                               T.C. Memo. 2013-11



                         UNITED STATES TAX COURT



 E. BRUCE DIDONATO AND DENISE A. AGNESS DIDONATO, Petitioners v.
        COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 10801-09.                       Filed January 14, 2013.



      Robert John Alter, for petitioners.

      Sze Wan Florence Char, Lydia A. Branche, and Marco Franco, for

respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


      LARO, Judge: Respondent determined deficiencies in petitioners’ 2003 and

2004 Federal income tax of $300,324 and $309,547, respectively, and accuracy-
                                        -2-

[*2] related penalties under section 6662(a) of $60,065 and $61,909, respectively.1

In an amended answer, respondent asserted a $69,278 increase to the 2003

deficiency as well as a $13,856 increase to the corresponding accuracy-related

penalty. Both increases stem from a disallowed depreciation deduction for 2003

and recapture of excess depreciation deductions claimed for 1999 through 2002 for

an undivided share in an aircraft that petitioner E. Bruce DiDonato (DiDonato)

owned through a limited liability company. In DiDonato v. Commissioner, T.C.

Memo. 2011-153, 101 T.C.M. (CCH) 1739 (2011), we held through partial

summary adjudication that petitioners were not entitled to a $1,870,000 charitable

contribution deduction for 2004 relating to the donation of a land conservation

easement to Mercer County, New Jersey (Mercer County), because they did not

obtain a contemporaneous written acknowledgment of the contribution as required

by section 170(f)(8).2




      1
        Unless otherwise indicated, section references are to the applicable version
of the Internal Revenue Code (Code), and Rule references are to the Tax Court
Rules of Practice and Procedure. Some dollar amounts are rounded.
      2
       More specifically, we held it was not possible for petitioners to obtain such
an acknowledgment in 2004 because the contribution was conditional until at least
December 2005, long after the 2004 year closed. See DiDonato v. Commissioner,
T.C. Memo. 2011-153, 101 T.C.M. (CCH) 1739, 1743 (2011).
                                          -3-

[*3] Following petitioners’ concession that they are not entitled to a dependency

exemption deduction for DiDonato’s father for 2003 and 2004 (subject years), we

decide the following issues:3 (1) whether petitioners underreported by $52,397 the

2004 gross receipts of DiDonato’s sole proprietorship optometry practice, Campus

Eye Group (CEG). We hold they did; (2) whether petitioners are entitled to

depreciation expense deductions of $29,058 for 2003 and $7,005 for 2004 for a

sport utility vehicle. We hold they are not; (3) whether DiDonato’s wholly owned

S corporation, Campus Eye Group, ASC, Inc. (ASC), is entitled to deduct amounts

claimed as employee achievement award expenses of $25,000 for 2003 and

$21,501 for 2004. We hold it is not; (4) whether ASC may deduct expenses for

conferences and meetings of $69,663 for 2003 and $59,117 for 2004. We hold it

may not; (5) whether DiDonato’s wholly owned S corporation, Campus Eye

Group ASC, Inc. (ASC), is entitled to deductions of $217,518 for 2003 and

$262,745 for 2004 for the lease of a fractional interest in an aircraft. We hold it is

not; (6) whether petitioners are entitled to deduct rental expenses of $549,203 for

2003 and $477,501 for 2004 relating to two residential properties DiDonato owned.

We hold they may to the extent stated herein; (7) whether petitioners are

      3
       We also deem the parties to agree, as respondent determined in the notice of
deficiency, that petitioners are entitled to a $3,000 capital loss deduction and
additional deductions for self-employment taxes due for each of the subject years.
                                           -4-

[*4] entitled to deduct losses of $694 for 2003 and $19,994 for 2004 they claim

were incurred in connection with a limited liability company’s aircraft leasing

activity. We hold they may to the extent stated herein; (8) whether for 2003

petitioners must recapture excess depreciation claimed with respect to their aircraft

leasing activity for 1999 through 2002. We hold they must; and (9) whether

petitioners are liable for accuracy-related penalties for substantial understatements

of income tax. We hold they are.4

                                  FINDINGS OF FACT

I.    Preliminaries

      Some facts were stipulated and are so found. The stipulated facts and the

exhibits submitted therewith are incorporated herein by this reference. Petitioners,

husband and wife, resided in New Jersey when the petition was filed. They have

two children: R.D. (age seven in 2003) and D.D. (age five in 2003).5




      4
        Because we conclude there was a substantial understatement of income tax
for each year at issue, we need not consider respondent’s alternative positions that
petitioners are liable for accuracy-related penalties due to negligence or disregard of
rules or regulations or substantial valuation misstatement under sec. 6662(a) and
(b)(1) and (3). See sec. 1.6662-2(c), Income Tax Regs.
      5
          The Court refers to minor children by their initials. See Rule 27(a)(3).
                                        -5-

[*5] II.     Petitioners

       A.    DiDonato

       DiDonato completed his undergraduate studies at Widener University, and he

holds a doctorate in optometry from the Pennsylvania College of Optometry (now

part of Salus University). He interned at the National Naval Medical Center

Hospital in Bethesda, Maryland. During the years at issue DiDonato was a

practicing optometrist, the owner and operator of an ambulatory surgical center, an

investor in stocks and bonds, and the owner of various commercial and residential

properties. He frequented many social clubs during the subject years, including the

Leash, the Philadelphia Club, and the Nassau Club.

       B.    Ms. DiDonato

       Petitioner Denise A. Agness DiDonato (Ms. DiDonato) attended St. John

Fisher College in Rochester, New York (Rochester), and she graduated from the

Pennsylvania College of Optometry with a doctorate in optometry. During the

years at issue Ms. DiDonato was a staff optometrist with CEG who oversaw

billing and administration for that entity. Ms. DiDonato was also the corporate
                                          -6-

[*6] secretary for ASC.6 At all relevant times, Ms. DiDonato had family who

resided in the greater Rochester area.

III.    The Prior Audit

        DiDonato’s (or petitioners’) 1995 and 1996 Federal income tax returns,

neither of which is at issue here, were selected for examination in or about 1997

(prior audit). The Internal Revenue Service (IRS) audited those returns, and in

particular, investigated whether DiDonato was a qualifying real estate professional

entitled to deduct losses related to his rental real estate activities. The IRS

determined in the prior audit, the findings of which are not binding in the instant

case, that DiDonato was a qualifying real estate professional during 1995 and 1996.

The record does not establish the extent to which (if at all) DiDonato’s real estate

activities during the subject years paralleled his real estate activities in 1995 and

1996.

IV.     Overview of Petitioners’ Activities Reported on the 2003 and 2004 Returns

        Petitioners timely filed joint Federal income tax returns for 2003 (2003

return) and 2004 (2004 return). Each of the 2003 and 2004 returns reported items


        6
        Although testimony elicited at trial indicated that Ms. DiDonato was CEG’s
corporate secretary, we decline to conclude she was because CEG is not organized
as a corporation. Because Ms. DiDonato declined to appear at her own trial, we do
not have the benefit of her testimony on this point.
                                         -7-

[*7] of income and expense from CEG, ASC, Equipment Leasing, L.L.C.

(Equipment Leasing), and Mallard Property Management Group (Mallard).

V.    CEG and ASC

      A.     CEG

      CEG is a multidisciplinary eye care practice that DiDonato has owned and

operated since September 1981. CEG was organized as a sole proprietorship

during the subject years, though it was later organized as a limited liability company

of which DiDonato was the sole member. For each of the subject years petitioners

reported CEG’s income and expenses on Schedule C, Profit or Loss From

Business.

      During the years at issue CEG used the services of approximately 30

optometrists, 20 independent contractors, and 50 staff employees.7 The

optometrists, independent contractors, and employees serviced patients in the areas

of neuroophthalmology, eye surgery, cornea service, ocular implants, optometry,

and medical management of eye disease, in addition to other services.

      7
        An optometrist is a doctor of optometry specializing in the examination and
diagnosis of eye diseases, visual conditions, and similar disorders. By contrast, an
ophthalmologist is a medical doctor specializing in eye and vision care trained to (in
addition to other skills) perform eye surgeries. While New Jersey recognizes
optometry as a profession, N.J. Stat. Ann. sec. 45:12-1 (West 2009), optometrists
are not necessarily permitted to practice medicine and perform surgeries, see id. sec.
45:12-9.7.
                                           -8-

[*8] The optometrists who associated with CEG owned roughly 52 affiliated offices

that used CEG’s offices to see patients.

      B.     ASC

      ASC is an ambulatory surgical center that DiDonato incorporated in 1990.

DiDonato is ASC’s sole shareholder and president. Since its inception, ASC has

elected to be treated as a small business corporation (S corporation) for Federal

income tax purposes and filed for each year at issue Form 1120S, U.S. Income Tax

Return for an S Corporation. DiDonato did not receive from ASC a regular

biweekly salary, but he received from ASC a cash distribution at the end of each

year.8 Petitioners reported DiDonato’s distributive share of income and loss from

ASC on Schedules E, Supplemental Income and Loss, attached to the 2003 and

2004 returns.

      During the subject years, ASC had, in addition to its employees, between

five and seven consulting ophthalmologists staffed as independent contractors.


      8
        Respondent does not assert, and we do not decide, whether the distributions
were compensation to DiDonato on which ASC owed employment taxes. See, e.g.,
Joseph M. Gray Public Accountant, P.C. v. Commissioner, 119 T.C. 121, 129-130
(2002) (sole shareholder and president of an S corporation was a corporate
employee for whom the corporation was liable to pay employment taxes under sec.
3121(d)(1)), aff’d, 93 Fed. Appx. 473 (3d Cir. 2004); see also David E. Watson,
P.C. v. United States, 668 F.3d 1008 (8th Cir. 2012), cert. denied,  U.S.     , 133
S. Ct. 364 (2012).
                                         -9-

[*9] Each ophthalmologist, a board certified medical doctor, was paid

approximately $100,000 annually, supposedly for services he or she performed as a

director of ASC.9 Each doctor allegedly handled varying aspects of ASC’s

regulatory environment in exchange for the fee, purportedly for ensuring

accreditation under the Accreditation Association for Ambulatory Health Care,

managing risk, giving testimony at depositions, and overseeing the purchase of new

equipment and implantable devices. The record does not establish the extent to

which (if at all) the recipients actually performed these functions during the subject

years or at any other time.

      The ophthalmologists performed patients’ surgeries at ASC’s facilities. The

ophthalmologists then billed their patients’ third-party payors (i.e., insurance

provider or Medicare) for services provided. At the same time, ASC billed the same

third-party payor for facility services such as operating room usage, the labor, and

implanted devices, in addition to other charges.




      9
        One doctor who has the title of associate medical director received $48,000
per year for purportedly overseeing the purchase of new medical equipment and
implantable devices. Although we may refer to one or more of the ophthalmologists
as directors, we render no opinion as to whether he or she actually provided
nonmedical services to ASC.
                                        - 10 -

[*10] C.     Relationship Between CEG and ASC

       CEG’s and ASC’s businesses were sizable; in the aggregate they handled

roughly 30,000 patients during the subject years. ASC’s patients came to it in one

of two ways.10 First, ASC’s ophthalmologists received referrals through CEG.

Second, ASC’s ophthalmologists performed surgeries for their patients at ASC’s

facility.

       Trial testimony made clear that the line of demarcation between CEG’s and

ASC’s practices was at times unclear. CEG and ASC mostly (if not entirely)

operated out of different suites within the same office complex. In that regard, ASC

paid to CEG for each subject year a facility fee for ASC’s use of five office

       10
         DiDonato expressed concern at trial over whether ASC’s relationship with
its medical directors (who doubled as surgeons) violated the Stark Act, 42 U.S.C.
sec. 1395nn, and/or the Anti-Kickback Act, 42 U.S.C. sec. 1320a-7b. In this
regard, DiDonato testified that during the years at issue he sought out the advice of
a law firm in Washington, D.C. (Washington), to review ASC’s activities as they
related to the Stark Act and the Anti-Kickback Act. The Stark Act prohibits
medical providers and hospitals from presenting claims to Federal healthcare
programs where those claims are the result of referrals from physicians with whom
the medical provider has a financial relationship. See 42 U.S.C. sec. 1395nn(a)
(2006). The Anti-Kickback Act imposes criminal liability on anyone who, among
other prohibited acts, knowingly and willingly solicits or receives any remuneration
(including a kickback, bribe, or rebate) to induce an individual to make referrals for
services that may be covered by a Federal health care program. See 42 U.S.C. sec.
1320a-7b(a) and (b). Because any potential violations of these laws are not at issue
in this civil tax case, we do not address them here. Nor do we address whether the
physician “director” fees of $100,000 each annually were for services actually
rendered.
                                         - 11 -

[*11] suites. ASC claimed deductions for rents of $600,944 for 2003 and $668,092

for 2004. In addition, CEG paid, on behalf of ASC, payroll and payroll taxes of

$204,650.13. Respondent allowed these payroll and payroll taxes as offsets to

CEG’s 2004 gross receipts.11

      D.     DiDonato’s Attempted Sale of ASC

      During the subject years DiDonato investigated the possibility of a sale of a

majority of his shares of ASC stock to a venture capital firm or a small cap

investor.12 In furtherance of such a stock sale, DiDonato engaged Michael Witter or

his firm (among others) to find a suitable buyer. One potential buyer, a public

company, had in or around 2003 offered to purchase a 51% stake in ASC for $33

million. DiDonato opted to not sell his shares of ASC stock during the subject years

though at trial he testified that he intended to sell his shares of ASC stock for $105

million in the summer of 2013.


      11
        Respondent reflected his allowance for payroll and payroll taxes paid by
CEG for the benefit of ASC as an “adjusting entry” to CEG’s gross receipts. The
record does not explain why respondent allowed this offset.
      12
        We decide that DiDonato intended to structure the sale of ASC as a stock
sale and not an asset sale because, as he testified, he was offered $33 million for a
51% majority interest (i.e., stock interest) in ASC. The record does not suggest that
DiDonato pursued the sale of ASC’s assets at any time. We note that Barry
Concool (sometimes, Dr. Concool) was a business associate of DiDonato who was
involved, to an extent, in discussions regarding DiDonato’s possible sale of ASC to
the public company.
                                         - 12 -

[*12] VI.      CEG’s Controverted Income

      A.       Overview

      Petitioners, relying on a trial balance printed at 2:20 p.m. on December 31,

2004 (2004 trial balance), reported gross receipts of $5,161,984 on CEG’s 2004

Schedule C, Profit or Loss from Business.13 Respondent determined on audit of the

2004 return that CEG’s gross receipts for that year should be increased to

$5,214,381; i.e., an increase of $52,397. We summarize now the relevant facts

related to this adjustment.

      B.       CEG’s Purchase of Surgical Supplies for Itself and ASC

      During the subject years, CEG purchased surgical supplies for its use and that

of ASC. From January 1, 2004, through 2:20 p.m. on December 31, 2004, ASC

“paid” $1,877,193 to CEG for the use of surgical supplies from January through

November 2004. At some point after 2:20 p.m. on December 31, 2004, ASC “paid”

$65,364.23 to CEG for the use of surgical supplies during December 2004. The

$65,364.23 was not included in CEG’s 2004 gross receipts. The record is not clear

whether amounts ASC paid for surgical supplies were actual transfers of cash by

check or otherwise or whether the payments were simply bookkeeping entries

adjusting intercompany obligations.

      13
           CEG did not close for business until 5 p.m. on December 31, 2004.
                                          - 13 -

[*13] C.     General Ledgers and Trial Balances

      CEG and ASC at all relevant times employed a full-time in-house accountant

to keep the companies’ books and records. During the years at issue, CEG used

proprietary software programs from which an individual could generate general

ledgers and trial balances and print hard copies thereof. CEG coded accounts for

“Contributed Capital--ASC” and “Contributed Capital” with account Nos. 4500 and

4700, respectively. Both contributed capital accounts (i.e., account nos. 4500 and

4700) refer to payments from ASC to CEG for ASC’s use of surgical supplies CEG

purchased that were to be included when calculating CEG’s gross receipts.

Respondent determined that all amounts credited to account nos. 4500 and 4700

should be included in CEG’s gross receipts. However, DiDonato testified at trial

that a portion of those amounts ($65,364.23) was nontaxable capital contributions.

      D.     Conflicting Trial Balances

      The parties have stipulated three CEG trial balances for the 2004 year: the

2004 trial balance, one dated August 21, 2006 (2006 trial balance), and the third

dated November 14, 2011 (2011 trial balance). As relevant here, the 2006 and 2011

trial balances each consistently included a credit (charge) to CEG’s account No.

4700 for $65,364.23 relating to ASC’s payment to CEG for the use of surgical
                                        - 14 -

[*14] supplies. The 2004 trial balance, on the other hand, omits entirely the

$65,364.23 capital contribution recorded under account No. 4700.

      E.     Respondent’s Determination of CEG’s Gross Receipts

      Respondent redetermined CEG’s 2004 gross receipts on the basis of the 2006

or 2011 trial balance or both by making three adjustments. Using CEG’s patient

fees as a starting point, respondent first increased CEG’s gross receipts by

$1,877,193 to reflect payments from ASC for the purchase of surgical supplies

through 2:20 p.m. on December 31, 2004. Second, respondent increased CEG’s

gross receipts by $65,364.23 to reflect payments from ASC for the purchase of

surgical supplies after 2:20 p.m. on December 31, 2004. Third, respondent reduced

CEG’s gross receipts by $204,650.13 to reflect payroll and payroll taxes CEG paid

for the benefit of ASC. To summarize, respondent determined CEG’s 2004 gross

receipts as follows:

      Patient fees                                           $3,476,473.98
      From ASC (surgical supplies)                            1,877,193.00
      From ASC (surgical supplies)                               65,364.23
      Adjusting entries (payroll and payroll taxes)1           (204,650.13)
       Total                                                  5,214,381.08

      1
        The adjusting entries relate to CEG’s payment of payroll and payroll taxes
for the benefit of ASC.
                                         - 15 -

[*15] VII.   CEG’s Controverted Deductions

      A.     Overview

      Petitioners claimed depreciation expense deductions of $29,058 and $7,005

for a GMC Yukon Denali (Denali) on CEG’s respective 2003 and 2004 Schedules

C. Respondent disallowed each of these deductions because, according to him,

petitioners did not establish the vehicle was used in a trade or business.

      B.     The Denali and CEG’s Transportation Services

      CEG and ASC, in addition to offering optometric and surgical services, also

provided to patients transportation to and from the companies’ facilities. During the

subject years, CEG employed between two and four full-time drivers and a few

part-time drivers and sometimes called upon staff or a limousine company to drive

patients as needed. CEG and ASC owned multiple vehicles to transport patients,

including two vans, one minivan, and the Denali (collectively, transport vehicles).

Each of the transport vehicles was kept at ASC’s parking lot when not in use. CEG

at all relevant times maintained logs of its patients’ appointments and denoted in the

log whether a patient was transported from CEG during a particular visit by

inserting a “T” on the comment line of the log. The logs do not indicate which of

CEG’s vehicles was used to transport the patient, the patient’s home address, the

pickup or dropoff location, or the distance the patient was driven.
                                       - 16 -

[*16] VIII. ASC’s Controverted Deductions

      A.     Overview

      Respondent disallowed various expenses ASC claimed as trade or business

expense deductions on its Forms 1120S, including: (1) “employee achievement”

awards paid to Mr. Witter and DiDonato Builders/Developers, Inc. (DiDonato

Builders), (2) expenses for conferences and meetings, and (3) lease payments to

Equipment Leasing.

      B.     Employee Achievement Awards

             1.    DiDonato Builders

      ASC had a relationship with DiDonato Builders, a general contractor business

owned by DiDonato’s cousin, Vincent DiDonato (Vincent). On each of September

12 and October 10, 2003, DiDonato Builders invoiced ASC (and ASC paid to

Vincent) $12,500 for a “bonus per agreement”. The parties have stipulated that

neither petitioners nor ASC has a written agreement purporting to entitle DiDonato

Builders to the $12,500 payments, and DiDonato testified at trial that the agreement

was oral.

      ASC claimed a $44,385 total deduction for employee achievement awards on

its 2003 Form 1120S. Respondent disallowed $25,000 of the $44,385 deduction for

employee achievement awards paid to Vincent.
                                       - 17 -

[*17]         2.    Firearm Purchase

        ASC claimed a $37,501 deduction for employee achievement awards on its

2004 Form 1120S. Respondent disallowed $21,501 of the $37,501 deduction for a

firearm DiDonato purchased in the United Kingdom for £11,250 ($21,501) on

February 10, 2004. DiDonato gave the firearm to Mr. Witter in connection with

investment advisory services related to the prospective sale of DiDonato’s shares of

ASC stock. The parties stipulated that the only document petitioners provided to

substantiate ASC’s entitlement to deduct the cost of the firearm was an American

Express statement indicating that ASC paid for the firearm.

        C.    Conferences and Meetings

        ASC claimed expenses of $69,663 for 2003 and $59,117 for 2004 for

conferences and meetings as other deductions on its Forms 1120S. More

specifically, ASC claimed a staff meeting expense deduction for each of the

following expenses for 2003:

    Item       Date                Payee                       Amount
      1       1/10/03    Covert & Moore                         $840.00
      2       1/27/03    Grand Island Lodge                    1,361.25
      3       1/27/03    MBNA Bank                             3,382.92
      4       2/28/03    Davis & Boring                       11,234.20
      5       3/1/03     Good Old Days                         4,375.00
      6       3/11/03    The Leash                               601.06
      7       5/4/03     Musky                                   657.50
      8       3/9/03     Amwell Valley Conservancy             2,500.00
                                      - 18 -

[*18] 9     3/20/03     Nassau Club                         150.00
      10    3/31/03     MBNA Bank                           752.28
      11    5/4/03      Musky1                              657.50
      12    4/24/03     The Retail Company                2,605.00
      13    5/23/03     Musky                               713.15
      14    5/23/03     Amwell Valley Conservancy         2,000.00
      15    7/17/03     The Leash                         1,004.78
      16    6/12/03     The Leash                           117.45
      17    8/6/03      Philadelphia Club                 2,000.00
      18    8/6/03      The Leash                           596.55
      19    8/11/03     River’s Edge Restaurant           1,200.00
      20    9/30/03     The Leash                            34.76
      21    9/30/03     Nassau Club                         500.00
      22    10/2/03     DiDonato                          2,767.37
      23    10/10/03    Grand Island Lodge                7,000.00
      24    10/16/03    The Leash                           857.25
      25    10/22/03    River’s Edge Restaurant           3,918.75
      26    12/14/03    Philadelphia Club                    50.00
      27    12/14/03    Atlantic Indian                     135.00
      28    12/27/03    River’s Edge Restaurant           4,350.00
      29    12/21/03    Davis & Boring                   10,000.00
      1
      We note that items 7 and 11 are in the same amount, bear the same invoice
number, and bear the same check number.

      ASC also claimed staff meeting expense deductions for 2004 as follows:

    Item     Date                 Payee                   Amount
      1     1/30/04      Philadelphia Club               $2,501.87
      2     1/30/04      Grand Island Lodge               1,590.24
      3     2/28/04      American Express                 1,806.34
      4     3/02/04      Davis & Boring                  13,198.30
      5     3/18/04      The Leash                          481.76
      6     3/30/04      Musky                            2,543.35
      7     4/7/04       Musky                            1,288.20
      8     5/8/04       Musky                              823.13
      9     5/7/04       The Leash                          107.00
                                        - 19 -

[*19] 10     6/24/04      The Leash                             208.37
      11     7/2/04       Amwell Valley Conservancy          2,000.00
      12     7/12/04      Nassau Club                        2,875.00
      13     7/13/04      The Leash                          1,642.41
      14     7/23/04      M&M                                1,032.50
      15     9/15/04      Philadelphia Club                  2,000.00
      16     9/20/04      Nassau Club                             50.00
      17     10/4/04      Nassau Club                           500.00
      18     10/7/04      Grand Island Lodge                 8,500.00
      19     10/19/04     Amwell Valley Conservancy               50.00
      20     11/6/04      River’s Edge Restaurant             4,355.00
      21     11/8/04      Nassau Club                            775.00
      22     11/19/04     The Leash                              116.23
      23     11/22/04     Philadelphia Club                      329.60
      24     11/27/04     River’s Edge Restaurant             4,355.50
      25     12/6/04      Nassau Club                              50.00
      26     12/6/04      Atlantic Indian                        135.00
      27     12/7/04      Marsilio’s                             318.00
      28     12/20/04     Philadelphia Club                   1,798.86
      29     12/20/04     Philadelphia Club                      100.00
      30     12/23/04     DiDonato                             2,810.50

      Respondent disallowed in full each of the deductions for conferences and

meetings. The parties have stipulated that the disallowed deductions relate to

“purported meals and entertainment expenses for ASC’s employees and staff.” The

parties also have stipulated that ASC provided to respondent copies of canceled

checks and invoices from the establishments that provided the services deducted as

the only documents to substantiate the expenses. Finally, the parties have stipulated

ASC did not maintain logs recording the members of its staff who were present at

the events or the business purpose of the expense, if any.
                                         - 20 -

[*20] D.     Lease Payments

             1.     Equipment Leasing

      Equipment Leasing, L.L.C. (Equipment Leasing), is a New Jersey limited

liability company that DiDonato formed in 1999 for purposes of holding a partial

ownership interest (aircraft share) in a Cessna Citation V Ultra aircraft (aircraft).

The aircraft is a jet with a crew of two pilots and can hold between seven and eight

passengers. DiDonato is Equipment Leasing’s sole member, and petitioners

reported his share of Equipment Leasing’s income and expenses for the subject

years on Schedules C attached to the 2003 and 2004 returns.

             2.     ASC’s Lease of the Aircraft

      On August 3, 1999, Equipment Leasing entered into a purchase agreement

with Executive Jet Sales, Inc., d.b.a. Net Jets (Net Jets), for a 6.25% undivided

interest in the aircraft for $375,000. Equipment Leasing in turn leased the aircraft

share to ASC. Equipment Leasing did not engage in any business activity other than

leasing the aircraft share to ASC.

             3.     ASC’s Policy Regarding and Personal Use of the Aircraft

      ASC had adopted a policy, which it did not follow, that the aircraft was to be

used for business purposes only. Under the terms of the policy, DiDonato had to

authorize any use of the aircraft, and any time DiDonato or Ms. DiDonato was
                                         - 21 -

[*21] on the plane, use of the aircraft was required to be authorized by one or more

of ASC’s other executives. In practice, however, the aircraft was frequently used

by petitioners and their children for personal reasons, or in connection with the sale

of DiDonato’s shares of ASC stock. As to the personal use of this aircraft, one log

for a flight in March 2003 (described more fully below) stated petitioners’ video

preferences as Barney and Thomas, ostensibly referring to the popular children’s

characters, Barney the dinosaur and Thomas the train. The same flight log also

stated petitioners’ in-flight meal selection as chicken finger dinner to serve two

children. We infer that the children referred to on the flight log were petitioners’

children.

      On one occasion in 2004 ASC used the aircraft to transport one of its

doctors, Harmon Stein (Dr. Stein), to his home in East Hampton, New York (East

Hampton), on the Friday of the Labor Day holiday weekend, purportedly so Dr.

Stein could perform surgeries on the same day at ASC’s office in New Jersey (Dr.

Stein had wanted to return to his home earlier that day). In this regard, petitioners

joined Dr. Stein on the outbound flight to East Hampton. The return flight, which

departed hours after the outbound flight landed, had petitioners as its sole

passengers. The lapse of time between when the outbound flight landed and the

return flight departed, coupled with petitioners’ presence on the return flight,
                                                - 22 -

[*22] suggests that the aircraft was used to transport petitioners to Dr. Stein’s East

Hampton home. The record does not explain the business purpose, if any, for

petitioners’ joining Dr. Stein on the outbound portion of this trip.

               4.        The Cost for Using the Aircraft Share

       Equipment Leasing paid an upfront fee of $375,000 for the aircraft share, and

it incurred a monthly management fee of an unspecified amount. In addition,

Equipment Leasing incurred an hourly rate of $1,400 to $1,500 per hour the aircraft

was in use (without a charge for deadhead time). DiDonato estimated the all-in cost

of the aircraft (i.e., inclusive of financing costs, the management fee, and the hourly

rate) to be approximately $4,000 per hour. While the cost for each of petitioners’

flights during the years at issue is not clear from the record, a one-way flight on this

aircraft from New Jersey to Washington cost around $3,000.

               5.        Petitioners’ Travels

       Petitioners traveled to the following destinations on the aircraft on the

following dates during 2003:

Trip         Date             Origin         Destination    Miles        Passengers1

 1     Thursday, 3/13/03    Trenton, NJ     Orlando, FL       897   Petitioners & children
 1     Tuesday, 3/18/03     Orlando, FL     Homestead, FL     210   Petitioners & children
 1     Tuesday, 3/18/03     Homestead, FL   Trenton, NJ     1,069   Petitioners & children
 2     Friday, 4/4/03       Trenton, NJ     Key West, FL    1,156   Petitioners, Mr. Witter & 1
                                                                     unknown individual
 2     Tuesday, 4/8/03      Key West, FL    Trenton, NJ     1,156   Petitioners, Mr. Witter & 1
                                                                     unknown individual
                                                        - 23 -
[*23] 3       Sunday, 4/27/032   Trenton, NJ            Washington, DC      168        Petitioners, Dr. Holt & 1
                                                                                        unknown individual
  3       Sunday, 4/27/03        Washington, DC        Trenton, NJ          168        Petitioners, Dr. Holt & 1
                                                                                        unknown individual
          Tuesday, 6/3/03        Trenton, NJ            Miami, FL         1,047        DiDonato, Dr. Holt & another
                                                                                        individual to discuss the sale
                                                                                        of ASC
  4       Tuesday, 6/10/03       Miami, FL          Trenton, NJ           1,047        DiDonato, Dr. Holt & another
                                                                                        individual to discuss the sale
                                                                                        of ASC
  5       Tuesday, 7/15/03       Trenton, NJ        New London, CT          162        DiDonato & 2 or 3 individuals
                                                                                        whose relationship to ASC is
                                                                                        not clear from the record
  5       Tuesday, 7/15/03       New London, CT     Trenton, NJ            162         DiDonato & 4 individuals
                                                                                        whose relationship to ASC is
                                                                                        not clear from the record
  6       Friday, 8/15/03        Trenton, NJ        Rochester, NY          246         Ms. DiDonato & 2 unknown
                                                                                        individuals
  6       Sunday, 8/17/03        Rochester, NY      Trenton, NJ             246        Ms. DiDonato & 2 unknown
                                                                                        individuals
  7       Thursday, 8/21/03      Trenton, NJ        Ukiah, CA             2,592        DiDonato, Mr. Witter & 2
                                                                                        individuals whose
                                                                                        relationship to ASC is not
                                                                                        clear from the record
  7       Tuesday, 8/26/03       Ukiah, CA          Trenton, NJ           2,592        DiDonato, Mr. Witter & 2
                                                                                        individuals whose
                                                                                        relationship to ASC is not
                                                                                        clear from the record
  8       Thursday, 9/18/03      Trenton, NJ        Wichita, KS          1,215         DiDonato, Dr. Stein, 2 ASC
                                                                                        doctors & 1 individual whose
                                                                                        relationship to ASC is not
                                                                                        clear from the record
  8       Thursday, 9/18/03      Wichita, KS        Las Vegas, NV          998         DiDonato, Dr. Stein, 2 ASC
                                                                                        doctors & 1 individual whose
                                                                                        relationship to ASC is not
                                                                                        clear from the record
  8       Sunday, 9/21/03        Las Vegas, NV      Trenton, NJ           2,200        DiDonato, Dr. Stein, 2 ASC
                                                                                        doctors & 1 individual whose
                                                                                        relationship to ASC is not
                                                                                        clear from the record
  9       Monday, 10/13/03       Trenton, NJ        Charlottesville,        245        DiDonato & 4 unknown
                                                     VA                                 individuals
  9       Monday, 10/13/03       Charlottesville,   Trenton, NJ             245        DiDonato & 4 unknown
                                  VA                                                    individuals
 10       Tuesday, 11/4/03       Trenton, NJ        Jacksonville, IL        818        DiDonato & Mr. Witter
 10       Friday, 11/7/03        Jacksonville, IL   Trenton, NJ             818        DiDonato & Mr. Witter
          1
           Our statement of the identity of the passengers on each flight is derived primarily from the Net Jets flight
logs, as informed by DiDonato’s testimony. Where we refer to a passenger as an “unknown individual”, we do so
because the record does not specify the person’s name or relationship to petitioners.
                                                       - 24 -
[*24] 2DiDonato testified that the purpose of this Sunday trip to Washington was to meet with DiDonato’s
lawyers for an afternoon seminar on “health care issues.” Leo Holt (Dr. Holt) is not an employee or staff member
of ASC, CEG, or DiDonato. The flight log for this flight, as well as for the return flight, states that a fourth
individual was on the aircraft, but that person is not identified in the record.

        Petitioners traveled to the following destinations using the aircraft on the

following dates in 2004:

Trip      Date        Day             Origin               Destination        Miles                  Passengers1

 1      Tuesday, 2/17/04           Trenton, NJ           Atlanta, GA            701             Petitioners
 1      Friday, 2/20/04            Atlanta, GA           Trenton, NJ            701             Petitioners
 2      Friday, 2/27/04            Trenton, NJ           Columbus, MS           895    DiDonato & Mr. Witter
 2      Sunday, 2/29/04            Columbus, MS          Trenton, NJ            895    DiDonato & Mr. Witter
 3      Wednesday, 3/24/04         Trenton, NJ           Nassau, Bahamas     1,061     Petitioners & children
 3      Sunday, 3/28/04            Nassau, Bahamas       Trenton, NJ         1,208     Petitioners & children
 4      Wednesday, 4/7/04          Trenton, NJ           Rochester, NY         246     Ms. DiDonato & children
 4      Saturday, 4/10/04          Rochester, NY         Trenton, NJ           246     Ms. DiDonato & children
 5      Thursday, 4/8/04           Trenton, NJ           Washington, DC        168     DiDonato & 1 unknown
                                                                                        individual
 5      Thursday, 4/8/04           Washington, DC        Trenton, NJ           168     DiDonato & 1 unknown
                                                                                         individual
 6      Thursday, 5/20/04          Trenton, NJ           Washington, DC        168     DiDonato & 4 individuals
                                                                                        whose relationship to
                                                                                        ASC is not clear from
                                                                                        the record
 6      Thursday, 5/20/04          Washington, DC        Trenton, NJ           168     DiDonato & 4 individuals
                                                                                        whose relationship to
                                                                                        ASC is not clear from
                                                                                        the record
 7      Thursday, 5/27/04          Trenton, NJ           Key West, FL         1,206    DiDonato & Mr. Witter
 7      Sunday, 5/30/04            Key West, FL          Trenton, NJ          1,156    DiDonato & Mr. Witter
 8      Thursday, 8/12/04          Trenton, NJ           Saratoga Springs,      198    DiDonato & 2 individuals
                                                          NY                            whose relationship to
                                                                                        ASC is not clear from
                                                                                        the record
 8      Saturday, 8/14/04          Saratoga Springs,     Trenton, NJ           198     DiDonato & 2 individuals
                                     NY                                                 whose relationship to
                                                                                        ASC is not clear from
                                                                                        the record
 9       Thursday, 8/26/04         Trenton, NJ           Washington, DC        168     Petitioners & children
 9       Saturday, 8/28/04         Washington, DC        Trenton, NJ           168     Petitioners & children
10       Friday, 9/3/042           Trenton, NJ           East Hampton,         143     Petitioners & Dr. Stein
                                                          NY
10        Friday, 9/3/04           East Hampton,         Trenton, NJ           143     Petitioners
                                    NY
                                                        - 25 -
[*25] 11 Wednesday, 9/8/04          Trenton, NJ            Las Vegas, NV         2,200      DiDonato, at least 2 ASC
                                                                                             doctors, and as many as
                                                                                             3 individuals whose
                                                                                             relationship to ASC is
                                                                                             not clear from the record
11       Saturday, 9/11/04          Las Vegas, NV          Trenton, NJ           2,200      DiDonato, at least 2 ASC
                                                                                             doctors, and as many as
                                                                                             3 individuals whose
                                                                                             relationship to ASC is
                                                                                             not clear from the record
12       Thursday, 10/7/04          Trenton, NJ            Rochester, NY           246      Ms. DiDonato & children
12       Monday, 10/11/04           Rochester, NY          Trenton, NJ             246      Ms. DiDonato & children
         1
           Our statement of the identity of the passengers on each flight is derived primarily from the Net Jets flight
logs, as informed by DiDonato’s testimony.

         2
         This trip occurred over the Labor Day holiday weekend.


                    6.     Flight Logs and Manifests

         Net Jets provided to Equipment Leasing flight logs for the use of the aircraft

during the subject years. The parties have stipulated that the only written records

maintained by ASC, the lessee, to substantiate the business purpose for the use of

the aircraft during the subject years were Net Jets travel logs and invoices, and

copies of brochures and registration materials of various eye care conferences.

         The travel logs specified the date, origin and destination of the flights, flight

distance, and flight and travel time and included a passenger manifest listing the

number and names of passengers on the flight, as well as any onflight services and

postflight transportation arrangements. However, some passenger manifests
                                          - 26 -

[*26] included discrepancies between the number of passengers on the flight and the

listed names.14

                  7.   Federal Income Tax Reporting of the Aircraft Share and
                       Respondent’s Proposed Adjustments

                       a.    Equipment Leasing

      Petitioners claimed accelerated depreciation expense deductions totaling

$278,950 on Equipment Leasing’s 1999 through 2002 Schedules C. In addition,

petitioners reported losses from Equipment Leasing for the years at issue as follows:

                  Item                    2003             2004

      Gross receipts                    $217,518         $262,745
      Less:
       Other expenses                     91,582          177,039
       Repairs and maintenance            64,320           67,872
       Depreciation                       43,200           21,600
       Interest expense                   19,110           16,228
        Income (loss)                       (694)         (19,994)




      14
          For example, the travel log for the trip to Orlando, Florida (Orlando), from
March 13 through 18, 2003 (Orlando flight), stated that four passengers were on the
plane, yet the manifests listed petitioners as the only passengers on the flight. At
trial, following question from the Court on the point, DiDonato acknowledged that
his children were on the Orlando flight. As another example, the passenger
manifests for the trip to Rochester, New York (Rochester trip), stated that three
passengers were on the plane, yet Ms. DiDonato was the only passenger listed.
                                         - 27 -

[*27] Respondent disallowed the loss deductions in full because, as he determined

in the notice of deficiency, petitioners had not established that such expenses were

incurred, paid, or ordinary and necessary business expenses of Equipment Leasing.

Alternatively, respondent determined that the loss deductions were not allowed

because Equipment Leasing had not established that its leasing activity was a bona

fide business venture entered into for profit or that the substantiation requirements

of section 274 had been met.

                    b.     ASC

      ASC, the lessee of the aircraft share, claimed equipment leasing expense

deductions on its Forms 1120S of $217,518 for 2003 and $262,745 for 2004.

Under the alternative depreciation system of section 168(g), the aircraft share was

depreciable under the straight-line method with a recovery period of 12 years.

Respondent disallowed ASC’s claimed equipment leasing expense deductions in

their entirety and increased petitioners’ distributive share of income from ASC

accordingly.

IX.   The Personal Residence and Mallard’s Real Estate Activities

      A.       Overview

      DiDonato’s real estate activities, with the exception of his ownership of his

personal residence and two office suites he owned through CEG, operated under
                                           - 28 -

[*28] the Mallard trade name.15 DiDonato, individually or through Mallard, owned

various properties in New Jersey during the subject years. First, he owned his

personal residence at 273 Cold Soil Road (personal residence), approximately 89

acres in size. Second, he owned two other residential rental properties on Cold Soil

Road: 245 Cold Soil Road (245 Cold Soil property), and 265 Cold Soil Road

property (265 Cold Soil property).16 The acreage of the personal residence and

the 245 and 265 Cold Soil properties, as DiDonato testified at trial, totals roughly

250 acres. The 245 and 265 Cold Soil properties are each adjacent to the personal

residence; and according to a map included with the record, the personal residence

was situated between the 245 and 265 Cold Soil properties. Third, he owned

seven suites in an office building in Hamilton, New Jersey (Hamilton), as well as

two additional commercial rental properties.17 During the subject years,

petitioners reported the income and expenses of nine real estate properties on


      15
          The record is not clear whether Mallard was a separate company or simply
a trade name through which DiDonato operated his rental real estate activities. Nor
does the record include documentary evidence indicating that Mallard owned legal
title to the properties in question. The parties stipulated, and we so find, that
petitioners used the Mallard trade name to manage many of DiDonato’s rental
properties.
      16
           The total acreage of these properties is not clear from the record.
      17
        Five of the suites operated under the Mallard trade name and two of the
suites were apparently owned by CEG.
                                        - 29 -

[*29] Schedules E attached to the 2003 and 2004 returns; namely, the 245 and 265

Cold Soil properties, fives suites in the Hamilton office building, and as explained

below, the two additional commercial rental properties. With the exception of the

245 and 265 Cold Soil properties and one of the office suites, DiDonato leased to

ASC the rental properties reported on Schedules E attached to the 2003 and 2004

returns.

      B.       Mallard’s Books and Records

      Mallard maintained books and records for the subject years. The books and

records omitted rental income purportedly received for the 245 and 265 Cold Soil

properties. At the same time, the books and records reported rental income from

each of the nine other properties Mallard purportedly managed. Notwithstanding

the fact that Mallard’s books and records do not show it received rental income

from the 245 and 265 Cold Soil properties, petitioners reported annual rental income

of $9,600 from each of the 245 and 265 Cold Soil properties. The parties have

stipulated petitioners do not have copies of any canceled checks showing they

received payments of rent for either the 245 Cold Soil property or the 265 Cold Soil

property during either of the subject years.
                                       - 30 -

[*30] C.      The Personal Residence

      Beginning in August 1997 and continuing through at least December 2001,

DiDonato was granted several construction permits for his personal residence.

Specifically, DiDonato received permission to build a 28,948-square-foot single-

family residence with 5 bedrooms, 11 bathrooms, 4 fireplaces, a 4-car garage, a

heated driveway and/or walkway, and an inground pool measuring 28 by 80 feet as

well as other improvements.18 DiDonato Builders was named on the permits as the

contractor for the personal residence. During the time of the examination of the

2003 and 2004 returns, in or around early 2006, the personal residence had a large,

power-operated gate with security cameras and stone-lined driveway.

      D.      245 and 265 Cold Soil Properties

              1.   Overview

      DiDonato, recognizing the opportunity to develop the lots adjacent to the

personal residence, acquired the 245 and 265 Cold Soil properties during the

early-to-mid-1990s. The record is not clear as to whether these properties are

titled in the name of DiDonato or in the name of Mallard. Petitioners conducted


      18
        The square footage of the personal residence was initially set at 16,652,
though permits included in the record proposed to increase it to 28,948 feet. We
understand a permit for installation of a snow-melting system at the personal
residence to mean a heated driveway and/or walkway.
                                         - 31 -

[*31] “farming activities” on the 245 and 265 Cold Soil properties, allegedly

including the buying and selling of colts, pheasants, and cows.19 As DiDonato

testified at trial, the “farming activities” were carried on to maintain the farm

designation on the properties and “to save money on [his] property taxes.” For the

most part, if not entirely, petitioners deducted the expenses related to their “farm”

operation as repair and maintenance expenses related to the 245 and 265 Cold Soil

properties. DiDonato paid the property taxes on the 245 and 265 Cold Soil

properties, and he included in the payments on those properties a portion of the real

estate taxes due on the personal residence not immediately clear from the record.

               2.   Sale of Development Rights

      DiDonato sold property rights in the personal residence and the 265 Cold Soil

property during 1997 and 1998. In 1997 he sold to Lawrence Township for

$50,182 development rights on a portion of the 265 Cold Soil property by which he

agreed to preserve a portion of the property as farmland; i.e., to not develop the

property for residential purposes. In 1998 DiDonato sold to Mercer County for




      19
        We refer to petitioners’ “farming activities” as “allegedly” conducted
because petitioners did not report any farming income on the 2003 and 2004 returns.
Nor is the record clear whether the alleged “farming activities” were performed by
DiDonato,
                                        - 32 -

[*32] $822,003 development rights on portions of his personal residence and the

265 Cold Soil property by which he agreed to restrict his use of those properties.

We note that DiDonato also transferred to Mercer County, New Jersey,

development rights on the 245 Cold Soil property discussed more fully in our prior

opinion in this case. See DiDonato v. Commissioner, 101 T.C.M. (CCH) at 1739-

1741.

                3.   Rental Agreements20

        The evidence includes a rental agreement reciting that DiDonato leased to his

father for $800 per month “the dwelling” located at the 265 Cold Soil property

during the years at issue. Included in this rent were utilities at an average monthly

cost of $400. The 2003 and 2004 returns each responded “No” to a question on

Schedules E asking whether a member of petitioners’ family used any properties

reported on that schedule for personal purposes for the greater of 14 days or 10% of

the total days rented at fair market value. DiDonato testified that he answered the

question this way because he did not consider his father a member of his family.




        20
        We render no opinion as to whether either rental agreement discussed in this
section was entered into at arm’s length.
                                        - 33 -

[*33] The evidence also includes a rental agreement reciting that DiDonato leased

to Matthew Richen, whose relationship to DiDonato is not clear, for $800 per month

“the dwelling” located at the 245 Cold Soil property. Like the rental for the 265

Cold Soil property, the rent included utilities at an average monthly cost of $400.

During 2003 and 2004, when the dwelling houses of the 245 and 265 Cold Soil

properties were respectively leased to DiDonato’s father and Mr. Richen, DiDonato

made major improvements to the land surrounding the dwelling houses.

              4.    Improvements to the 265 Cold Soil Property

      Respondent’s revenue agent examined the 2003 and 2004 returns in March

2005. At or around that time, on two occasions, the revenue agent toured the

personal residence, the 245 Cold Soil property, and the 265 Cold Soil property. The

tours allowed the revenue agent to learn that the single-family residence associated

with the 265 Cold Soil property had not been substantially improved despite

DiDonato’s contrary representation. Substantial improvements had been made,

however, to the barn and land of the 265 Cold Soil property, including the building

of ditches, swales, and bridges.

      As will shown to be relevant, the revenue agent observed that the driveway

to the 265 Cold Soil property was not protected by a gate and that the 245 Cold

Soil property had a dirt gravel road for a driveway with no structures placed
                                        - 34 -

[*34] thereon. The 265 Cold Soil property contained a single-family residence, a

large barn, a small barnlike structure, several smaller structures, and a chicken coop.

The large barn had several horses in it and one of the other structures contained

machinery. The 245 Cold Soil property contained a single-family residence, a barn,

a chicken coop, and a structure that was being used as a hunting lodge. There was a

double line of trees running across the entire length of the personal residence and

the 245 and 265 Cold Soil properties.

               5.   Purported Rental Expenses

      Petitioners submitted thousands of pages of receipts, purchase orders, and

invoices, purporting to substantiate expenses Mallard allegedly incurred in respect

of DiDonato’s rental properties. Some expenses were claimed to be exempt from

New Jersey sales tax because Mallard had completed a Form ST-7, Farmer’s

Exemption Certificate.21 Other purchase orders explicitly referenced that the work

to be performed was to be completed at the personal residence; namely, electrical




      21
         N.J. Stat. Ann. sec. 54:32B-8.16 (West 2002) provides: “Receipts from
sales of tangible personal property and production and conservation services to a
farmer for use and consumption directly and primarily in the production, handling,
and preservation for sale of agricultural or horticultural commodities at the farming
enterprise of that farmer are exempt from the tax imposed under the ‘Sales and Use
Tax Act.’”
                                          - 35 -

[*35] work, installation of a security gate, the rental of dumpsters, and equipment

for the construction of a swale (i.e., a wetland).22

      Included among the expenses claimed by petitioners as deductions for repairs

and maintenance of the 245 and 265 Cold Soil properties (or both) were the

following: $2,300 for a room at the Carlyle Hotel in New York, New York, over

the New Year’s Day holiday; $374 to a toy store on December 15, 2003; a barbecue

grill; a scarecrow motion-activated sprinkler; a security system; a lightning

protection system; a farm gate; pool paint; dog food; fish food; toilet paper; 44

poinsettias; 75 strands of garland; ice scrapers; a salt lick for “Lucky”; equine

shampoo; alfalfa cubes; cracked corn; chicken feed; clover seed; 136 bales of hay;

hundreds of spruce, fir, and pine trees; flowers; grass seed; 42 live plant stalks of

corn; 110 live pumpkin plants; poultry wire; and 3 signs stating a waterway was a

“Private Streamway”, in addition to many others. Suffice it to say, some expenses

were personal, others concerned the status of the 245 and 265 Cold Soil properties

as farms, and many bore no apparent relationship to the rental of the dwelling

houses of the 245 and 265 Cold Soil properties.


      22
        While the individual who delivered the dumpster and equipment for the
swale listed the address to which the work related as the personal residence,
DiDonato Builders referenced the property to which the expenses related as being
for DiDonato generally at “Cold Soil Road”.
                                         - 36 -

[*36]           6.   Expenses Reported on the 2003 and 2004 Returns

        The parties stipulated Mallard’s books and records included all of the

purported expenses of the 245 and 265 Cold Soil properties which petitioners

claimed as deductions on the 2003 and 2004 returns. Mallard’s books and records

do not, however, show that Mallard received any rental income with respect to

either the 245 Cold Soil property or the 265 Cold Soil property.

        Petitioners claimed the following income and expense items on Schedule E of

their 2003 Form 1040:

    Item                   245 Cold Soil Property        265 Cold Soil Property
Income
 Rental income                       $9,600                         $9,600
Expenses
 Advertising                            148                             -0-
 Insurance                            3,703                          3,703
 Legal                                6,689                          3,765
 Mortgage interest                   93,199                         46,912
 Repairs                             95,944                        161,324
 Taxes                                5,590                         50,090
 Utilities                            2,898                          4,836
 Other                               17,158                         17,670
 Depreciation                        18,886                         16,688
   Net loss                         234,615                        295,388

        Petitioners claimed the following income and expense items on Schedule E of

their 2004 Form 1040:
                                           - 37 -

 [*37] Item                245 Cold Soil Property      265 Cold Soil Property
Income
 Rental income                       $9,600                        $9,600
Expenses
 Advertising                           -0-                            50
 Insurance                           4,237                         6,024
 Legal                                  -0-                        5,357
 Mortgage interest                  82,171                        45,945
 Repairs                           105,200                        48,925
 Taxes                               5,853                        51,081
 Utilities                           3,414                         3,056
 Other                              20,698                         7,176
 Depreciation                       26,641                        61,683
   Net loss                        238,614                       219,697

      E.       Commercial Rental Properties

      Respondent did not determine adjustments with respect to DiDonato’s (or

Mallard’s) commercial rental properties, though we summarize the related rental

activities for completeness and clarity.

      DiDonato owned seven office suites in an office building in Hamilton,

referred to as A-1, A-2, A-3, A-4, A-5, B-1, and B-2 (collectively, Hamilton office

complex). CEG owned and occupied building A-1 (CEG office). CEG leased to

ASC buildings A-2, A-3, A-4, A-5, B-1, and B-2 (collectively, ASC offices).

DiDonato also occupied building A-5 for purposes of keeping a personal office,

conference room, and secretarial center. He also claims to have “managed” his real

estate out of building A-5. DiDonato never offered the ASC offices for rent to any
                                         - 38 -

[*38] party other than ASC and did not advertise them for rent to any other party.

On Schedules E attached to the 2003 and 2004 returns, petitioners reported rents

from the ASC offices totaling $530,391 and $529,513, respectively. ASC claimed

corresponding deductions on its 2003 and 2004 Forms 1120S. DiDonato also owned

two additional rental properties which are not at issue in this proceeding.

X.     Tax Advice

       A.      Overview

       DiDonato has used the tax and accounting services of Amper, Politziner &

Mattia, LLP (Amper), since at least 1997 when the firm represented him in the prior

audit. Staff at Amper prepared the 2003 and 2004 returns. Paul Dougherty, a

certified public accountant and tax lawyer with 25 years’ experience, supervised the

preparation of and reviewed the 2003 and 2004 returns. Mr. Dougherty also

provided petitioners with various tax advice for the years at issue. Petitioners

obtained from Amper separate written tax advice with respect to DiDonato’s 1995

real estate activities and Equipment Leasing’s ownership and operation of the

aircraft.

       B.      Rental Real Estate Activities

       On June 28, 1995, Amper provided to DiDonato an opinion letter (real

estate opinion) addressing various aspects of DiDonato’s real estate activities. As
                                         - 39 -

[*39] relevant here, the real estate opinion reflected a “will” comfort level that the

conservation easement contribution would yield a charitable contribution deduction

on DiDonato’s individual return.23 The real estate opinion, without specifying the

property to which the expenses related, opined that DiDonato “will” be able to

“depreciate the building and take all the related expenses.” The real estate opinion

went on to state that the author of the letter had not fully researched the proper tax

treatment of rent-free occupancy of rental properties. The remainder of the opinions

reached in the real estate opinion are so general as to have no usefulness for our

discussion.

      C.       Aircraft Advice and Reporting Positions

               1.   Aircraft Letter

      On June 16, 1999, Amper provided to DiDonato a letter (aircraft letter)

stating its recommendation on how to structure the ownership and operation of

the fractional share. The aircraft letter, less than two full pages in length, began by

recognizing DiDonato’s intention to purchase the aircraft share for “business and

personal purposes.” After some general advice on owning the aircraft share

       23
        In tax parlance there are a number of different “comfort levels” at which an
opinion letter can be issued. An opinion issued at the “will” level (as compared
with the “should” or “more likely than not” levels) is generally the highest level of
comfort. See Robert P. Rothman, “Tax Opinion Practice”, 64 Tax Law. 301, 311-
319 (2011).
                                         - 40 -

[*40] through Equipment Leasing, the aircraft letter advised DiDonato that personal

use of the aircraft by him or his employees would be considered a fringe benefit

includible in the gross income of the individual using the aircraft. The letter further

advised DiDonato that Equipment Leasing’s operating and management expenses

may be limited due to personal use. Although the aircraft opinion concluded the use

of the aircraft would be deductible by ASC as a travel expense, it did not address

whether ASC’s lease of the aircraft was an ordinary and necessary business expense.

DiDonato did not secure any additional written tax advice on the aircraft share after

1999.

                2.   DiDonato’s Misstatements to Amper

        Amper approved petitioners’ claimed deductions for use of the aircraft share

because, as DiDonato explained to Mr. Dougherty or his staff, the aircraft was not

used for personal travel.24 Neither Mr. Dougherty nor his staff reviewed the flight

logs in connection with their preparation of the 2003 and 2004 returns. Mr.

Dougherty acknowledged at trial that had he known that petitioners’ children were

on board the aircraft during the subject years, his firm would not have taken the

reporting position that the aircraft was not used for personal travel.

        24
        DiDonato advised Mr. Dougherty that when he flew for personal reasons,
he flew commercial airliners. The record does not include any evidence showing
that DiDonato flew on a commercial airliner at any time during the subject years.
                                          - 41 -

[*41] XI.      Notice of Deficiency, Petition, and Amended Answer

      Respondent issued to petitioners a notice of deficiency proposing various

adjustments to the 2003 and 2004 returns. First, respondent determined petitioners

were not entitled to depreciation expense deductions for the Denali of $29,058 for

2003 and $7,005 for 2004. Second, respondent determined CEG’s gross receipts

for 2004 were $5,214,381 and not $5,161,984 as reported on the 2004 return.

Third, respondent determined petitioners did not hold the 245 and 265 Cold Soil

properties as rental properties, that all expenses related thereto were nondeductible

personal expenses, and that petitioners’ taxable income should be increased by

$549,203 for 2003 and $477,511 for 2004.25 Fourth, respondent determined

petitioners were not entitled to losses of $694 for 2003 and $19,994 for 2004

relating to Equipment Leasing’s Aircraft share because petitioners had not

established that the aircraft leasing expenses were ordinary and necessary business

expenses or, in the alternative, that the aircraft leasing activity was a bona fide

business venture entered into for profit, or that the substantiation requirements of


       25
         Respondent determined, in the alternative, that if the 245 and 265 Cold Soil
properties were rental properties, then repair expenses claimed as deductions in the
amounts of $257,268 for 2003 and $154,125 for 2004 were disallowed because,
according to respondent, petitioners did not establish that the expenses were
actually incurred or, if the expenses were actually incurred, then the expenses were
capital expenditures that were not currently deductible.
                                         - 42 -

[*42] section 274(d) had been met. Fifth, respondent determined petitioners’ share

of “Other Income” from ASC was increased by $312,181 for 2003 and $343,363 for

2004 because, respondent determined, ASC was not entitled to deductions for (1)

lease payments to Equipment Leasing for the aircraft share of $217,518 for 2003 and

$262,745 for 2004, (2) employee achievement awards of $25,000 for 2003 and

$21,501 for 2004, or (3) expenses for conferences and meetings of $69,663 for 2003

and $59,117 for 2004.26 Sixth, respondent determined for 2003 a favorable

adjustment allowing an additional capital loss of $2,384, which is not at issue.

Seventh, respondent determined adjustments to petitioners’ self-employment tax and

the corresponding self-employment tax deductions. Eighth, respondent determined

petitioners were entitled to additional itemized deductions for real estate taxes of

$55,680 for 2003 and $56,934 for 2004. Ninth, respondent determined petitioners

were not entitled to a charitable contribution deduction of $1,870,000 for 2004

relating to a land conservation easement. Tenth, respondent determined petitioners

were not entitled to a dependency exemption deduction for DiDonato’s father.

Petitioners petitioned the Court in response to the notice of deficiency.




       26
         The notice of deficiency determined that adjustments to “Other Income”
related to CEG and not ASC, but the parties have stipulated that the adjustments
related to ASC and not CEG.
                                         - 43 -

[*43] Respondent amended his answer to assert increases to the 2003 deficiency

and accuracy-related penalty. Specifically, respondent alleged petitioners are not

entitled to an accelerated depreciation expense deduction for 2003 but that they must

use the straight-line depreciation method. Respondent further contends petitioners

must recapture for 2003 the excess depreciation claimed for 1999 through 2002.

                                      OPINION

I.    Perception of Witnesses

      During a three-day trial in New York, New York, we heard the testimony of

four fact witnesses; namely, DiDonato, Brian M. Cohen, Mr. Dougherty, and Carol

Domanski, respondent’s revenue agent. Our charge as the trier of fact is, in part, to

review the credibility of witnesses and the reliability of evidence for purposes of

finding disputed facts. In discharging that duty, we observe the truthfulness, candor,

and demeanor of each witness to evaluate his or her testimony. See Diaz v.

Commissioner, 58 T.C. 560, 564 (1972); Garavaglia v. Commissioner, T.C. Memo.

2011-228, 102 T.C.M. (CCH) 286, 296 (2011); HIE Holdings, Inc v. Commissioner,

T.C. Memo. 2009-130, 97 T.C.M. (CCH) 1672,1733 (2009). The evidence is

weighed, necessary inferences are drawn, and disputed facts are resolved with a

view toward ascertaining the truth.
                                         - 44 -

[*44] It is fundamental to our system of jurisprudence that the presiding judge is “not

a mere moderator, but is the governor of the trial for the purpose of assuring its

proper conduct and of determining questions of law.” Quercia v. United States, 289

U.S. 466, 469 (1933); see Geders v. United States, 425 U.S. 80, 86-87 (1976);

Loque v. Dore, 103 F.3d 1040, 1045 (1st Cir. 1997); Warner v. Transam. Ins. Co.,

739 F.2d 1347, 1351 (8th Cir. 1984); United States v. Beaty, 722 F.2d 1090, 1092-

1093 (3d Cir. 1983). We have discretion to participate in the trial process, see

United States v. Wilensky, 757 F.2d 594, 597 (3d Cir. 1985), and we may examine a

witness so as to unearth the truth, ensure the proper administration of justice, and

make certain that there is no misunderstanding of testimony, see Fed. R. Evid.

614(b); Beaty, 722 F.2d at 1093 (citing Riley v. Goodman, 315 F.2d 232, 234 (3d

Cir. 1963)); Nordmann v. Nat’l Hotel Co., 425 F.2d 1103, 1109 n.3 (5th Cir. 1970)

(citing Posey v. United States, 416 F.2d 545, 555 (5th Cir. 1969)). Of course, we

are careful to temper our participation in the conduct of a trial to maintain

impartiality, fairness, and justice. See Notes of the Advisory Committee on Fed. R.

Evid. 614(b); see also Beaty, 722 F.2d at 1093 (citing United States v. Green, 544

F.2d 138, 147 (3d Cir. 1976)); United States v. Nobel, 696 F.2d 231, 237 (3d Cir.

1982).
                                          - 45 -

[*45] After observing DiDonato at trial, we believe he is sophisticated in many

subjects, including certain aspects of the Federal tax law, and we believe him to be a

manipulator of the facts and of the law. For example, DiDonato testified that his

father, for whom petitioners claimed a dependency exemption deduction and listed

their qualifying relationship as “parent,” was not a family member for purposes of

qualifying the 265 Cold Soil property as a rental property. He testified that his

taking private flights over weekends was necessary to ASC’s business because he

had “immense responsibilities” that demanded he be at ASC’s offices Monday

through Friday. Yet, when DiDonato testified about the time he purportedly devoted

to his rental real estate activities, he stated that ASC “pretty much runs itself” and

that his work there occupied “maybe” 5% of his time. DiDonato testified to the

effect that he believed that he was entitled to deduct as business expenses the cost of

the flights on which his children were present because, unlike the Federal building in

which the trial was held, where there was apparently a daycare facility, “[w]e don’t

have daycare center[s] in the private sector.”

      DiDonato’s testimony, especially with respect to his claimed business use of

the aircraft, was repeatedly vague, confusing, and inconsistent. The Court, so as to

facilitate our decisionmaking process and ascertain petitioners’ use of the aircraft,

questioned DiDonato on, among other items, the particulars of the Orlando trip. In
                                          - 46 -

[*46] this regard, DiDonato’s dialogue with the Court accentuates the unreliability of

his testimony. Whereas passage of time tends to fade memories, manipulation of the

facts can hardly be disguised as poor memory. The former is excusable; the latter is

not. The following dialogue, which we believe to illustrate the unreliability of

DiDonato’s testimony, occurred at trial with respect to the Orlando trip in March

2003:

              The Court: So you say you went down and visited some
        business associates, right?

              DiDonato: Yeah, Dr. Barry Concool.

              The Court: Okay. How long did that take?

             DiDonato: Well, I don’t remember. Let’s see how many days
        we were there.

              The Court: It looks like you were there for five days.

              DiDonato: Yes, we were there for five days.

               The Court: So you visited him for one day. What did you do
        the other four days.

               DiDonato: Well, we didn’t visit him for one day. We visited
        him for most of that time. I would say three days of that time. He --
        let me tell you who Dr. Barry Concool is.

              The Court: That’s all right. Let me ask you something. Where
        did you spend the night?

              DiDonato: I don’t recall.
                                     - 47 -

[*47] The Court: You don’t know if you spent it in Orlando?

     DiDonato: We may have spent the first night there. I don’t
remember where we stayed.

         The Court: So let me understand this trip. You flew to Orlando,
right?

         DiDonato: Right.

       The Court: You arrived before noon. Did you immediately
leave to go see your business associate?

     DiDonato: Yes, we did. We probably saw him the next
morning, or we saw him that evening.

         The Court: You saw him that evening in Fort Lauderdale?

       DiDonato: Perhaps we did, yes. I didn’t keep records of my
itinerary.

         The Court: You just said you spent the night in Orlando.

         DiDonato: I think we did.

      The Court: So you arrived, you drove two hours down to Fort
Lauderdale, saw him for whatever you did for that evening, then you
drove back to Orlando that night?

        DiDonato: No. Generally -- what time of the year was this?
March. It generally doesn’t work that way. With these small business
jets --

         The Court: How [sic] tell me how it worked in this instance.

     DiDonato: In this instance, in this instance I don’t remember
why we flew to Orlando. Probably it was weather-related. I
                                 - 48 -

[*48] remember when we went out of -- we tried to get out of Fort
Lauderdale but they rescheduled us out of Homestead. So there are
thunderstorms there all the time, and they are always delaying us and
moving us, canceling us, or making us go to another city.

     The Court: So are you saying you intended to go to Fort
Lauderdale but you in fact had to go to go Orlando?

      DiDonato: That’s probably what happened.

      The Court: Well, when you say “probably”, you either know or
you don’t know.

      DiDonato: I don’t remember what happened.

      The Court: All right.

      DiDonato: But I do remember --

      The Court: If you don’t know it’s better --

      DiDonato: I do remember flying out of Homestead.

      The Court: Listen to me.

      DiDonato: Okay.

      The Court: If you don’t know, it’s better to say “I don’t know.”

      DiDonato: Okay.

       The Court: Okay. So now you arrive in Orlando at around noon
and you drive down two hours to visit this associate and you say you
spent the night back in Orlando.

      DiDonato: No, we never went back to Orlando.
                                  - 49 -

[*49] The Court: Well, you said a few moment[s] ago that you spent
the night in Orlando?

      DiDonato: On the front end.

      The Court: That’s what I’m talking about.

      DiDonato: Right.

      The Court: What do you mean on the front end?

      DiDonato: On the arrival.

      The Court: So you didn’t go the first day?

       DiDonato: My recollection is that we landed in Orlando, drove
to Fort Lauderdale. Then drove to Homestead, and flew home. That’s
what the record shows.

       The Court: Yes. I’m afraid I’m confused. Let’s try it again.
You arrive a little before noon on Thursday, March 13th, is that about
right?

      DiDonato: Correct.

      The Court: Now what do you do after you arrive?

      DiDonato: Probably got a rental car.

      The Court: Okay, than what do you do?

      DiDonato: My recollection is we stayed there probably because
the weather was bad.

      The Court: So you stayed in Orlando?

      DiDonato: Right.
                               - 50 -

      [*50] The Court: When did you go see the business associate?

      DiDonato: Probably the next day.

       The Court: Because a few moments ago you said you saw him
that day in the evening and now you are saying something different.

      DiDonato: Well, I don’t know.

      The Court: Okay.

      DiDonato: I don’t know exactly.

      The Court: If you don’t know say “I don’t know.”

      DiDonato: Yeah, I don’t know what happened nine years ago.

      The Court: Okay, so now you’re saying you went there the next
day. So how long did you spend with him the next day?

      DiDonato: Over the course of three or four days we --

      The Court: No, the next day how long did you spend?

      The Witness: All day.

      The Court: You spent from what, from 9 a.m. until 5:00 p.m.
with him?

      DiDonato: Correct.

      The Court: On Friday?

      DiDonato: Correct.

      The Court: Okay.
                                - 51 -

[*51] DiDonato: Because that was a business day with patient care,
we did patient care with him.

      The Court: All right. So you spent the entire day with him.

      DiDonato: Right.

      The Court: You and your wife?

      DiDonato: Correct.

      The Court: Okay. Where did you spend that night?

      DiDonato: Probably somewhere in Fort Lauderdale.

      The Court: You don’t know?

      DiDonato: I don’t remember the hotel.

      The Court: Okay. Now the next day is Saturday.

      DiDonato: Right.

      The Court: What did you do on Saturday?

      DiDonato: We spent Saturday and Sunday with him.

      The Court: Doing what?

      DiDonato: Everything that you would do on a weekend.

      The Court: So it’s personal stuff?

      DiDonato: No, business stuff. We were --

     The Court: Well, you usually don’t do business stuff on a
weekend.
                                - 52 -

      [*52] DiDonato: I do.

      The Court: Okay, so what did you do with him?

       DiDonato: We were laying foundation. He was the contact with
TLC Laser Centers. I am bound by a confidentiality agreement but if
I’m allowed to discuss it here I will.

      Petitioners’ Counsel: You are.

       DiDonato: Okay. We were -- he was our go- between TLC
Laser Centers, he was a contractor at TLC Laser Centers, and he was
putting together a deal for TLC Laser Centers to buy our LASIK and
Ambulatory Surgical Center, and he was going to receive a fee for that
service.

     The Court: Okay. So you woke up Saturday morning in Fort
Lauderdale.

      DiDonato: Right.

      The Court: What time did you start with him?

      DiDonato: Eight - nine.

      The Court: And just the three of you?

      DiDonato: And his entire staff.

      The Court: And you worked the whole day?

      DiDonato: I believe I was there all day.

      The Court: When you say you believe, you either know or you
don’t know.

      DiDonato: Well, let’s define all day. We had patient care in
                                - 53 -

[*53] the morning, then he did laser procedures in the afternoon. He
was probably done about three or 3:30, have you call it all day.

      The Court: So he had procedures on a Saturday?

      DiDonato: No, I’m still talking about Friday, sir.

      The Court: Okay. Let’s go to Saturday. Where were you on
Saturday.

       DiDonato: Saturday, woke up late in the hotel, met Dr. Concool
for lunch probably and spent three or four hours --

       The Court: When you say “I met him for lunch probably”, you
either did or you didn’t.

      DiDonato: I did.

      The Court: You did meet him for lunch?

      DiDonato: Right.

      The Court: The three of you met for lunch?

      DiDonato: Yes.

      The Court: Okay. Then what happened?

      DiDonato: Same thing on Sunday.

      The Court: Well, what happened after lunch?

      DiDonato: We went back to our hotel.

      The Court: Which was where?

      DiDonato: In Fort Lauderdale.
                                  - 54 -

[*54] The Court: Okay. Now on Sunday what happens?

      DiDonato: Same thing. We met him again.

      The Court: You met him again at nine in the morning.

     DiDonato: Yeah. What time did we come home? Did we come
home Sunday or Monday? Let’s see.

      The Court: Actually you came home on Tuesday.

      DiDonato: Tuesday, okay.

      The Court: So you meet him again now on Sunday, right?

      DiDonato: Right.

      The Court: At nine in the morning?

      DiDonato: Right.

      The Court: Okay. And now what happens?

     DiDonato: My recollection is that we were going to stay there
Sunday and then fly home on Monday, and I think we flew home on
Tuesday because we couldn’t get out.

       The Court: Okay, but let’s stay with Sunday. You meet him at
nine in the morning and what happens?

      DiDonato: What happened that Sunday?

      The Court: Yes.

      DiDonato: I don’t recall.

      The Court: All right.
                                 - 55 -

[*55] DiDonato: But we spent the day with him.

      The Court: Okay. You’re sure you spent the day with him?

      DiDonato: Yeah, I’m sure I spent the day with him. I spent the
whole weekend with him.

    The Court: Okay. Now we have Monday, what did you do on
Monday?

     DiDonato: I think our plan was to come home on Monday but
we couldn’t get out.

      The Court: So what did you do?

      DiDonato: We had to go back and re-check into our hotel after
we checked out. Got on the plane, couldn’t leave because of
thunderstorms, so we ended up getting -- we wanted to go home. We
went out to another airport and we had to wait until the next day. That
happens frequently.

      The Court: Okay.

      DiDonato: With these winds.

      The Court: So where did you spend the night on Monday night?

     DiDonato: I don’t know. I don’t have where we stayed at Fort
Lauderdale?

     The Court: Because you left at 8:30 in the morning from
Orlando. So you got up real early on Tuesday morning, didn’t you?

              *      *     *     *       *     *     *     *
      The Court: So, if you spent that night in Fort Lauderdale and
you left at 8:30 in the morning and it’s a two-hour drive.
                                  - 56 -

[*56] DiDonato: According to this then we went back to Orlando.
Yeah, that’s what we did.

      The Court: When you say “according to this”?

      DiDonato: Your Honor, I can’t remember nine years ago.

       The Court: Okay, I can understand that. I can’t remember nine
years ago either, but the point is if you don’t remember it’s best to say
“I don’t remember” rather than coming up with a story.

       DiDonato: Well, no, I’m trying to be cooperative. I’m trying to
tell you what happened.

       The Court: I don’t want you to cooperate by making things up.
If you don’t know say, “I don’t know,” and I’m satisfied with “I don’t
know.”

      DiDonato: Okay.

      The Court: So is it I don’t know?

      DiDonato: What was your question again?

       The Court: The question is did you spend the night, Monday
night, March 17th in Fort Lauderdale and get up rather early --

      DiDonato: I don’t know.

       The Court: Okay, that’s fine. So this flight leaves Orlando at
8:30 and goes to Homestead, why would that be so? It’s a 48 minute
flight. Why would you do that?

      DiDonato: I don’t remember.

             *      *      *     *         *   *      *
                                 - 57 -

[*57] The Court: If you forward yourself a little bit in the
documents, you come across the meeting for Neurological Society
March 13th to 15th in Orlando. So you’re saying you never attended
that meeting because you were down in Fort Lauderdale.

     DiDonato: Well, you’ve got me confused now because these
documents are all out of order.

      The Court: Well, take your time. See if we can understand
what happened. Take a look at the Net Jets’ memo dated Tuesday,
March 18th. Do you see that?

      DiDonato: Right.

       The Court: Okay, now flip to the next page, and it looks like
there is a meeting in Orlando on March 13 through the 15th, and you’re
saying you never went to that meeting because you were in Fort
Lauderdale.

      DiDonato: No, I went to that meeting.

      The Court: So you went to the meeting and you went to Fort
Lauderdale. That’s a pretty good trip. I don’t see how you could
spend all your time in Fort Lauderdale and still go to the meeting in
Orlando.

      DiDonato: Well, obviously, your Honor, I had it mixed up.

      The Court: All right. So your testimony was incorrect when you
said you went to Fort Lauderdale?

      DiDonato: Well, they are out of order here. Let’s see. Can I
have one minute please.

      The Court: Surely.

      DiDonato: Well, obviously I misspoke. I believe that I did go
                                         - 58 -

       [*58] down and meet with Dr. Concool and I did spend several days
       with him, but it didn’t encompass this weekend. I’m trying to recall
       from nine years ago, but I obviously I made a mistake. I thought that
       was the Dr. Concool trip because I had written here Dr. Concool,
       that’s my handwriting. But that threw me. I thought that was the trip
       with Dr. Concool. But clearly now I’m looking at the date of the neuro
       meeting, and that was the 13th, so what I was describing to you was
       another trip. [Emphasis added.]

      Setting aside for the moment that portions of DiDonato’s testimony were

fabricated, as with the Orlando trip, his testimony was also internally inconsistent.

For example, DiDonato testified that he and his family flew into Orlando because

they wanted to take the drive to Fort Lauderdale, but he contradicted himself

moments later by testifying the Orlando arrival was “weather related”. After we

heard him testify that he and his wife spent the duration of the Orlando trip in Fort

Lauderdale, our review of the record revealed that his wife incurred a $560 charge

for a Disney special activity in Lake Buena Vista, Florida, during the same

weekend.27 We assign very limited weight to DiDonato’s testimony, and insofar as

we discounted any part of that testimony, we did so because we perceived him to be

untrustworthy when giving it.

      In addition to our perception of DiDonato, we also draw certain adverse

inferences from Ms. DiDonato’s decision not to testify. The Supreme Court noted

       27
        The bank statement on which this charge appears is buried about 265 pages
into Exhibit 29-J.
                                         - 59 -

[*59] in United States v. Hale, 422 U.S. 171, 176 (1975): “In most circumstances

silence is so ambiguous that it is of little probative force.” The Supreme Court went

on to note, however, that “[s]ilence gains more probative weight where it persists in

the face of accusation, since it is assumed in such circumstances that the accused

would be more likely than not to dispute an untrue accusation.” Id. Recently, in

Loren-Maltese v. Commissioner, T.C. Memo. 2012-214, 104 T.C.M. (CCH) 115,

116 (2012), we reflected a similar sentiment in that we observed: “[P]eople have a

natural tendency to defend their reputation, and that silence in the face of accusations

suggests that there might be some merit to the charges.”

      Ms. DiDonato allegedly supervised administrative matters for CEG, she was

ASC’s corporate secretary, and she was a passenger on many of the flights at issue

in this case, sometimes with her children. We regard Ms. DiDonato’s absence from

the trial of this case, especially given respondent’s clear accusation that she used

the aircraft share for personal purposes, as giving rise to an inference that her

testimony would have been unfavorable to petitioners’ position. Accord Wichita

Terminal Elevator Co. v. Commissioner, 6 T.C. 1158, 1165 (1946) (“The rule is

well established that the failure of a party to introduce evidence within his

possession and which, if true, would be favorable to him, gives rise to the
                                         - 60 -

[*60] presumption that if produced it would be unfavorable.”), aff’d, 162 F.2d 513

(10th Cir. 1947).

      As to petitioners’ other witnesses, namely, Mr. Cohen and Mr. Dougherty, we

found their testimony to be credible but not fully informed. The record supports that

DiDonato was not forthcoming with his business associates (Mr. Cohen) or his tax

adviser (Mr. Dougherty). Thus, although we generally credit these individuals’

testimony, we appreciate fully that DiDonato failed to disclose material facts to

them, rendering unreliable some of their testimony. We need not accept improbable,

unreasonable, or unreliable testimony. See Barasso v. Commissioner, T.C. Memo.

1978-432, 37 T.C.M. (CCH) 1783 (1978), aff’d sub nom. De Cavalcante v.

Commissioner, 620 F.2d 23 (3d Cir. 1980). Although we found respondent’s sole

witness, Ms. Domanski, to be credible, her testimony was of limited use to us in that

she testified about DiDonato’s rental activities only.

II.   Burden of Proof

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

presumed correct, and taxpayers bear the burden of proving those determinations

erroneous. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933). The

Commissioner bears the burden of proof with respect to a new matter or increased

deficiency pleaded in the answer. Rule 142(a). Where a case involves unreported
                                           - 61 -

[*61] income and is appealable to the U.S. Court of Appeals for the Third Circuit, as

this case is barring a contrary written stipulation, the Commissioner’s determination

of unreported income is not presumptively correct until the Commissioner produces

foundational evidence linking the taxpayers to the tax-generating activity. See

Anastasato v. Commissioner, 794 F.2d 884, 887 (3d Cir. 1986) (citing Gerardo v.

Commissioner, 552 F.2d 549, 554 (3d Cir. 1977), aff’g in part, rev’g in part, and

remanding T.C. Memo. 1975-341, 34 T.C.M. (CCH) 1480 (1975)), vacating and

remanding T.C. Memo. 1985-101, 49 T.C.M. (CCH) 893 (1985). Whereas the

burden of proof as to factual matters may shift to the Commissioner under section

7491(a), we conclude it does not do so here because, as discussed throughout this

opinion, petitioners have not complied with the substantiation requirements of

section 274 or maintained all records required under the internal revenue laws.28 See

sec. 7491(a)(2)(A) and (B).

III.   CEG’s Unreported Income

       Petitioners, relying on the 2004 trial balance, reported CEG’s gross receipts

for 2004 as $5,161,984. Respondent, pointing to the 2006 and 2011 trial balances,

determined that petitioners underreported CEG’s 2004 gross receipts by $52,397.


        28
          Petitioners’ brief is consistent in this result in that petitioners do not assert
 that sec. 7491(a) applies in this case.
                                        - 62 -

[*62] Petitioners maintain that they computed CEG’s 2004 gross receipts on the

basis of the 2004 trial balance which, according to them, was a more accurate

reflection of CEG’s gross receipts for 2004 than the 2006 or 2011 trial balance.

DiDonato testified at trial that the additional $65,354.23 with which CEG is charged

as gross receipts was really a nontaxable capital contribution from him to CEG. We

conclude that CEG’s 2004 gross receipts were underreported by $52,397.

      Gross income is defined in section 61 to include “all income from whatever

source derived, including (but not limited to) * * * [g]ross income derived from

business”. Sec. 61(a)(2). As a general rule, items of gross income must be included

in the gross income of a cash method taxpayer for the year in which the taxpayer

actually or constructively received the income. See sec. 451(a); sec. 1.451-1(a),

Income Tax Regs. Income not actually reduced to a taxpayer's possession is

constructively received by a taxpayer in the year during which the income is credited

to an account, set apart, or otherwise made available so that the taxpayer may draw

upon it at any time. See sec. 1.451-2(a), Income Tax Regs.

      Where taxpayers keep books and records that do not clearly reflect income,

the Commissioner is authorized under section 446(b) to reconstruct the taxpayers’

income using a method of accounting which, in the opinion of the Commissioner,
                                        - 63 -

[*63] clearly reflects income. Petzoldt v. Commissioner, 92 T.C. 661, 686-687

(1989). The Commissioner ordinarily regards an accounting method as clearly

reflecting income where the method the taxpayers chose reflects the consistent

application of generally accepted accounting principles in accordance with accepted

conditions and practices of the taxpayers’ trade or business. Sec. 1.446-1(a)(2),

Income Tax Regs. The Commissioner’s income reconstruction need not be exact,

but must be reasonable in the light of the surrounding facts and circumstances.

Petzoldt v. Commissioner, 92 T.C. at 687. Once the Commissioner offers sufficient

evidence linking the taxpayers with the income-generating activity, the burden of

persuasion is on the taxpayers to prove the income determinations erroneous. Rule

142(a).

      Respondent meets his burden of production with the stipulated 2004, 2006,

and 2011 trial balances. The 2004, 2006, and 2011 trial balances each consistently

include in gross receipts the $1,877,193 ASC “paid” to CEG for surgical supplies for

January 1 through November 30, 2004. The 2004 trial balance, printed three hours

before CEG’s business closed for the year, omits the $65,364.23 ASC “paid” to

CEG for surgical supplies in December 2004. Each of the 2006 and 2011 trial

balances, given to respondent after the 2004 return was audited, includes the

$65,364.23 in CEG’s gross receipts. Given CEG’s inconsistent treatment of
                                         - 64 -

[*64] amounts received for surgical supplies across periods (i.e., December 2004 as

compared with the rest of the year) and its books and records (i.e., the 2004 trial

balance as compared with the 2006 and 2011 trial balances), we conclude that

respondent was justified in recreating CEG’s gross receipts under section 1.446-

1(a)(2), Income Tax Regs. Thus, petitioners bear the burden of proving the

determinations in error, see Rule 142(a), including whether amounts deposited to

CEG were capital contributions, see Fin Hay Realty Co. v. United States, 398 F.2d

694, 699 (3d Cir. 1968).

      Petitioners do not dispute that CEG received from ASC the $65,364.23 for

the use of surgical supplies. Instead, petitioners assert that the amount they

reported as CEG’s gross receipts for 2004 was correct because, as they maintain,

the 2004 trial balance used to compute CEG’s gross receipts was the most accurate

account of operations. We disagree. The 2004 trial balance is not a reliable

statement of CEG’s operations because it was printed before CEG closed its

business for 2004. DiDonato confirmed this point when he testified that the

purpose of his working on January 1 of each year was to close out CEG’s books

for the previous year. We agree with respondent it is likely that entries were made

in the three or so hours after the 2004 trial balance was printed that resulted in

the inconsistencies between the 2004 trial balance and the 2006 and 2011 trial
                                        - 65 -

[*65] balances. Therefore, we reject petitioners’ proposition that the 2004 trial

balance was less reliable than the 2006 or 2011 trial balance.

      Nor are we persuaded by DiDonato’s testimony that the $65,364.23 was a

nontaxable capital contribution from him to CEG. Petitioners did not offer any

corroborating documentary evidence such as a canceled check, a check register, a

bank statement, or another similar document. See Grossman v. Commissioner, T.C.

Memo. 1994-231, 67 T.C.M. (CCH) 3001, 3003-3006 (1994) (rejecting taxpayers’

claim of capital contributions in the absence of documentary evidence). Nor does the

record establish that a capital contribution was necessary to the continuation of

CEG’s business. CEG was a mature optometry practice with sufficient working

capital from its eyecare practice and sale of surgical supplies to ASC. Petitioners

have not explained why CEG’s financial needs were not met by its existing capital

base. Absent documentary evidence to show that a capital contribution was made,

and bearing in mind that such a contribution did not seem necessary to keep CEG a

going concern, we reject DiDonato’s testimony that the $65,364.23 was a nontaxable

capital contribution to CEG.

      Respondent’s computation of CEG’s gross receipts was reasonably based on

the surrounding facts. The 2004 trial balance included $1,877,193 paid from ASC to

CEG for the purchase of surgical supplies. The 2004 trial balance, however,
                                        - 66 -

[*66] omitted $65,364.23 believed to have been paid from ASC to CEG for the

purchase of surgical supplies in December 2004. The revenue agent followed the

2006 and 2011 trial balances, which both included $65,364.23 for the purchase of

surgical supplies in December 2004. We conclude that respondent acted reasonably

when including in CEG’s gross receipts for 2004 the $65,364.23 for surgical

supplies. The revenue agent, in an exercise of discretion, allowed CEG to reduce its

gross receipts by $204,650.13 for CEG’s payment of payroll and payroll taxes paid

on behalf of ASC. Respondent did not challenge the related adjusting entries in his

pleadings, and we will defer to the decision to allow them as an offset to gross

receipts given the close relationship between CEG and ASC. Accordingly, we hold

CEG’s 2004 gross receipts are increased by $52,397.

IV.   CEG’s Deductions--The Denali

      Respondent determined petitioners were not entitled to depreciation expense

deductions of $29,058 for 2003 and $7,005 for 2004 related to the Denali because,

as he contends on brief, petitioners did not comply with the substantiation

requirements of section 274(d). Petitioners rely on the testimony of DiDonato and

Mr. Cohen, as well as a sample CEG patient log, to prove their entitlement to the

claimed depreciation expense deductions. Petitioners, citing Cohan v.

Commissioner, 39 F.2d 540 (2d Cir. 1930), and Vanicek v. Commissioner, 85 T.C.
                                         - 67 -

[*67] 731 (1985), ask the Court to estimate the allowable depreciation expense

deductions to the extent they have not proven the amounts to which they believe they

are entitled. We will sustain the disallowance of the depreciation deductions for the

Denali.

      Section 162(a) allows a deduction for all ordinary and necessary expenses

paid or incurred during the taxable year in carrying on a trade or business. Section

6001, in turn, requires taxpayers to maintain records sufficient to substantiate the

amounts of the deductions claimed. See also sec. 1.6001-1(a), Income Tax Regs.

Certain expenses specified in section 274 are subject to heightened substantiation

requirements. Specifically, section 274(d)(4) provides that no deduction shall be

allowed under section 162 for listed property unless the taxpayers substantiate, with

adequate records, the following elements: (1) the amount of the expense; (2) the

mileage for each business use of the vehicle as well as the total mileage for all

purposes during the taxable period; (3) the date on which the property was used; and

(4) the business purpose of the property. See sec. 1.274-5T(b)(6), Temporary

Income Tax Regs., 50 Fed. Reg. 46016 (Nov. 6, 1985). Section 280F(d)(4) defines

the term “listed property” to mean, in addition to other property, any passenger

automobile or any other property used as a means of transportation. Without

adequate records, such as an account book, a diary, a log, a statement of expenses,
                                         - 68 -

[*68] trip sheets, or a similar record, taxpayers still may substantiate mileage

expenses with sufficiently detailed written or oral statements and other collateral

evidence showing the expense was incurred. See sec. 1.274-5T(c)(2), (3)(i),

Temporary Income Tax Regs., 50 Fed. Reg. 46017, 46020 (Nov. 6, 1985).

      Although we are satisfied CEG occasionally used the Denali during the

subject years for business purposes, we will not allow petitioners the depreciation

deductions to which they claim entitlement. The Denali is listed property because

CEG used it for transportation.29 See sec. 280(f)(d)(4)(A)(ii). Thus, the section

274(d) substantiation requirements apply. Sec. 274(d)(4). The patient logs

petitioners relied on to satisfy the substantiation requirements of section 274(d) are

not reliable. The logs do not indicate whether it was the Denali or another one of

the transport vehicles that was used to drive the particular patient. Nor do the logs

state the number of miles driven, the origin, the destination, or any other information

that would allow us to determine when, where, and for what purpose the Denali

was driven. That being so, we do not treat the patient logs as adequate records

within the meaning of section 274(d). See Royster v. Commissioner, T.C.

Memo. 2010-16, 99 T.C.M. (CCH) 1077, 1079 (2010) (nonspecific documentary

       29
         The Denali, because it weighed more than 6,000 pounds, was not deemed to
be listed property as a passenger automobile under sec. 280F(d)(4). See sec.
280F(d)(5)(A).
                                         - 69 -

[*69] evidence did not satisfy section 274(d) substantiation requirements); see also

Fleming v. Commissioner, T.C. Memo. 2010-60, 99 T.C.M. (CCH) 1239, 1241

(2010) (absence of business purpose on logs meant they were inadequate

substantiation under section 274(d)).

      Nor does the testimony of DiDonato and Mr. Cohen qualify as sufficiently

detailed oral statements showing the expense was incurred. Neither DiDonato nor

Mr. Cohen made a specific showing as to the business purpose associated with the

use of the Denali, the total miles driven for business and personal uses, or the dates

on which the Denali was used. The record does not establish whether the Denali

was predominantly used for business or personal reasons. Moreover, DiDonato

testified that on at least one occasion he used the Denali to take his surgeons and

staff “down the shore” for what he testified was a personal trip. Given the absence

of specific testimony on the point, and bearing in mind that the Denali was used at

least once for personal travel, we decline to conclude that the Denali was

predominantly used for business purposes or that the substantiation requirements of

section 274(d) have been met. See Dyer v. Commissioner, T.C. Memo. 2012-224,

104 T.C.M. (CCH) 145, 151 (2012); Royster v. Commissioner, 99 T.C.M. (CCH)

at 1079; Larson v. Commissioner, T.C. Memo. 2008-187, 96 T.C.M. (CCH) 73,

77 (2008). Whereas petitioners urge us to apply the Cohan rule to allow them
                                        - 70 -

[*70] depreciation expense deductions for the Denali, we are precluded from doing

so because the section 274(d) substantiation requirements supersede the Cohan rule.

See Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff’d, 412 F.2d 201 (2d Cir.

1969); sec. 1.274-5T(a), Temporary Income Tax Regs., 50 Fed. Reg. 46014 (Nov. 6,

1985). Insofar as petitioners have not met the section 274(d) substantiation

requirements or established that the Denali was predominantly used for business

purposes, they may not claim a depreciation expense deduction for that vehicle for

either of the subject years. Sec. 274(d)(4). Accordingly, we hold petitioners are not

entitled to a depreciation expense deduction for the Denali of $29,058 for 2003 or

$7,005 for 2004.

V.    ASC’s Deductions and Increase to DiDonato’s Distributable Income

      A.      Employee Achievement Expenses

              1.   Overview

      Respondent disallowed ASC’s claimed employee achievement award

deductions of $25,000 for 2003 and $21,501 for 2004. The disallowed deduction

for 2003 stems from two payments of $12,500 to DiDonato Builders. The

disallowed deduction for 2004 is attributable to DiDonato’s purchase of a $21,501

firearm for Mr. Witter in connection with DiDonato’s possible sale of his ASC
                                         - 71 -

[*71] shares of stock. We will sustain respondent’s disallowance of these employee

achievement expenses.

               2.   Guiding Principles

      Sections 162 and 212 allow as a deduction all the ordinary and necessary

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

business or for the production or collection of income. See secs. 162(a), 212(1).

Among the potentially deductible expenses set forth in section 162 is a reasonable

allowance for salaries or other compensation for personal services actually rendered.

Sec. 162(a)(1). Personal, living, or family expenses are generally not deductible.

Sec. 262(a).

               3.   Payments to DiDonato Builders

      DiDonato testified that the payments from ASC to DiDonato Builders were for

final payment of construction and maintenance work purportedly performed on the

Hamilton office complex by Vincent, his cousin. Respondent contends that, other

than DiDonato’s self-serving testimony, the record does not support that the services

were performed for business purposes. We will sustain respondent’s determination

as to the nondeductibility of payments to DiDonato Builders.

      Taxpayers generally may not deduct the payment of another’s expense. See

Deputy v. du Pont, 308 U.S. 488 (1940); Dietrick v. Commissioner, 881 F.2d 336
                                        - 72 -

[*72] 6th Cir. 1989), aff’g T.C. Memo. 1988-180, 55 T.C.M. (CCH) 706 (1988).

The alleged bonuses paid to DiDonato Builders were purportedly for work done on

buildings owned by CEG, Mallard, or DiDonato and merely leased to ASC. The

record does not include a copy of any lease between ASC and CEG, Mallard, or

DiDonato, and we thus have no way to know whether it was the lessor (ASC) or the

lessee (CEG, Mallard, or petitioners) who was responsible for improvements to

leased buildings. Even if we assume that ASC was responsible for improving the

Hamilton office complex, which we do not, petitioners have not established that the

employee achievement payments to DiDonato Builders are deductible.

      The test for the deductibility of compensation payments, such as bonuses to

a nonemployee, is whether the amounts are (1) reasonable in amount, and (2) paid

for services actually rendered to the payor in or before the year of payment.30 See

Lucas v. Ox Fibre Brush Co., 281 U.S. 115, 119 (1930); sec. 1.162-7(a), Income

Tax Regs. Petitioners have not proven that either requirement for deductibility has

been met. First, petitioners offered no evidence, documentary or testimonial, as to

whether the amounts paid to DiDonato Builders for work on ASC’s leased space




       30
       The record does not suggest that Vincent was an employee of ASC, and
consequently, we do not consider the applicability of sec. 274(j) or sec. 1.162-9,
Income Tax Regs., to this case.
                                           - 73 -

[*73] were reasonable in amount when compared with the amount of compensation

paid to other builders for similar work.

      Second, the record does not reveal whether the work DiDonato Builders

allegedly completed was for space leased to ASC or to another one of DiDonato’s

businesses. Where a payment is made in the context of a family relationship, we

carefully scrutinize the facts to ensure there was a bona fide business relationship

and that the payment was not made on account of the familial relationship. See

Commissioner v. Culbertson, 337 U.S. 733, 746 (1949); Martens v. Commissioner,

T.C. Memo. 1990-42, 58 T.C.M. (CCH) 1288, 1292 (1990), aff’d without

published opinion, 934 F.2d 319 (4th Cir. 1991). The record does not establish that

DiDonato Builders rendered services to ASC in connection with the achievement

awards or whether the builder was under a preexisting duty to provide those

services. To the contrary, DiDonato only testified vaguely that DiDonato Builders

worked on roughly 14 properties during a 12-to-15-year period. Among the work

DiDonato Builders allegedly performed was fitting the interior of certain

unspecified rental properties not owned by ASC, performing maintenance on some

of DiDonato’s rental properties which the record does not show ASC was obliged
                                        - 74 -

[*74] to perform, and building out offices for DiDonato and ASC’s surgeons.31 This

testimony does not fix whether the two $12,500 payments to DiDonato Builders

related to services rendered in 2003 or in another year.

      Moreover, we find a notable inconsistency between the statement on the

invoices that the payments were a “bonus per agreement” and DiDonato’s testimony

that the payments were an oral settlement for work performed. We find it curious

that DiDonato would accept as a final settlement release an invoice referring to the

payment as a “bonus”. We also question the business purpose of the payments,

given that DiDonato Builders was the primary contractor for the personal residence.

On the basis of the foregoing, we hold petitioners may not deduct employee

achievement payments to DiDonato Builders totaling $25,000 for 2003.

              4.   Firearm Purchase

      Petitioners claimed a deduction of $21,501 on ASC’s 2004 Form 1120S for a

firearm DiDonato gave to Mr. Witter in connection with Mr. Witter’s efforts

regarding the possible sale of DiDonato’s shares of ASC stock. Respondent




       31
        DiDonato did not reveal in his testimony that DiDonato Builders was the
contractor named in multiple construction permits to improve the personal
residence. Nor did he explain the extent to which, if at all, payments to DiDonato
Builders for work completed on the personal residence overlapped with payments
for work completed at ASC’s offices.
                                         - 75 -

[*75] maintains the deduction is not allowable for two reasons. First, respondent

asserts that the cost of the firearm is not an ordinary and necessary business expense

of ASC because it was purchased in connection with the possible sale of DiDonato’s

shares of ASC stock and so is a personal expense of DiDonato. Second, respondent

argues that even if we were to conclude that the cost of the firearm was an ordinary

and necessary expense of ASC, the amount of the deduction is limited to $25 under

section 274(b). We agree that the cost of the firearm was not an ordinary and

necessary expense of ASC and that the cost of the firearm is not deductible.

      An expense is ordinary if it is considered normal, usual, or customary in the

context of the particular business out of which it arose, see Du Pont, 308 U.S. at 495,

and an expense is necessary if it is appropriate and helpful to the operation of the

taxpayer’s trade or business, see Welch v. Helvering, 290 U.S. at 113. The cost of a

gift may be an ordinary and necessary business expense to the extent the gift is

related to the taxpayer’s opportunity to generate business income. Bruns v.

Commissioner, T.C. Memo. 2009-168, 98 T.C.M. (CCH) 30, 35 (2009) (citing

Brown v. Commissioner, T.C. Memo. 1984-120, 47 T.C.M. (CCH) 1255 (1984)).

However, the amount of the deduction allowed for a gift is limited to $25 per donee

per year. Sec. 274(b)(1). Moreover, section 274(d) requires that the taxpayer
                                          - 76 -

[*76] claiming the gift amount as a deduction substantiate with adequate records (1)

the cost of the gift, (2) the date and description of the gift, (3) the business purpose

of the gift, and (4) the business relationship of the person receiving the gift. Sec.

1.274-5T(b)(5), Temporary Income Tax Regs., supra. Petitioners bear the burden of

proving the extent to which (if at all) the firearm gift contributed to ASC’s income.

See Sutter v. Commissioner, 21 T.C. 170, 173-174 (1953).

      Petitioners have not established that the firearm DiDonato gave to Mr. Witter

was an ordinary and necessary business expense of ASC or that it increased ASC’s

future earnings potential. DiDonato testified to purchasing the firearm for Mr. Witter

in connection with investment advisory services related to the possible sale of his

shares of ASC stock. Expenses related to the sale of a shareholder’s stock in a

corporation are not deductible at the corporate level. Accord Snyder Bros. Co. v.

Commissioner, T.C. Memo. 1980-275, 40 T.C.M. (CCH) 762, 772 (1980) (fees paid

by a corporation for the sale of a shareholder’s stock were expenses paid for the

benefit of another and are nondeductible). Moreover, petitioners offered no evidence

as to any future income ASC expected to realize from the services of Mr. Witter.

Any goodwill that may have been realized from the gift of the firearm was to the

personal benefit of DiDonato and not ASC. In this regard, the firearm was a

personal gift born out of DiDonato’s appreciation for services Mr. Witter provided
                                        - 77 -

[*77] to him in connection with the possible sale of his shares of ASC stock.32 An

individual generally may not deduct his or her personal, living, or family expenses.

See sec. 262(a). In view of the foregoing, we hold ASC, and therefore petitioners,

may not deduct employee achievement expenses of $21,501 for 2004.33

      B.      Conferences and Meetings

      Petitioners claimed on ASC’s 2004 Form 1120S deductions for expenses for

conferences and meetings of $69,663 for 2003 and $59,177 for 2004. Respondent

disallowed the claimed deductions because, as he states on brief, the expenses

related almost exclusively to meals and entertainment expenses not properly

substantiated under section 274(d). Petitioners sought to meet the substantiation

requirements of section 274(d) through DiDonato’s testimony and documentary

evidence, including canceled checks and invoices. We conclude petitioners may




       32
         Respondent also asserts, and we agree, that the substantiation requirements
of sec. 274(d) have not been met with respect to the firearm. No evidence was
offered at trial, and certainly not adequate records or detailed testimony, showing
Mr. Witter’s business relationship to ASC or that the gift of the firearm furthered a
legitimate business purpose of ASC. Whereas the business relationship between
Mr. Witter and DiDonato (in his capacity as ASC’s shareholder) is apparent from
the record, the same cannot be said of Mr. Witter and ASC.
       33
        Because we conclude the firearm purchase was not an ordinary and
necessary business expense of ASC, we need not decide whether sec. 274(b) limits
the amount of the deduction to $25.
                                         - 78 -

[*78] not deduct the expenses for conferences and meetings as reported on ASC’s

2003 and 2004 Forms 1120S.

      Deductions are a matter of legislative grace, and taxpayers bear the burden of

proving their entitlement to the deductions claimed. Rule 142(a); INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992). Section 274 imposes heightened

substantiation requirements with respect to deductions for meals and entertainment

expenses. No deduction is allowed for meals and entertainment expenses, unless the

taxpayer establishes with adequate records or other credible evidence: (1) the

amount of the expense; (2) the time and place of the entertainment; (3) the business

purpose of the expense; and (4) the business relationship of the taxpayer to the

persons entertained, including the name, title, or other designation sufficient to

establish the business relationship to the taxpayer. See sec. 274(d); sec. 1.274-

5T(b)(3), Temporary Income Tax Regs., 50 Fed. Reg. 46015 (Nov. 6, 1985).

      Before a deduction is allowed for entertainment expenses, the taxpayer must

establish that the expenditure was (1) directly related to the active conduct of the

taxpayer’s trade or business, or (2) associated with the active conduct of the trade or

business where the expenditure was incurred directly before or directly after a

substantial and bona fide business discussion. Sec. 274(a)(1)(A); see also sec.

1.274-2(a)(1), Income Tax Regs. An expenditure is for entertainment directly
                                         - 79 -

[*79] related to the active conduct of a trade or business if, among other situations,

(1) the taxpayer had more than a general expectation of deriving some income or

other future benefit, (2) the entertainment occurred in a clear business setting in

furtherance of the taxpayer’s trade or business, (3) the entertainment was for the

benefit of a nonemployee and in the nature of compensation for services rendered, or

(4) the expenditure was a portion of club dues allocable to certain facilities used by

the taxpayer to furnish food and beverages. See sec. 1.274-2(c), Income Tax Regs.

      An expenditure for entertainment is associated with the active conduct of the

taxpayer’s trade or business where the taxpayer establishes a clear business purpose

in incurring the expense, such as to obtain new business or to encourage the

continuation of an existing business relationship. See sec. 1.274-2(d)(2), Income

Tax Regs. For a taxpayer to establish a substantial and bona fide business

discussion, the taxpayer must show that the taxpayer actively engaged in a business

meeting, negotiation discussion, or other bona fide business transaction, other than

entertainment, to obtain income or some other specific benefit. Sec. 1.274-

2(d)(3)(i)(a), Income Tax Regs. In addition, the taxpayer must prove the business

meeting, negotiation, discussion, or transaction was substantial in relation to the

entertainment. Id.
                                        - 80 -

[*80] Petitioner introduced into evidence canceled checks and invoices from most of

the service providers to which the conference and meeting expenses relate. While

these records establish that DiDonato paid amounts to various social clubs and

proprietors, they are not adequate records under section 274(d) because they do not

establish the time and place of the entertainment, the business purpose of the

entertainment, or ASC’s relationship to the person entertained. Petitioners’ attempts

to buttress their documentary evidence with DiDonato’s testimony does not satisfy

the strict requirements of section 274 because we find DiDonato’s testimony in

isolation to be not credible. See sec. 1.274-5T(c)(2), (3), Temporary Income Tax

Regs., supra (the taxpayer must prove the business purpose of an expense with

“direct evidence” such as a written statement or the oral testimony of the persons

entertained).

      As a preliminary matter, we note that DiDonato testified that CEG (and not

ASC) paid the conference and meeting expenses at issue.34 Even gratuitously

construing DiDonato’s testimony as confusing ASC and CEG, we reject the

contention that he has satisfied the substantiation requirements of section 274.

DiDonato did not name each of the individuals present at any of the 29 or 30


       34
      In response to the question “[A]re these expenses that were paid by CEG?”
DiDonato stated “Yes.”
                                         - 81 -

[*81] conferences and meetings held in 2003 and 2004, respectively. He did not call

these individuals to testify as to their presence at the conferences and meetings, their

business relationship to ASC, or the business purpose of the conferences or meetings

they purportedly attended. Nor did he state the business relationship between ASC

and the persons entertained by, for example, giving the person’s name, title, or other

affiliation to ASC. We thus decline to find his testimony sufficiently detailed to

satisfy the section 274 substantiation requirements. Accord Tyson v. Commissioner,

T.C. Memo. 2009-176, 98 T.C.M. (CCH) 66, 70 (2009) (no meals and entertainment

expense deductions where the business relationship between the taxpayer and the

person entertained was not accompanied with the name, title, or other designation of

the person entertained); Clooney v. Commissioner, T.C. Memo. 1999-194, 77

T.C.M. (CCH) 2156, 2159 (1999) (credit card statements and receipts alone do not

establish a business purpose for the expense); Hankenson v. Commissioner, T.C.

Memo. 1984-200, 47 T.C.M. (CCH) 1567, 1569 (1984) (costs of lunch meetings that

did not have a stated business purpose were nondeductible personal expenses).

      Moreover, DiDonato did not explain how the expenditures for conferences

and meetings related to ASC’s trade or business. DiDonato did not establish that

ASC expected a future economic benefit as a result of any of the meetings, or that
                                         - 82 -

[*82] any expense was incurred in a clear business setting. In addition, many

expenses at issue were incurred at social clubs such as the Leash, the Philadelphia

Club, and the Nassau Club, all of which bear strong personal elements. Multiple

notes on invoices from the Leash indicated that the invoices could not be paid from

business accounts, indicating to us further that these expenses were not for business.

Accordingly, we hold petitioners may not deduct conference and meeting expenses

of $69,663 for 2003 and $59,177 for 2004.

      C.       Aircraft Leasing Expense

               1.   Parties’ Arguments

      Respondent determined that ASC was not entitled to deduct lease payments of

$217,518 for 2003 and $262,745 for 2004 to Equipment Leasing for use of the

aircraft. Respondent asserts on brief that the aircraft lease was not an ordinary or

necessary business expense of ASC because petitioners used the aircraft mostly for

personal purposes that were unrelated to ASC’s trade or business. Respondent,

relying on Harbor Med. Corp. v. Commissioner, T.C. Memo. 1979-291, 38 T.C.M.

(CCH) 1144 (1979), aff’d without published opinion, 676 F.2d 710 (9th Cir. 1982),

also argues it was unreasonable for ASC to lease the aircraft from Equipment

Leasing because, as respondent asserts, the cost of operating the aircraft was

“exponentially greater” than commercial air travel. Lastly, respondent maintains
                                         - 83 -

[*83] that ASC may not deduct the cost of the aircraft lease even if petitioners prove

the aircraft was an ordinary and necessary business expense because, respondent

contends, petitioners have not met the substantiation requirements of section 274(d).

Petitioners counter that they used the aircraft for legitimate business purposes more

than 50% of the time and that their children’s presence on some of the flights does

not limit their deduction. We conclude that petitioners have failed to show the use of

the aircraft was primarily related to petitioners’ business and that in any even they

have not met the stringent substantiation requirements under section 274(d) to

support the reported expenses.

               2.   Guiding Principles

      Section 162 provides for a deduction of ordinary and necessary business

expenses including traveling expenses paid or incurred in carrying on any trade or

business. Sec. 162(a)(2). The Code recognizes traveling expenses as a type of

expense for which a deduction under section 162 may be allowed. Like all trade or

business expenses, traveling expenses are deductible only to the extent the

expenditures are reasonably necessary in, and directly attributable to, the taxpayers’

trade or business. Commissioner v. Flowers, 326 U.S. 465, 470 (1946); sec. 1.162-

2(a), Income Tax Regs. When taxpayers travel to a destination and engage in both

business and personal activities thereat, traveling expenses to and from the location
                                          - 84 -

[*84] are deductible only if the trip is primarily related to the taxpayers’ business.

Sec. 1.162-2(b)(1), Income Tax Regs. Whether a given trip is primarily related to

the taxpayers’ business or personal pursuits depends upon the facts and

circumstances of each case. Sec. 1.162-2(b)(2), Income Tax Regs. As the trier of

fact, we draw inferences and conclusions from the totality of the record, see

Commissioner v. Scottish Am. Inv. Co., 323 U.S. 119, 122-123 (1944), and whether

traveling expenses are directly related to a trade or business is a primarily a factual

determination, see Commissioner v. Heininger, 320 U.S. 467, 475 (1943). In

deciding whether a trip is primarily personal, an important factor to consider is the

amount of time during the trip spent on personal activities as compared with the

amount of time spent on business activities. Sec. 1.162-2(b)(2), Income Tax Regs.

Petitioners bear the burden of proving that the expense of leasing an aircraft was

deductible.35 See Rule 142(a).




       35
         The Secretary recently promulgated regulations providing that if a corporate
jet is used for both business and entertainment purposes, the corporation must
allocate the actual aircraft expenses person by person and flight by flight between
the two types of uses, under either an occupied-seat hours or occupied-seat miles
method. See sec. 1.274-10, Income Tax Regs. (effective Aug. 1, 2012).
                                          - 85 -

[*85]           3.   Analysis

        Of the 10 trips taken in 2003, see supra pp. 22-23, at least 7 were completely

personal; namely, trips 1, 2, 4, 5, 6, 7, and 10.36 As to trip 1, petitioners’ children

were on board; and although DiDonato provided inconsistent testimony as to

whether he stayed in Orlando or Fort Lauderdale, Ms. DiDonato’s credit card

statements established that at least she was in or around Disney World. As to trips

2, 4, 5, 7, and 10, DiDonato testified at trial that each of these trips were for the sale

of his personal shares of ASC stock. As explained at section V.A.4 of this opinion,

expenses related to the sale of a shareholder’s stock in a corporation are not

deductible by the corporation as a business expense of the corporation. See Snyder

Bros. Co. v. Commissioner, 40 T.C.M. (CCH) at 772; cf. sec. 1.280F-6(d)(2),

Income Tax Regs. (a qualified business use does not include use for which a

deduction is allowable under section 212; i.e., for the production or collection of

income or for the management, conservation, or maintenance of property held for

the production of income). As for trip 6, DiDonato testified that Ms. DiDonato

traveled to Rochester on a Friday and returned on a Sunday, purportedly to meet


        36
         Insofar as petitioners’ children were present on a flight and the flight was
used in furtherance of the sale of DiDonato’s shares of ASC stock, we count the
flights only once as being in connection with the sale of DiDonato’s shares of ASC
stock.
                                          - 86 -

[*86] with a supplier of eyecare products. We regard this trip as personal because

Ms. DiDonato traveled on a weekend, her children were present on board the flight,

and her family resided in the area.

      The remaining trips taken in 2003, namely, trips 3, 8, and 9, had a business

purpose that was questionable at best. As to trip 3, we question the business

elements of that trip because we do not find credible DiDonato’s testimony that he

flew to Washington on a Sunday primarily to attend a seminar at his law firm and

doubt there was a legitimate business purpose for the trip. As to trips 8 and 9,

purportedly for a conference at the Vision Expo in Las Vegas and to visit a research

facility, respectively, petitioners have failed to persuade us with credible evidence

that these trips were primarily motived by a business purpose. Thus, we conclude

that expenses reported and incurred in connection with the use of the aircraft in 2003

were personal.

      Of the 12 trips taken in 2004, see supra pp. 24-25, at least seven of those trips

were completely personal; namely, trips 2, 3, 4, 7, 8, 10, and 12. As to trips 2, 3, 4,

7, and 8, DiDonato testified at trial that each of these trips was for the sale of his

personal shares of ASC stock. As just explained, expenses related to the sale of a

shareholder’s stock in a corporation are not deductible by the corporation as a

business expense of the corporation. See Snyder Bros. Co. v. Commissioner, 40
                                        - 87 -

[*87] T.C.M. (CCH) at 772; cf. sec. 1.280F-6(d)(2), Income Tax Regs. (a qualified

business use does not include use for which a deduction is allowable under section

212; i.e., for the production or collection of income or for the management,

conservation, or maintenance of property held for the production of income). As to

trip 10, a trip to East Hampton, we conclude the trip was personal, seeing that

petitioners flew to East Hampton with Dr. Stein and flew back to New Jersey

without the doctor after a lengthy layover. DiDonato did not explain why it was

necessary to ASC’s business that he and his wife be present on the flight to East

Hampton, and he did not explain what he and his wife did during the layover they

had while in East Hampton. We thus conclude that trip 10 was for personal

purposes. As to trip 12, a flight Ms. DiDonato and her children took to Rochester,

we conclude this trip was personal for the same reasons stated above.

      As to the other five trips taken in 2004, petitioners have not shown a primary

business purpose existed. As to trip 1, from Trenton, New Jersey, to Atlanta,

Georgia, DiDonato testified that he and Ms. DiDonato took this trip to attend the

Southern Council of Optometry meeting. Petitioners offered no supporting details

to corroborate the business purpose of this trip, and we decline to accept

DiDonato’s self-serving testimony on the issue. See Tokarski v. Commissioner, 87

T.C. 74, 77 (1986). As to trips 5, 6, and 9, DiDonato testified that he flew to
                                          - 88 -

[*88] Washington to meet with his lawyers and his congressman, but he failed to

show that these trips was made primarily to further a legitimate business purpose.

As to trip 9 specifically, we note that petitioners’ children were on board this flight,

suggesting there were personal or recreational elements to this trip as well. Finally,

as to trip 11, another trip to a conference in Las Vegas, which we find inherently

suspect, petitioners have not persuaded us that it was primarily related to a legitimate

business purpose. For reasons explained, we conclude expenses reported and

incurred in connection with the use of the aircraft in 2004 were also personal.

      Even if we were to believe that one or more of the trips taken had a

legitimate business purpose, we agree with respondent that no deductions are

allowed because the heightened substantiation requirements of section 274(d) have

not been met. See Lysford v. Commissioner, T.C. Memo. 2012-41, 103 T.C.M.

(CCH) 1217, 1220-1221 (2012) (declining to credit the taxpayer with business use

of a personal aircraft where the taxpayer did not maintain written documentary

evidence of the business purpose of the flights, the names of persons visited, or a

description of the business actually or attempted to be conducted); Weekend

Warrior Trailers, Inc. v. Commissioner, T.C. Memo. 2011-105, 101 T.C.M. (CCH)

1506, 1521 (2011) (general testimony of individuals who flew on an airplane and
                                         - 89 -

[*89] their alleged business relationship, without specific testimony as to the

business purpose for each airplane use, did not satisfy the substantiation

requirements of section 274). See generally Sanford v. Commissioner, 50 T.C. at

827 (section 274(d) supersedes the Cohan rule); sec. 1.274-5T(a), Temporary

Income Tax Regs., supra.

        D.      Effect of Disallowed Deductions

        The disallowed deductions result in increases to ASC’s income. Because

DiDonato was ASC’s sole shareholder during the subject years, it follows that

petitioners must include in income 100% of the adjustments on Schedule E. See sec.

1366.

VI.     Mallard’s Expenses for the 245 and 265 Cold Soil Properties

        A.      Overview

        Respondent disallowed Schedule E rental real estate expenses relating to the

245 and 265 Cold Soil properties of $549,203 for 2003 and $477,511 for 2004. In

support of his position, respondent raises three related arguments. First, he asserts

petitioners (or Mallard) did not hold the 245 and 265 Cold Soil properties as rental

properties during the subject years. Second, he maintains all expenses claimed for

the 245 and 265 Cold Soil properties are nondeductible personal expenses. Third, he

avers petitioners were not engaged in the rental real estate or farming activities
                                          - 90 -

[*90] for profit. Petitioners assert that expenses incurred in the ownership,

management, and rental of the 245 and 265 Cold Soil properties were deductible.

We agree with respondent that petitioners’ deductions of the expenses are limited as

stated herein.

      B.         Whether the 245 and 265 Cold Soil Properties Were Rental
                 Properties

      Respondent asserts that all of the claimed expenses related to the 265 Cold

Soil property are nondeductible because, he contends, neither property was held as a

rental property for either of the subject years. With respect to the 265 Cold Soil

property, respondent cites section 280A(d) as standing for the proposition that the

property is deemed to have been used for personal purposes by virtue of his father’s

residing there. As to the 245 Cold Soil property, respondent argues the property is

not a rental property because, as he sees it, petitioners failed to establish that they

received rent from the property. Petitioners argue that the 245 and 265 Cold Soil

properties were each rented at a fair rent and, with respect to the 265 Cold Soil

property, section 280A(d) does not disallow the claimed expense deductions for the

property. We agree with respondent that expense deductions claimed with respect

to the 265 Cold Soil property are disallowed under section 280A(d), and we hold

that petitioners may deduct only the expenses, i.e., real estate taxes, specified
                                         - 91 -

[*91] herein. We disagree with respondent that the 245 Cold Soil property was not

held as a rental property for the subject years, though we conclude that deductible

“losses” related to the 245 Cold Soil property are limited by section 183(b).

      Section 280A disallows otherwise allowable deductions with respect to a

dwelling unit used as a taxpayer’s residence. Section 280A(d)(1) provides that a

taxpayer is considered to have used a dwelling unit as a residence where the

property is used for personal purposes for a number of days which exceeds the

greater of 14 days or 10% of the number of days during which the property is rented

at a fair rent. Section 280A(d)(1) specifies that a dwelling unit may not be treated as

rented at fair rental value for any day for which the property is used for personal

purposes. In general, a taxpayer is generally deemed to have used a dwelling unit for

personal purposes if, during any part of a day, a member of the taxpayer’s family (as

defined in section 267(c)(4)) uses the unit for personal purposes. Sec. 280A(d)(2).

A member of the taxpayer’s family includes, among other enumerated relationships,

the taxpayer’s ancestors. Sec. 267(c)(4).

      Notwithstanding the general rule that a family member’s use of a dwelling unit

is imputed to the taxpayer, a taxpayer is not treated as using the property for

personal purposes for any period where the dwelling unit is rented to the family

member for use as the family member’s personal residence at a fair rent. Sec.
                                         - 92 -

[*92] 280(d)(3)(A). DiDonato’s father rented the dwelling at the 265 Cold Soil

property during the entire period of the subject years. Therefore, under section

280A(d), DiDonato is deemed to have used the dwelling unit on that property for

personal purposes under section 280A(d), and so his rental expenses may not be

deducted unless the dwelling was rented at a fair rent.

      The determination of whether a dwelling unit is rented at a fair rent is made in

the light of the facts and circumstances that existed when the rental agreement was

entered into. See sec. 280A(d)(2)(C); sec. 1.280A-1(e)(3)(iii), Proposed Income Tax

Regs., 48 Fed. Reg. 33320 (July 21, 1983). Although the term “fair rent” is not

defined in the Code or the regulations under section 280A, the legislative history

makes clear that the fairness component be determined on the basis of comparable

rents in the area. See H.R. Rept. No. 97-404, at 8 (1981); see also Senate

Explanation to Pub. L. 97-119, 27 Cong. Rec. S15487 (daily ed. Dec. 16, 1981).

Petitioners bear the burden of proving the fair rental value of the dwelling unit. See

Rule 142(a); Crotty v. Commissioner, T.C. Memo. 1990-261, 59 T.C.M. (CCH)

691, 695-696 (1990); Smith v. Commissioner, T.C. Memo. 1985-446, 50 T.C.M.

(CCH) 904, 905 (1985); Bindseil v. Commissioner, T.C. Memo. 1983-411, 46

T.C.M. (CCH) 764, 765 (1983).
                                          - 93 -

[*93] Petitioners offered no evidence at trial as to the fair rental value of the 265

Cold Soil property other than DiDonato’s testimony that the amount of rent to be

charged was set by his tax attorney and, in DiDonato’s view, the rent was fair by

virtue of his belief that the property was in “deplorable shape”. DiDonato’s

testimony alone is unpersuasive. The record does not include the methodology, if

any, the tax attorney used to determine the fair rental value. Because petitioners did

not call this individual to testify on their behalf, we do not have the benefit of his

reasoning. Nor does the record include evidence as to the fair rental value of

comparable homes in the area surrounding the 265 Cold Soil property. We decline

to accept DiDonato’s uncorroborated and self-serving testimony that monthly rent of

$400 for a single-family residence in New Jersey was fair rental value. See Gerdau

Macsteel, Inc. v. Commissioner, 139 T.C. ___, ___ (slip op. at 143) (2012); see also

Tokarski v. Commissioner, 87 T.C. at 77; Barasso v. Commissioner, T.C. Memo.

1978-432. In the absence of reliable evidence that the 265 Cold Soil property was

rented at fair rental value, we conclude that it was not. See Epstein v.

Commissioner, T.C. Memo. 1994-34, 67 T.C.M. (CCH) 2046, 2051 (1994) (the

failure of a party to introduce evidence as to the fair rental value of a dwelling unit

creates a presumption that the evidence would be unfavorable to that party’s

position); Roy v. Commissioner, T.C. Memo. 1998-125, 75 T.C.M. (CCH) 2081,
                                         - 94 -

[*94] 2083 n.3 (1998) (taxpayers could not prevail in the absence of evidence on the

fair rental value of that portion of a dwelling unit rented); Bindseil v. Commissioner,

46 T.C.M. (CCH) at 765 (taxpayer not able to prevail in the absence of expert

evidence to support his claim of fair rental value). As far as Mallard’s books and

records suggest, DiDonato’s father paid no rent at all. This documentary evidence

(or lack thereof) is consistent with testimony of respondent’s revenue agent, who

testified that rent was not received by Mallard or petitioners.

      We are mindful of section 1.280A-1(e)(6), Proposed Income Tax Regs., 48

Fed. Reg. 33320 (July 21, 1983), which states that a taxpayer shall not be

deemed to have used a dwelling unit for personal purposes on any day on which

the principal purpose of the unit’s use was to perform repair or maintenance work on

the dwelling unit. Still, our conclusion is unchanged. The record abounds with

evidence showing that most (if not all) of the repairs and maintenance to the 265

Cold Soil property related to work on two barns, several smaller structures, a

chicken coop, grounds, and other like alterations. While DiDonato testified about

general improvements to the dwelling house on the 265 Cold Soil property, he did

not offer specific testimony about whether the work performed qualified as repairs

and maintenance on the dwelling unit. Indeed, a pretrial request respondent made
                                         - 95 -

[*95] to the Township of Lawrence pursuant to New Jersey’s Open Public Records

Act, N.J.S.A. sec. 47:1A-1, et seq., and requesting information as to work performed

on the 265 Cold Soil property, revealed that construction permits for the dwelling

house of that property had not been issued until late 2009. The lack of evidence on

fair rental value of the 265 Cold Soil property, coupled with the testimony of

respondent’s revenue agent that the dwelling unit at the 265 Cold Soil property had

not undergone significant repairs or maintenance, leads us to conclude that the 265

Cold Soil property was used for DiDonato’s personal purposes under section

1.280A-1(e)(6), Proposed Income Tax Regs., supra.

      As to the 245 Cold Soil property, respondent argues the property is not a

rental property because, he posits, petitioners failed to establish that they received

rent from the property. We are not persuaded. Included in the record is a rental

agreement reciting that DiDonato leased to Mr. Richen for $800 per month the

dwelling house located at the 245 Cold Soil property. The record does not include

evidence suggesting that Mr. Richen was a member of DiDonato’s family within the

meaning of section 267(c)(4). We thus find that section 280A does not require the

disallowance of any of the expenses petitioners claimed with respect to the 245 Cold

Soil property.
                                         - 96 -

[*96] Pursuant to section 280A(d)(2)(A), petitioners are deemed to have used the

dwelling at the 265 Cold Soil property for personal purposes during the subject

years, because the record does not establish that the 265 Cold Soil property was

rented at fair rental value at any point during the subject years. Therefore, none of

the claimed deductions are allowable under section 280A(c)(3) and (e)(1), except

deductions allowable without regard to their connection with DiDonato’s rental real

estate activities; specifically, property taxes of $50,090 for 2003 and $51,081 for

2004 are the only claimed expenses for which deductions are allowed. See sec.

164(a)(1). Insofar as the 265 Cold Soil property was not a qualified residence to

petitioners under section 163(h)(4)(A)(i) they are not entitled to mortgage interest

deductions with respect to that property. See Epstein v. Commissioner, 67 T.C.M.

(CCH) at 2049 n.4.

      C.       Whether Petitioners’ Real Estate Activities Were Entered Into for
               Profit

               1.    Overview

      Respondent claims that petitioners may not deduct expenses relating to the

245 and 265 Cold Soil properties because petitioners did not hold either property

with the primary purpose of making a profit. Petitioners are deemed to have used the

265 Cold Soil property for personal purposes throughout the subject years, and
                                         - 97 -

[*97] we therefore need not decide whether section 183 applies for that property.

See sec. 280A(f)(3) (where section 280A(a) applies with respect to the use of a

dwelling unit for any year, section 183 generally does not apply to that unit for that

year); sec. 1.183-1(g), Proposed Income Tax Regs., 37 Fed. Reg. 13679 (July 13,

1972). After considering the claimed deductions relating to the 245 Cold Soil

property in the light of section 183, we agree with respondent and conclude that

petitioners’ activities with respect to that property were not engaged in for profit.

      Sections 162 and 212 allow a deduction for all the ordinary and necessary

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

business or for the production or collection of income. See secs. 162(a), 212(1).

Section 183 generally limits deductions for an activity not engaged in for profit to the

amount of the activity’s gross income. Sec. 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 allowable for the taxable year under section 162 or under

paragraph (1) or (2) of section 212.”

               2.   Whether Petitioners’ Real Estate Activities Should Be
                    Aggregated or Examined in Isolation

      Petitioners contend on brief that the Court should consider DiDonato’s real

estate activities in the aggregate when evaluating his section 183 profit motive
                                         - 98 -

[*98] because petitioners purportedly elected to aggregate his rental real estate

activities as one activity under section 469(c)(7)(A).37 We decline to do so for two

reasons. The first reason is lack of conforming proof. The record does not include a

copy of petitioners’ (or DiDonato’s) Federal income tax return showing a proper

election was made under section 469 to aggregate the real estate activities as a single

activity. See sec. 1.469-9(g)(3), Income Tax Regs. (requiring an election to be made

on a statement accompanying the taxpayer’s original tax return). In the absence of

reliable documentary evidence establishing that such an election was properly made,

we decline to conclude it was.

      The second reason is a blend of law and fact. The regulations promulgated

under section 183 specify that, as an initial matter, in determining whether section

183 applies for a particular activity of the taxpayer, a determination must be made

as to the scope of the activity. Sec. 1.183-1(d)(1), Income Tax Regs. The activity to

be considered under section 183 may encompass a single undertaking by the

taxpayer or the activity may comprise several undertakings by the taxpayer. Id.

For purposes of section 183, each undertaking may be its own activity or several

       37
         Petitioners claim on brief, as they stated at trial, that DiDonato elected to
aggregate his rental real estate activities under sec. 465. We are unaware of any
election available under sec. 465 allowing a taxpayer to aggregate his or her rental
real estate activities. We understand petitioners to refer to the election available
under sec. 469(c)(7)(A).
                                          - 99 -

[*99] undertakings may be treated as a one activity. Id. In ascertaining whether the

taxpayer’s multiple undertakings constitute a single activity or separate activities, all

the facts and circumstances of the case are taken into account. Id. In general, the

most important facts and circumstances to be evaluated in deciding the scope of the

activity are the degree of organizational and economic interrelationship of the various

undertakings, the similarity of the undertakings, and the extent to which the overall

business purpose is or may be served by carrying on the various undertakings

separately or together. Id. Where it is determined that the taxpayer’s multiple

undertakings are separate activities, deductions and income attributable to each

activity must be treated separately and cannot be aggregated in determining whether

an activity is subject to section 183 or when applying the section 183 loss limitation

for that activity. Id.

       Significantly, regulations interpreting section 183 provide an example of a

taxpayer who engages in farming on land purchased or held primarily for profit from

appreciation. See sec. 1.183-1(d)(1), Income Tax Regs. In such an instance, the

farming and the holding of the land will ordinarily be considered a single activity

only if the farming activity reduces the net cost of carrying the land for its

appreciation in value. Id. Thus, the farming and the holding of land will be

considered a single activity only if the income derived from the farming activity
                                         - 100 -

[*100] exceeds the deductions attributable to the farming activity that are not directly

attributable to holding the land. Id.

      Applying these general principles in this case, we will treat petitioners’ real

estate undertaking with respect to the 245 Cold Soil property as a separate activity

for purposes of section 183. As we find, the facts and circumstances of this case

lead us to conclude that the undertaking involving the 245 Cold Soil property was

not sufficiently interrelated to petitioners’ other rental real estate undertakings so as

to constitute a single activity. DiDonato’s rental real estate activity in respect of

the 245 Cold Soil property was limited to renting to Mr. Richen the dwelling house

on that property. The rental real estate activity with respect to the 265 Cold Soil

property was also limited to renting to DiDonato’s father the dwelling house on that

property. The undertaking as to the 245 Cold Soil property was not related to the

undertaking as to the 265 Cold Soil property. To the contrary, DiDonato specifically

rejected offers from developers to purchase the properties. Moreover, since 1997,

DiDonato had sold property rights related to the personal residence and the 245

and 265 Cold Soil properties without any apparent regard for the possible

development of these properties in a subdivision. Nor do DiDonato’s commercial

rental real estate activities bear any apparent relationship to his undertakings at the

245 or 265 Cold Soil property. Considering the foregoing, we will examine
                                          - 101 -

[*101] DiDonato’s profit objective with respect to the 245 Cold Soil property

independent of his other rental real estate undertakings.

               3.    Guiding Principles

      The test for deciding whether an activity is engaged in for profit is whether the

taxpayers entered into the activity with an “‘actual and honest objective of making a

profit.’” See Elliott v. Commissioner, 84 T.C. 227, 236 (1985), aff’d without

published opinion, 782 F.2d 1027 (3d Cir. 1986); Purdey v. Commissioner, T.C.

Memo. 1989-657, 58 T.C.M. (CCH) 947, 950 (1989) (quoting Dreicer v.

Commissioner 78 T.C. 642, 645 (1982), aff’d without published opinion, 702 F.2d

1204 (D.C. Cir. 1983)), aff’d without published opinion, 922 F.2d 833 (3d Cir.

1990). In this context, the term “profit” focuses on economic profit independent of

tax savings. Seaman v. Commissioner, 84 T.C. 564, 588 (1985); Fox v.

Commissioner, 80 T.C. 972, 1006 (1983), aff’d without published opinion sub nom.

Rosenblatt v. Commissioner, 734 F.2d 7 (3d Cir. 1984). A reasonable expectation of

profit is not needed, but the facts and circumstances must indicate the taxpayers

entered into or continued the activity with the objective of making a profit. Sec.

1.183-2(a), Income Tax Regs. In determining whether an activity is engaged in for

profit, we lend greater weight to objective facts than to a taxpayer’s statements of his

or her intent. Id.
                                         - 102 -

[*102] Regulations interpreting section 183 include a nonexclusive list of objective

factors to be evaluated in determining whether an activity is engaged in for profit.

The factors to be considered are: (1) the manner in which the taxpayers carry on the

activity; (2) the expertise of the taxpayers or their advisors; (3) the time and effort

expended by the taxpayers in carrying on the activity; (4) the expectation that assets

used in the activity may appreciate in value; (5) the success of the taxpayers in

carrying on other similar or dissimilar activities; (6) the taxpayers’ history of income

or loss with respect to the activity; (7) the amount of occasional profits, if any, which

are earned; (8) the financial status of the taxpayers; and (9) whether elements of

personal pleasure or recreation are involved. Sec. 1.183-2(b), Income Tax Regs. No

single factor is outcome determinative, and we may look to factors not specifically

enumerated. Id.

                    a.     Petitioners’ Conduct of Their Activity

      The fact that taxpayers carry on their activity in a businesslike manner may

indicate the existence of a profit objective. Sec. 1.183-2(b)(1), Income Tax Regs. In

deciding whether a taxpayer conducted an activity in a businesslike manner, we

consider whether complete and accurate books and records were kept, whether the

activity was conducted in a manner substantially similar to other comparable for-

profit activities, and whether changes were made in an attempt to earn a profit. Id.
                                        - 103 -

[*103] Although petitioners maintained books and records for Mallard and engaged

Amper to prepare the 2003 and 2004 returns, we are not persuaded they conducted

their real estate activity as to the 245 Cold Soil property in a businesslike manner.

Respondent’s revenue agent testified credibly that petitioners’ representative told her

during the audit that rental income from the 245 Cold Soil property was never

received (or collected) from the tenants. We credit this testimony in the light of the

fact that Mallard’s books failed to report rental income from the 245 Cold Soil

property. We further credit the revenue agent’s testimony given that Mallard’s

books and records showed that petitioners (or Mallard) received rental income in

respect of DiDonato’s seven other rental properties. The record does not include

copies of canceled checks or bank account statements showing that rental income

was received for the 245 Cold Soil property, further leading us to conclude that

petitioners were not concerned with receiving the rental income of the 245 Cold Soil

property.

      Moreover, we are unpersuaded that petitioners ever meaningfully changed any

aspects of their rental activity of the 245 Cold Soil property with the primary

objective of making a profit. The annual expenses petitioners claimed for the 245

Cold Soil property, net of depreciation, exceeded the annual income earned from
                                        - 104 -

[*104] that property by $215,729 for 2003 and $211,973 for 2004.38 Simply for

petitioners to break even during the subject years, a tenant residing in the 245 Cold

Soil property would have to have paid monthly rent of roughly $18,777 for 2003 and

$18,464 for 2004, significantly greater than the $400 per month charged to Mr.

Richen (or his successor).39 No explanation was provided at trial as to the grossly

disproportionate charge of income to expense or how (if at all) petitioners intended

to ultimately profit from the 245 Cold Soil property. This factor disfavors a finding

that a profit objective existed.

                    b.     Petitioners’ Expertise in the Rental Real Estate Activity

      We next consider the level of expertise of petitioners or their advisers with

respect to the rental of the 245 Cold Soil property. Extensive study of accepted

business practices within a given activity or a willingness to consult with experts

therein may connote the existence of a profit objective. Sec. 1.183-2(b)(2), Income

Tax Regs. Where taxpayers have made such preparation or procured such expert

advice but do not carry on the activity in accordance with such practices, a lack of



       38
       Calculated as total Schedule E expenses for the 245 Cold Soil property
($244,215 for 2003 and $248,214 for 2004), less depreciation expense ($18,886 for
2003 and $26,641 for 2004), less rental income ($9,600 for 2003 and 2004).
       39
        Calculated as total Schedule E expenses for the 245 Cold Soil property, net
of depreciation ($225,329 for 2003 and $221,573 for 2004) divided by 12 months.
                                        - 105 -

[*105] intent to derive profit may be indicated unless it appears that the taxpayers

are aiming to develop a new or superior technique which may result in profits from

the activity. Id.

       Although we agree with petitioners that DiDonato possessed the requisite

expertise in real estate management to indicate a profit objective, we are unwilling to

find that the rental real estate activity at the 245 Cold Soil property showed a bona

fide profit objective. DiDonato incurred expenses for the 245 Cold Soil property, net

of depreciation expense, of almost $450,000 for the subject years on an investment

that yielded him a mere $19,200 of rental income for the same years. Finally, we

question DiDonato’s motivation for substantially improving the grounds of the 245

Cold Soil property. As DiDonato testified on direct examination, he did not incur

these expenses to make his rental real estate activity more profitable but “to maintain

the reduced farmland/agricultural property tax assessment.” We treat this testimony

as direct evidence of his desire to obtain favorable tax treatment and not to make

profitable the 245 Cold Soil property rental real estate activity. This factor weighs

against finding a profit objective.

                    c.     The Time and Efforts Expended by Petitioners

       The taxpayers’ dedication of much time and effort to carrying on an activity

may indicate a profit objective. Sec. 1.183-2(b)(3), Income Tax Regs. Although
                                         - 106 -

[*106] DiDonato claimed at trial to have devoted between 60% and 70% of his time

to his real estate activities, we decline to credit this testimony for a few reasons.

First, DiDonato rented the 245 and 265 Cold Soil properties and nine commercial

rental buildings only to ASC, his father, Mr. Richen, or another individual

throughout the subject years. Second, DiDonato’s testimony concerning the amount

of time he spent managing his rental properties was inconsistent. In this regard,

DiDonato contradicted his testimony about the amount of time devoted to his rental

real estate activities when he testified to “immense responsibilities” at ASC and that

he “tr[ies] to be there Monday through Friday.” DiDonato went on to contradict

himself by later testifying that ASC “pretty much runs itself” and that he spends

“maybe five percent” of his time at ASC and that he spends the rest of his time (i.e.,

roughly 95% of his time) managing real estate. We do not credit DiDonato’s

conflicted testimony in the absence of documentary evidence to support the

amount of time he claims to have spent managing his rental real estate activity. The

record does not include a logbook, a diary, a planner, or other reliable evidence

from which we might deduce the hours he actually spent on his rental real

estate activity. In view of the fact that most of DiDonato’s rental real estate

activities occurred between related entities or parties, we conclude he did not
                                         - 107 -

[*107] expend as much time and effort on his rental real estate activities as he claims

to have done. This factor weighs against the finding of a profit objective.

                    d.     Expectation of the 245 Cold Soil Property’s
                           Appreciation in Value

      For purposes of section 183, the term “profit” encompasses appreciation in the

value of assets, such as land, used in the activity. Sec. 1.183-2(b)(4), Income Tax

Regs. Even if no profit is derived from the current operation of the activity, the

taxpayers may intend that an overall profit will result when appreciation in the value

of the asset used in the activity is realized because income from the activity together

with the appreciation of the asset will exceed expenses of operation. Id.

      Petitioners presented no specific evidence regarding the likelihood of any

appreciation in value of the 245 Cold Soil property or how DiDonato intended to

recoup losses related to that property. DiDonato sold development rights to Mercer

County with respect to the 245 Cold Soil property, see DiDonato v. Commissioner,

101 T.C.M. (CCH) at 1739-1741, he declined offers from real estate developers to

sell the property, and he erected barns, chicken coops, and fences on the land. The

weight of this evidence suggests to us that DiDonato did not hold the 245 Cold Soil

property for appreciation but for personal reasons lacking a profit objective. This

factor disfavors our finding a profit objective.
                                          - 108 -

[*108]               e.     Petitioners’ Success in Carrying On Similar Activities

       We next examine petitioners’ success in carrying on other similar activities.

The taxpayers’ success in similar activities may indicate the taxpayers had a profit

objective even though the current activity is not presently profitable. Sec. 1.183-

2(b)(5), Income Tax Regs. DiDonato had previously worked with rental real estate

properties, but he has not shown the profitability or success of his endeavors with

reliable evidence. DiDonato testified that he first got involved with rental properties

at the age of 18 and that since that time he has purchased, sold, owned, managed, or

mortgaged at least 75 commercial and residential rental properties in Mercer County.

Petitioners did not offer any evidence to corroborate DiDonato’s testimony, and we

decline to accept it given the fact that the 2003 and 2004 returns reported the extent

of his rental real estate activities as pertaining to only nine rental properties. As far

as the record is concerned, DiDonato appears to be a successful optometrist who has

limited experience in the rental real estate market by virtue of his leasing rental

properties to entities he owned and operated. We question DiDonato’s claim to have

had success in his rental real estate activities given that the only reliable history in

that respect concerns his renting each of nine rental properties to ASC, his father, or

Mr. Richen (or another individual). This factor is neutral at best.
                                         - 109 -

[*109]              f.     Petitioners’ History of Income and Loss

      We next examine petitioners’ history of income and loss with respect to the

rental real estate activity. A series of substantial losses may indicate the taxpayer did

not conduct the activity for profit. Golanty v. Commissioner, 72 T.C. 411, 427

(1979), aff’d without published opinion, 647 F.2d 170 (9th Cir. 1981); sec. 1.183-

2(b)(6), Income Tax Regs. Losses during the initial stage of an activity do not

necessarily indicate, however, that the activity was not conducted for profit. Engdahl

v. Commissioner, 72 T.C. 659, 669 (1980); sec. 1.183-2(b)(6), Income Tax Regs.

      Petitioners reported sizable losses with respect to the 245 Cold Soil property

for each of the subject years. They offered no evidence that the rental activity for the

245 Cold Soil property became profitable in later years or that they sold the property

for a gain. At the same time, DiDonato rebuffed inquiries from real estate

developers about the sale of the 245 Cold Soil property. This factor weighs against

the finding of a profit objective.

                    g.     The Amount of Occasional Profits

      The amount of profits earned in relation to the amount of losses incurred, the

amount of the investment, and the value of the assets in use may indicate a profit

objective. Sec. 1.183-2(b)(7), Income Tax Regs. The opportunity to earn
                                        - 110 -

[*110] substantial profits in a highly speculative venture may be sufficient to indicate

that the activity is engaged in for profit even though only losses are produced. Id. In

determining whether the taxpayers entered into the activity for profit, a small chance

of making a large profit may indicate the requisite profit objective. Id.

      Petitioners presented no evidence that their investment in the 245 Cold Soil

property might create a windfall profit to them apart from tax savings. Although real

estate developers may have sought out the 245 Cold Soil property, among others,

DiDonato was then unwilling to discuss the sale of that property. The record does

not include evidence to suggest petitioners might earn a profit from the sale of the

245 Cold Soil property. In the absence of such information, we conclude it does not

exist or it would not be favorable to petitioners’ position. Accord Wichita Terminal

Elevator Co. v. Commissioner, 6 T.C. at 1165 (“The rule is well established that the

failure of a party to introduce evidence within his possession and which, if true,

would be favorable to him, gives rise to the presumption that if produced it would be

unfavorable.”). This factor does not favor a finding of a profit objective.
                                         - 111 -

[*111]              h.     Petitioners’ Financial Status

      The fact that taxpayers do not have considerable income from sources other

than the activity may indicate the activity is engaged in for profit. See sec. 1.183-

2(b)(8), Income Tax Regs. Substantial income from other sources may indicate a

lack of a profit objective, however, particularly if there are personal or recreational

elements in the activity. Id.

      Petitioners reported sizable total income for each of the subject years; they

reported receiving $237,196 for 2003 and $222,279 for 2004. Because petitioners

aggregated their rental income and expenses on Schedules E, they were able to

claim losses from their activity at the 245 Cold Soil property to offset rental income

that they (or Mallard) received from ASC for the commercial rental properties.

Indeed, the losses from the 245 and 265 Cold Soil properties, net of depreciation,

would have enabled petitioners to offset all rental income they (or Mallard)

received from ASC. The considerable tax savings petitioners claimed from

structuring their investment in the 245 Cold Soil property to offset gains from other

rental real estate activities undercuts the claim that petitioners engaged in the

activity with an intent to profit without regard for tax savings.40 See Seaman v.

         40
       Petitioners’ farming activity, as it related to the personal residence and the
245 and 265 Cold Soil properties, also enabled them to reduce their local property
                                                                          (continued...)
                                         - 112 -

[*112] Commissioner, 84 T.C. at 588; see, e.g., Smith v. Commissioner, T.C.

Memo. 2007-154, 93 T.C.M. (CCH) 1371, 1376 (2007) (using losses to offset

income weighs in favor of finding the taxpayer was not engaged in an activity for

profit); Kahla v. Commissioner, T.C. Memo. 2000-127, 79 T.C.M. (CCH) 1846,

1852 (2000), aff’d without published opinion, 273 F.3d 1096 (5th Cir. 2001). This

factor weighs against the finding of a profit objective.

                    i.     Elements of Personal Pleasure

      The existence of elements of personal pleasure or recreation relating to the

activity may indicate the absence of a profit objective. Sec. 1 .183-2(b)(9), Income

Tax Regs. An activity will not be treated as not engaged in for profit simply because

the taxpayers have purposes or motivations other than making a profit. Id. The

record does not suggest that petitioners derived any satisfaction from the rental




      40
        (...continued)
taxes by hundreds of thousands of dollars. On this point DiDonato testified that his
failure to secure farm and agricultural designation of these properties for assessment
purposes would result in the “county government * * * confiscating his property.”
He went on to explain that “two-hundred [sic] fifty acres assessed at market value,
I’d have a tax bill of $750,000 a year plus rollback taxes. You can’t do it. Nobody
in New Jersey has acreage more than five acres without getting a farm assessment.
To get a farm assessment, you have to sell agricultural products. Everybody in New
Jersey sells agricultural products.” We reject the suggestion that manipulating local
property tax law creates an actual and honest profit objective for Federal income tax
purposes.
                                         - 113 -

[*113] of the 245 Cold Soil property apart from the Federal income tax and local

property tax savings they expected to realize therefrom. We view this factor as

neutral.

                    j.     Summary

      On balance, one factor weighs in favor of a profit objective, one factor is

neutral, and eight weigh against a finding of a profit objective. We conclude

petitioners’s rental real estate activity with respect to the 245 Cold Soil property was

not entered into with an actual or honest objective of making a profit. Thus,

petitioners may not deduct expenses for the 245 Cold Soil property under section

162(a) or 212. Petitioners are, however, entitled to deductions under section 183(b)

with respect to the 245 Cold Soil property as follows. First, petitioners are allowed

deductions for expenses that are deductible without regard to whether the rental real

estate activity was engaged in for profit; specifically, real estate taxes of $5,590 for

2003 and $5,853 for 2004. See secs. 164(a)(1), 183(b)(1); Brannen v.

Commissioner, 78 T.C. 471, 499-500 (1982), aff’d, 722 F.2d 695 (11th Cir. 1984).

Second, petitioners are allowed deductions for expenses that would be deductible if

the rental real estate activity was engaged in for profit, but only to the extent of gross

receipts from the activity; namely $9,600 for each of the subject years. See sec.

183(b)(2). Because the 245 Cold Soil property was not a qualified residence
                                        - 114 -

[*114] of petitioners under section 163(h)(4)(A)(i), they are not entitled to mortgage

interest deductions over and above that already allowed under section 183(b)(2).

See Epstein v. Commissioner, 67 T.C.M. (CCH) at 2049 n.4.

VII. Equipment Leasing’s Losses and Recapture of Excess Depreciation

      A.      Overview

      Petitioners claimed loss deductions that flowed through from Equipment

Leasing’s aircraft leasing activity of $694 for 2003 and $19,964 for 2004.

Petitioners took the reporting position on their 1999 through 2003 returns that the

aircraft was predominantly used in a qualified business use. Consistent with that

position, petitioners claimed accelerated depreciation expense deductions totaling

$278,950 on Schedules C attached to the 1999 through 2002 returns. Petitioners

also took the position that the aircraft was predominantly used in a qualified business

use during 2003. Consistent therewith, they claimed accelerated depreciation

expense deductions of $43,200 and $21,600 on Equipment Leasing’s Schedules C

attached to their 2003 and 2004 returns, respectively. On brief, petitioners assert

that they are entitled to an accelerated depreciation expense deduction for each of the

years 1999 through 2004 because the aircraft share was used in a qualified business

use more than 50% of the time.
                                        - 115 -

[*115] Respondent challenges petitioners’ entitlement to loss deductions from

Equipment Leasing’s aircraft leasing activity for 2003 and 2004, and he alleges

through an amended answer that petitioners must recapture in 2003 excess

depreciation claimed for 1999 through 2002. We agree with respondent on both

points.

      B.      Burden of Proof

      Petitioners generally bear the burden of proving their entitlement to the aircraft

leasing activity loss deductions claimed for 2003 and 2004. See Rule 142(a).

Respondent concedes on brief that he must prove that petitioners must recapture for

2003 excess depreciation claimed for 1999 through 2002. See id.

      C.      Loss Deductions Claimed for 2003 and 2004

      Respondent disallowed loss deductions of $694 for 2003 and $19,964 for

2004 with respect to Equipment Leasing’s aircraft leasing activity. Respondent

concedes on brief that petitioners are entitled to claim items of income and expense

as reported on the Schedules C for Equipment Leasing attached to the 2003 and

2004 returns, but respondent maintains that petitioners must depreciate the aircraft

using the alternative depreciation system of section 168(g) and recapture in 2003

excess depreciation claimed on their 1999 through 2002 Federal income tax

returns. On the basis of respondent’s concession, Equipment Leasing’s net profit
                                        - 116 -

[*116] or loss for the subject years shall be calculated as reported on the 2003 and

2004 returns, except as modified immediately below.

      D.       Recapture of Excess Depreciation

      Respondent alleges in his amended answer that petitioners did not use the

aircraft share in a qualified business use during 2003 for two reasons. First, he

asserts that the aircraft share was not predominantly used in a qualified business use

under section 280F because Equipment Leasing and ASC were related parties. See

sec. 280F(d)(6)(C)(i). Second, he contends that less than 25% of the total use of the

aircraft share consisted of a qualified business use that was not between related

parties. See id. Respondent argues that because the aircraft share was not used in a

qualified business use during 2003, petitioners are not entitled to claim an

accelerated depreciation expense deduction for 2003 but must use the straight-line

depreciation method. See secs. 168(g)(1), 280F(b)(1). Respondent further contends

that petitioners must recapture for 2003 the excess depreciation claimed for 1999

through 2002. See sec. 280F(b)(2). Petitioners maintain that they used the aircraft

share for a qualified business use more than 50% of the time. We agree with

respondent.

      Depreciation deductions are principally governed by sections 167 and 168.

Section 167(a) allows as a depreciation deduction a reasonable allowance for the
                                        - 117 -

[*117] exhaustion, wear, and tear (including a reasonable allowance for

obsolescence) of property used in a trade or business or held for the production of

income. Section 168(a) specifies that the amount allowed as a depreciation

deduction under section 167(a) is determined by using the applicable depreciation

method, the applicable recovery period, and the applicable convention. As relevant

to the aircraft share at issue here, the applicable depreciation method is generally the

200% declining balance method, switching to the straight line method for the first

taxable year in which the straight line method yields a larger allowance than the

200% double declining balance method. Sec. 168(b)(1).

      Section 280F may limit the allowable depreciation deduction where listed

property, including property used for transportation, is not predominantly used in a

qualified business use. See sec. 280F(b)(1), (d)(4)(A)(ii); sec. 1.280F-6(b), Income

Tax Regs. (recognizing airplanes as transportation). As a general rule, where any

listed property is not predominantly used in a qualified business use for the taxable

year, the general depreciation method of section 168(b)(1) (i.e., double declining

switching to straight line, is not used). See sec. 280F(b)(1). Rather, the alternative

depreciation system of section 168(g) (i.e., the straight-line method) is used to

compute the allowable depreciation deduction. See secs. 280F(b)(1), 168(g)(1) and

(2). Moreover, where the qualified business use of any listed property falls to 50%
                                        - 118 -

[*118] or less, the taxpayer is required to include in gross income (recapture) for the

taxable year in which the property is first not predominantly used in a qualified

business use. See sec. 280F(b)(2)(A). The term “excess depreciation” means the

excess, if any, of (1) the amount of depreciation deductions allowed when the

property was predominantly used in a qualified business use, over (2) the amount of

depreciation deductions allowed when the property was not predominantly used in a

qualified business use. Sec. 280F(b)(2)(B).

      Property is treated as predominantly used in a qualified business use if the

business use for the year exceeds 50%. Sec. 280F(b)(3). The term “qualified

business use” generally means any use in the taxpayer’s trade or business. Sec.

280F(d)(6)(B). Qualified business use does not, however, include leasing property

to a 5% owner or a related person. Sec. 280F(d)(6)(C)(i). Where an aircraft is at

issue, however, qualified business use still includes leasing property to any 5%

owner or related person so long as at least 25% of the total use of the aircraft during

the year consists of qualified business use that is not excluded under section

280F(d)(6)(C)(ii). See sec. 1.280F-6(d)(2)(ii), Income Tax Regs. A 5% owner

not a corporation is any person who owns more than 5% of the capital or profits

interest in the entity. See secs. 280F(d)(6)(D)(i), 416(i)(1)(B)(i). Related persons

include, among other relationships, an individual and a corporation where the
                                        - 119 -

[*119] individual controls more than 50% of the value of the corporation’s stock.

See secs. 280F(d)(6)(D)(ii), 267(b)(2). The aircraft share was owned by Equipment

Leasing, an LLC of which DiDonato is the only member. Equipment Leasing leased

the aircraft to ASC, an S corporation that is wholly owned by DiDonato. Thus, we

conclude that Equipment Leasing and ASC are related persons as two corporations

which are members of the same controlled group under section 267(b)(3) and are

therefore related for purposes of section 280F(d)(6)(D)(ii) and (c)(i)(I).

      As set out by Tech. Adv. Mem. 200945037 (July 29, 2009), whether a

taxpayer has used the aircraft for a qualified business use more than 50% of the

time is generally a two-step analysis. The failure to satisfy both steps requires a

finding that the aircraft was not predominantly used in a qualified business and

therefore that the allowable depreciation deduction under section 168 is

determined under the alternative depreciation system of section 168(g). See sec.

280F(b)(1). Under step 1, we determine whether the qualified business use of the

aircraft satisfies the 25% threshold under section 280F(d)(6)(C)(ii), exclusive of

uses listed under section 280F(d)(6)(C)(i). If the 25% threshold is met, the

business uses excluded under section 280F(d)(6)(C)(i) may be taken into account as

qualified business use to determine whether more than 50% of the total use of the
                                         - 120 -

[*120] aircraft is qualified business use for purposes of section 280F(b)(1). If the

25% threshold under section 280F(d)(6)(ii) is met with regard to section

280F(d)(6)(C)(i), we proceed to step 2.

      Under step 2, business use excluded under section 280F(d)(6)(C)(i) may be

taken into account as qualified business use to determine whether more than 50% of

the total use of the aircraft is qualified business use for purposes of section

280F(b)(1). To the extent the taxpayer’s qualified business use of the aircraft

exceeds 50%, section 280F(b)(1) is satisfied, and the taxpayer may be entitled to

deduct depreciation under section 168(a), additional first-year deprecation (bonus

depreciation) under section 168(k)(1), and any deduction allowable under section

179. See also sec. 280F(b)(1), (d)(1), (6). To the extent the taxpayer’s qualified

business use of the aircraft is 50% or less, section 280F(b)(1) is not satisfied, and the

taxpayer must use the general depreciation method of section 168(b)(1) (i.e., double

declining switching to straight line). See sec. 280F(b)(1). Moreover, as explained

above, where the qualified business use of any listed property falls to 50% or less,

the taxpayer is required to include in gross income (recapture) for the taxable year in

which the property is first not predominantly used in a qualified business use. See

sec. 280F(b)(2)(A).
                                         - 121 -

[*121] Applying the foregoing test in the instant case, we conclude that petitioners

are not entitled to accelerated and bonus depreciation and that they must recapture

in 2003 excess depreciation claimed for 1999 through 2002. The aircraft was listed

property under section 280F(d)(4) because it was used for transportation. See sec.

280F(d)(4)(A)(ii); sec. 1.280F-6(b), Income Tax Regs. Under step 1 of the analysis

we examine whether the use of the aircraft meets the 25% threshold of section

280F(d)(6)(C)(ii). We conclude petitioners fail this step. All leasing of the aircraft

by Equipment Leasing during the subject years was to ASC, a related party under

sections 167(b)(3) and 280F(d)(6)(D)(ii) and (C)(i)(I). Also during the subject

years, Equipment Leasing did not lease the aircraft to an unrelated party.

Therefore, for each of the subject years, zero percent of the leasing was to an

unrelated person and Equipment Leasing fails the 25% threshold required under

section 280F(d)(6)(C)(ii). Because the 25% threshold of section 280F(d)(6)(C)(ii) is

not met for either of the subject years, petitioners are not entitled under section 168

to accelerated depreciation, see sec. 280F(b)(1), and are required for 2003 to

recapture excess depreciation claimed for 1999 through 2002, see sec. 280F(b)(2).

The amounts of the depreciation expense deductions for 2003 and 2004 and the

amount of excess depreciation required to be recaptured in 2003, as well as their
                                         - 122 -

[*122] effect on petitioners’ deficiencies for the subject years, shall be determined in

the parties’ Rule 155 computations.

VIII. Accuracy-Related Penalties

      A.       Overview

      Section 6662(a) and (b)(1), (2), and (3) provides that taxpayers are liable for a

20% accuracy-related penalty on the portion of any underpayment of income tax

attributable to, among other things, negligence or disregard of rules or regulations,

substantial understatements of income tax, or substantial valuation misstatements.

Only one accuracy-related penalty may be applied with respect to any portion of an

underpayment of tax, even if that portion resulted from more than one of the types of

misconduct described in section 6662. Sec. 1.6662-2, Income Tax Regs.

An accuracy-related penalty under section 6662 does not apply to any portion of an

underpayment of tax for which the taxpayer had (1) reasonable cause and acted in

good faith, see sec. 6664(c)(1), (2) substantial authority for the treatment of the items

at issue, see sec. 6662(d)(2)(B)(i), or (3) adequately disclosed in the return the

relevant facts affecting the item’s tax treatment and a reasonable basis for the

claimed treatment, see sec. 6662(d)(2)(B)(ii).

      Respondent determined petitioners are liable for the accuracy-related penalty

for a substantial understatement of income tax for each year at issue. See sec.
                                        - 123 -

[*123] 6662(a), (b)(2). Petitioners do not deny that the accuracy-related penalties

apply in accordance with their terms. Rather, petitioners argue they are not liable for

the accuracy-related penalties because, as they see it, there was substantial authority

for their positions, they disclosed the items at issue on the 2003 and 2004 returns,

and they qualify for the reasonable cause defense of section 6664(c) by relying in on

the advice of their tax professional. We will sustain respondent’s imposition of the

accuracy-related penalties.

      B.       Burden of Proof

      Respondent bears the burden of production with respect to the imposition of

the accuracy-related penalties in that he must produce sufficient evidence that it is

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

T.C. 438, 446 (2001). Respondent has satisfied his burden of production by showing

the understatement for each of the subject years exceeds the greater of 10% of the

tax required to be shown on the return and $5,000. See sec. 6662(d)(1)(A). Thus,

the burden of proof is upon petitioners to show they are not liable for the penalties

because of reasonable cause, substantial authority, or adequate disclosure grounded

in a reasonable basis.
                                         - 124 -

[*124] C.      Substantial Authority

      Petitioners argue that the accuracy-related penalties may not be imposed as to

the disallowed deductions because, as they see it, there was substantial authority for

the deductions claimed. We disagree.

      Where taxpayers have substantial authority for the tax treatment of any item

reported on a Federal tax return, the tax attributable to those items is not included in

deciding whether there was an understatement of tax. See sec. 1.6662-4(d)(1),

Income Tax Regs. Substantial authority for the treatment of an item exists only if the

weight of the authorities supporting the treatment of the item is substantial in relation

to the weight of authorities supporting contrary treatment. Sec. 1.6662-4(d)(3),

Income Tax Regs. The weight of the authorities is determined in the light of all

relevant facts and circumstances. Id. The substantial authority standard is an

objective standard involving an analysis of the law and application of the law to the

relevant facts. Sec. 1.6662-4(d)(2), Income Tax Regs.

      Petitioners maintain that there was substantial authority for the charitable

contribution deduction claimed on the 2004 return and disallowed in our prior

opinion in this case. We disagree. At the outset, petitioners appear to confuse

the grounds on which the charitable contribution deduction was disallowed.

Petitioners assert that there was substantial authority for the position that the
                                        - 125 -

[*125] appraisal attached to the 2004 return was a qualified appraisal pursuant to

section 1.170A-13(c)(3), Income Tax Regs. However, as explained in DiDonato v.

Commissioner, 101 T.C.M. (CCH) at 1742-1743, petitioners were denied a

charitable contribution deduction because they failed to secure a contemporaneous

written acknowledgment. In this regard, we held it was not possible for petitioners

to secure such an acknowledgment in 2004 because DiDonato’s obligation to

transfer the development rights remained conditional until at least December 2005.

Id. at 1743. Moreover, we expressed concern that the appraisal was not qualified,

see id. at 1741 n.8, but noted that respondent did not allege any defect in the

appraisal, see id. And contrary to petitioners’ contention, the requirement of section

170(f)(8) to obtain a contemporaneous written acknowledgment is not a mere

formality. Because petitioners have not pointed us to any authority allowing a

charitable contribution deduction for a conditional gift or for one which lacked a

contemporaneous written acknowledgment, we decline to conclude there was any

such authority when they filed the 2004 return.

      We are not persuaded there was substantial authority for any of the disputed

positions taken on the 2003 and 2004 returns. Contrary to petitioners’ claim, the

weight of the authorities establishes petitioners were not entitled to the deductions

claimed. Nor was there substantial authority for petitioners’ position that they
                                         - 126 -

[*126] could claim loss deductions for rental real estate activity where the dwelling

unit was rented to a member of the taxpayer’s family as in the case of the 265 Cold

Soil property, or that was not engaged in for profit, as in the case of the 245 Cold

Soil property. With respect to the accelerated depreciation recapture, we have

concluded that zero percent of the leasing of the aircraft was to an unrelated person

and that Equipment Leasing did not meet the 25% threshold required by section

280F(d)(6)(C)(ii), see supra p. 121; petitioners have not cited substantial authority

supporting the contrary. As to the remaining disputed deductions, petitioners have

not cited any authority, much less substantial authority, for the deductibility of items

that were inherently personal and not adequately substantiated.

      D.       Disclosure and Reasonable Basis

      Petitioners assert that the accuracy-related penalties may not be imposed as to

the charitable contribution deduction disallowed in DiDonato v. Commissioner, T.C.

Memo. 2011-153, because, they believe, they fully disclosed the facts regarding the

claimed contribution on the 2004 return. We disagree.

      Petitioners’ assertion that they adequately disclosed the facts relating to the

charitable contribution deduction is not supported by the record. As we explained in

DiDonato v. Commissioner, 101 T.C.M. (CCH) at 1742-1743, petitioners failed to

disclose that the contribution of the development rights was conditional until at
                                         - 127 -

[*127] least December 2005, and indeed, our own analysis required that we research

New Jersey law to understand the process for when a contribution becomes final.

Any claim that petitioners adequately disclosed the particulars of the transfer is

simply not supported by the record. Thus, we reject petitioners’ claim that they

adequately disclosed the facts relevant to the charitable contribution deduction.

Even if the disclosure were adequate, petitioners could not avail themselves of the

defense under section 6662(d)(2)(B)(ii) because they have failed to provide authority

that could provide a reasonable basis for their return position. See sec. 1.6662-

4(e)(2)(i), Income Tax Regs.; see also sec. 1.6662-3(b)(3), Income Tax Regs.

(“Reasonable basis is a relatively high standard of tax reporting, that is, significantly

higher than not frivolous or not patently improper. The reasonable basis standard is

not satisfied by a return position that is merely arguable or that is merely a colorable

claim.”).

      E.       Reasonable Cause

      Finally, petitioners maintain that they are not liable for the accuracy-related

penalties because they satisfy the reasonable cause defense of section 6664(c)(1).

As petitioners see it, DiDonato’s longstanding relationship with Amper and his lack

of formal education in accounting and tax matters entitles them to find a safe harbor

under the reasonable cause defense.
                                         - 128 -

[*128] Under section 6664(c)(1), the section 6662(a) accuracy-related penalty does

not apply to any portion of an underpayment for which the taxpayers establish that

they: (1) had reasonable cause and (2) acted in good faith. The taxpayers’ reliance

on the advice of a professional, such as an accountant, may constitute reasonable

cause and good faith where the taxpayers prove by a preponderance of the evidence

that: (1) the taxpayers reasonably believed that the professional upon whom the

reliance is placed is a competent tax adviser with sufficient expertise to justify

reliance; (2) the taxpayers provided necessary and accurate information to the

adviser; and (3) the taxpayers actually relied in good faith on the adviser’s judgment.

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98-99 (2000), aff’d, 299

F.3d 221 (3d Cir. 2002); see also sec. 1.6664-4(c)(1), Income Tax Regs. On the

basis of the record as a whole, we conclude petitioners have not satisfied the second

or third requirement.

      The record establishes that DiDonato did not actually rely on the advice he

received from Amper. The aircraft letter was clear that any personal use of the

aircraft would require that gross income be imputed to DiDonato. Petitioners did

not charge themselves gross income for the personal use of the aircraft by

themselves and their children. Moreover, the aircraft letter was procured from

Amper in 1999, but as far as the record is concerned, was never updated as to the
                                         - 129 -

[*129] relevant status of the law. We do not agree that it was reasonable under these

facts for petitioners to rely upon the opinion of an accounting firm almost five years

after the fact without receiving an update as to possible changes in the law and of

their use of the aircraft.

       Nor does the record establish that petitioners provided to their accountants

necessary and accurate information concerning the deductions claimed. In this

regard, Mr. Dougherty testified that Amper did not have in its possession the flight

logs relating to the plane and that the determination that the aircraft was used for a

qualified business use for depreciation purposes was made on the basis of

conversations with DiDonato. On the basis of those conversations, Mr. Dougherty

understood that DiDonato did not use the aircraft for personal purposes during the

subject years which, as the record establishes, was untrue. Mr. Dougherty also

testified that had he known that petitioners’ children were on board during the flights

purportedly flown for business purposes, Amper would not have advised DiDonato

to claim that the cost of the flights were deductible business expenses. Thus, in

addition to the lack of actual reliance on their accountant’s opinion, petitioners did

not provide accurate information on which the accountants could formulate an

opinion which might properly have been relied upon.
                                          - 130 -

[*130] As to the real estate opinion, we conclude that the opinion was not sufficient

for reliance to be placed on it. The real estate opinion contained numerous factual

errors. The real estate opinion concluded that DiDonato “will * * * be able to

depreciate the building and take all the related expenses.” The real estate opinion

never addresses which “building” is depreciable or which expenses are deductible.

The real estate opinion concluded, without supporting facts or legal analysis, that a

discount sale or an outright donation of development rights “will” yield a charitable

contribution deduction on DiDonato’s individual return. The real estate opinion does

not discuss the value of the transferred development rights, whether the donee was a

qualifying organization, or any other facts which would substantially guarantee

deductibility under section 170(a). Accordingly, we conclude that petitioners did not

rely on the advice of Amper. It follows that petitioners are liable for accuracy-

related penalties to the extent stated herein.

         The Court has considered all arguments for a contrary result and, to the extent

not discussed herein, we conclude those arguments are irrelevant, moot, or without

merit.
                                        - 131 -

[*131] To reflect the parties’ concessions and to give effect to the foregoing,


                                              Decision will be entered

                                           under Rule 155.
