                          T.C. Memo. 1999-116



                        UNITED STATES TAX COURT



   WILLIAM E. FLANAGIN AND BARBARA J. FLANAGIN, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 12585-97.                         Filed April 6, 1999.



     William E. Flanagin, pro se.

     Joseph T. Ferrick, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     VASQUEZ, Judge:     Respondent determined the following

deficiencies in, and accuracy-related penalties on, petitioners'

Federal income taxes:

                                       Accuracy-related Penalty
     Year           Deficiency               Sec. 6662(a)

     1992                $10,000                  $2,000
     1993                  6,762                   1,352
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      All section references are to the Internal Revenue Code in

effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure.    The issues for

decision are:   (1) Whether William E. Flanagin's (Mr. Flanagin)

software development activity was an activity engaged in for

profit; and (2) whether petitioners are liable for penalties

pursuant to section 6662 for 1992 and 1993 due to a substantial

understatement of income tax.

                         FINDINGS OF FACT

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

The stipulations of facts and the attached exhibits are

incorporated herein by this reference.    At the time they filed

their petition, petitioners, husband and wife, resided in

Illinois.

I.   The Software Development Activity

      Prior to and during the years in issue, Mr. Flanagin was a

mainframe computer consultant.    During this time, Mr. Flanagin

also conducted an activity (the software development activity)

that involved writing new software and trouble-shooting old

software for use on the Zenith Z-100 computer (Z-100).

      Zenith Data Systems (Zenith) first produced the Z-100 in

late 1982.   By this time, IBM had introduced the IBM personal

computer (PC) and had taken the industry by storm.    The Z-100 was

non-PC compatible, and in 1986, Zenith stopped production of the
                                 - 3 -


Z-100.    Mr. Flanagin was aware that Zenith stopped production of

the Z-100.

     During the years in issue, a generous estimate of the total

number of Z-100 users was a few thousand.      Mr. Flanagin was aware

of the limited number of Z-100 users.

     A.    The Floppy Disk Driver

     In the late 1980's, Mr. Flanagin developed a floppy disk

device driver (DiskPack) for the Z-100.      He contacted Zenith to

inquire whether it was interested in this software.      Zenith

informed Mr. Flanagin it was not interested in DiskPack.

     Zenith referred Mr. Flanagin to Paul Herman (Mr. Herman) who

owned Paul Herman, Inc. (PHI).      PHI was a one-man, mail-order

operation that distributed a newsletter (the Z-100 Lifeline) and

Z-100 parts, products, and software to Z-100 users.

     In 1988 or 1989, Mr. Flanagin contacted Mr. Herman.      After

some correspondence, Mr. Herman informed Mr. Flanagin that he

(Mr. Herman) wanted to distribute DiskPack.      In May 1989, Mr.

Herman told Mr. Flanagin that he (Mr. Herman) had absolutely no

way of knowing what the sales of DiskPack might be.      Mr. Herman

suggested a selling price of $39 with Mr. Flanagin receiving a

15-percent royalty on gross sales.

     By August 1992, PHI had sold 250 units of the DiskPack

program.    In the fall of 1992, PHI offered an updated version of
                                 - 4 -


DiskPack for $5.   By April 1993, PHI had sold a total of

approximately 300 copies of DiskPack.

     During this time, Mr. Flanagin also worked on possible

modifications to DiskPack so that it would work on PC emulators.

The Z-100 Lifeline solicited interest in such modifications.    By

December 1992, only two people expressed interest in a PC-

emulating version of DiskPack.

     B.   The SCSI Board

     In November 1990, there was a get-together of Z-100 users.

Approximately 50 people attended.    A discussion among the

attendees led to the suggestion that some of the more

knowledgeable Z-100 users should attempt to produce a SCSI Host

Adaptor (SCSI board) that would allow Z-100's to interface with

Z-100 peripherals such as CD ROM's, tape backup units, and

removable cartridge drives.   Mr. Herman recruited four

individuals, including Mr. Flanagin, to develop the SCSI board

for the Z-100.   Mr. Flanagin would develop the software necessary

to run the SCSI board.

     As of February 1991, Mr. Herman and the group had not

determined how to finance, promote, or sell the SCSI board.

     By mid-to-late 1991, the SCSI board project was nearly

completed.   Mr. Herman solicited orders for the SCSI board

through the Z-100 Lifeline.   The announced price was $249.   At
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this time, the Z-100 Lifeline's circulation was between 400 and

500 people.

      In April 1992, PHI began shipping the SCSI board.   By August

1992, PHI had sold 45 SCSI boards.     In September 1993, PHI sold

the remainder of the 60 SCSI boards.

      During 1992 and 1993, Mr. Flanagin also attempted to develop

software that allowed additional drivers to be used with the SCSI

board.

II.   Other Background Information

      Mr. Flanagin kept receipts for the various computer-related

expenses he incurred in conducting his software development

activity.   He kept no other books and records of financial

information.   Mr. Flanagin did not maintain a budget or financial

projections for his software development activity.    He kept no

records of projects undertaken or hours worked on specific

projects.   Mr. Flanagin never prepared any marketing or financial

plans or projections.   At no time did Mr. Flanagin undertake any

study of what costs he might incur in attempting to develop

working software for the SCSI board.

      Petitioners deducted expenses related to the software

development activity on Schedule C of their tax returns.

Petitioners reported the following income, receipts, and

expenses:
                                      - 6 -


                     Nonsoftware      Software Activity   Software Activity
     Year          Activity Income      Gross Receipts         Expenses

     1989            $67,889                     $0             $5,917
     1990            102,224                  1,178              5,484
     1991            104,780                      0             10,405
     1992            156,773                    248             31,318
                      1
     1993               63,838                   94             24,908
     1
        This is the amount Mr. Flanagin reported on his 1993 original
     separate return. An amended return was filed for 1993; however, it was
     not made part of the record. The amended return reported more taxable
     income than the original return and additional tax due. We believe,
     therefore, that in 1993 Mr. Flanagin's nonsoftware activity income was
     at least $63,838.

Since 1984, petitioners annual gross receipts from the software

activity never exceeded $1,200.

     Petitioners reported losses from the software development

activity were as follows:

            Year                                Loss

            1984                              ($11,237)
            1985                                (6,643)
            1986                               (11,565)
            1987                                (5,365)
            1988                                (2,038)
            1989                                (5,917)
            1990                                (4,306)
            1991                               (10,405)
            1992                               (31,070)
            1993                               (24,814)

                                     OPINION

I.   The Software Development Activity

     Section 183(a) provides generally that, if an activity is

not engaged in for profit, no deduction attributable to such

activity shall be allowed except as provided in section 183(b).

Section 183(c) defines an "activity not engaged in for profit" as

"any activity other than one with respect to which deductions are
                               - 7 -


allowable for the taxable year under section 162 or under

paragraph (1) or (2) of section 212."

     For a deduction to be allowed under sections 162 or 212(1)

or (2), a taxpayer must establish that he or she engaged in the

activity with an actual and honest objective of making an

economic profit independent of tax savings.   See Antonides v.

Commissioner, 91 T.C. 686, 693-694 (1988), affd. 893 F.2d 656

(4th Cir. 1990); Dreicer v. Commissioner, 78 T.C. 642, 644-645

(1982), affd. without opinion 702 F.2d 1205 (D.C. Cir. 1983).

The expectation of profit need not have been reasonable; however,

the taxpayer must have entered into the activity, or continued

it, with the objective of making a profit.    See Hulter v.

Commissioner, 91 T.C. 371, 393 (1988); sec. 1.183-2(a), Income

Tax Regs.

     Whether the requisite profit objective exists is determined

by looking to all the surrounding facts and circumstances.      See

Keanini v. Commissioner, 94 T.C. 41, 46 (1990); sec. 1.183-2(b),

Income Tax Regs.   Greater weight is given to objective facts than

to a taxpayer's mere after-the-fact statement of intent.      See

Thomas v. Commissioner, 84 T.C. 1244, 1269 (1985), affd. 792 F.2d

1256 (4th Cir. 1986); sec. 1.183-2(a), Income Tax Regs.

Petitioners bear the burden of proof.   See Rule 142(a).

     Section 1.183-2(b), Income Tax Regs., provides a list of

factors to be considered in the evaluation of a taxpayer's profit

objective:   (1) The manner in which the taxpayer carries on the
                               - 8 -


activity; (2) the expertise of the taxpayer or his advisers; (3)

the time and effort expended by the taxpayer in carrying on the

activity; (4) the expectation that assets used in the activity

may appreciate in value; (5) the success of the taxpayer in

carrying on other similar or dissimilar activities; (6) the

taxpayer's history of income or loss with respect to the

activity; (7) the amount of occasional profits, if any, from the

activity; (8) the financial status of the taxpayer; and (9)

elements of personal pleasure or recreation.    This list is

nonexclusive, the number of factors for or against the taxpayer

is not necessarily determinative, and more weight may be given to

some factors than to others.   See sec. 1.183-2(b), Income Tax

Regs.; cf. Dunn v. Commissioner, 70 T.C. 715, 720 (1978), affd.

615 F.2d 578 (2d Cir. 1980).

     Petitioners contend that the losses from the software

development activity are properly deductible because the activity

was profit motivated.   Conversely, respondent asserts that the

activity was not engaged in for profit.    We agree with

respondent.

     A.   Manner in Which the Activity Is Conducted

     The fact that a taxpayer carries on the activity in a

businesslike manner and maintains complete and accurate books and

records may indicate a profit objective.    See sec. 1.183-2(b)(1),

Income Tax Regs.   A taxpayer ordinarily should use some

accounting techniques that, at a minimum, provide the taxpayer
                                - 9 -


with the information required to make informed business

decisions.   See Burger v. Commissioner, 809 F.2d 355, 359 (7th

Cir. 1987), affg. T.C. Memo. 1985-523.   Without such a basis for

decision, any profit would be fortuitous, and losses would be

expected.    See id.

     Mr. Flanagin did not make any written forecasts or

projections of future income.   He conducted his activity unaware

of the amount of revenue he could expect and had no concept of

what his ultimate costs might be or how he might achieve any

degree of cost efficiency.

     Mr. Flanagin did not keep adequate records of the software

development activity.   The record demonstrates that Mr.

Flanagin's actions were not businesslike and indicates that he

lacked a profit motive.

     B.   Expertise of Mr. Flanagin

     A taxpayer's expertise, research, and study of an activity,

as well as his consultation with experts, may be indicative of a

profit intent.   See sec. 1.183-2(b)(2), Income Tax Regs.

"Taxpayers should not only familiarize themselves with the

undertaking, but should also consult or employ an expert, if

needed, for advice on how to make the operation profitable."

Burger v. Commissioner, supra at 359.

     Mr. Flanagin had software writing experience; however, he

was not knowledgeable about the economics of the activity.   Mr.

Flanagin did not seek professional advice on the economic aspects
                                - 10 -


of software development.    These facts do not persuade us that Mr.

Flanagin had a profit motive.

     C.   Elements of Personal Pleasure

     The absence of personal pleasure or recreation relating to

the activity in question may indicate the presence of a profit

objective.    See sec. 1.183-2(b)(9), Income Tax Regs.   The mere

fact that a taxpayer derives personal pleasure from a particular

activity, however, does not, per se, demonstrate a lack of profit

motive.     See Rinehart v. Commissioner, T.C. Memo. 1998-205.

     Based on the record in this case, it appears to us that Mr.

Flanagin enjoyed developing and debugging computer software

programs.    Mr. Flanagin sent vendors working copies of software

products he developed.    He testified that he was willing to take

the risk that the software he developed would be stolen or might

be utilized without receiving compensation.    We conclude that it

was personal pleasure and satisfaction that drove Mr. Flanagin to

spend his time and money developing software for an obsolete

computer.    Accordingly, this factor weighs against petitioner.

     D.   History of Income or Losses

     A record of substantial losses over several years may be

indicative of the absence of a profit motive.    See Golanty v.

Commissioner, 72 T.C. 411, 426 (1979), affd. without opinion 647

F.2d 170 (9th Cir. 1981).    Mr. Flanagin suffered an uninterrupted

history of losses from the software development activity from
                                - 11 -


1984 through 1993.     Mr. Flanagin's history of losses indicates a

lack of a profit motive.

     E.   Petitioners' Financial Status

     Substantial income from sources other than the activity in

question, particularly if the activity's losses generate

substantial tax benefits, may indicate that the activity is not

engaged in for profit.     See sec. 1.183-2(b)(8), Income Tax Regs.

In 1992 and 1993, Mr. Flanagin had nonsoftware activity income of

at least $156,773 and $63,838, respectively.       Mr. Flanagin could

afford to operate the software development activity as a hobby.

This factor indicates a lack of profit objective.

     F.   Other Factors

     Mr. Flanagin knew that the useful life of the Z-100 was

nearing its end.     Petitioners argue, however, that Mr. Flanagin's

work relating to the Z-100 was laying the foundation for

developing PC-compatible software.       At the trial, Mr. Flanagin

testified that he had no evidence to support this contention.

Even if Mr. Flanagin had been attempting to move into the PC-

compatible market, the aforementioned factors still weigh against

petitioners.

     G.   Conclusion

     After reviewing the entire record, we conclude that Mr.

Flanagin did not engage in the software development activity with
                                - 12 -


an actual and honest objective of making a profit within the

meaning of section 183.

II.   Accuracy-Related Penalty for a Substantial Understatement

      Respondent determined that petitioner is liable for the

accuracy-related penalty for 1992 and 1993 because there were

substantial understatements of income tax on petitioners' 1992

and 1993 Federal income tax returns.     See sec. 6662(a) and

(b)(2).    An "understatement" is the difference between the amount

of tax required to be shown on the return and the amount of tax

actually shown on the return.     See sec. 6662(d)(2)(A).    A

"substantial understatement" exists if the understatement exceeds

the greater of (1) 10 percent of the tax required to be shown on

the return for a taxable year, or (2) $5,000.     See sec.

6662(d)(1).   The understatement is reduced to the extent that the

taxpayer has (1) adequately disclosed his or her position or (2)

has substantial authority for the tax treatment of an item.      See

sec. 6662(d)(2)(B).   Petitioners have the burden of proving they

are not liable for the penalty.     See Rule 142(a).

      Petitioners make no arguments regarding the accuracy-related

penalty.   Based on the record, we conclude that there was a

substantial understatement of income tax in each of the years in

issue, and respondent's determination is sustained.

      To reflect the foregoing,

                                           Decision will be entered

                                      for respondent.
