                        T.C. Memo. 1998-457



                    UNITED STATES TAX COURT



               CHAR-LIL CORPORATION, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4084-97.           Filed December 30, 1998.



     Charles Norman Woodward, for petitioner.

     Ann L. Darnold, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION

     WHALEN, Judge:     Respondent determined the following

deficiencies in and additions to petitioner's income tax:


                                    Additions to Tax
   Year      Deficiency      Sec. 6651(a)(1)    Sec. 6662(a)

   1989       $15,995           $3,492.50        $3,199.00
   1990        11,825               --            2,365.00
   1991        13,261               --            2,652.20
                              - 2 -


   1992      37,645                   --              7,529.00
   1993      48,752                   --              9,750.40
   1994      12,173                   --              2,434.60


All section references are to the Internal Revenue Code in

effect during the years in issue, and all Rule references

are to the Tax Court Rules of Practice and Procedure,

unless otherwise indicated.

     The issues for decision are:          (1) Whether petitioner

is subject to the personal holding company tax imposed by

section 541 for the years in issue; (2) whether petitioner

incurred passive activity losses, as defined by section

469(d), in 1992 and 1993, that are disallowed as deduc-

tions in those years, as determined by respondent; and

(3) whether petitioner is liable for the accuracy-related

penalty under section 6662(a) because of a substantial

understatement of income tax for each of the years in

issue.

                      FINDINGS OF FACT

     Petitioner, an Oklahoma corporation, maintained its

principal place of business in Lawton, Oklahoma, at the

time the instant petition was filed on its behalf.

Petitioner was incorporated on December 15, 1976, and

commenced business as of January 1, 1977.          The articles

of incorporation described the purposes for which the

corporation was formed as follows:
                              - 3 -



                          ARTICLE FOUR

          The purposes for which this corporation is
     formed are: To construct, buy, sell, trade,
     lease, rent or otherwise engage in the obtaining
     of residential and commercial property of any
     kind as an investment by holding for resale or
     to lease or rent at a profit. To engage in the
     construction or destruction of any such building.

          To engage in any business enterprise of a
     retail or wholesale nature that may be operated
     from or in any of the real estate owned by the
     corporation or any other business enterprise
     lawful in the State of Oklahoma, and to hold
     title in its own name of real estate used or to
     be used in the lawful business of the corporation
     and to do all things necessary to carry out the
     purposes of this corporation.


During the years in issue, there were 2,000 shares of

petitioner's stock outstanding.       All of the stock was owned

by Mr. Charles McKelvey, his wife, Lilly, and his daughter,

Kay, as follows:


             Mr. Charles McKelvey        1,800 shares
             Ms. Lilly McKelvey            160 shares
             Ms. Kay McKelvey               40 shares


During the years in issue, Mr. McKelvey was petitioner's

president.    His wife was petitioner's secretary and

treasurer, and his daughter was vice president.         They

also composed petitioner's board of directors.

     On January 1, 1977, Mr. McKelvey transferred nine

pieces of real estate to petitioner in exchange for stock
                                                    - 4 -


in the corporation.                      Thereafter, petitioner acquired eight

other pieces of real estate.                                From 1977 through January 24,

1989, petitioner disposed of 12 of those properties.                                                    From

January 24, 1989, through 1994, petitioner neither

purchased nor sold any real property.                                       Set out below is a

schedule of petitioner's acquisitions and dispositions of

real property:

                                              Char-Lil Corporation
                                Schedule of Acquisitions and Sales of Real Property

                                  Date        Cost or          Date         Sale      Accum.    Years
Description of Real Property     Acquired     Other Basis      Sold         Price     Depr.     Held
                                 1
613 Lee, Lawton                   1/01/77      $30,100        7/29/83     $40,000     $13,678    6.5
                                 1
509 Lee, Lawton                   1/01/77       25,925        1/02/86      44,529      21,971    9.0
                                 1
602 - 616 Lee, Lawton             1/01/77      300,995        9/29/86     500,000     100,678    9.5
                                 1                               2
2116 Fort Sill Blvd., Lawton      1/01/77      331,756                       --       225,023   18.5
                                 1                               2
2112 Fort Sill Blvd., Lawton      1/01/77      144,428                       --        86,849   18.5
 1108 Lincoln Blvd., Lawton
                                 1                               2
515 Lee Blvd., Lawton              1/01/77      28,000                       --        28,000   18.5
                                 1                               2
1207 S. 6th, Lawton                1/01/77      10,000                       --        10,000   18.5
Commercial Property, Fletcher      2/01/77      53,155        9/01/82     150,000      16,792    5.5
626 D Ave., Lawton                 7/01/81     116,525        8/19/82     175,000       4,729    1.0
608 D Ave., Lawton                 7/01/81     115,000        9/01/82     175,000       4,500    1.0
                                                                                         3
802 S.E. 3d, Lawton                3/01/82      12,500        7/01/85      27,500         -0-    3.0
802 S.E. 3d, Lawton                3/01/82     163,388       12/15/87      85,000      74,484    5.5
45th & E. Gore, Lawton             4/01/83     315,743         1/24/89    230,000     126,460    5.5
Sheridan & Hoover, Lawton        12/01/83      212,845         1/24/89    155,000      63,798    5.0
                                  1
6302-04 Cache Rd., Lawton          1/01/77     282,488       10/25/88     250,000      82,164   11.5
                                                                                         3
38th & Lee (lots), Lawton          1/01/86      23,250         5/01/86     30,687         -0-    0.5


   1
    Date of incorporation. Cost basis represents sec. 351 transfer from majority shareholder.
   2
    Property was owned by petitioner as of Dec. 31, 1994.
   3
    Undeveloped land.


         The following is a brief description of Mr. McKelvey's

and petitioner's activity with respect to each of the above

properties.
                             - 5 -


     613 Lee, Lawton:    Mr. McKelvey purchased this property

from an estate.    He tore down a house that was on the

property and built a building which he leased to a business

that operated a bar.    On January 1, 1977, Mr. McKelvey

contributed the property to petitioner.    On July 29, 1983,

petitioner sold the property to Mr. Billy Caldwell,

Mr. McKelvey's and petitioner's accountant.    Petitioner

did not engage a real estate agent in connection with

the sale.   Petitioner financed the sale by taking

Mr. Caldwell's promissory note for part of the purchase

price.

     509 Lee, Lawton:    Mr. McKelvey purchased this

property and tore down a house that was on it.    He built

a commercial building on the property which he leased for

$350 per month to an individual, Mr. Mike Harrison, for

use as an alignment shop.    On January 1, 1977, Mr. McKelvey

contributed the property to petitioner.    When petitioner

proposed to increase the tenant's rent to $500 per month,

Mr. Harrison agreed to purchase the property.    Petitioner

did not engage a real estate agent in connection with the

sale to Mr. Harrison.

     602-616 Lee, Lawton:    These properties compose a strip

shopping center.   Initially, Mr. McKelvey purchased two

lots and built a store for his business.   He then added
                              - 6 -


properties.    On January 1, 1977, Mr. McKelvey contributed

the shopping center to petitioner.      After Mr. McKelvey and

petitioner had rented the shopping center for some time, it

was in need of renovations that would cost approximately

$200,000.   Mr. McKelvey decided, on petitioner's behalf, to

sell the properties, and he engaged a real estate agent to

assist in the sale.    Petitioner sold the properties on

September 29, 1986, to Ashworth, Inc.

     2116 Fort Sill Boulevard, Lawton:      Mr. McKelvey

purchased this property and tore down a house that was

on it to make way for a building which he leased.      On

January 1, 1977, Mr. McKelvey contributed the property

to petitioner.     In 1995, petitioner sold the property to

an individual who had worked for Mr. McKelvey, Mr. Jimmy

Parker, for $290,000.     Petitioner financed the sale of the

property.     Petitioner did not engage a real estate agent

in connection with the sale.

     2112 Fort Sill Boulevard and 1108 Lincoln Boulevard:

Mr. McKelvey purchased a building at 2112 Fort Sill

Boulevard and a house on a contiguous property at 1108

Lincoln Boulevard from a friend.      On January 1, 1977, he

contributed the properties to petitioner.      Petitioner

leased the properties to Mr. Rick Taylor.      In 1985 or 1986,

petitioner renovated the building, and in 1995, petitioner
                              - 7 -


sold the properties to Mr. Taylor.       Petitioner financed

the sale.     Petitioner did not retain a real estate agent

in connection with this sale.

        515 Lee Boulevard, Lawton and 1207 S. 6th, Lawton:

The property at 515 Lee Boulevard was improved with a

house, and the property at 1207 S. 6th was improved

with a garage and an apartment.       Mr. McKelvey purchased

the properties and tore down the house and the garage and

built a service station for lease to Champlin Oil.       On

January 1, 1977, Mr. McKelvey contributed the properties

to petitioner.    Recently, petitioner tore down the service

station and built a new building for lease to a tenant

who operates a pawn shop.    Petitioner still owns these

properties.

     Commercial Property, Fletcher:       Petitioner acquired

this property in February 1977.       It was improved with a

store building.    On September 1, 1982, petitioner sold

the property to a person who had worked for Mr. McKelvey.

Petitioner financed the sale of the property.       Petitioner

did not retain a real estate agent in connection with the

sale.

     626 D Avenue, Lawton:     Petitioner acquired this

property at an auction on July 1, 1981.       Shortly there-

after, petitioner listed the property with a real estate
                             - 8 -


agent and sold it on August 19, 1982, to a local radio

station in Lawton, KLAW.    Petitioner financed the sale.

     608 D Avenue, Lawton:    Petitioner acquired this

property at auction on July 1, 1981, and, shortly

thereafter, listed it for sale with a real estate agent,

Finley Properties.   On September 1, 1982, petitioner sold

the property to Mr. Billy Reed.      Petitioner financed the

sale of the property.

     802 S.E. 3d, Lawton (Two Properties):      Petitioner

purchased two properties from Finley Properties that were

leased to Ensco Oil.    After 2 years, the lessee "folded up

and moved".   The two properties are composed of five lots,

three of which were vacant, and two of which were improved

with a building.   After the properties were vacant for

approximately 3 years, petitioner listed them for sale with

a real estate agent and on July 1, 1985, sold the three

vacant lots to a bakery.    On December 15, 1987, petitioner

sold the building to Mr. Kent Wallar.

     45th & E. Gore, Lawton:    On April 1, 1983, petitioner

purchased this unimproved property from Champlin Oil Co.

and built a store on the property.      Petitioner leased the

store for some time and on January 24, 1989, sold the

property to Mr. Stanley Booker.      Petitioner financed the
                             - 9 -


sale of the property.    Petitioner did not engage a real

estate agent in connection with this sale.

     Sheridan & Hoover, Lawton:      Petitioner purchased this

property at auction on December 1, 1983.     It was improved

with a car wash which petitioner tore down.     Petitioner

built a commercial building on the property which it

leased until it sold the property to Mr. Stanley Booker

on December 24, 1989.    Petitioner financed this sale.

Petitioner did not engage a real estate agent in connection

with the sale.

     6302-04 Cache Road, Lawton:      Mr. McKelvey purchased

this property which was improved with a one-bay service

station.    He tore down the service station and built a

commercial building for a specific tenant.     On January 1,

1977, Mr. McKelvey transferred the property to petitioner.

Petitioner continued to lease the property until

October 25, 1988, when it sold it to Mr. Stanley Booker.

Petitioner financed this sale.    Petitioner did not engage

the services of a real estate agent in connection with

the sale.

     38th & Lee (Lots), Lawton:      Petitioner purchased

several vacant lots in a doctors' complex on January 1,

1986.   Shortly thereafter, petitioner listed the property
                           - 10 -


for sale with a real estate agent, Mr. Bill Clements, and

sold the property on May 1, 1986.

     Petitioner paid no dividends during any of the years

in issue.   Petitioner paid no dividends after the close of

any of the taxable years in issue that could be eligible

for the election in section 563(b).    Finally, petitioner

did not make a consent dividend pursuant to section 565

during any of the years in issue.

     For Federal income tax purposes, petitioner computed

taxable income using the cash receipts and disbursements

method of accounting and the calendar year.    Petitioner

filed timely returns on Form 1120, U.S. Corporation Income

Tax Return, for each of the years in issue, except for the

return for 1989, which was due on September 15, 1990, but

was not filed until August 12, 1991.

     Petitioner's returns for 1989 through 1994 report the

following income, deductions, and taxable income:
                                                     - 11 -


       Petitioner's Returns                1989           1990         1991           1992          1993         1994

Interest                               $137,367.70    $128,743.28   $124,298.52   $119,573.90   $114,634.00   $111,817.00
Gross rents                              52,572.00      53,715.00     52,292.26     48,633.00     42,775.00     45,200.00
Capital gain net income (Schedule D)     20,546.42      59,739.59      9,508.23     10,364.34     11,279.00     12,851.00
Net gain or (loss from Form 4797)        38,532.43        -0-            -0-           -0-           -0-           -0 -

 Total income                           249,018.55     242,197.87    186,099.01    178,571.24    168,688.00    169,868.00

Compensation of officers                 68,895.00      28,900.00         -0-           -0-        4,100.00     39,000.00
Salaries and wages                                      36,000.00     38,250.00     39,750.00     39,750.00        -0-
Repairs                                   3,401.81       3,842.12        972.32      2,043.20        825.87      4,570.92
Taxes                                    17,016.38       7,076.76     24,427.67      8,651.66     14,537.41     18,660.02
Interest                                 26,730.81      19,606.99     18,450.48      8,136.20      3,963.54     15,497.83
Depreciation                             29,389.44      24,033.68     20,474.72     23,520.07     25,867.58     23,702.00

Other deductions
Auto expense                              1,754.34         868.65      1,177.59      1,417.00      1,456.29        177.50
Electricity                                  93.20          --             --            --             --           --
Insurance                                 1,484.60       1,980.40      1,904.00      1,699.00      1,913.00      2,827.00
Labor                                     3,247.47       7,578.46      6,031.70      5,869.00      6,698.33      5,582.50
Legal and accounting                      3,363.50          50.00      3,000.00      2,095.50      1,500.00      1,558.00
Miscellaneous                               377.95          --         2,390.00        627.31      1,321.69         78.76
Supplies                                     41.92          --            50.53        389.10        171.53        231.24
Telephone                                   394.88         360.47        282.79        394.99        517.09        705.50
Yard work                                 2,779.98       2,475.00      2,700.00      3,589.96      2,847.92      2,745.27
Management fees                               --            --            --            --            --         5,100.00
Contribution                                   --           --            --            --            --           415.00

  Total deductions                      158,971.28     132,772.53    120,111.80     98,182.99    105,470.25    120,851.54


  Taxable income                         90,047.27     109,425.34     65,987.21     80,388.25     63,217.75     49,016.46




         Except for small amounts paid by a bank and by the

Internal Revenue Service, the interest income reported by

petitioner consists of interest paid on promissory notes

accepted by petitioner to finance its sale of various

parcels of real property.                            We refer to these obligations as

purchase money obligations.                             Set out below is a schedule of

the interest income reported by petitioner during the years

1989 through 1994, showing the payor of the interest and

the property with respect to which the interest was paid:
                                                              - 12 -


   Payor                                 Property                     1989         1990          1991        1992          1993         1994

Billy Caldwell                     613 Lee, Lawton                  $3,506.33    $3,388.42    $3,258.20    $3,114.32    $2,955.40     $2,779.80
Mike Harrison                      509 Lee, Lawton                                4,923.51                  4,649.32     4,485.64      4,301.17
Ashworth, Inc.                     602-616 Lee, Lawton               5,037.91    23,281.57     4,794.59    21,941.78    21,173.40     20,330.87
                                   2116 Fort Sill Blvd., Lawton     23,864.37        --       22,642.54        --           --            --
                                   2112 Fort Sill Blvd., Lawton         --           --           --           --           --             --
                                    1108 Lincoln Blvd., Lawton          --                        --
                                   515 Lee Blvd., Lawton                             --                        --           --            --
                                   1207 S. 6th, Lawton                  --           --           --           --           --            --
Marian Booker                      Commercial Property, Fletcher        --       3,071.75         --           --           --            --
KLAW                               626 D Ave., Lawton               10,863.06    11,219.89        --       11,082.70     9,582.40     10,538.88
Billy Reed                         608 D Ave., Lawton               12,706.57    13,740.70    12,677.03    12,556.05    11,859.06     11,081.37
Finley Commercial Property, Inc.   802 S.E. 3d, Lawton              14,242.55                 13,180.75
Finley Commercial Property, Inc.   802 S.E. 3d, Lawton                            7,170.61                  6,836.74     6,643.16      6,429.30
Stanley Booker                     45th & E. Gore, Lawton                           -0-                        -0-      21,013.17     20,424.56
Stanley Booker                     Sheridan & Hoover, Lawton         7,314.21       -0-        7,011.99        -0-      14,161.04     13,764.35
Stanley Booker                     6302-04 Cache Rd., Lawton            -0-      61,946.83       -0-       59,392.99    22,761.17     22,087.30
                                   38th and Lee (lots), Lawton          -0-          --          -0-           --           --            --
Cache Rd. Bank                                                      59,832.70        --       60,733.42         --          --            78.76
Internal Revenue                                                        --           --           --             --          23.28           .80
                                                                        --                        --
                                                                        --      128,743.28          --    119,573.90   114,657.72    111,817.16

                                                                   137,367.70
                                                                                             124,298.52



                        Each of the returns filed by petitioner during the

            years in issue includes Forms 6252, Installment Sale

            Income, on which petitioner computes the installment sale

            income with respect to the principal payments received

            during the year on each of its purchase money obligations.

            The installment sale income reported by petitioner is

            summarized in the following schedule:
                                                       - 13 -


    Form 6252
    Installment
    Sale Income                Property               1989        1990        1991       1992        1993        1994

Billy Caldwell      613 Lee, Lawton                    $663.65     $733.16    $809.93     $894.74     $989.00   $1,092.00
Mike Harrison       509 Lee, Lawton                     732.95      825.90     930.65    1,048.68    1,181.00    1,332.00
Ashworth, Inc.      602-616 Lee, Lawton               3,119.14    3,420.22   3,750.34    4,112.35    4,509.00    4,944.00
                    2116 Fort Sill Blvd., Lawton        --          --          --         --          --          --
                    2112 Fort Sill Blvd., Lawton        --          --          --         --          --          --
                     1108 Lincoln Blvd., Lawton
                    515 Lee Blvd., Lawton               --          --          --         --          --          --
                    1207 S. 6th, Lawton                 --          --          --         --          --          --
Marian Booker       Commercial Property, Fletcher    12,885.46   51,392.98      --         --          --          --
KLAW                626 D Ave., Lawton                1,386.54    1,398.18   1,825.68    1,869.31    1,885.00    2,461.00
Billy Reed          608 D Ave., Lawton                1,324.90    1,478.21   1,649.28    1,840.12    2,053.00    2,291.00
Finley Commercial
 Property, Inc.     802 S.E. 3d, Lawton
Finley Commercial
 Property, Inc.     802 S.E. 3d, Lawton                --          --          --         --          --          --
Stanley Booker      45th & E. Gore, Lawton             122.99      147.61     163.07      180.14      199.00      220.00
Stanley Booker      Sheridan & Hoover, Lawton          --          --          --         --          --          --
Stanley Booker      6302-04 Cache Rd., Lawton          310.79      343.33     379.28      419.00      463.00      511.00
                    38th & Lee (lots), Lawton           --          --         --         --          --          --


 Total                                               20,546.42   59,739.59   9,508.23   10,364.34   11,279.00   12,851.00




Petitioner reported the aggregate installment sale income

for each of the years in issue on Form 4797, Sales of

Business Property, as "section 1231 gain from installment

sales from Form 6252".                              Each of the above totals was also

reported on Schedule D, Capital Gains and Losses, as long-

term capital gain.

          During the audit of petitioner's returns, Mr. McKelvey

told respondent's agent that petitioner held the real

properties that it owned for rental, but that petitioner

would sell one of the properties when a good deal came

along.            When any of its properties was for sale, petitioner

did not advertise either in newspapers or by a sign in

front of the property.                              Petitioner did not regularly or
                           - 14 -


consistently retain real estate agents to assist in the

sale of its properties.

     Mr. McKelvey also told respondent's agent during the

audit that most of the persons who had purchased any of

petitioner's properties had previously been tenants and he

knew them to be good payors so that it required very little

effort to collect payments from them after the purchase.

Furthermore, Mr. McKelvey told the agent that petitioner's

operating expenses related to the rental properties.

     In the subject notice of deficiency, respondent

determined that during each of the years in issue,

petitioner was a personal holding company, as defined by

section 542.   The notice of deficiency states as follows:


     Since over 50 [sic] percent of your adjusted
     ordinary gross income reported for the taxable
     years 1989, 1990, 1991, 1992, 1993, and 1994
     was from dividends, rents and interest, you
     qualified as a personal holding company as
     defined by Section 542 of the Internal Revenue
     Code. Therefore, you were subject to the
     personal holding company tax imposed by Section
     541 of the Code.


     Respondent also disallowed a portion of the deductions

claimed by petitioner for the years 1992 and 1993 on the

ground that the total deductions claimed for each of those

taxable years exceeded the income from petitioner's passive
                           - 15 -


activities.   Respondent's notice of deficiency states as follows:



     The total deductions of $98,183.00 shown on your
     return are reduced by $39,186.00 because to the
     extent that the total deductions from passive
     activities exceed the total income from such
     activities for the tax year, the excess is not
     allowed as a deduction for that year. Therefore,
     your taxable income for the taxable year ended
     December 31, 1992 is increased $39,186.00.

     The total deductions of $105,470.00 shown on your
     return are reduced by $51,416.00 because to the
     extent that the total deductions from passive
     activities exceed the total income from such
     activities for the tax year, the excess is not
     allowed as a deduction for that year. Therefore,
     your taxable income for the taxable year ended
     December 31, 1993 is increased $51,416.00.


     Respondent determined that petitioner is liable for

the additions to tax under section 6651(a)(1) for 1989

because petitioner's 1989 return was not timely.

Petitioner does not challenge this adjustment.   Finally,

respondent determined that petitioner is liable for the

addition to tax under section 6662(a) for the years in

issue because of a substantial understatement of tax with

respect to each of those years.


                           OPINION

Personal Holding Company Tax

     The first issue for decision is whether petitioner

is subject to the personal holding company tax imposed by
                          - 16 -


section 541 for the years in issue.    Section 542(a) defines

personal holding company as follows:



          SEC. 542(a). General Rule.--For purposes
     of this subtitle, the term "personal holding
     company" means any corporation (other than a
     corporation described in subsection (c)) if--

               (1) Adjusted ordinary gross income
          requirement.--At least 60 percent of
          its adjusted ordinary gross income (as
          defined in section 543(b)(2)) for the
          taxable year is personal holding
          company income (as defined in section
          543(a)), and

               (2) Stock ownership requirement.--
          At any time during the last half of the
          taxable year more than 50 percent in value
          of its outstanding stock is owned, directly
          or indirectly, by or for not more than 5
          individuals. For purposes of this
          paragraph, an organization described in
          section 401(a), 501(c)(17), or 509(a) or a
          portion of a trust permanently set aside or
          to be used exclusively for the purposes
          described in section 642(c) or a
          corresponding provision of a prior income
          tax law shall be considered an individual.


Petitioner concedes that it meets the stock ownership

requirement of section 542(a)(2) during the last half

of each of the subject taxable years.   The issue is

whether petitioner meets the adjusted ordinary gross income

requirement of section 542(a)(1) during each of the subject

years.

     For purposes of the adjusted ordinary gross income

requirement, section 543(a) defines "personal holding
                          - 17 -


company income" generally to include dividends; interest;

royalties; rents; mineral, oil, and gas royalties;

copyright royalties; produced film rents; amounts received

as compensation for the use of corporate property by

certain large shareholders; amounts received under a

contract to furnish personal services; and certain amounts

relating to estates and trusts.    The provision dealing with

rents, section 543(a)(2), provides that the term "personal

holding company income" means the portion of the adjusted

gross income which consists of:


          (2) Rents.--The adjusted income from rents;
     except that such adjusted income shall not be included
     if--

               (A) such adjusted income constitutes 50
          percent or more of the adjusted ordinary gross
          income, and

               (B) the sum of--

                    (i) the dividends paid during the
               taxable year (determined under section 562),

                    (ii) the dividends considered as paid
               on the last day of the taxable year under
               section 563(c)[(d)] (as limited by the
               second sentence of section 563(b)), and

                    (iii) the consent dividends for the
               taxable year (determined under section 565),

     equals or exceeds the amount, if any, by which the
     personal holding company income for the taxable year
     (computed without regard to this paragraph and
     paragraph (6), and computed by including as personal
     holding company income copyright royalties and the
     adjusted income from mineral, oil, and gas royalties)
     exceeds 10 percent of the ordinary gross income.
                             - 18 -



Thus, according to section 543(a)(2), adjusted income from

rents is taken into account in computing personal holding

company income if it amounts to less than 50 percent of the

corporation's adjusted ordinary gross income.    See sec.

543(a)(2).    If adjusted income from rents amounts to 50

percent or more of the corporation's adjusted ordinary

gross income, and a condition involving the corporation's

dividends for the year is met, then adjusted income from

rents is not taken into account in computing personal

holding company income.    See sec. 543(a)(2).

     The phrase "adjusted income from rents" is defined by

section 543(b)(3) as follows:


          (3) Adjusted income from rents.--The term
     "adjusted income from rents" means the gross income
     from rents, reduced by the amount subtracted under
     paragraph (2)(A) of this subsection [i.e., deprecia-
     tion, property taxes, interest expense, and rent].
     For purposes of the preceding sentence, the term
     "rents" means compensation, however designated, for
     the use of, or right to use, property, and the
     interest on debts owed to the corporation, to the
     extent such debts represent the price for which real
     property held primarily for sale to customers in the
     ordinary course of its trade or business was sold or
     exchanged by the corporation; but such term does not
     include--

                  (A) amounts constituting personal holding
             company income under subsection (a)(6),

                  (B) copyright royalties (as defined in
             subsection (a)(4)),

                  (C) produced film rents (as defined in
             subsection (a)(5)(B)),
                             - 19 -


                  (D) compensation, however designated, for
             the use of, or the right to use, any tangible
             personal property manufactured or produced by the
             taxpayer, if during the taxable year the taxpayer
             is engaged in substantial manufacturing or
             production of tangible personal property of the
             same type, or

                  (E) active business computer software
             royalties (as defined in subsection (d)).


     Based upon the above, the narrow question at issue in

this case is whether the interest income received by

petitioner in connection with the purchase money

obligations taken to facilitate its sale of real properties

is included in the term "rents" as defined by section

543(b)(3).    This depends upon whether the purchase money

obligations on which the interest was paid are "debts"

which represent "the price for which real property held

primarily for sale to customers in the ordinary course of

its trade or business was sold or exchanged by the

corporation".    Sec. 543(b)(3).

     The language of section 543(b)(3), "property held

primarily for sale to customers in the ordinary course of

its trade or business", is nearly identical to the language

of section 1221(1).    Accordingly, this and other courts

have used the cases decided under section 1221(1) for

guidance in deciding whether section 543(b)(3) applied.

See Kent Indus. Corp. v. Commissioner, 25 T.C. 215, 219

(1955).   The same should also be true of the cases under
                           - 20 -


section 1231(b)(1)(B), which contains nearly identical

language.   See Cottle v. Commissioner, 89 T.C. 467, 485-486

(1987).

     In deciding whether a particular piece of real

property is held for sale to customers in the ordinary

course of a taxpayer's trade or business, courts have

considered the following factors:


     (1) the nature and purpose of the acquisition of
     the property and the duration of the ownership;
     (2) the extent and nature of the taxpayer's
     efforts to sell the property; (3) the number,
     extent, continuity and substantiality of the
     sales; (4) the extent of subdividing, developing,
     and advertising to increase sales; (5) the use of
     a business office for the sale of the property;
     (6) the character and degree of supervision or
     control exercised by the taxpayer over any
     representative selling the property; and (7) the
     time and effort the taxpayer habitually devoted
     to the sales. * * * [United States v. Winthrop,
     417 F.2d 905, 910 (5th Cir. 1969).]

     See also Major Realty Corp. and Subsidiaries
     v. Commissioner, 749 F.2d 1483, 1488 (11th Cir.
     1985), affg. and revg. on another issue a
     Memorandum Opinion of this Court; Daugherty v.
     Commissioner, 78 T.C. at 629. * * *


Cottle v. Commissioner, supra at 487 (fn. ref. omitted);

see Thrift v. Commissioner, 15 T.C. 366, 369 (1950).

     With respect to each of the years in issue, if the

interest on petitioner's purchase money obligations is

treated as "rents" and, thus, is included in "adjusted

income from rents", as defined by section 543(b)(3), then
                            - 21 -


the amount of petitioner's adjusted income from rents

constitutes 50 percent or more of the adjusted ordinary

gross income and, pursuant to section 543(a)(2),

petitioner's rents are not taken into account in computing

personal holding company income.     In that event, petitioner

does not qualify as a personal holding company in any of

the years in issue because the amount of petitioner's

personal holding company income would not amount to at

least 60 percent of its adjusted ordinary gross income.

Sec. 542(a).    Otherwise, if the interest on purchasers'

purchase money obligations is not treated as "rents", then

petitioner's rental income would be taken into account in

computing personal holding company income because the

amount of petitioner's adjusted income from rents would

constitute less than 50 percent of the adjusted ordinary

gross income.    See sec. 543(a)(2)(A).   In addition,

petitioner's interest income would be taken into account in

computing personal holding company income.     See sec.

543(a)(1).   As a result, in that event, petitioner would

qualify as a personal holding company in each of the years

in issue.

     Petitioner contends that the interest received on its

purchase money obligations should be included in adjusted

income from rents because "Petitioner was in the real

estate operating business buying, improving, renting and
                           - 22 -


selling commercial real estate property" and "an integral

part of Petitioner's business was to finance the sale of

the commercial real estate property which it sold to its

customers."   According to petitioner, it is "a bona fide

operating company" that is "outside of the intent of the

penalizing effect of the personal holding company tax."

Petitioner argues that its principal officer, Mr. McKelvey,

developed customers by first renting a property to the

prospective buyer.   Petitioner also argues that "the

depressed commercial real [estate] market in Lawton,

Oklahoma during the late 1980's and early 1990's"

substantially slowed petitioner's business activity by

requiring petitioner to hold properties until market

conditions improved in the mid 1990's.   After making a

property-by-property analysis, petitioner argues that it

is "a real estate operating company acquiring commercial

properties, improving those properties and selling those

properties to buyers which it has located and nurtured as

customers."   Finally, petitioner argues that it has

consistently engaged in the business of "acquiring,

improving, leasing and selling property to its established

customers."

     Petitioner argues that if it had held all of the

property as rental property, "then clearly its rental

income would have exceeded 50% of its adjusted ordinary
                           - 23 -


gross income and not been treated as personal holding

company subject to personal holding company tax."

According to petitioner, respondent is seeking to impose

personal holding company tax on petitioner because

"petitioner changed the nature of this income from rental

income to interest income by selling the property to its

rental customers and other customers".    Petitioner contends

that this case "is exactly the reason that Congress

provided in I.R.C. § 543(b)(3) that interest income which

is derived from mortgages from the sale of property in the

ordinary course of business be treated as rental income for

the purpose of determining whether rents qualify as

personal holding company income."

     Respondent argues that the subject properties were

held primarily for rental and investment and were not held

primarily for sale to customers.    Respondent points out

that there is no evidence that the properties were actively

marketed for sale.   To the contrary, except in several

instances when petitioner listed a property with a real

estate agent, it held the properties for rental but would

sell a property if it received an acceptable offer.

Respondent notes that petitioner claimed depreciation

deductions with respect to each of the subject properties

and reported the gains from the sale of all of its

properties in a manner that is inconsistent with its
                           - 24 -


position in this case.   Petitioner reported its sales of

real property as "property used in the trade or business",

as defined by section 1231(b), and reported the sales as

"installment [sales]" as defined by section 453(b).    Thus,

petitioner took the position on each of its returns for the

years in issue that the properties were not held primarily

for sale to customers in the ordinary course of a trade or

business.   Respondent argues that petitioner's sales of

property have been erratic, that the average holding period

of petitioner's properties is 8 years, and that only one

property was held for less than 1 year.

     Respondent also argues that petitioner's dividends for

the year do not equal or exceed the amount by which the

nonrent personal holding company income for the year

exceeds 10 percent of the ordinary gross income, as

required by section 543(a)(2).   For example, respondent

notes that petitioner's ordinary gross income for 1989 is

$189,941.   Respondent argues that "based on the factual

background of this case and testimony offered at trial,

petitioner cannot establish that its personal holding

company income is less than $18,994."

     We agree with respondent that petitioner has not shown

that a sufficient number of its purchase money obligations

are debts that "represent the price for which real property

held primarily for sale to customers in the ordinary course
                            - 25 -


of its trade or business was sold or exchanged".   Thus,

petitioner has not shown that a sufficient amount of its

interest income should be treated as rents, such that

petitioner's aggregate rental income is excluded from the

computation of personal holding company income pursuant to

section 543(a)(2).   Accordingly, we agree that petitioner

has not overcome respondent's determination that petitioner

is a personal holding company.

      Petitioner's argument that it is "a bona fide

operating company which buys, improves, rents and sells

commercial real property" is based upon the testimony

of its principal stockholder, Mr. McKelvey, and an overview

of petitioner's purchases and sales of property.   Unlike

petitioner, we believe that, with several exceptions,

petitioner was in the business of developing and holding

real property for rental.   This finding is based upon all

of the facts and circumstances of this case which suggest

that petitioner's activities with respect to each of the

subject properties were undertaken for the principal

purpose of holding and renting the property and not to sell

it.   In this connection, we note the long holding period of

most of the properties, petitioner's failure to advertise

any property for sale, and petitioner's failure to retain

real estate agents, except in several instances.   This

finding is also consistent with Mr. McKelvey's statements
                           - 26 -


to respondent's revenue agent during the audit that

petitioner held the properties for rental.   On the basis of

the record in this case, we cannot find that petitioner has

shown that it held real property for sale to customers in

the ordinary course of its trade or business.

     Our finding that petitioner did not hold the subject

properties for sale to customers in the ordinary course of

its trade or business is also consistent with the manner in

which petitioner reported its sales of real property for

Federal income tax purposes.   As described above, in each

of its returns for the years in issue, petitioner took the

position that all of its sales of real properties consisted

of "property used in the trade or business" as defined by

section 1231(b).   That provision specifically excludes,

among other things, "property held by the taxpayer

primarily for sale to customers in the ordinary course of

his trade or business".   Sec. 1231(b)(1)(B).   Furthermore,

petitioner reported all of its sales as "installment

sales", as defined by section 453(b).   Thus, petitioner

took the position in each of the returns in issue that

its sales of real property did not include "dealer

dispositions"; i.e., "Any disposition of real property

which is held by the taxpayer for sale to customers in the

ordinary course of the taxpayer's trade or business."    Sec.

453(l)(1)(B).   Accordingly, based upon all the facts and
                           - 27 -


circumstances of this case, we find that most of the

properties with respect to which petitioner received

interest income during the years in issue were not

properties held by petitioner for sale to customers in the

ordinary course of its trade or business.    Thus, we find

that petitioner is a personal holding company as defined by

section 542(a), in each of the years in issue, and is

subject to personal holding company tax imposed by section

541, as determined by respondent.


Passive Loss Limitation

     The second issue for decision is whether deductions

claimed on petitioner's 1992 return in the amount of

$39,186 and deductions claimed on petitioner's 1993

return in the amount of $51,416 are disallowed under

section 469(a) as passive activity losses.    Resolution

of this issue turns on whether the interest income from

petitioner's purchase money obligations, described

above, is portfolio income because it was not derived

in the ordinary course of a trade or business.    See sec.

469(e)(1)(A)(i)(I); sec. 1.469-2T(c)(3)(i)(A) and (ii),

Temporary Income Tax Regs., 53 Fed. Reg. 5713 (Feb. 25,

1988).   If the interest income is not portfolio income,

as petitioner contends, then it is taken into account in

determining the income or loss from petitioner's rental
                           - 28 -


real estate activity.   In that event, there is a passive

activity gain for both 1992 and 1993, rather than a passive

activity loss.   On the other hand, if the interest income

is portfolio income, as respondent contends, then it is not

taken into account in determining the income or loss from

petitioner's rental real estate activity.   Sec.

469(e)(1)(A)(i)(I).   In that event, there are passive

activity losses for 1992 and 1993, as computed by

respondent.

     The parties agree that section 469 does not apply to

petitioner after 1993 by reason of the amendment of section

469 that added the special rules for taxpayers in the real

property business set forth in section 469(c)(7).     We also

note that respondent did not apply section 469 to

petitioner's returns for years before 1992.

     Petitioner's principal argument is that it was in "the

trade or business of acquiring and selling real estate and

carrying the mortgages on real property which it sold."

Accordingly, petitioner takes the position that "the

interest income which it received during taxable years 1992

and 1993 should be included in computing whether or not

petitioner incurred a [passive activity] loss from its real

estate business during the years in question."     Petitioner

relies upon the same arguments described above in

connection with its contention that its interest income is
                           - 29 -


includable in adjusted income from rents as defined by

section 543(b)(3).   That is, petitioner contends that the

subject interest income was paid on debts that represent

the price for which real property held primarily for sale

to customers in the ordinary course of its trade or

business was sold or exchanged.

     Respondent argues that petitioner is not in the

business of selling real estate.    Therefore, according

to respondent, the subject interest income received from

the installment sale of real estate is portfolio income

that is not taken into account in computing the net income

or loss from petitioner's rental activity, pursuant to

section 469(e)(1)(A)(i)(I).   Respondent points out that

gains from the sale or exchange of passive activity

property is properly includable in computing income or loss

from a passive activity but that "interest received as

installment sales of real estate represents portfolio

income, which is nonpassive."   In support, respondent cites

section 1.469-2T(c)(3)(iv), Example (1), Temporary Income

Tax Regs., 53 Fed. Reg. 5714 (Feb. 25, 1988), which states

as follows:


          Example (1). A, an individual engaged in
     the trade or business of farming, disposes of
     farmland in an installment sale. A is not
     engaged in a trade or business of selling
     farmland. Therefore, A's interest income from
                                            - 30 -


      the installment note is not gross income derived
      in the ordinary course of a trade or business.


      Alternatively, petitioner argues that, even assuming

that petitioner's interest income is treated as portfolio

income, respondent has incorrectly allocated all of

petitioner's business expenses to its rental income and,

thereby, respondent has overstated the amount of the

deductions that are disallowed under section 469.                                     Set

forth below are schedules that show the allocation of

expenses made in the notice of deficiency, the allocation

of expenses that petitioner contends is appropriate,

respondent's allocation, and the difference between the

two allocations:


                                                      Notice of      Petitioner's   Respondent's
                                     Allocation of Expenses for 1992 Deficiency     Allocation
     Allocation                       Difference

   Rental receipts                   $48,633.00     $48,633.00       $48,633.00         -0-
   Capital gain, installment sales    10,364.00      10,364.00        10,364.00         -0-

   Income from rental activity        58,997.00       58,997.00        58,997.00        -0-

   Officer compensation               39,750.00       14,906.25        39,750.00    ($24,843.75)
   Auto expense                        1,417.00          531.38          1,417.00       (885.62)
   Insurance                           1,699.00        1,699.00          1,699.00        -0-
   Interest                            8,136.00        8,136.00          8,136.00        -0-
   Labor                               5,869.00        5,869.00          5,869.00        -0-
   Legal and accounting                2,096.00          692.52           692.52         -0-
   Miscellaneous                         627.00          207.16           627.00        (419.84)
   Repairs and maintenance             2,043.00        2,043.00         2,043.00         -0-
   Supplies                              389.00          128.53           389.00        (260.47)
   Taxes
     Payroll                           3,267.88        1,225.46         3,267.88      (2,042.42)
     Real estate                          -0-             -0-              -0-           -0-
     Franchise/Income                  5,383.78        1,778.80         1,778.80         -0-
   Utilities and telephone               395.00          130.50           395.00        (264.50)
   Yard work and mowing                3,590.00        3,590.00         3,590.00         -0-
                                            - 31 -


   Management fees                        -0-             -0-              -0-          -0-
   Depreciation                       23,520.00       23,520.00        23,520.00        -0-

     Total expenses                  98,182.66       64,457.60        93,174.20      (28,716.60)

   Loss from rental activity         (39,185.66)     (5,460.60)      (34,177.20)


                                                      Notice of      Petitioner's   Respondent's
                                     Allocation of Expenses for 1993 Deficiency     Allocation
     Allocation                       Difference

   Rental receipts                   $42,775.00     $42,775.00       $42,775.00         -0-
   Capital gain, installment sales    11,279.00      11,279.00        11,279.00         -0-

   Income from rental activity        54,054.00       54,054.00        54,054.00        -0-

   Officer compensation               39,750.00       14,906.25        39,750.00    ($24,843.75)
   Auto expense                        1,456.00          546.00         1,456.00        (910.00)
   Insurance                           1,913.00        1,913.00         1,913.00         -0-
   Interest                            3,964.00        3,964.00         3,964.00         -0-
   Labor                               6,698.00        6,698.00         6,698.00         -0-
   Legal and accounting                1,500.00          480.60          480.60          -0-
   Miscellaneous                       1,321.00          423.25         1,321.00        (897.75)
   Repairs and maintenance               826.00          826.00           826.00         -0-
   Supplies                              171.00           54.79           171.00        (116.21)
   Taxes
     Payroll                           3,162.73        1,186.02         3,162.73      (1,976.71)
     Real estate                       4,996.78        4,996.78         4,996.78         -0-
     Franchise/Income                  6,381.90        2,044.76         2,044.76         -0-
   Utilities and telephone               517.00          165.65           517.00        (351.35)
   Yard work and mowing                2,848.00        2,848.00         2,848.00         -0-
   Management fees                     4,100.00        1,313.64         4,100.00      (2,786.36)
   Depreciation                       25,868.00       28,520.00        25,868.00       2,652.00

     Total expenses                  105,473.41      70,886.74       100,116.87      (29,230.13)

   Loss from rental activity         (51,419.41)    (16,832.74)      (46,062.87)


      Petitioner argues that its expenses for officer

compensation, automobile, and payroll taxes which relate

entirely to Mr. McKelvey's employment should be allocated

between petitioner's rental and sales activities in

accordance with Mr. McKelvey's testimony that he spent an

average of 25 hours per week or 62.5 percent of his time
                                 - 32 -


(25/40) "searching for property to buy and customers to

which to sell his property."        Petitioner also argues that

its expenses for miscellaneous, supplies, utilities and

telephone, legal and accounting, and franchise and income

taxes should be allocated to petitioner's rental activity

in the same ratio as petitioner's rental income bears to

total income; i.e., 33.04 percent in 1992 and 32.04 percent

in 1993.   Petitioner computes those percentages as follows:

                      1992          Percent     1993        Percent

  Rental income     $58,997.34       33.04    $54,054.00     32.04
  Interest income   119,573.90       66.96    114,634.44     67.96

    Total income    178,571.24      100.00    168,688.44    100.00


     Respondent rejects petitioner's assertion that 62.5

percent of Mr. McKelvey's salary, the payroll tax

attributable thereto, and the expense for the automobile

furnished to Mr. McKelvey should be treated as nonpassive

expenses that can offset portfolio income.             Respondent

argues that neither collecting monthly note payments nor

looking for additional properties to purchase justifies

petitioner's allocation.         As to the former, respondent

points to Mr. McKelvey's testimony that he spends only 1

day per month collecting note payments from his buyers.               As

to the latter, respondent points out that petitioner did

not purchase or sell any real property during 1992 and 1993

and argues that the estimate of the amount of time spent by
                            - 33 -


Mr. McKelvey looking for additional properties, i.e., 25 to

30 hours per week, is not reasonable.

     Respondent also rejects petitioner's contention that

the expenses for miscellaneous items, supplies, and

utilities and telephone should be allocated to petitioner's

rental activity in the same ratio as petitioner's rental

activity bears to total income.      Respondent argues that

there is no factual basis to allocate these expenses to an

activity other than petitioner's rental activity in view of

the fact that petitioner made no purchase or sale of

property during 1992 or 1993 and the fact that petitioner's

actions, taken through Mr. McKelvey, were focused on

managing and maintaining petitioner's rental properties.

Furthermore, respondent notes that there is no evidence

to establish the nature of certain expenses, such as the

miscellaneous expenses.    Finally, respondent accepts

petitioner's position regarding the reallocation of

petitioner's legal and accounting expenses, franchise

taxes, and income taxes.

     The general rule regarding the duration of temporary

regulations as set forth in section 7805(e)(2) provides

that any temporary regulation expires within 3 years after

the date of issuance.   In general, this 3-year limitation

applies to any regulation issued after November 20, 1988.

In this case, we note that section 1.469-2T, Temporary
                           - 34 -


Income Tax Regs., 53 Fed. Reg. 5711 (Feb. 25, 1988), was

initially adopted on February 19, 1988.   T.D. 8175, 1988-1

C.B. 191.   Although amendments to section 1.469-2T,

Temporary Income Tax Regs., supra, have occurred since

adoption, the specific subsections relied upon by

respondent and cited herein have not changed.   Therefore,

because section 1.469-2T, Temporary Income Tax Regs.,

supra, was promulgated before section 7805(e)(2) became

effective, it is not subject to the 3-year limitation on

temporary regulations.   Accordingly, section 1.469-2T is

valid despite its temporary form.

     The principal issue raised by petitioner is whether

the subject interest income is taken into account as

passive activity gross income, as defined by section 1.469-

2T(c)(1), Temporary Income Tax Regs., 53 Fed. Reg. 5711

(Feb. 25, 1988), or whether the subject income qualifies as

portfolio income which is specifically excluded from

passive activity gross income, sec. 1.469-2T(c)(3)(i),

Temporary Income Tax Regs., supra.   Portfolio income

includes all gross income, other than income derived in the

ordinary course of a trade or business (as defined by

section 1.469-2T(c)(3)(ii)), Temporary Income Tax Regs.,

supra, that is attributable to several items, including

interest.   Sec. 1.469-2T(c)(3)(i)(A), Temporary Income Tax

Regs., supra.   The legislative history of section 469
                            - 35 -


explains why portfolio income is not taken into account in

determining the income or loss from a passive activity as

follows:


            Portfolio investments ordinarily give rise
       to positive income, and are not likely to
       generate losses which could be applied to shelter
       other income. Therefore, for purposes of the
       passive loss rule, portfolio income generally is
       not treated as derived from a passive activity,
       but rather is treated like other positive income
       sources such as salary. To permit portfolio
       income to be offset by passive losses or credits
       would create the inequitable result of restrict-
       ing sheltering by individuals dependent for sup-
       port on wages or active business income, while
       permitting sheltering by those whose income is
       derived from an investment portfolio.


S. Rept. 99-313, at 728 (1986), 1986-3 C.B. (Vol. 3) 1,

728.

       We agree with respondent that petitioner has not shown

that it was in the trade or business of selling real

properties.    Rather, petitioner's business was developing

and holding real property for rental.    Based upon that

finding, we agree with respondent that the interest

received by petitioner was "not derived in the ordinary

course of a trade or business" and is not taken into

account in determining the income or loss from petitioner's

rental activity.    See sec. 469(e)(1)(A)(i)(I).   This find-

ing is based upon all of the facts and circumstances of

this case and is consistent with Mr. McKelvey's statements
                            - 36 -


to respondent's agent during the audit of petitioner's

returns.   On the other hand, petitioner's argument is

inconsistent with petitioner's reporting of its real

property sales using the installment method and, in

effect, representing that none of those sales involved

a "disposition of real property which is held by the

taxpayer for sale to customers in the ordinary course of

the taxpayer's trade or business."    See sec. 453(l)(1)(B),

(b)(2)(A).

     We also agree with respondent regarding the allocation

of petitioner's expenses.    Respondent accepts petitioner's

position with respect to the allocation of legal and

accounting expenses, franchise taxes, and income taxes.

Accordingly, we need not discuss those expenses.    In the

case of Mr. McKelvey's compensation, the payroll tax

attributable thereto, and the expense for the automobile

furnished to Mr. McKelvey, we agree with respondent that

petitioner's proposed allocation is not reasonable in light

of Mr. McKelvey's testimony regarding the small amount of

time he spent collecting note payments and the fact that

petitioner did not purchase or sell any real estate during

1992 or 1993.   Similarly, petitioner has failed to

establish a factual basis to allocate its miscellaneous

expenses, its expenses for supplies, and its expenses for

utilities and telephone.    This is particularly true in
                              - 37 -


light of the fact that most of petitioner's actions involve

managing and maintaining petitioner's rental properties.


Addition to Tax Under Section 6662(a)

     The third issue for decision is whether petitioner

is subject to the accuracy-related penalty under section

6662(a).   In the notice of deficiency, respondent

determined that the entire underpayment for each of the

years in issue is attributable to a substantial

understatement of income tax.     See sec. 6662(b)(2).     Thus,

in the notice of deficiency, respondent added 20 percent

of the underpayment to the tax determined with respect to

each of the years in issue.     See sec. 6662(a).

     Generally, there is a substantial understatement of

income tax for any taxable year if the amount of the

understatement exceeds the greater of 10 percent of the tax

required to be shown on the return for the taxable year or

$5,000 ($10,000 in the case of a corporation other than an

S corporation or a personal holding company).       Sec.

6662(d)(1)(A).   In this context, the term "understatement"

is defined to mean the excess of the amount of the tax

required to be shown on the return over the amount of the

tax imposed which is shown on the return, reduced by any

rebate.    Sec. 6662(d)(2).   In determining whether an

understatement is substantial, the amount of the
                           - 38 -


understatement is reduced by any portion attributable to an

item if there is or was substantial authority for the

taxpayer's treatment of the item, or if the relevant facts

affecting the item's tax treatment are adequately disclosed

in the return or in a statement attached thereto.    Sec.

6662(d)(2)(B).

     Petitioner argues that for each of the years in

issue the understatement is reduced, pursuant to section

6662(d)(2)(B)(ii), by the portion thereof which is

attributable to the personal holding company tax adjust-

ment because that "issue was adequately disclosed and 'set

forth' in each of the tax returns filed for the years 1989

through 1994."   In the case of petitioner's 1994 return,

petitioner points to the fact that there is attached

thereto a Schedule PH, U.S. Personal Holding Company (PHC)

Tax, setting forth petitioner's position that it is not

subject to the tax, accompanied by various materials that

discuss personal holding companies and a document entitled

"Note #1 - Schedule PH Explanation" that states as follows:


     CHAR-LIL CORPORATION INCOME CONSISTS OF INTEREST
     INCOME FROM INSTALLMENT SALES OF REAL PROPERTY
     DERIVED IN THE ORDINARY COURSE OF TRADE OR
     BUSINESS AND RENTAL INCOME FROM REAL ESTATE OWNED
     BY THE CORPORATION.

     CHAR-LIL CORPORATION'S ONLY BUSINESS IS THAT OF
     REAL ESTATE OPERATION, INVOLVING SALES,
     PURCHASES, RENTALS, ETC. THE INTEREST INCOME
     THAT IS RECEIVED FROM INSTALLMENT SALES OF REAL
                          - 39 -


     ESTATE IS TO BE TREATED AS ADJUSTED INCOME FROM
     RENTS, AS PER CODE SEC. 543(A)(2) AND (B)(3).

     """SEE ATTACHED"""

     CHAR-LIL CORPORATION'S ADJUSTED INCOME FROM
     RENTS, AS DEFINED MEETS THE 50% TEST AND THE 10%
     TEST TO BE EXCLUDABLE FROM PERSONAL HOLDING
     COMPANY INCOME, AS PER CODE SECS. 541-547.

     IT IS OUR CONCLUSION THAT CHAR-LIL CORPORATION
     IS NOT SUBJECT TO PERSONAL HOLDING COMPANY TAX
     BECAUSE IT DOES NOT MEET THE 60% TEST ON PERSONAL
     HOLDING COMPANY INCOME!

     """SEE ATTACHED"""


     In the case of petitioner's returns for 1989 through

1993, petitioner argues that there was adequate disclosure

because the personal holding company tax issue is apparent

from the face of each return.   In support of that argument,

petitioner points to the testimony of respondent's revenue

agent, who stated that he identified the issue based upon a

review of petitioner's 1993 return.   The agent's testimony

on cross-examination on this point is as follows:


          Q Mr. Neubauer, you testified that, at the
     time you began the audit, you identified the
     personal holding company issue as a subject of
     your audit. Is that correct?

          A Potentially, the personal holding company
     tax could apply.

          Q What--on what basis did you make that
     identification of that audit issue?

          A Just the--just with the comparison of the
     interest income versus the rents.
                          - 40 -


          Q Is that based on a review of the returns
     themselves?

          A Exactly. That's all I had was just the--
     I believe it was the 1993 return that the audit
     began with.

          Q That's the only return you had looked at
     that time?

          A Yes. I believe that is correct. It
     was 1993 or 1992. 1994 had not been filed. I
     believe I began with the 1993 return. It's in
     the record if it needs to be verified.


     Respondent's position is that the exception for

adequate disclosure provided in section 6662(d)(2)(B)(ii)

does not apply and "the penalty should be sustained in full

for each of the years 1989 through 1994."   Respondent asks

the Court to reject petitioner's argument that the personal

holding company issue is apparent from the face of the

returns for 1989 through 1993.   Respondent does not provide

an analysis of the face of the returns but argues that the

ability of respondent's agent to immediately spot the

personal holding company tax issue does not mean that the

issue was adequately disclosed on the returns, within the

meaning of section 6662(d)(2)(B)(ii).   Respondent does not

address the disclosure made in petitioner's 1994 return.

     Respondent also argues:


     Even if the Court were to conclude that the
     relevant facts affecting the item's tax treatment
     were adequately disclosed in the returns, no
     evidence has been offered that the petitioner had
                          - 41 -


     a reasonable basis for the failure to report its
     liability for the personal holding company tax on
     the returns.


In this connection, respondent notes that petitioner's

return preparer, Mr. Billy Caldwell, acknowledged that he

"was not aware of the personal holding company tax issue at

all before it was raised by respondent."   In effect,

respondent argues that petitioner could have had no

reasonable basis for its failure to report personal holding

company tax.

     To begin with, we note that petitioner does not

advance any reason why the portion of the understatement

for each of the years 1992 and 1993 that is attributable

to the passive loss adjustment, described above, is not a

substantial understatement of income tax that is subject

to the accuracy-related penalty.   Accordingly, we hereby

sustain respondent's determination of the accuracy-related

penalty on the portion of the underpayment in 1992 and 1993

which is attributable to the passive loss adjustment.

     The statutory provision under which an understatement

is reduced with respect to any item if the relevant facts

are adequately disclosed, section 6662(d)(2)(B)(ii), was

amended effective for returns due after December 31, 1993.

Omnibus Budget Reconciliation Act of 1993, Pub. L. 103-66,
                             - 42 -


sec. 13251, 107 Stat. 531.    After the amendment, section

6662(d)(2)(B)(ii) provides as follows:


          (B) Reduction for understatement due to
     position of taxpayer or disclosed item.-- The
     amount of the understatement under subparagraph
     (A) shall be reduced by that portion of the
     understatement which is attributable to--

               *   *   *     *   *    *   *

          (ii) any item if--

               (I) the relevant facts affecting
          the item's tax treatment are adequately
          disclosed in the return or in a state-
          ment attached to the return, and

               (II) there is a reasonable basis
          for the tax treatment of such item by
          the taxpayer.


Thus, in the case of returns for tax years 1993 and 1994,

the tax treatment of an item must be adequately disclosed

in the return or in an attached statement, and there must

be a reasonable basis for the tax treatment.    Sec. 1.6662-

4(e) and (f), Income Tax Regs.    The conference report

issued in connection with this amendment, H. Conf. Rept.

103-213, at 669 (1993), 1993-3 C.B. 393, 547, describes the

intent of the conferees concerning the meaning of the

phrase "reasonable basis" as follows:


     The conferees intend that "reasonable basis" be a
     relatively high standard of tax reporting, that
     is, significantly higher than "not patently
     improper." This standard is not satisfied by a
                          - 43 -


     return position that is merely arguable or that
     is merely a colorable claim.


     Furthermore, regulations promulgated under section

6662, section 1.6662-4(f), Income Tax Regs., provide the

following methods for making adequate disclosure:


          (f) Method of making adequate disclosure--

               (1) Disclosure statement. Disclosure is
          adequate with respect to an item (or group of
          similar items, such as amounts paid or incurred
          for supplies by a taxpayer engaged in business)
          or a position on a return if the disclosure is
          made on a properly completed form attached to
          the return or to a qualified amended return (as
          defined in § 1.6664-2(c)(3)) for the taxable
          year. In the case of an item or position other
          than one that is contrary to a regulation,
          disclosure must be made on Form 8275 (Disclosure
          Statement); in the case of a position contrary
          to a regulation, disclosure must be made on
          Form 8275-R (Regulation Disclosure Statement).

               (2) Disclosure on return. The Commis-
          sioner may by annual revenue procedure (or
          otherwise) prescribe the circumstances under
          which disclosure of information on a return
          (or qualified amended return) in accordance
          with applicable forms and instructions is
          adequate. If the revenue procedure does not
          include an item, disclosure is adequate with
          respect to that item only if made on a
          properly completed Form 8275 or 8275-R, as
          appropriate, attached to the return for the
          year or to a qualified amended return.


During the years in issue, the annual revenue procedures

issued pursuant to the above regulation did not include

liability for personal holding company tax as an item with

respect to which disclosure could be made on a taxpayer's
                            - 44 -


return.   See Rev. Proc. 89-11, 1989-1 C.B. 797; Rev. Proc.

90-16, 1990-1 C.B. 477; Rev. Proc. 91-19, 1991-1 C.B. 523;

Rev. Proc. 92-23, 1992-1 C.B. 737; Rev. Proc. 93-33, 1993-2

C.B. 470; Rev. Proc. 94-36, 1994-1 C.B. 682; Rev. Proc. 94-

74, 1994-2 C.B. 823.

     Before the 1993 amendment, section 6662(d)(2)(B)(ii)

provided as follows:


          (B) Reduction for understatement due to
     position of taxpayer or disclosed item.-- The
     amount of the understatement under subparagraph
     (A) shall be reduced by that portion of the
     understatement which is attributable to--

                *   *   *   *   *    *   *

                (ii) any item with respect to
           which the relevant facts affecting the
           item's tax treatment are adequately
           disclosed in the return or in a
           statement attached to the return.


Thus, for tax years 1989 through and including 1992, the

statute did not impose the reasonable basis requirement.

However, regulations promulgated under section 6662 to

implement the adequate disclosure exception, former section

1.6662-4(e) and (f), Income Tax Regs., provided as follows:


          (e) Disclosure of certain information--
     (1) Effect of adequate disclosure. Items for
     which there is adequate disclosure as provided
     in this paragraph (e) and in paragraph (f) of
     this section are treated as if such items were
     shown properly on the return for the taxable year
     in computing the amount of the tax shown on the
     return. Thus, for purposes of section 6662(d),
                     - 45 -


the tax attributable to such items is not
included in the understatement for that year.

(2) Circumstances where disclosure will not have
an effect. The rules of paragraph (e)(1) of this
section do not apply where the item or position
on the return is--

          (i) Frivolous (as defined in § 1.6662-
     3(b)(3));

          (ii) Attributable to a tax shelter (as
     defined in section 6662(d)(2)(C)(ii) and
     paragraph (g)(2) of this section); or

          (iii) Not properly substantiated, or
     the taxpayer failed to keep adequate books
     and records with respect to the item or
     position.

     (f) Method of making adequate disclosure--
(1) Disclosure statement. Disclosure is adequate
with respect to an item (or group of similar
items, such as amounts paid or incurred for
supplies by a taxpayer engaged in business) or a
position on a return if the disclosure is made on
a properly completed form attached to the return
or to a qualified amended return (as defined in §
1.6664-2(c)(3)) for the taxable year. In the
case of an item or position other than one that
is contrary to a regulation, disclosure must be
made on Form 8275 (Disclosure Statement); in the
case of a position contrary to a regulation,
disclosure must be made on Form 8275-R
(Regulation Disclosure Statement).

(2) Disclosure on return. The Commissioner may
by annual revenue procedure (or otherwise)
prescribe the circumstances under which
disclosure of information on a return (or
qualified amended return) in accordance with
applicable forms and instructions is adequate.
If the revenue procedure does not include an
item, disclosure is adequate with respect to that
item only if made on a properly completed Form
8275 or 8275-R, as appropriate, attached to the
return for the year or to a qualified amended
return.
                           - 46 -


Section 1.6662-3(b)(3), Income Tax Regs., states that a

"frivolous" position is one that is "patently improper".

     The above provisions of the regulations governing the

adequate disclosure exception, former section 1.6662-4(e)

and (f), Income Tax Regs., were effective for income tax

returns due after December 31, 1991.   Former sec. 1.6662-

2(d), Income Tax Regs.   Thus, for 1991 and 1992 returns,

the amount of the understatement is reduced with respect

to an item if there is adequate disclosure of the item

and the tax treatment of the item is not frivolous.

     Regarding income tax returns due before the effective

date of the initial regulations promulgating rules for

making adequate disclosure under section 6662(d)(2)(B)(ii),

i.e., income tax returns due before December 31, 1991

(determined without regard to extensions of time for

filing), the Internal Revenue Service announced that the

rules applicable to section 6661 would be used for

determining what constitutes adequate disclosure under

section 6662(d)(2)(B).   Notice 90-20, 1990-1 C.B. 328.

The regulations under former section 6661 governing the

adequate disclosure exception, former section 1.6661-4,

Income Tax Regs., provided as follows:


     § 1.6661-4 Disclosure of certain information

          (a) In general. Items (other than tax
     shelter items as defined in § 1.6661-5(c)) for
                     - 47 -


which there is adequate disclosure are treated as
if such items were shown properly on the return
for the taxable year in computing the amount of
tax for purposes of section 6661, shown on the
return. Thus, the tax attributable to such items
is not included in the understatement for the
year. (See paragraph (d)(2) of § 1.6661-2.)
Disclosure is adequate with respect to the tax
treatment of an item on a return only if it is
made on such return or in a statement attached
thereto. Thus, disclosure with respect to a
recurring item, such as the basis of recovery
property, made on a return or statement attached
thereto for one taxable year is not adequate
disclosure with respect to the item for any other
taxable year. See paragraph (d) of this section
for special rules relating to disclosure with
respect to carrybacks and carryovers.

     (b) Disclosure in attached statement--
(1) In general. Disclosure will be adequate with
respect to an item (or group of similar items,
such as the specific deduction of business bad
debts or the deduction of amounts paid or
incurred for supplies by a taxpayer engaged in
business), if it is made on a properly completed
Form 8275 or if it takes the form of a statement
attached to the return that includes the
following:

          (i) A caption identifying the statement
     as disclosure under section 6661.

          (ii) An identification of the item (or
     group of similar items) with respect to
     which disclosure is made.

          (iii) The amount of the item (or group
     of similar items).


               (iv) The facts affecting the
          tax treatment of the item (or
          group of similar items) that
          reasonably may be expected to
          apprise the Internal Revenue
          Service of the nature of the
          potential controversy con-cerning
                            - 48 -


                 the tax treatment of the item (or
                 items).

            (2) Disclosure of legal issue. In lieu of
       setting forth the facts affecting the tax treat-
       ment of an item (or group of similar items) in
       accordance with paragraph (b)(1)(iv) of this
       section, the taxpayer may set forth a concise
       description of the legal issue presented by such
       facts.

            (3) Requirement of particularity.
       Disclosure is not adequate with respect to an
       item (or group of similar items) if it consists
       of undifferentiated information that is not
       arranged in a manner that reasonably may be
       expected to apprise the Internal Revenue Service
       of the identity of the item, its amount, and the
       nature of the potential controversy concerning
       the item (or items). For example, attachment to
       the return of an acquisition agreement generally
       will not constitute adequate disclosure of the
       issues involved in determining the basis of
       certain acquired assets.

            (c) Disclosure on return. The Commissioner
       may by revenue procedure prescribe the circum-
       stances in which information provided on the
       return in accordance with the applicable forms
       and instructions will be adequate disclosure
       for purposes of section 6661.


       We agree with respondent that petitioner has not

established that the understatement for any of the

years in issue should be reduced pursuant to section

6662(d)(2)(B)(ii) with respect to the portion of the

understatement attributable to the personal holding company

tax.    A review of each of petitioner's returns for 1989

through 1993 might cause the reviewer to wonder about the

application of personal holding company tax, but it would
                           - 49 -


not apprise the reviewer of the specific nature of

petitioner's claim that the interest on its purchase money

obligations is includable in adjusted income from rents,

such that rents are excluded from the computation of

personal holding company income.    Nor would a review of

petitioner's returns disclose the relevant facts regarding

petitioner's claim that it held real properties for sale to

customers in the ordinary course of business, such that the

interest income was from "debts" that "represent the price

for which real property held primarily for sale to

customers in the ordinary course of its trade or business

was sold or exchanged by the corporation".    Sec. 543(b)(3).

In fact, as discussed above, petitioner's returns report

just the opposite.   According to petitioner's returns, its

sales of real property involve "property used in the trade

or business", as defined by section 1231(b), and "install-

ment sales", as defined by section 453(b).    Thus, according

to petitioner's returns its sales of real property did not

involve real property held for sale to customers in the

ordinary course of petitioner's trade or business.    See

secs. 453(l)(1)(B), 1231(b)(1)(B).

     Moreover, in the case of petitioner's returns for

1989 through 1993, regulations promulgated under section

6662(d)(2)(B)(ii) and former section 6661(b)(2)(B)(ii)

set forth the method of making an adequate disclosure.
                             - 50 -


See sec. 1.6662-4(f), Income Tax Regs., and former sec.

1.6661-4, Income Tax Regs.    As to these years, petitioner

claims that sufficient information was set forth in each

of the returns to constitute adequate disclosure of its

liability for personal holding company tax.    The governing

regulations, however, require explicit and detailed

disclosure in order for the disclosure to be considered

adequate.   Sec. 1.6662-4(f), Income Tax Regs.; former sec.

1.6661-4(b), Income Tax Regs.    Petitioner fails to make any

reference to the operative regulations.    Petitioner does

not explain how the purported disclosures on each of the

returns for 1989 through 1993 satisfy the requirements of

the regulations, nor does petitioner present any reason to

conclude that the regulations do not apply.

     Petitioner's 1994 return contains a Schedule PH, U.S.

Personal Holding Company (PHC) Tax, and other information

explicitly setting forth petitioner's position that it is

not subject to personal holding company tax.    Even accept-

ing petitioner's position that the attachments to its 1994

return constitute adequate disclosure under section

6662(d)(2)(B)(ii), petitioner has made no attempt to show

that it had a "reasonable basis" for that position.

     Upon consideration of the foregoing,

                                  Decision will be entered

                             under Rule 155.
