                               T.C. Memo. 2015-84



                        UNITED STATES TAX COURT



     COASTAL HEART MEDICAL GROUP, INC., ET AL.,1 Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos. 145-11, 146-11,                  Filed May 4, 2015.
                 8695-12, 8696-12.



      John Alan Harbin, Joseph P. Wilson, and Daniel W. Layton, for petitioners.

      Katherine Holmes Ankeny and Jeri L. Acromite, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      NEGA, Judge: Respondent issued a notice of deficiency to Anil V. Shah

(Dr. Shah) and Preeti A. Shah (Mrs. Shah) (Shahs, collectively), for tax years 2004


      1
       Cases of the following petitioners are consolidated herewith: Anil V. Shah
and Preeti A. Shah, docket Nos. 146-11 and 8695-12; and Coastal Heart Medical
Group, Inc., docket No. 8696-12.
                                        -2-

[*2] through 2006. Respondent contemporaneously issued Dr. Shah’s solely

owned corporation--Coastal Heart Medical Group, Inc. (Coastal Heart), a notice of

deficiency for fiscal years ending July 31, 2004, 2005, and 2006. Respondent

issued separate notices of deficiency to the Shahs for the 2007 tax year and to

Coastal Heart for fiscal years ending July 31, 2007 and 2008. Petitioners’ cases

were consolidated for trial, briefing, and opinion. The following deficiency

determinations and penalty are at issue for the Shahs:2

                                                            Penalty
                 Year            Deficiency               sec. 6662(a)
                 2004             $108,435                    n/a
                 2005               96,065                    n/a
                 2006               72,259                    n/a
                 2007              105,747                  $21,149

The following deficiency determinations and penalties are at issue for Coastal

Heart:
                                                            Penalty
             FYE July 31         Deficiency               sec. 6662(a)
                 2004             $53,520                  $10,704
                 2005              38,621                     7,724


         2
       All section references are to the Internal Revenue Code as in effect for the
tax years at issue. All Rule references are to the Tax Court Rules of Practice and
Procedure. All dollar amounts are rounded to the nearest dollar.
                                       -3-

            [*3] 2006              54,519                 16,051
                 2007             135,568                 27,113
                 2008              45,396                  9,079

      After concessions, the issues for decision are: (1) whether the Shahs

improperly claimed a nonpassive loss deduction from Coastal Imaging Center,

LLC (Coastal Imaging), for 2004; (2) whether the Shahs received unreported

income in the form of a constructive dividend from Coastal Heart in 2004; (3)

whether the Shahs improperly claimed nonpassive loss deductions for 2005-07

from various entities Dr. Shah managed; (4) whether Coastal Heart improperly

included the gross income of Coastal Imaging and improperly claimed deductions

that belonged to Coastal Imaging for 2004-06; and (5) whether the Shahs and

Coastal Heart are liable for accuracy-related penalties. We answer all five

questions in the affirmative.

                                FINDINGS OF FACT

      The stipulation of facts and the accompanying exhibits are incorporated

herein by this reference. The Shahs resided in California when their petitions were

filed. Coastal Heart’s principal place of business was in California when its

petitions were filed.
                                        -4-

[*4] The Shahs’ Claimed Loss From Coastal Imaging and Constructive Dividend

      Dr. Shah is a cardiologist who conducts his medical practice through

Coastal Heart. On November 4, 2003, Coastal Heart leased3 a cardiac CT scanner

from Siemens Medical Solutions USA, Inc. (Siemens), for a 60-month term. Dr.

Shah signed the lease on behalf of Coastal Heart, and the lease was secured by a

$500,000 life insurance policy on Dr. Shah naming Siemens as the beneficiary.

The lease provided that Coastal Heart could not assign or dispose of its rights or

obligations under the lease or enter into any sublease without Siemens’ written

consent. The lease also included an option to purchase the CT scanner at less than

fair market value. At the end of the 60-month term, the lease was extended for

another 18 months. Coastal Heart was the signatory on the lease renewal

agreement.

      On January 25, 2004, Coastal Heart paid $4,000 to Zabala Custom

Constructions for construction work to accommodate the CT scanner. The

construction work included erecting new lead walls to assist with the functionality

of the scanner and housing the scanner on the bottom floor of Coastal Heart’s new

two-story office.

      3
       We find that the transaction between Coastal Heart and Siemens was a
conditional purchase rather than a lease. However, for simplicity we use the terms
“lease” and “purported lease” interchangeably.
                                       -5-

[*5] In 2004 Dr. Shah formed Coastal Imaging, a registered California limited

liability company, with two other individuals to manage the CT scanner.4 One of

these individuals was a doctor, and the other was Dr. Shah’s former patient. Dr.

Shah was the managing member of Coastal Imaging.

      For the 2004 tax year the Shahs asserted that Dr. Shah had personally

guaranteed the lease of the CT scanner and claimed a nonpassive loss deduction

from Coastal Imaging of $291,985. Because the Shahs did not provide a copy of

the guaranty, respondent determined that Dr. Shah did not have enough basis in

Coastal Imaging to cover the entire loss. Therefore, respondent disallowed

$272,244 of the loss deduction. Respondent also determined that the Shahs

received a $4,000 constructive dividend from Coastal Heart for the 2004 tax year

because of the construction work performed by Zabala Custom Constructions.

Dr. Shah’s Claimed Real Estate Activities

      In 2004 Tenant Healthcare (Tenant), the company that owned the hospital

where Dr. Shah was a leading physician, decided to sell that hospital and four

others in the region. Dr. Shah thought it would be a good idea if the physicians

      4
        For Federal income tax purposes, Coastal Imaging reported on its Forms
1065, U.S. Return of Partnership Income, for 2004 through 2008, and we so find,
that Coastal Imaging is a partnership not subject to the TEFRA partnership audit
and litigation procedures of secs. 6221 through 6234. See sec. 301.7701-3(a) and
(b)(1)(i), Proced. & Admin. Regs.; see also sec. 6231(a)(1)(B).
                                        -6-

[*6] themselves owned and operated the hospitals, so he placed a bid for the

hospitals. To facilitate the transaction, Dr. Shah became the executive chairman of

Integrated Healthcare Holdings, Inc. (IHHI), a hospital acquisition and

management company. Dr. Shah raised capital for the purchase of the hospitals

through an entity called the Orange County Physicians Investment Network

(OCPIN). OCPIN was made up of various physician investors with Dr. Shah as

manager. To ensure that the physicians would own the hospitals, OCPIN bought a

controlling stake in IHHI. In 2005 after a year of deliberation, negotiation, and

State Senate meetings in Sacramento, IHHI bought the hospitals from Tenant for

$57 million. Dr. Shah testified that he spent around 16 hours a day negotiating the

transaction with Tenant.

      As executive chairman of IHHI, Dr. Shah was responsible for setting the

overall strategies and direction of the company, monitoring and overseeing

corporate performance, and guiding the board of directors in its oversight of the

corporate activities and performance. IHHI compensated Dr. Shah for his role as

executive chairman. After the sale, IHHI immediately split the real estate holdings

portion of the transaction from the hospital operations aspect. In that respect,

Pacific Coast Holdings Investment, LLC (PCHI), would own the properties
                                        -7-

[*7] purchased from Tenant and IHHI would manage the operations of the

hospitals. After the division, $50 million of the investment belonged to PCHI and

$7 million belonged to IHHI.

      In order for the physicians and Dr. Shah to maintain an interest in the real

estate portion of the deal, an entity called West Coast Holdings, LLC (West

Coast), was formed to be a substantial investor in PCHI. West Coast had an

ownership structure similar to OCPIN’s, and Dr. Shah managed West Coast and

comanaged PCHI.

      Thereafter, PCHI leased the hospital properties purchased from Tenant to

several different hospitals. Because the leases to these hospitals were “triple-net

leases”, the hospitals themselves were responsible for routine maintenance and

repairs, not PCHI. Instead, Dr. Shah’s duties as a comanager for PCHI during the

years at issue were negotiating leases with the other hospitals, dealing with

lawsuits pertaining to the transactions, and avoiding bankruptcy. Dr. Shah also

spent time finding investors for the hospitals, refinancing loans used for the

purchase of the hospitals, and obtaining guaranties on two properties that PCHI

rented instead of owned.

      The Shahs also managed RPS, LLC (RPS), during the years at issue. RPS

owned the 30-suite office building where Coastal Heart’s office and the CT
                                          -8-

[*8] scanner were located. As property managers of RPS, the Shahs collected

rents for the building, prepared the leases, took care of maintenance and repairs

throughout the building, and managed the utilities.

       For each of the taxable years at issue the Schedule E, Supplemental Income

and Loss, that petitioners filed contained the following warning: “Caution: Your

rental real estate loss * * * may be limited. * * * Real estate professionals must

complete line 43 on page 2.” Despite this statement, petitioners left blank line 43

of Schedule E, dealing with “Reconciliation for Real Estate Professionals”.

       Petitioners did not make an election to group activities together for purposes

of measuring material participation, nor did they elect to treat all of their interests

in rental activities as one activity.

       For tax years 2005 through 2007 the Shahs claimed nonpassive losses from

RPS, West Coast, OCPIN, and an entity called Danon Danon Shah Younis Singh

(DDSYS). For these years respondent determined that the Shahs’ losses from

these entities were from rental real estate activities and therefore were passive.

Coastal Heart’s Reported Income and Claimed Deductions

       As sole owner and manager of Coastal Heart and Coastal Imaging,

respectively, Dr. Shah maintained separate books for both entities. For the years

at issue Coastal Heart reported income generated by the CT scanner for patients’
                                         -9-

[*9] use of its heart scanning services, while Coastal Imaging claimed depreciation

deductions for the CT scanner. Coastal Heart also claimed deductions related to

the CT scanner including: (1) salaries and wages of three employees involved in

the operation of the CT scanner; (2) repairs and maintenance of the CT scanner

and the office shared by Coastal Imaging and Coastal Heart; (3) monthly rental of

the shared office; (4) depreciation of office furniture in the shared office; (5) rental

payments on the CT scanner lease; and (6) expenses for operating the CT scanner.

      Respondent determined that Coastal Heart had improperly included the

gross income and business expenses of Coastal Imaging on its corporate tax

returns for tax years 2004-06. At trial Dr. Shah testified that it was Coastal Heart,

not Coastal Imaging, that paid the lease on the CT scanner, paid for training and

employment of special technicians for the CT scanner, was the sole tenant of the

office space in which the CT scanner operated, and made the downpayment and

paid the construction costs related to the CT scanner. Respondent contends that

Coastal Heart and Coastal Imaging are separate and distinct entities and that

expenses and income related to the CT scanner should be allocated to Coastal

Imaging.

      For the years at issue the Shahs and Coastal Heart had the same accountant

prepare their tax returns.
                                         - 10 -

[*10]                                  OPINION

I.      Burden of Proof

        The Commissioner’s determinations in a notice of deficiency are generally

presumed correct, and the taxpayer bears the burden of proving those

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

(1933). The evidence does not establish that the burden of proof shifts to

respondent under section 7491(a) as to any issue of fact.

        We will first discuss the three remaining and somewhat disparate issues

related directly to the Shahs’ tax liabilities and then discuss the tax issues of

Coastal Heart. Finally, we will discuss the penalty issues for both the Shahs and

Coastal Heart.

II.     The Shahs’ Tax Liabilities

        A.    The Shahs’ Claimed Nonpassive Loss Deduction From Coastal
              Imaging for 2004

        Coastal Imaging was a registered California limited liability company with

three members. For Federal income tax purposes, an LLC with more than one

member generally is treated as a partnership unless it elects to be treated as an

association (i.e., a corporation). See sec. 301.7701-3(a) and (b)(1)(i), Proced. &
                                         - 11 -

[*11] Admin. Regs. Coastal Imaging did not make an election to be treated as a

corporation, and for tax purposes it is treated as a partnership.

      A partnership is not subject to Federal income tax at the partnership level;

instead, persons carrying on business as partners are liable for income tax only in

their separate or individual capacities. Sec. 701; see secs. 702, 704 (providing

rules for determining partners’ distributive shares), sec. 703 (providing rules for

computing taxable income of a partnership). A partner must take into account his

or her distributive share of each item of partnership income, gain, loss, deduction,

and credit. Sec. 702(a); Vecchio v. Commissioner, 103 T.C. 170, 185 (1994).

      Section 704(d) limits the deductibility of a partner’s distributive share of

partnership losses. Those losses are deductible only to the extent of the adjusted

basis of a partner’s interest in the partnership. Sennett v. Commissioner, 80 T.C.

825 (1983), aff’d, 752 F.2d 428 (9th Cir. 1985). A partner’s adjusted basis in the

partnership is essentially the partner’s contribution to the partnership increased by

the partner’s distributive share of partnership income and decreased by all cash

distributions and the partner’s distributive share of partnership losses. Sec. 705(a).

If a partner’s distributive share of partnership losses is greater than the partner’s

available adjusted basis, the excess loss cannot be deducted by the partner for that

year but must instead be carried forward until the partner has an adjusted basis
                                         - 12 -

[*12] sufficient to offset the amount of the loss. See sec. 1.704-1(d)(1), Income

Tax Regs.

        Generally, when a partner contributes property subject to a liability to a

partnership, the partnership is treated as having assumed the liability. Sec. 1.752-

1(e), Income Tax Regs. When a partnership assumes an individual partner’s

liabilities, the assumption of those liabilities results in a deemed distribution to the

partner and, consequently, decreases the basis of the partner’s interest in the

partnership by the amount assumed by the partners. Sec. 752(b). Conversely,

when a partner assumes the partnership’s liabilities, the assumption of such

liabilities results in a deemed contribution by the partner to the partnership and,

consequently, increases the basis of the partner’s interest in the partnership by the

amount assumed. Sec. 752(a); sec. 1.752-1(b), Income Tax Regs.; see HGA

Cinema Trust v. Commissioner, 950 F.2d 1357, 1362 (7th Cir. 1991), aff’g T.C.

Memo. 1989-370; Callahan v. Commissioner, 98 T.C. 276, 280 (1992). A partner

may assume a partnership’s liabilities when the partner contributes property

subject to a liability to a partnership but remains personally liable to the creditor

and none of the other partners bear any of the economic risk of loss for the liability

under State law or otherwise. See sec. 1.752-1(g), (Example) (1), Income Tax

Regs.
                                         - 13 -

[*13] For the 2004 tax year the Shahs claimed a nonpassive loss deduction from

Coastal Imaging of $291,985. Respondent concedes that Dr. Shah materially

participated in Coastal Imaging for purposes of the section 469 passive activity

loss rules5 but argues that the loss from Coastal Imaging was limited to the

adjusted basis of his interest in Coastal Imaging.

      Petitioners argue that Dr. Shah had sufficient basis in Coastal Imaging to

claim the loss deduction because Dr. Shah personally guaranteed the lease. In the

alternative, petitioners argue that Coastal Heart was obligated to pay the lease, and

because Coastal Heart was related to Dr. Shah, Dr. Shah had sufficient basis to

claim the loss deduction. Petitioners’ arguments assume that the lease was a

partnership liability--in other words, a liability to Coastal Imaging. Normally, an

obligation to make payments under an operating lease is not characterized as a

liability. See CSX Transp., Inc. v. Ga. State Bd. of Equalization, 448 F. Supp. 2d

1330, 1349 (N.D. Ga. 2005), aff’d, 472 F.3d 1281 (11th Cir. 2006), rev’d on other

grounds, 552 U.S. 9 (2007). However, if the terms of the lease give rise to a

conditional purchase, the lease will be characterized as a liability. Id.; see also

Yearout Mech. & Eng’g, Inc. v. Commissioner, T.C. Memo. 2008-217, slip op. at


      5
        For a detailed discussion of the passive activity loss rules see infra section
titled “The Shahs’ Claimed Nonpassive Losses for 2005 through 2007”.
                                       - 14 -

[*14] 27 n.22. Petitioners were simultaneously characterizing the lease with

Siemens as a lease and a conditional purchase by Coastal Heart: Coastal Heart

was claiming rental deductions on the CT scanner as if it were leasing the scanner,

while Coastal Imaging was claiming depreciation deductions on the CT scanner as

if it owned the scanner. We therefore need to examine the details of the lease.

Although there are no specific provisions in the U.S. tax laws governing the

differentiation of true leases and conditional purchases, the substance of the

transactions, not the form, will govern the nature of the lease. See Helvering v. F.

& R. Lazarus & Co., 308 U.S. 252, 255 (1939); Gregory v. Helvering, 293 U.S.

465, 470 (1935). With respect to the transfer of equipment, courts have stated that

factors indicating that a conditional purchase more likely exists include: (1) the

lease term extends throughout the equipment’s entire useful life, Mt. Mansfield

Television, Inc. v. United States, 239 F. Supp. 539, 543 (D. Vt. 1964), aff’d, 342

F.2d 994 (2d Cir. 1965); (2) the sum of the rental payments approximately equals

the cost of the equipment, Chi. Stoker Corp. v. Commissioner, 14 T.C. 441, 445

(1950); and (3) the lessee has an option at the end of the agreement to purchase the

equipment at a nominal or below-market price, Transam. Corp. v. United States, 7

Cl. Ct. 441, 448 (1985).
                                        - 15 -

[*15] The CT scanner is high-technology medical equipment, and its useful life is

five years. See sec. 168(e)(3)(B)(iv), (i)(2)(A)(iii), (C). The term of the purported

lease is 60 months--five years. Therefore, the term extends throughout the CT

scanner’s entire useful life. Furthermore, the parties agree that Coastal Heart had

an option to purchase the CT scanner at the end of the purported lease term at a

less-than-fair-market price. Accordingly, we characterize the purported lease of

the CT scanner as a conditional purchase by Coastal Heart. As a conditional

purchase, the purported lease gave rise to a liability to Coastal Heart. We now

need to determine whether the liability was transferred to Coastal Imaging--i.e., if

it was a partnership liability.

      Section 752 applies only to partnership liabilities. The regulations define a

liability for section 752 purposes as any obligation that gives rise to: (1) the

creation of, or an increase in, the basis of property owned by the obligor

(including the cash attributable to borrowings), (2) an immediate deduction, or (3)

an expenditure that is not deductible in computing taxable income and not

properly chargeable to capital account.6 Sec. 1.752-1(a)(4), Income Tax Regs.

      6
        The temporary regulations issued in 1988 used this same definition of a
partnership liability. The final sec. 752 regulations adopted in 1991 excluded this
definition. The change was made only for the purpose of simplification and not to
change the substance of the regulation. The current sec. 752 regulations, as of
                                                                       (continued...)
                                         - 16 -

[*16] In order for property subject to a liability to be a partnership liability, and

for section 752 to apply, the property needs to be contributed to the partnership.

See id. para. (e). The CT scanner was not contributed to Coastal Imaging. Dr.

Shah, not Coastal Heart, was a member of Coastal Imaging, and the CT scanner

was not Dr. Shah’s to contribute. Furthermore, there were no written agreements

between Coastal Heart and Coastal Imaging that purported to assign the lease to

Coastal Imaging. Even if there were, Coastal Heart could not have assigned the

lease because the lease itself prohibited assignments without Siemens’ approval.

Finally, the record does not reflect that Coastal Heart intended to contribute the

CT scanner to Coastal Imaging. Rather, petitioners state Dr. Shah created Coastal

Imaging to simply manage the CT scanner. We conclude that the CT scanner was

never contributed to Coastal Imaging. Therefore, it did not give rise to a liability

of Coastal Imaging, and section 752 does not allow Dr. Shah to claim an increased

basis in his interest in Coastal Imaging either through his own purported personal

guaranty of the lease or Coastal Heart’s obligation under the lease. Accordingly,

we sustain respondent’s determination to disallow $272,244 of the loss deduction

that the Shahs claimed from Coastal Imaging for the 2004 tax year.


      6
       (...continued)
2005, include this definition of a liability.
                                       - 17 -

[*17] B.     The Constructive Dividend From Coastal Heart for 2004

      The determination of constructive dividend income received by Dr. Shah is

a determination of unreported income. The Court of Appeals for the Ninth Circuit,

to which an appeal in this case would lie, has held that for the presumption of

correctness to attach to the notice of deficiency in unreported income cases, the

Commissioner “must offer some substantive evidence showing that the taxpayer

received income from the charged activity.” See Weimerskirch v. Commissioner,

596 F.2d 358, 360 (9th Cir. 1979), rev’g 67 T.C. 672 (1977); see also Edwards v.

Commissioner, 680 F.2d 1268, 1270-1271 (9th Cir. 1982). Once the

Commissioner sufficiently connects the taxpayer with the unreported income, the

burden shifts to the taxpayer, who must establish by a preponderance of the

evidence that the deficiency determination was arbitrary or erroneous. See Hardy

v. Commissioner, 181 F.3d 1002, 1004 (9th Cir. 1999), aff’g T.C. Memo. 1997-97.

      Section 301 requires a taxpayer to include in gross income amounts

received as dividends. Generally, a dividend is a distribution of property by a

corporation to its shareholders out of its earnings and profits. Sec. 316(a). A

dividend need not be formally declared or even intended by a corporation. Noble

v. Commissioner, 368 F.2d 439, 442-443 (9th Cir. 1966), aff’g T.C. Memo. 1965-
                                        - 18 -

[*18] 84. When a corporation pays the personal expenses of a shareholder without

expectation of repayment, there may exist a constructive dividend distribution that

is taxable to the shareholder. Magnon v. Commissioner, 73 T.C. 980, 993-994

(1980). Whether a constructive dividend exists turns on whether the distribution

was primarily for the benefit of the shareholder. Hood v. Commissioner, 115 T.C.

172, 179-180 (2000). The existence of some benefit to the corporation is not

enough to permit a corporate deduction; the Court must weigh the benefit to the

shareholder and the corporation, and “where the business justifications put

forward are not of sufficient substance to disturb a conclusion that the distribution

was primarily for shareholder benefit” a constructive dividend will be found.

Sammons v. Commissioner, 472 F.2d 449, 452 (5th Cir. 1972), aff’g in part, rev’g

in part and remanding T.C. Memo. 1971-145. The determination of whether the

shareholder or the corporation primarily benefits is a question of fact. See id. To

avoid constructive dividend treatment, the taxpayer must show that the corporation

primarily benefited from the payment of the shareholder’s expenses. Hood v.

Commissioner, 115 T.C. at 181. “In determining whether or not the expenditure

related to the business of the corporation, we must ascertain whether the payment

or expenditure has independent and substantial importance to the paying

corporation.” Gow v. Commissioner, T.C. Memo. 2000-93, slip op. at 38 (citing
                                        - 19 -

[*19] T.J. Enters., Inc. v. Commissioner, 101 T.C. 581 (1993)), aff’d, 19 Fed.

Appx. 90 (4th Cir. 2001). “An expenditure generally does not have independent

and substantial importance to the distributing corporation if it is not deductible

under section 162.” Id. (citing P.R. Farms, Inc. v. Commissioner, 820 F.2d 1084,

1088 (9th Cir. 1987), aff’g T.C. Memo. 1984-549).

      We find respondent has sufficiently established an evidentiary foundation to

shift the burden to the Shahs on this issue. Respondent introduced evidence that

on January 25, 2004, Coastal Heart paid $4,000 to Zabala Custom Constructions

to renovate and expand Coastal Heart’s office in order to accommodate the

operation of the CT scanner. Dr. Shah is the sole shareholder of Coastal Heart,

and he is a member of Coastal Imaging, the entity that manages the CT scanner.

Respondent introduced sufficient evidence to show that Dr. Shah was a

beneficiary of the expansion and received unreported income through his interest

in Coastal Imaging, regardless of whether Coastal Heart benefited from the

expansion. The Shahs contend that they received no constructive dividend

because the shared office construction was merely an incidental benefit to Coastal

Imaging and did not discharge any obligation of Dr. Shah as a member of Coastal

Imaging. Although the expansion provided a place to house the CT scanner leased

by Coastal Heart, the CT scanner was managed by Coastal Imaging. As we have
                                        - 20 -

[*20] found, respondent has provided a minimal evidentiary foundation for his

determination that the expansion was primarily for Coastal Imaging’s benefit and

therefore Dr. Shah’s benefit as a member of Coastal Imaging. On this issue we

find that the Shahs failed to construct a satisfactory record to support their

position. The Shahs presented no evidence apart from Dr. Shah’s own testimony

and did not adequately explain how Coastal Heart and Coastal Imaging worked in

concert. Furthermore, there was no testimony on the interests of the other two

members of Coastal Imaging and whether they differed in any meaningful way

from the interests of Coastal Heart. The Shahs did not establish that respondent’s

determination with respect to this issue was arbitrary or erroneous. Therefore, we

hold that Coastal Heart’s payment of the construction fee was a corporate

distribution to Dr. Shah.7

      C.     The Shahs’ Claimed Nonpassive Loss Deductions for 2005-07

      For tax years 2005-07 the Shahs claimed nonpassive losses from the

following entities: (1) OCPIN, (2) West Coast, (3) RPS, and (4) DDSYS.




      7
       In a recomputation of the deficiency hereunder, the parties will be
permitted to submit computations of earnings and profits in accordance with this
opinion to determine what portion of the payment was a taxable dividend. See
Magnon v. Commissioner, 73 T.C. 980, 996-997 (1980).
                                        - 21 -

[*21] Respondent determined that the Shahs’ losses from these entities were from

rental real estate activities and therefore were passive.

      Although taxpayers may deduct ordinary and necessary expenses they paid

or incurred during the year in carrying on a trade or business for the production of

income, the Code limits the deduction for losses arising from a “passive activity”.

Secs. 162, 212, 469(a).

      A passive activity is any trade or business in which the taxpayer does not

materially participate. Sec. 469(c)(1). A passive activity loss is the excess of the

aggregate losses from all passive activities for the year over the aggregate income

from all passive activities for that year. Sec. 469(d)(1). A rental activity is

generally treated as a per se passive activity regardless of whether the taxpayer

materially participates. Sec. 469(c)(2). There are special rules under section

469(c)(7) that allow a taxpayer in the real property business (real estate

professional) to deduct rental losses against all income provided that the taxpayer

materially participates in the rental activity. See also sec. 1.469-9(e)(1), Income

Tax Regs.

      The Shahs assert that they are entitled to deduct their rental losses for 2005-

07 and that these losses are not subject to the passive activity loss limitations

under section 469. They contend that Dr. Shah qualifies as a real estate
                                         - 22 -

[*22] professional under section 469(c)(7) and that he materially participated in

his rental activities. The Shahs do not contend that Mrs. Shah qualifies as a real

estate professional.

      Under section 469(c)(7)(B), a taxpayer qualifies as a real estate professional

and a rental real estate activity of the taxpayer is not a per se passive activity under

section 469(c)(2) if:

             (i) more than one-half of the personal services performed in
      trades or businesses by the taxpayer during such taxable year are
      performed in real property trades or businesses in which the taxpayer
      materially participates, and

             (ii) such taxpayer performs more than 750 hours of services
      during the taxable year in real property trades or businesses in which
      the taxpayer materially participates.

In the case of a joint return, the above requirements are satisfied if and only if

either spouse separately satisfied these requirements. Sec. 469(c)(7)(B). Thus, if

either spouse qualifies as a real estate professional, the rental activities of the real

estate professional are exempt from being a per se passive activity under section

469(c)(2). Instead, the real estate professional’s rental activities would be subject

to the material participation requirements of section 469(c)(1). Sec. 1.469-9(e)(1),

Income Tax Regs.
                                        - 23 -

[*23] Since the Shahs are claiming deductions for losses from OCPIN, West

Coast, RPS, and DDSYS, we need to examine whether any of these entities were

engaged in rental activities for section 469(c)(7) to apply. We also need to

examine whether these entities were real property trades or businesses for the

purpose of aggregating Dr. Shah’s hours spent performing services in real property

trades or businesses in order for him to qualify as a real estate professional. A

determination that Dr. Shah was a real estate professional would be

inconsequential if OCPIN, West Coast, RPS, and DDSYS were not rental

activities. In that case, we would examine the entities only to see whether Dr.

Shah materially participated in them for the passive activity rules to apply.

Furthermore, if any of these entities were not real property trades or businesses,

the hours Dr. Shah spent performing personal services for them would count

against the Shahs’ claim that Dr. Shah qualifies as a real estate professional.

      The Code defines a real property trade or business as “any real property

development, redevelopment, construction, reconstruction, acquisition,

conversion, rental, operation, management, leasing, or brokerage trade or

business.” Sec. 469(c)(7)(C). Mere financing of or investing in real property is

not included within the plain language of section 469(c)(7)(C). OCPIN and West

Coast acted merely as investment vehicles for IHHI and PCHI, respectively. They
                                        - 24 -

[*24] were used presumably as an accessible way for physicians to invest in the

hospitals and operations of the hospitals without having to go out and buy and

finance these entities themselves. OCPIN and West Coast did not own rental real

property, and there is no evidence that they performed any management or

operations functions for IHHI or PCHI that could remotely be considered real

property trades or businesses. See Aragona Trust v. Commissioner, 142 T.C. 165

(2014). Because OCPIN and West Coast were not engaged in real property

businesses, let alone rental activities, section 469(c)(7) does not apply to them and

we must examine whether Dr. Shah materially participated in these entities for

their losses to qualify as nonpassive. Furthermore, the hours Dr. Shah spent

performing personal services for these entities would count against the Shahs’

claim that he was a real estate professional.

      RPS is a real property business engaged in rental real estate activity. It

owned an office building where it leased different suites to businesses including

Coastal Heart. The Shahs were property managers for RPS, and they collected

rents for the building, prepared the leases, took care of maintenance and repairs

throughout the building, and managed the utilities. Because the Shahs performed

rental activities, we must use the section 469(c)(7)(B) test to determine whether
                                        - 25 -

[*25] Dr. Shah was a real estate professional to prevent RPS’ losses from being

characterized as per se passive.

      The section 469(c)(7)(B) test specifically compares the taxpayer’s personal

services in real property trades or businesses he materially participates in with the

personal services the taxpayer performs in other trades or businesses in order to

determine whether the taxpayer was a real estate professional. Therefore, we need

to determine what businesses were real property trades or businesses that Dr. Shah

performed personal services for, and if there are any, whether he materially

participated in them.

      We have already concluded that OCPIN and West Coast were not real

property trades or businesses. Therefore, the hours Dr. Shah performed for these

entities count towards the hours he spent in his other trades or business. We have

also concluded that RPS was a real property trade or business--so the hours Dr.

Shah spent performing services for RPS will count towards the hours he spent in

real property trades or businesses. That leaves us to determine whether IHHI,

PCHI, and DDSYS were real property trades or businesses.

      The Shahs failed to create an adequate record to support their position. The

record does not reflect any information about DDSYS, so the Court cannot make

any conclusive determination about this entity. The record does contain
                                        - 26 -

[*26] information about IHHI and PCHI. IHHI bought five local hospitals from

Tenant for $57 million in 2005. IHHI was engaged in hospital acquisition and

management. This meets the definition of real property trade or business for

purposes of section 469(c)(7)(C). At trial Dr. Shah testified that after the sale,

IHHI split the real estate holding portion of the deal from the hospital operations

aspect. After the division, $50 million of the investment belonged to PCHI and $7

million belonged to IHHI. PCHI was the owner of the real property after the deal

and thereafter leased this property to other hospitals. Thus PCHI also meets the

definition of real property trade or business, and we must examine whether Dr.

Shah materially participated in IHHI, PCHI, and RPS. Only those real property

trades or businesses that Dr. Shah materially participated in can be used for

purposes of the section 469(c)(7)(B) comparison.

      Material participation is defined as involvement in the operations of an

activity on a basis which is regular, continuous, and substantial. Sec. 469(h)(1).

As explained in section 1.469-5T(a), Temporary Income Tax Regs., 53 Fed. Reg.

5725 (Feb. 25, 1988), a taxpayer can satisfy the material participation requirement

if the individual meets any one of the seven regulatory tests:

            (1) The individual participates in the activity for more than 500
      hours during such year;
                                         - 27 -

      [*27] (2) The individual’s participation in the activity for the taxable
      year constitutes substantially all of the participation in such activity
      of all individuals (including individuals who are not owners of
      interests in the activity) for such year;

             (3) The individual participates in the activity for more than 100
      hours during the taxable year, and such individual’s participation in
      the activity for the taxable year is not less than the participation in the
      activity of any other individual (including individuals who are not
      owners of interests in the activity) for such year;

             (4) The activity is a significant participation activity * * * for
      the taxable year, and the individual’s aggregate participation in all
      significant participation activities during such year exceeds 500
      hours;

            (5) The individual materially participated in the activity * * *
      for any five taxable years (whether or not consecutive) during the ten
      taxable years that immediately precede the taxable year;

             (6) The activity is a personal service activity * * *, and the
      individual materially participated in the activity for any three taxable
      years (whether or not consecutive) preceding the taxable year; or

             (7) Based on all facts and circumstances * * *, the individual
      participates in the activity on a regular, continuous, and substantial
      basis during such year.

      “Participation” generally means all work done in an activity by an

individual who owns an interest in the activity. Sec. 1.469-5(f)(1), Income Tax

Regs. Work done by an individual in the individual’s capacity as an investor in an

activity is not generally treated as participation in the activity. Id. subpara.

(2)(ii)(A), 53 Fed. Reg. 5727. Additionally, work done by the individual is not
                                         - 28 -

[*28] treated as participation in the activity if the work is not of a type that is

customarily done by an owner of such activity and one of the principal purposes

for performing such work is to avoid the passive activity limitations of section

469. Id. subdiv. (i), 53 Fed. Reg. 5726. In determining whether a taxpayer

materially participates, the participation of the spouse of the taxpayer shall be

taken into account. Sec. 469(h)(5).

      Dr. Shah was the executive chairman of IHHI, and he comanaged both

PCHI and RPS. Although he was an investor in IHHI and PCHI, we believe he

participated in these entities for purposes of section 469. Assuming that he

materially participated in all three of the entities (a determination we are not

willing to make at this juncture), we would then have to compare the hours he

spent performing personal services for these entities against the hours he spent

performing personal services for his other trades or businesses.

      With respect to the evidence that may be used to establish hours of

participation, section 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg.

5727 (Feb. 25, 1988), provides:

      The extent of an individual’s participation in an activity may be
      established by any reasonable means. Contemporaneous daily time
      reports, logs, or similar documents are not required if the extent of
      such participation may be established by other reasonable means.
      Reasonable means for purposes of this paragraph may include but are
                                       - 29 -

      [*29] not limited to the identification of services performed over a
      period of time and the approximate number of hours spent performing
      such services during such period, based on appointment books,
      calendars, or narrative summaries.

Dr. Shah did not offer a log, a calendar, or any other writing to prove the amount

of time that he spent working at IHHI, PCHI, or RPS. He was duly compensated

as executive chairman of IHHI, but he was also duly compensated as a cardiologist

for the years at issue. Furthermore, on his tax returns Dr. Shah did not claim to be

a real estate professional.

      At trial Dr. Shah testified that he spent 14 to 16 hours a day, seven days a

week in 2004 on negotiating the purchase of several hospitals. He further testified

that he worked over 1,000 hours in 2005 and 2006 negotiating leases for the

hospitals, finding investors for PCHI, West Coast, and IHHI, and refinancing

loans related to the purchase of the hospitals. Although the regulations permit

some flexibility concerning the records to be maintained by taxpayers, the Court is

not required to accept a postevent “ballpark guesstimate” or the unverified,

undocumented testimony of taxpayers. See, e.g., Moss v. Commissioner, 135 T.C.

365, 369 (2010); Lum v. Commissioner, T.C. Memo. 2012-103; Estate of

Stangeland v. Commissioner, T.C. Memo. 2010-185. Dr. Shah’s testimony

appears to be exaggerated and self-serving. On the basis of that testimony we
                                        - 30 -

[*30] cannot determine with any clarity how many hours Dr. Shah devoted to each

entity for which he performed personal services. Dr. Shah did not distinguish the

number of hours he spent finding investors for West Coast, a non-real-property

trade or business, from the total number of hours he claimed. Furthermore, the

Shahs did not describe with any specificity the number of hours they spent

performing services for RPS, a legitimate rental real estate trade or business. We

decline to accept Dr. Shah’s vague testimony regarding the maze of businesses he

performed personal services for without adequate documentary support.

      The trial record also does not reflect any objective measure of time Dr. Shah

spent as a cardiologist during the years at issue. Therefore, the Court cannot

compare the hours he spent on personal services in real property businesses--IHHI,

PCHI, and RPS--against the hours he spent performing personal services for

OCPIN, West Coast, and as a cardiologist.

      Dr. Shah therefore does not qualify as a real estate professional under

section 469(c)(7), and the rental activities of the Shahs as managers of RPS are per

se passive activities under section 469(c)(2) for the years at issue. See sec.

469(c)(4). Furthermore, we cannot conclude that Dr. Shah materially participated

in OCPIN, West Coast, and DDSYS (the other entities he claimed losses for on his

tax returns for the years 2005-07) because of the lack of corroborating evidence as
                                         - 31 -

[*31] to whether he was involved in the operations of these entities on a regular,

continuous, and substantial basis. Therefore, the loss deductions the Shahs

claimed on their tax returns for the years 2005-07 from RPS, OCPIN, West Coast,

and DDSYS are passive.

III.   Coastal Heart’s Tax Liabilities

       The tax issues for Coastal Heart are whether it can report income generated

by the CT scanner and claim deductions related to the scanner.

       Section 61(a)(2) provides that gross income includes all income from

whatever source derived, including gross income derived from business.

       Section 162(a) allows a taxpayer to deduct “all the ordinary and necessary

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

business”. A necessary expense is one that is “appropriate and helpful” to the

taxpayer’s business; ordinary expenses are those that are common or frequent in

the type of business in which the taxpayer is engaged. Deputy v. du Pont, 308

U.S. 488, 495 (1940); Welch v. Helvering, 290 U.S. at 113.

       Deductions are a matter of legislative grace, and the taxpayer bears the

burden of proving that claimed expenses are ordinary and necessary. Rule 142(a).

The taxpayer also bears the burden of substantiating his claimed deductions by

keeping and producing records sufficient to enable the Commissioner to determine
                                       - 32 -

[*32] the correct tax liability. Sec. 6001; INDOPCO, Inc. v. Commissioner, 503

U.S. 79, 84 (1992); sec. 1.6001-1(a), (e), Income Tax Regs. The failure to keep

and present such records counts heavily against a taxpayer’s attempted proof.

Rogers v. Commissioner, T.C. Memo. 2014-141, at *17. However, if a taxpayer

establishes that deductible expenses were incurred but fails to establish the precise

amounts, we may estimate allowable amounts if there is a rational basis for such

an estimate. Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930);

Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985).

      Deductions for depreciation of property used in a trade or business cannot

be claimed by a taxpayer who has no capital investment or economic interest in the

property. Helvering v. F. & R. Lazarus & Co., 308 U.S. 252; Estate of Franklin v.

Commissioner, 544 F.2d 1045, 1049 (9th Cir. 1976), aff’g 64 T.C. 752 (1975).

Generally, a taxpayer’s capital investment in the property is the cost of acquiring

the depreciable property. See secs. 167(c), 1011, 1012; Durkin v. Commissioner,

872 F.2d 1271, 1276 (7th Cir. 1989), aff’g 87 T.C. 1329 (1986); sec. 1.1012-1(a),

Income Tax Regs. The taxpayer who is entitled to the depreciation deduction is

the one who suffers the economic loss of his investment by virtue of the wear and

tear or exhaustion of the property--the one who has the economic benefits and

burdens of ownership. Frank Lyon Co. v. United States, 435 U.S. 561 (1978);
                                        - 33 -

[*33] Leahy v. Commissioner, 87 T.C. 56 (1986). Consequently, a stockholder

normally is not entitled to depreciate property of his corporation because he lacks

a direct economic interest or investment in the property itself. See Hunter v.

Commissioner, 46 T.C. 477, 489-490 (1966).

      The CT scanner generated income by providing heart scanning services to

patients, who in turn paid for these services through their insurers. The CT

scanner also had many associated costs. All of the expenses at issue for Coastal

Heart relate to the CT scanner. Specifically, Coastal Heart reported expenses

related to the scanner for: (1) lease payments; (2) the salaries of technicians who

operated it; (3) repairs and maintenance; (4) rent for the portion of Coastal Heart’s

office that accommodated it; and (5) depreciation of office furniture in the area

that accommodated it. Respondent argues that the income and expenses should be

allocated to Coastal Imaging because it managed the scanner. The Shahs argue

that Coastal Heart should be allowed to deduct the expenses because it paid them.

To illustrate the confusion surrounding the issue, Coastal Heart--the constructive

owner of the scanner--was deducting rental payments made on the scanner while

Coastal Imaging--the mere managing entity of the scanner--was deducting

depreciation for the scanner.
                                        - 34 -

[*34] A payment for the use or possession of business property is deductible as

rent only if made for property to which the taxpayer does not take title or in which

he has no equity. Sec. 162(a)(3). In other words, payments are not deductible as

rent when they are actually part of the purchase price of the property--i.e.,

constitute a conditional purchase. See Calbom v. Commissioner, T.C. Memo.

1981-95.

      As discussed earlier, the lease of the CT scanner between Siemens and

Coastal Heart was a conditional purchase of the scanner by Coastal Heart.

Therefore, Coastal Heart should have capitalized the rental payments on the lease.

Since Coastal Heart was the constructive owner of the scanner and the scanner

was not contributed to Coastal Imaging, Coastal Heart was entitled to depreciation

deductions on the scanner--not Coastal Imaging.

      Although the CT scanner was not contributed to Coastal Imaging, its

business purpose was to manage the scanner. The Shahs asserted that Coastal

Imaging managed the scanner and Dr. Shah separated the income between Coastal

Heart and Coastal Imaging for this purpose. Therefore, the gross income derived

from the scanner should have been reported by Coastal Imaging, not Coastal

Heart. See sec. 61(a)(2).
                                       - 35 -

[*35] Similarly, Coastal Heart did not meet its burden of showing that the

expenses it claimed relating to the CT scanner were ordinary and necessary to its

business. Although the scanner was located in a portion of Coastal Heart’s office,

Coastal Heart expanded its office primarily to accommodate the scanner and run

the business of Coastal Imaging. Coastal Heart has not met its burden of proving

the claimed expenses were ordinary and necessary to its business. Accordingly,

we sustain respondent’s determinations with respect to this issue.

IV.   Section 6662(a) Penalties Determined Against the Shahs and Coastal Heart

      Section 6662(a) and (b)(2) imposes a 20% accuracy-related penalty on any

underpayment of Federal income tax which is attributable to, among other things,

a substantial understatement of income tax. An understatement of income tax is

substantial if it exceeds the greater of 10% of the tax required to be shown on the

return or $5,000. Sec. 6662(d)(1)(A). In the case of a corporation (other than an S

corporation or a personal holding company), an understatement of income tax is

substantial if it exceeds the lesser of 10% of the tax required to be shown on the

return (or, if greater, $10,000) or $10 million. Sec. 6662(d)(1)(B).

      The Commissioner bears the burden of production with regard to the Shahs’

penalty and must come forward with sufficient evidence indicating that it is

appropriate to impose the penalty. See sec. 7491(c); Higbee v. Commissioner, 116
                                        - 36 -

[*36] T.C. 438, 446-447 (2001). Coastal Heart, as a corporation, bears the burden

of proving that it is not liable for accuracy-related penalties pursuant to section

6662(a). See NT, Inc. v. Commissioner, 126 T.C. 191, 195 (2006). If the

understatements of income tax for the years at issue are substantial, respondent has

satisfied the burden of producing evidence that the penalties are appropriate.

      With respect to the Shahs, respondent’s deficiency determination for tax

year 2007 exceeds 10% of the tax required to be shown on their joint return for

this year, which is greater than $5,000. Thus respondent’s burden of going

forward has been satisfied with respect to them. With respect to Coastal Heart,

respondent’s deficiency determinations for tax years 2004, 2005, 2006, and 2008

exceed $10,000, which is greater than 10% of the tax required to be shown on its

returns for these taxable years. Respondent’s deficiency determination for tax

year 2007 exceeds 10% of the tax required to be shown on its return, which is

greater than $10,000. Therefore, Coastal Heart’s understatements for the years at

issue were substantial.

      Once the Commissioner has met the burden of production, the taxpayer

must come forward with persuasive evidence that the penalty is inappropriate

because, for example, the taxpayer acted with reasonable cause and in good faith.

Sec. 6664(c)(1); Higbee v. Commissioner, 116 T.C. at 448-449. The decision as
                                        - 37 -

[*37] to whether a taxpayer acted with reasonable cause and in good faith is made

on a case-by-case basis, taking into account all of the pertinent facts and

circumstances. See sec. 1.6664-4(b)(1), Income Tax Regs. Reliance on the advice

of a tax professional may, but does not necessarily, establish reasonable cause and

good faith for the purpose of avoiding a section 6662(a) penalty. United States v.

Boyle, 469 U.S. 241, 251 (1985) (“Reliance by a lay person on a lawyer [or

accountant] is of course common; but that reliance cannot function as a substitute

for compliance with an unambiguous statute.”). The caselaw sets forth the

following three requirements in order for a taxpayer to use reliance on a tax

professional to avoid liability for a section 6662(a) penalty: “(1) The adviser was

a competent professional who had sufficient expertise to justify reliance, (2) the

taxpayer provided necessary and accurate information to the adviser, and (3) the

taxpayer actually relied in good faith on the adviser’s judgment.” See

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299

F.3d 221 (3d Cir. 2002); see also Charlotte’s Office Boutique, Inc. v.

Commissioner, 425 F.3d 1203, 1212 n.8 (9th Cir. 2005) (quoting with approval

the above three-prong test), aff’g 121 T.C. 89 (2003). In addition, the advice must

not be based on unreasonable factual or legal assumptions (including assumptions

as to future events) and must not unreasonably rely on the representations,
                                       - 38 -

[*38] statements, findings, or agreements of the taxpayer or any other person. Sec.

1.6664-4(c)(1)(ii), Income Tax Regs.

      The fact that petitioners had an accountant prepare their returns does not, in

and of itself, prove that they acted with reasonable cause and in good faith. See

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. at 99-100. Dr. Shah’s

failure to properly document his time spent performing personal services for real

property trades or businesses was detrimental to his ultimate effort to substantiate

all of the time he spent on his real property trades or businesses. See sec. 6001;

sec. 1.6001-1, Income Tax Regs. This made it impossible for his accountant to

have all the accurate information necessary to make an informed tax decision. The

accountant relied on the Shahs for an accurate representation of the number of

hours Dr. Shah worked on his real property trades or businesses; however, the

Shahs were unable to provide a reasonable estimate of the number of hours Dr.

Shah performed services for each of the entities he was managing. Some of these

entities were real property trades or business and some were not, and Dr. Shah

failed to make that distinction. Therefore, the Shahs have not proven reasonable

cause for their underpayment and they are liable for the section 6662 accuracy-

related penalty for tax year 2007.
                                         - 39 -

[*39] With respect to Coastal Heart, we are unpersuaded that Dr. Shah, as the sole

shareholder of Coastal Heart, reasonably relied on the correctness of the contents

of its returns simply because they were prepared by a certified public accountant.

The mere fact that the certified public accountant prepared its tax returns does not

mean that the accountant commented on any or all of the items reported therein.

In this regard, the record contains no evidence that Dr. Shah asked the accountant

to comment on the legitimacy of his treatment of the allocation of expenses

between Coastal Imaging and Coastal Heart--especially when the managing entity,

Coastal Imaging, claimed depreciation deductions on the CT scanner and the

constructive owner, Coastal Heart, claimed deductions for rental payments for the

scanner. Dr. Shah separated the income of Coastal Imaging and Coastal Heart,

and he should have had a clear, or at least basic, understanding of how each entity

functioned in relation to the other. The record and Dr. Shah’s testimony do not

reflect that this is the case. Therefore, we conclude that Coastal Heart is liable for

the accuracy-related penalties that respondent determined.

         We have considered all the other arguments made by the parties, and to the

extent not discussed above, find those arguments to be irrelevant, moot, or without

merit.
                                  - 40 -

[*40] To reflect the foregoing,


                                           Decisions will be entered

                                  under Rule 155.
