business plan cj racing was not incorporated under the laws of any state and had no official relation to any of mr johnson’s other business ventures for most of his involvement with cj racing mr johnson operated the racing activity from a facility in irvington alabama the facility was located near mobile international dragway and consisted of two structures a large automobile shop and a smaller building used for office and storage space within the automobile shop mr johnson regularly engaged in automotive performance work including the fabrication and tuning of customer vehicle sec_3 and mr johnson’s race car during the years at issue cj racing regularly participated in professional drag race events mr johnson devoted on average approximately hours per week to his racing activity this time included extensive preparation of his race car for competition travel to and from his operating facilities travel to and from racing events in alabama and mississippi and participation in racing events mr johnson’s preparation for these race events routinely involved automobile 3it is unclear who these customers were mr johnson and his witnesses testified that he had been working on several cars on the premises however no explanation was offered as to who the customers were what he was doing for them whether he was being compensated for these services and for what entity he was acting while servicing these cars the timeline of events represented by mr johnson and his supporting witnesses suggests that these vehicles were present before he established jms chip and performance llc discussed below in addition there is no evidence in the record that mr johnson reported income to himself or any of his associated entities from services rendered to these customers 4mr johnson’s primary vehicle was a ford mustang that was subject_to several mechanical modifications and a full engine replacement during its use in cj racing it appears that mr johnson already owned this vehicle before forming cj racing but it is unclear when it was originally purchased and for what use in date mr johnson replaced this vehicle with a ford mustang discussed below 5mr johnson lived in florida for all of the years at issue mr johnson admits that his estimates of the hours he devoted to cj racing included those spent commuting long distance between florida alabama and mississippi maintenance and repair automotive fabrication and extensive performance tuning at the events themselves mr johnson was the primary driver of the vehicle until he was injured in a racing accident on date after the accident mr johnson ceased driving race cars in competition and used other drivers6 to participate in races on behalf of cj racing despite mr johnson’s efforts cj racing never earned a profit during tax_year the activity earned only dollar_figure of income from race winnings during tax years and cj racing had no income from race winnings the only income petitioners reported for cj racing for tax years and was from the sale of t-shirts and other miscellaneous items of dollar_figure and dollar_figure respectively mr johnson attempted to procure sponsorships from various 6mr johnson testified that he made agreements with these drivers that any winnings from cj racing would be split however no winnings were generated during the remainder of cj racing’s operation 7in addition mr johnson’s ford mustang was destroyed in this accident consequently mr johnson purchased a ford mustang to use as the new race car for cj racing 8it is also of note that for tax_year mr johnson claims to have spent dollar_figure in entry fees to racing events therefore cj racing’s winnings were barely enough to cover the mere entry fees of racing much less any expenses beyond that automotive companies but was largely unsuccessful failing to secure any sponsorship that resulted in cash income to cj racing iii transition to jms chip and performance llc in the spring of mr johnson and a partner monty johnson started a separate business venture to provide custom computer tuning perform vehicle modifications and build race cars for a client base of amateur and professional racersdollar_figure this venture was organized as jms chip and performance llc jms a nevada limited_liability_company for its first few months of existence jms was operated from mr johnson’s automotive facility in irvington alabama in early date mr johnson discontinued use of the automotive facility in irvington alabama and moved to a new facility in lucedale 9mr johnson did testify that he received support from several minor sponsors in the form of products and services in the sponsorship proposal he circulated mr johnson lists the following companies as sponsors of cj racing tci sct jdm engineering gunn racecraft wilson manifolds pro engine ford performance solutions perry’s auto paul’s auto wynn speed mustang dyno and other private individuals despite this extensive list mr johnson did not report any income from sponsorships either in cash or as barter income for the products and services he allegedly received from these sponsors 10monty johnson is not related to christopher w johnson jr 11a third member tim roy was also involved but his interest in the company was later sold mississippidollar_figure concurrently with the move mr johnson decided to end cj racing and use the new facility to bring jms into full operation although it ceased operations mr johnson transported all of the records relating to cj racing to a storage room at the new facility in lucedale on date hurricane katrina made landfall in new orleans louisiana and proceeded into southern mississippi causing severe flooding and property destruction mr johnson’s facility in lucedale mississippi was in the general path of hurricane katrina and sustained substantial damage as a result the storage room at the lucedale facility was destroyed along with all of the records relating to cj racing iv schedule c reporting petitioners did not file timely federal_income_tax returns for tax years and petitioners’ returns for the years at issue were due on april 12mr johnson asserts that because of a right-of-way dispute with the state of alabama he was forced to move from the irvington location 13despite cj racing’s ceasing operations in favor of the newly formed llc jms chip and performance petitioners still claimed several extraneous items as deductions on schedule c profit or loss from business of their federal_income_tax return for amounts paid between date and date date and date respectively however petitioners actually filed their returns for the years at issue on june and date and date respectively petitioners reported income and loss from cj racing on schedules c of their federal_income_tax returnsdollar_figure for tax years and petitioners reported expenses of dollar_figure dollar_figure and dollar_figure respectively after netting the meager income reported on behalf of cj racing petitioners claimed schedule c losses for cj racing of dollar_figure dollar_figure and dollar_figure for tax years and respectively petitioners used these losses to offset substantial income received from mr johnson’s other ventures resulting in a significant reduction of their tax_liability for the years at issue on date respondent issued to mr johnson a notice_of_deficiency for tax_year on date respondent issued to both petitioners a notice_of_deficiency for tax years and on date mr johnson timely 14date fell on a saturday so petitioners’ return for that year was due on monday date 15only the transactions of cj racing would be considered appropriate to report on a schedule c the rest of mr johnson’s entities zoom chips sct and jms were organized as multiple-member limited_liability companies the transactions of which would have been more appropriately reported on their corresponding schedules k partner’s distributive_share items of their partnership returns filed a petition in this court for review of the notice_of_deficiency for tax_year on date both petitioners timely filed a petition in this court for review of the notice_of_deficiency for tax years and a motion to consolidate the two cases under rule was granted on date i burden_of_proof opinion the commissioner’s determinations in the notice_of_deficiency are presumed correct and the taxpayer generally bears the burden of proving that the determinations are in error see rule a 290_us_111 taxpayers also bear the burden of proving that they are entitled to any deductions claimed see 503_us_79 292_us_435 taxpayers must maintain sufficient records to establish the amounts of allowable deductions and to enable the commissioner to determine the taxpayers’ correct_tax liabilities see sec_6001 112_tc_183 sec_1_6001-1 income_tax regs sec_7491 provides an exception that can shift the burden_of_proof to the commissioner the burden to disprove a claimed deduction shifts to the commissioner if the taxpayer introduces credible_evidence regarding relevant factual issues and has complied with all relevant substantiation requirements complied with all relevant recordkeeping requirements and has cooperated with reasonable requests by the commissioner for meetings interviews witnesses documents and information sec_7491 and a and b credible_evidence is evidence that after critical analysis the court would find sufficient upon which to base a decision on the issue if no contrary evidence were submitted 116_tc_438 a taxpayer who provides only self-serving testimony and inconclusive documentation has been held not to have provided credible_evidence see id pincite blodgett v commissioner tcmemo_2003_212 aff’d 394_f3d_1030 8th cir at trial petitioners16 failed to produce any primary records in relation to cj racing for the tax years at issue instead petitioners produced secondary materials in the form of bank and credit card statements in an attempt to substantiate the deductions claimed on their return petitioners contend that 16while both petitioners christopher and jill johnson were represented by legal counsel only christopher johnson participated in the trial jill johnson chose not to attend because the loss of primary documentation was due to the extensive damage caused by hurricane katrina and because they attempted to reconstruct those records from secondary sources they should be deemed to have met the requirements of sec_7491dollar_figure the court disagrees while petitioners made an effort to reconstruct their expenses from secondary records those records were incomplete and inconclusive said records were only bolstered and supplemented by the self-serving testimony of mr johnson while the court finds some of this evidence to be credible petitioners have not made a sufficient showing to shift the burden_of_proof to respondent under sec_7491 accordingly petitioners retain the burden of proving that respondent’s determinations are in error ii sec_183 under sec_183 if an activity is not engaged in for profit then no deduction attributable to that activity is allowed except to the extent provided by 17it is also of note that petitioners filed their federal_income_tax returns in this case for tax years and on june and date and date respectively the court takes notice that hurricane katrina made landfall in louisiana on or about date and had moved north through tennessee as a tropical depression on or about date petitioners thus filed their tax returns for the years at issue at least months after hurricane katrina destroyed their records therefore petitioners constructed and filed federal_income_tax returns that were not only substantially late but claimed rather aggressive deductions and loss figures without having any of the primary records to aid in substantiation sec_183 in pertinent part sec_183 allows those deductions that would have been allowable had the activity been engaged in for profit only to the extent of gross_income derived from the activity reduced by deductions attributable to the activity that are allowable without regard to whether the activity was engaged in for profit sec_183 defines an activity_not_engaged_in_for_profit as any activity other than one with respect to which deductions are allowable for the taxable_year under sec_162 or under paragraph or of sec_212 deductions are allowable under sec_162 or under sec_212 or if the taxpayer is engaged in the activity with the actual and honest objective of making a profit 78_tc_642 aff’d without published opinion 702_f2d_1205 d c cir the taxpayer need not however establish that his or her expectation of profit was reasonable 72_tc_411 aff’d without published opinion 647_f2d_170 9th cir sec_1_183-2 income_tax regs the existence of the requisite profit objective is a question of fact that must be decided on the basis of all of the facts and circumstances 84_tc_227 aff’d without published opinion 782_f2d_1027 3d cir sec_1_183-2 income_tax regs in resolving this factual question greater weight is given to objective facts than to a taxpayer’s statement of intent see elliott v commissioner t c pincite sec_1_183-2 income_tax regs the regulations set forth a nonexhaustive list of factors that may be considered in deciding whether a profit objective exists these factors are the manner in which the taxpayer carries on the activity the expertise of the taxpayer or his advisers the time and effort expended by the taxpayer in carrying on the activity the expectation that the assets used in the activity may appreciate in value the success of the taxpayer in carrying on other similar or dissimilar activities the taxpayer’s history of income or losses with respect to the activity the amount of occasional profits if any which are earned the financial status of the taxpayer and any elements indicating personal pleasure or recreation sec_1_183-2 income_tax regs these factors are not exclusive and no single factor is determinative id a manner of carrying on the activity the first factor to consider is the manner in which petitioners carried on cj racing the fact that the taxpayer carries on an activity in a businesslike manner and maintains complete and accurate books_and_records may indicate that the activity is engaged in for profit sec_1_183-2 income_tax regs similarly where an activity is carried on in a manner substantially_similar to other profitable activities of the same nature a profit_motive may be indicated id a change_of operation methods adoption of new techniques or abandonment of unprofitable methods in a manner consistent with an intent to improve profitability may also indicate a profit_motive id a taxpayer should use some cost accounting techniques that at a minimum provide the entrepreneur with the information required to make informed business decisions 809_f2d_355 7th cir aff’g tcmemo_1985_523 without such a basis for decisions affecting the enterprise the incidence of a profit in any period would be wholly fortuitous and losses would be expected id the court has held that a lack of profit_motive is indicated where a taxpayer fails to create a business plan or formal budget fails to estimate income and practice cost control and fails to maintain a separate bank account for the activity smith v commissioner tcmemo_2007_368 aff’d 364_fedappx_317 9th cir specific to the field of drag racing the court has also held that a lack of a bona_fide profit objective is indicated where the taxpayer fails to procure a substantial sponsorship for his racing endeavor kraettli v commissioner tcmemo_1988_ at trial petitioners did not introduce any evidence to show that they ever maintained complete and accurate books or created a formal budget for cj racing either before or after the hurricane there is similarly no evidence to suggest that petitioners took any measures to implement any accounting controls or operation methods that would be consistent with an intent to increase profitability petitioners admitted that they never formulated an actual business plan for cj racing additionally it is clear that petitioners did not maintain a separate bank or credit account for cj racing petitioners contend that mr johnson conducted cj racing in a manner similar to his other profitable businesses and that this indicates that the activity was engaged in for profit however petitioners’ position is dependent on the notion that mr johnson’s other profitable ventures were of the same nature as cj racing while mr johnson’s other ventures were tangentially related to automobile performance they were engaged in a fundamentally different manner of business practice accordingly those enterprises cannot be considered to be of the same nature as cj racing it is also of note that in the course of conducting cj racing petitioners were unable to secure any significant sponsorships while mr johnson claims that several companies provided him with free car parts and intellectual_property his failure to procure any substantial sponsorships during the operation of cj racing does not help to establish that petitioners had a bona_fide profit objective petitioners have failed to show that they carried on cj racing in a manner which indicates that it was engaged in for profit this factor weighs against petitioners b expertise the next factor to consider is the expertise of mr johnson and his advisers preparation for the activity by extensive study of its accepted business economic and scientific practices or consultation with those who are expert therein may indicate that the taxpayer has a profit_motive where the taxpayer carries on the activity in accordance with such practices sec_1_183-2 income_tax regs with respect to auto racing a distinction must be drawn between expertise in the mechanics of an activity and expertise in the business economic and scientific practices relating to its conduct burger v commissioner f 2d pincite zidar v commissioner tcmemo_2001_200 failure to consult with persons who have made a profit in auto racing or to inquire as to how to make a profit in such a venture indicates a lack of a bona_fide profit objective emerson v commissioner tcmemo_2000_137 mr johnson has established that he is extremely knowledgeable in the fields of automobile mechanics software and hardware design and performance enhancement mr johnson also has some amateur experience with racing automobiles and is familiar with many aspects of race car design development and mechanics however these realms of expertise relate to the mechanics of the underlying activity being performed by the company none of these fields assist in the business or economic practices that would improve the profitability of a racing operation it is true that mr johnson has been engaged in a number of businesses throughout his career that have been successful in the design and sale of various automotive performance devices however this too does not suggest the requisite expertise for the venture at hand the companies with which mr johnson was involved before cj racing were businesses that manufactured and tested products and sold them to various clients racing is a vastly different business model in which the racing teams depend on sponsorships marketing merchandising and winnings mr johnson’s acumen in retail sales would not and indeed did not do him much good in a racing enterprise petitioners contend that mr johnson not only relied on his own expertise in pursuing this activity but also consulted with other persons whose expertise should be considered mr johnson names several people with whom he spoke in regard to his racing endeavor however mr johnson has not shown that any of the people he consulted with had run profitable racing teams further mr johnson has not shown that in any of these consultations he sought advice on how to run a profitable racing team as opposed to advice on the mechanics and development of the cars themselves it seems discordant for mr johnson to claim to have such extensive and well- suited expertise and yet generate only a few thousand dollars a year in gross revenue from cj racing mr johnson and his associates may indeed have extensive expertise in the field of automobile performance devices but he has failed to demonstrate that he or any of his advisers possessed any knowledge of the profitability of auto racing a vastly different enterprise this factor weighs against petitioners c time and effort expended the third factor to consider is the time and effort expended by the taxpayer in carrying on the activity the fact that the taxpayer devotes much of his personal time and effort to carrying on an activity particularly if the activity does not have substantial personal or recreational aspects may indicate an intention to derive a profit sec_1_183-2 income_tax regs a taxpayer’s withdrawal from another occupation to devote most of his energies to the activity may also be evidence that the activity is engaged in for profit id the fact that the taxpayer devotes a limited amount of time to an activity does not necessarily indicate a lack of profit_motive where the taxpayer employs competent and qualified persons to carry on such activity id mr johnson testified that he worked hours per week with cj racing combined with his full-time employment at sct in and this means that he was working hours per week total granting petitioners this fact it is of little indicative value given the recreational nature of the racing business further mr johnson’s admitted propensity for amateur racing shows that he has devoted substantial portions of his past free time to racing without a profit_motive during the years at issue mr johnson did not consciously scale back his hours at sct to devote more time to cj racing mr johnson also did not hire any employees to assist with day to day operations at cj racing accordingly neither of these indicia of a profit_motive is applicable in this case petitioners have shown that mr johnson devoted significant time and effort to cj racing however the recreational nature of the activity undermines this point this factor does not weigh either for or against petitioners d expectation of appreciation the fourth factor to consider is the expectation that the assets used in the activity may appreciate in value the term profit encompasses appreciation in the value of assets such as land used in the activity sec_1_183-2 income_tax regs thus the taxpayer may intend to derive a profit from the operation of the activity and may also intend that even if no profit is derived from current operations an overall profit will result when appreciation in the value of the asset used in the activity is realized since income from the activity together with the appreciation of the asset will exceed expenses of operation id petitioners contend that there was an expectation for the assets used in cj racing to appreciate because the intellectual_property used in the automobile performance software chips and hardware would increase in value and result in a profit to them however the future profitability of automobile performance equipment developed in the process of fielding a racing team is at best only tangentially related to the purpose of the racing team in fact such profit expectation would be more befitting of one of the automotive performance companies in which mr johnson was engaged and any product developed and sold in that arena and merely tested in his race cars would be irrelevant to this inquiry the primary asset of cj racing was the race car used by mr johnson mr johnson admitted at trial that he did not expect the race car to appreciate in value accordingly this factor weighs against petitioners e success in other activities the fifth factor to consider is the success of the taxpayer in carrying on other similar or dissimilar activities the fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that he is engaged in the present activity for profit even though the activity is presently unprofitable sec_1_183-2 income_tax regs here mr johnson has been successful in businesses that while not entirely similar were tangentially related to cj racing mr johnson’s past successes in the realm of automotive performance may indeed have led him to believe that he could field a profitable auto racing team this factor weighs in favor of petitioners f history of income or losses the sixth factor to consider is the taxpayer’s history of income or losses with respect to the activity in question a series of losses during the initial or startup stage of an activity may not necessarily be an indication that the activity is not engaged in for profit sec_1_183-2 income_tax regs however where losses continue to be sustained beyond the period which customarily is necessary to bring the operation to profitable status such continued losses if not explainable as due to customary business risks or reverses may be indicative that the activity is not being engaged in for profit id a record of substantial losses combined with a remote chance of achieving a profitable operation are important factors bearing on a taxpayer’s intent to make a profit schlafer v commissioner tcmemo_1990_66 during the years at issue petitioners reported expenses from cj racing of dollar_figure dollar_figure and dollar_figure respectively in those same years petitioners reported revenues from cj racing of only dollar_figure dollar_figure and dollar_figure respectively the disparity in these amounts resulted in substantial losses in all three years at issue it is certainly true that the initial investment in a racing team would be a significant one the expenses associated with an investment of such magnitude would likely require some time to recoup however petitioners have not shown that they made any effort to increase the profitability of the activity in any meaningful way given petitioners’ record of substantial losses with minimal effort to right this imbalance there is no indication that they had a bona_fide profit objective this factor weighs against petitioners g amount of profit the seventh factor to consider is the amount of occasional profits if any which are earned in the course of conducting the activity profit is generally defined as receipts in excess of costs see 497_us_154 the amount of profits in relation to the amount of losses_incurred and in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity may provide useful criteria in determining the taxpayer’s intent sec_1_183-2 income_tax regs an occasional small profit from an activity generating large losses or from an activity in which the taxpayer has made large investment would not generally be determinative that the activity is engaged in for profit id however an opportunity to earn a substantial ultimate profit in a highly speculative venture is ordinarily sufficient to indicate that the activity is engaged in for profit even though losses or only occasional small profits are actually generated id in emerson v commissioner tcmemo_2000_137 the taxpayer was engaged in an automobile drag racing activity the taxpayer incurred substantial expenses that far exceeded the small cash awards that he received as revenue for the years at issue id the court stated that the small cash awards petitioner received were miniscule in relation to both the losses he incurred and his total investment in the activity and without a sponsor petitioner never had an opportunity to earn a substantial ultimate profit id accordingly the court held this factor in favor of the commissioner id like the taxpayer in emerson petitioners generated only small cash revenues of a few thousand dollars for each year at issue during that time petitioners incurred large losses as a result of the disparity between their miniscule revenues and substantial expenses while mr johnson boosted revenues slightly in and by selling shirts this does little to show that the racing operation could have been made any more profitable in those same years mr johnson did not have any income from winning races and during the entire three years at issue he secured no significant sponsorships as in emerson the court finds that the occasional profits both realized and potential do not indicate a profit_motive this factor weighs against petitioners h petitioners’ financial status the eighth factor to consider is the financial status of the taxpayer the fact that the taxpayer does not have substantial income or capital from sources other than the activity may indicate that an activity is engaged in for profit sec_1_183-2 income_tax regs substantial income from sources other than the activity particularly if the losses from the activity generate substantial tax benefits may indicate that the activity is not engaged in for profit especially if there are personal or recreational elements involved id petitioners reported expenses from cj racing of dollar_figure dollar_figure and dollar_figure for tax years and respectively petitioners reported revenue from cj racing of only dollar_figure dollar_figure and dollar_figure respectivelydollar_figure as a 18it is of note that in calculating revenue for cj racing petitioners failed to report any amount of barter income received through products and services that mr johnson claimed to have obtained through minor sponsorships gross_income includes the fair_market_value of property or services received in exchange for other services sec_61 sec_1_61-2 income_tax regs if petitioners were receiving auto parts and services as the result of sponsorship agreements entered into by mr johnson they should have been reporting the fair_market_value of those goods and services as schedule c income to cj racing had petitioners properly reported such income it would have decreased their schedule c losses for the years at issue result petitioners claimed schedule c losses of dollar_figure dollar_figure and dollar_figure for tax years and respectively for the tax years at issue petitioners had significant income from sources other than cj racing the losses claimed in relation to cj racing had the effect of reducing petitioners’ taxable_income from dollar_figure to dollar_figure for tax_year from dollar_figure to dollar_figure for tax_year and from dollar_figure to dollar_figure for tax_year the claimed offset of these losses would have conveyed substantial tax benefits to petitioners for the years at issue further as discussed below the nature of the activity is such that it involved elements of recreation which mr johnson found pleasurable accordingly the court finds that the financial status of petitioners does not indicate a profit_motive this factor weighs against petitioners i personal pleasure or recreation the final factor that should be considered is whether the activity in question involves personal pleasure or recreation the presence of personal motives in the carrying on of an activity may indicate that the activity is not engaged in for profit especially where there are recreational or personal elements involved sec_1 b income_tax regs mr johnson argues that while automobile racing is typically engaged in for amusement or as a hobby the hours of work and preparation that go into a race were not enjoyable however it is clear from mr johnson’s testimony as well as the other witnesses at trial that mr johnson derived significant recreational enjoyment and personal pleasure from automobile drag racing mr johnson has spent several years and untold amounts of money involved with automobile drag racing with little financial return it is difficult to believe that mr johnson would engage in such behavior without deriving any recreational benefit the court finds that the personal and recreational nature of the activity do not indicate a profit_motive this factor weighs against petitioners on the basis of the record and considering the nine factors discussed above the court finds that petitioners did not engage in cj racing for profit accordingly petitioners are not allowed to deduct expenses under schedule c associated with this activity for tax years and gross_receipts relating to this activity should be classified as other income and deductions will be limited to the amount of those receipts iii sec_6651 addition_to_tax failure_to_file a tax_return on the date prescribed leads to a mandatory addition_to_tax unless the taxpayer shows that such failure was due to reasonable cause and not due to willful neglect sec_6651 for each month the return is late an addition_to_tax equal to of the amount of tax required to be shown on the return shall be assessed not exceeding of the aggregate id under sec_7491 the commissioner has the burden of production to show that the imposition of an addition_to_tax under sec_6651 is appropriate respondent has met this burden by presenting evidence that petitioners failed to timely file their federal_income_tax returns the burden of proving reasonable_cause and lack of willful neglect falls on the taxpayer rule a 469_us_241 reasonable_cause exists where a return is late despite the taxpayer’s exercising ordinary business care and prudence sec_301_6651-1 proced admin regs circumstances that are considered to constitute reasonable_cause are typically those outside of the taxpayer’s control for example unavoidable postal delays timely filing of a return with the wrong office death or serious illness of the taxpayer or a member of the taxpayer’s immediate_family taxpayer’s unavoidable absence from the united_states destruction by casualty of taxpayer’s records or place of business and reliance on the erroneous advice of an internal_revenue_service officer_or_employee 114_f3d_366 2d cir aff’g tcmemo_1995_547 mr johnson filed his tax_return late on date petitioners filed their tax returns for and late on date and date respectively petitioners contend that they had reasonable_cause to file their tax returns late because their records were destroyed by hurricane katrina the court finds mr johnson’s testimony credible however hurricane katrina did not make landfall until late august of for tax years and the returns were already late by the time hurricane katrina would have destroyed petitioners’ records accordingly petitioners are liable for the additions to tax under sec_6651 for tax years and with respect to tax_year the court finds petitioners’ argument more persuasive after the complete destruction of their records in late august petitioners could not be expected to file their tax_return on time especially considering the volume of data to be reconstructed the court holds that petitioners’ failure to timely file their return was due to reasonable_cause and not due to wilful neglect accordingly petitioners are not liable for the addition_to_tax determined under sec_6651 for tax_year iv sec_6662 penalty sec_6662 imposes an accuracy-related_penalty equal to of the underpayment attributable to any substantial_understatement_of_income_tax or to negligence or disregard of rules or regulations sec_6662 and b and under sec_7491 the commissioner has the burden of production to show that the imposition of a penalty under sec_6662 is appropriate respondent has met this burden by presenting evidence that petitioners had an underpayment attributable to a substantial_understatement_of_income_tax no penalty will be imposed under sec_6662 if the taxpayer establishes that he acted with reasonable_cause and in good_faith sec_6664 circumstances that indicate reasonable_cause and good_faith include reliance on the advice of a tax professional or an honest misunderstanding of the law that is reasonable in light of all the facts and circumstances sec_1_6664-4 income_tax regs the taxpayer has the burden of proving that he acted with reasonable_cause and in good_faith rule a higbee v commissioner t c pincite sec_6662 defines substantial_understatement as the greater of of the amount of tax required to be shown on the return or dollar_figure negligence includes any failure to make a reasonable attempt to comply with the provisions of the code and disregard includes any careless reckless or intentional disregard of rules or regulations sec_6662 on their tax returns petitioners reported income_tax due of dollar_figure dollar_figure and dollar_figure for tax years and respectively petitioners’ only argument is that these amounts were correct and therefore no substantial_understatement exists however respondent’s position as sustained by the court is that the correct amounts required to be shown on those returns were dollar_figure dollar_figure and dollar_figure consequently petitioners substantially understated their income_tax for each of the years at issuedollar_figure respondent has met his burden of production in showing that the imposition of the sec_6662 penalty was appropriate petitioners make no showing that they acted with reasonable_cause and in good_faith in claiming the deductions at issue accordingly petitioners are liable for the accuracy-related_penalty under sec_6662 for tax years and the court has considered all of the arguments made by the parties and to the extent they are not addressed herein they are considered unnecessary moot irrelevant or without merit 19the understatements for tax years and were dollar_figure dollar_figure and dollar_figure respectively each of these amounts are greater than of the amount required to be shown for each respective year dollar_figure for dollar_figure for and dollar_figure for to reflect the foregoing appropriate decisions will be entered