                              T.C. Memo. 2018-40



                        UNITED STATES TAX COURT



       CHARLES BRUMBAUGH AND C.E. HOLIFIELD, Petitioners v.
         COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 9161-14.                         Filed April 3, 2018.



      Ronald A. Hughes, Michael R. Morris, and Mayer Nazarian, for petitioners.

      Kris H. An and Jordan S. Musen, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      LAUBER, Judge: With respect to petitioners’ Federal income tax for 2007

the Internal Revenue Service (IRS or respondent) determined a deficiency of

$152,602 and an accuracy-related penalty of $30,520. The deficiency stems from

the disallowance of a $348,347 flow-through loss deduction that petitioners

claimed on their Schedule E, Supplemental Income and Loss, and of a $163,915
                                         -2-

[*2] mortgage interest expense deduction that they claimed on their Schedule C,

Profit or Loss From Business.

      In a previous opinion filed April 6, 2015, we held that we lack jurisdiction

in this proceeding to review the disallowance of the claimed interest expense

deduction, a TEFRA partnership-level item. See Brumbaugh v. Commissioner,

T.C. Memo. 2015-65. Before trial the parties stipulated that petitioner C.E.

Holifield is entitled to relief under section 6015(c)1 from joint and several liability

for 2007 and that she is not entitled to any refund for that year. The issues left for

decision are: (1) whether petitioners’ claimed flow-through loss deduction is sub-

ject to the passive activity loss restrictions of section 469 and (2) whether petition-

er husband is liable for an accuracy-related penalty. We resolve both issues in

respondent’s favor.

                                FINDINGS OF FACT

      The parties filed a stipulation of facts with accompanying exhibits and a

stipulation of settled issues, both of which are incorporated by this reference. At

the time they filed their petition, petitioners were married and lived in California.

They have since divorced.

      1
        All statutory references are to the Internal Revenue Code (Code) in effect at
all relevant times, and all Rule references are to the Tax Court Rules of Practice
and Procedure. We round all monetary amounts to the nearest dollar.
                                        -3-

[*3] Charles Brumbaugh (petitioner) is a real estate developer who began his

career as an urban planner. In 1995, after obtaining a law degree, he entered the

real estate development business. Through numerous closely held entities, he

specialized in the development of affordable housing projects. Until 2005 he con-

ducted these activities mainly in the greater Los Angeles area.

      In early 2005 petitioner purchased, through one of his affiliates, a large pro-

perty in Oakley, California. This property is northeast of Oakland on the way to

Sacramento. Petitioner entered into a partnership with the Corporation for Better

Housing (CBH), a section 501(c)(3) organization, to develop the Oakley property

into a multi-unit housing project with units for families and senior citizens. Peti-

tioner had previously partnered with CBH to develop other properties.

      One of the entities petitioner used to purchase and develop real estate was

BLH Construction, Inc. (BLH), a C corporation. During 2007 the stock of BLH

was owned as follows: 60% by petitioner, 30% by Benjamin Lingo, and 10% by

Brian Holland. Petitioner’s primary responsibilities at BLH involved general busi-

ness logistics, while Mr. Lingo and Mr. Holland focused on project financing and

construction, respectively. In 2007 petitioner devoted substantially more than 500

hours to BLH’s activities.
                                         -4-

[*4] Headquartered in Bakersfield, California, BLH does construction work for

properties developed by petitioner’s other real estate entities. Most of its projects

involved affordable housing units. Petitioner used BLH to perform construction

activity on the Oakley property and other properties in northern California.

      Before 2006 petitioner, Mr. Lingo, and Mr. Holland typically traveled to

Oakley by taking a commercial flight to Oakland airport and then driving about 52

miles to the project site. To reduce travel time, BLH began chartering aircraft to

fly into smaller airports closer to Oakley and other sites in northern California.

Sometime in 2006 petitioner discussed with Mr. Lingo the possibility that BLH

might itself purchase an aircraft to transport BLH employees to these project sites.

Mr. Lingo demurred to this suggestion because he did not wish BLH to incur the

financial obligations of owning an aircraft.

      Petitioner accordingly decided to purchase an aircraft himself. In February

2006 he formed N444SS, LLC (N444SS), a California entity that has been treated

at all times as a partnership for Federal income tax purposes. Petitioner owned a

51% membership interest in N444SS, and Ms. Holifield owned a 49% member-

ship interest. Sometime in mid-2006 N444SS purchased a Beechcraft Premier I jet

aircraft (Premier jet).
                                          -5-

[*5] On August 29, 2006, N444SS entered into a management agreement with

KMR Aviation, Inc. (KMR). Operating out of Ontario Airport near Los Angeles,

KMR provides aircraft management and chartering services. The contract stipulat-

ed that KMR was to be responsible for all managerial duties related to the Premier

jet and gave KMR the exclusive right to charter the aircraft for commercial flights

by third parties whenever petitioner was not using it. KMR’s responsibilities in-

cluded: (1) registering the aircraft; (2) performing any work necessary to retain

FAA certification; (3) providing and paying flight crews; (4) performing all neces-

sary aircraft maintenance; and (5) creating flight logs for all flights. The agree-

ment required N444SS to reimburse KMR for all expenses attributable to the air-

craft.

         KMR set rates for chartering the Premier jet to third-party clients and was

responsible for billing and collecting fees from clients. It then credited N444SS’

account for payments it received (less service charges). KMR chartered the Prem-

ier jet on a first-come, first-served basis; N444SS had no priority over other KMR

customers for scheduling its use. If petitioner needed an aircraft when his Premier

jet was chartered to another party, he had access to any other aircraft that KMR

managed. If he chartered another KMR-managed aircraft, he received an “owner’s

discount” in the form of a lower hourly rate.
                                        -6-

[*6]    During 2007 KMR chartered the Premier jet to third-party customers on 66

occasions. BLH used the aircraft only once during that year. On that occasion,

BLH paid KMR the applicable charter fee, and KMR credited N444SS’ account

with that fee (less service charges). On four other occasions, when KMR had

chartered the Premier jet to third parties, BLH chartered another KMR-managed

aircraft. Mr. Holland and Mr. Lingo accompanied petitioner on some of these

flights, but they also traveled to Northern California via commercial flights to

Oakland airport.

        In June 2007 the Premier jet manifested a problem with peeling paint that

grounded the aircraft. For this and other reasons petitioner decided to buy a more

expensive jet. On July 31, 2007, through a complex like-kind exchange, N444SS

acquired a Gulfstream G-IV jet aircraft (Gulfstream jet). N444SS then entered in-

to a management agreement with a different aircraft chartering company, World-

wide Jet Management Corp. (Worldwide). Worldwide thereby assumed for the

Gulfstream jet management responsibilities similar to those which KMR had as-

sumed for the Premier jet. The FAA did not issue an airworthiness certificate for

the Gulfstream jet until February 2008, and there is no evidence that petitioner or

any other BLH employee used the Gulfstream jet for business purposes during

2007.
                                         -7-

[*7] Petitioner prepared and timely filed for N444SS a Form 1065, U.S. Return

of Partnership Income, for 2007. On that return N444SS reported an ordinary loss

of $683,034 from its aircraft chartering activities. Petitioners filed Form 1040,

U.S. Individual Income Tax Return, for 2007, on which they claimed petitioner’s

51% share of the flow-through loss, or $348,347, as a nonpassive loss deduction

on Schedule E.

      The IRS selected petitioners’ 2007 return for examination and recharacter-

ized this loss as a passive loss, determining that petitioner had not materially parti-

cipated in N444SS’ activities. The IRS also determined an accuracy-related penal-

ty under section 6662(a). It subsequently issued petitioners a timely notice of de-

ficiency setting forth these adjustments, and they timely petitioned this Court for

redetermination.

                                      OPINION

      The IRS’ determinations in a notice of deficiency are generally presumed

correct, and the taxpayer bears the burden of proving them erroneous. Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). Deductions are a matter of

legislative grace; the taxpayer bears the burden of proving entitlement to deduc-

tions allowed by the Code and of substantiating the amounts of claimed deduc-

tions. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); sec. 1.6001-1(a),
                                        -8-

[*8] Income Tax Regs. In certain circumstances the burden of proof on factual

issues may shift to respondent. See sec. 7491(a). Petitioners have not provided

“credible evidence” on the relevant factual issues, and they have not maintained

all records required by the Code. See id. paras. (1), (2)(B). The burden of proof

thus remains on them.

I.    Deductibility of Flow-through Loss

      Individual taxpayers may generally deduct, under sections 162 and 212 re-

spectively, ordinary and necessary expenses paid or incurred in carrying on a trade

or business or for the production of income. But the Code disallows any current

deduction for a “passive activity” loss. Sec. 469(a)(1), (b). Congress designed

section 469 to prevent taxpayers from reducing nonpassive income by losses at-

tributable to passive activities. See Hillman v. Commissioner, 118 T.C. 323, 329

(2002). A “passive activity loss” is the amount (if any) by which the aggregate

losses from the taxpayer’s passive activities exceed the aggregate income from

passive activities. Sec. 469(d)(1).

      Passive losses cannot be used to offset income from nonpassive activities,

such as wage income. See Krukowski v. Commissioner, 279 F.3d 547, 549 (7th

Cir. 2002), aff’g 114 T.C. 366 (2000). A disallowed passive activity loss is not

lost; rather, it is deferred or suspended and remains available as a deduction
                                          -9-

[*9] against future passive income. Sec. 469(b). A passive activity is an activity

involving the conduct of a trade or business in which the taxpayer does not “ma-

terially participate.” Sec. 469(c). Participation in an activity is “material” if it is

regular, continuous, and substantial. Sec. 469(h). Regulations under section 469

provide various tests to determine whether the taxpayer materially participated in

an activity.2

       A.       Grouping

       The focus of the parties’ disagreement is whether petitioner “materially par-

ticipated” in the aircraft chartering activity in which N444SS engaged. Petition-

er’s threshold contention is that N444SS’ activity should be grouped with BLH’s

real estate activity for purposes of testing whether he “materially participated.”

       Section 469 does not define “activity.” See Schwalbach v. Commissioner,

111 T.C. 215, 223 (1998). However, the Secretary has promulgated a regulation

that allows certain activities to be grouped together and treated as a single activity

       2
        The parties have debated whether N444SS’ aircraft chartering activity
should be considered a “rental activity.” See sec. 469(c)(2) (providing generally
that “the term ‘passive activity’ includes any rental activity” regardless of whether
the taxpayer materially participates); sec. 1.469-4(d)(1), Income Tax Regs. (limit-
ing the circumstances under which a “rental activity” may be grouped with a
“trade or business activity”). Because we conclude for other reasons that petition-
er’s flow-through loss from N444SS was a passive loss, we need not decide this
question. For purposes of our analysis we will assume arguendo that the aircraft
chartering activity was a “trade or business activity.”
                                        - 10 -

[*10] for purposes of the “material participation” test. See sec. 1.469-4(c), Income

Tax Regs. This regulation provides that one or more business activities “may be

treated as a single activity if the activities constitute an appropriate economic unit

for the measurement of gain or loss for purposes of section 469.” Ibid.

      Whether activities constitute an “appropriate economic unit” involves a

“facts and circumstances” test. See sec. 1.469-4(c)(2), Income Tax Regs. The fol-

lowing factors “are given the greatest weight” in making this determination:

(1) similarities and differences between the two businesses; (2) the extent of com-

mon control; (3) the extent of common ownership; (4) geographic location of the

business activities; and (5) interdependencies between or among the activities.

Ibid. “Interdependencies” exist (for example) where the two businesses have sub-

stantial transactions between them, sell products or services that are normally pro-

vided together, have the same customers, have the same employees, or have a

single set of books and accounting records. Ibid.

      We find that none of these factors favors grouping the activities of N444SS

with those of BLH. First, in functional terms, the two businesses have no similari-

ties whatever. BLH is engaged in real estate construction. N444SS’ sole activity

during 2007 was to charter aircraft through KMR, and virtually all of the charters

(66 out of 67) were made to third parties unrelated to BLH.
                                        - 11 -

[*11] We confronted a similar situation in Williams v. Commissioner, T.C.

Memo. 2014-158, 108 T.C.M. (CCH) 128. The taxpayer there, an employee of his

father’s telephone sales training business, chartered airplanes to travel to custom-

ers’ locations instead of taking commercial flights to avoid “the notorious pat

downs and searches * * * and lost baggage with the airlines.” Id. at 129. After

acquiring the business (a sole proprietorship) from his father, the taxpayer caused

it to purchase an airplane and enter into agreements with flight schools to generate

revenue when he was not using the plane. Ibid.

      The flight schools rented out the aircraft for flight lessons and remitted a

portion of the proceeds to the taxpayer. Id. at 130. The flight schools performed

all maintenance on the aircraft, collected rental fees, marketed the aircraft, and

scheduled trainings. Ibid. The taxpayer had no priority to use the aircraft, so that

he had to rent other planes when the flight schools were using his. Id. at 130. We

held that the taxpayer could not group the telephone sales training activity with the

airplane activity for purposes of determining his “material participation” in the lat-

ter. Id. at 131. We based this holding chiefly on the lack of similarities between

the two businesses and the absence of interdependence between them. Id. at 132.

      As in Williams, there is no functional similarity here between the business

of chartering airplanes and the business of developing real estate. N444SS entered
                                        - 12 -

[*12] into a management agreement with KMR to generate revenue from third-

party charters so as to reduce petitioner’s net cost of owning the aircraft. The

aircraft was not integrated into BLH’s business in any way. Indeed, BLH’s

employees during 2007 flew on the Premier jet only once, and the Gulfstream jet

was not available for their use at all. The first factor thus weighs heavily against

grouping.

      The second and third factors--the extent of common ownership and control--

are neutral. Petitioner held controlling interests in BLH (60%) and N444SS

(51%). But the ownership interests were quite different: Ms. Holifield held the

other 49% of N444SS, whereas Messrs. Lingo and Holland held the other 40% of

BLH. And it is significant that Mr. Lingo, who held 30% of BLH, made clear that

he wanted nothing to do with owning an aircraft.

      The fourth factor, which focuses on “geographic location,” weighs against

petitioner. The nerve center of N444SS’ operations was at Ontario Airport, where

KMR was headquartered. All chartering, maintenance, and day-to-day manage-

ment activities with respect to the Premier jet occurred there. By contrast, BHL

had its main office in Bakersfield and jobsites throughout California.

       The fifth factor, which considers “interdependencies” between the two bus-

inesses, weighs heavily against petitioner. The business activities of BLH and
                                        - 13 -

[*13] N444SS were completely distinct. They did not serve the same customers;

they did not share any employees; they used separate books and records to track

each entity’s financial results; there were no meaningful transactions between

them; and they did not offer “products or services that are normally provided

together.” Sec. 1.469-4(c)(2), Income Tax Regs. (final sentence). There was no

integration or synergy of any sort between the two businesses.

      Petitioner asserts that he purchased the Premier jet to reduce the amount of

time BLH employees spent traveling to Northern California jobsites. But BLH

chartered the Premier jet only once during 2007 whereas KMR chartered the air-

craft 66 times to unrelated parties. This disparity by itself shows the lack of inte-

gration between the aircraft chartering business and the real estate business.

      Petitioner notes that BLH chartered KMR-managed jets on four occasions

when the Premier jet was chartered to other KMR clients. But we fail to see how

this helps petitioner’s case. The ease with which BLH could charter other aircraft

at Ontario Airport underscores the absence of synergy between N444SS’ business

and its own. Assuming arguendo that BLH needed chartered aircraft to run its

business efficiently--a dubious proposition, given that its employees could (and
                                         - 14 -

[*14] often did) fly commercially to Northern California through Oakland--BLH

was perfectly capable of satisfying that need without assistance from N444SS.3

       In sum, the factors set forth in the regulations, as applied to the facts of this

case, establish that BLH’s real estate business and N444SS’ aircraft chartering

business should not “be treated as a single activity” because they do not “consti-

tute an appropriate economic unit.” Sec. 1.469-4(c)(1), Income Tax Regs. Here,

as in Williams, the aircraft chartering activity was designed to generate revenue

and thus reduce the taxpayer’s cost of owning a private jet, not to benefit the tax-

payer’s principal business in any meaningful way. We accordingly conclude that

N444SS’ aircraft chartering activity may not be grouped with BLH’s real estate

activity for purposes of determining whether petitioner “materially participated” in

the former.




      3
        The KMR management agreement, which gave petitioner no priority in
scheduling use of the Premier jet, underscores the lack of synergy between
N444SS’ business and BLH’s business. Petitioner notes that, by owning a jet
managed by KMR, he became entitled to an “owner’s discount” when BLH chart-
ered another KMR-managed jet. This discount took the form of a 10% to 15%
reduction in the hourly rate for flight time. This discount does not give rise to a
meaningful “interdependence” between BLH’s real estate business and N444SS’
aircraft chartering business.
                                          - 15 -

[*15] B.     Material Participation

      The regulations provide that a taxpayer will be treated as “materially parti-

cipating” in an activity if he satisfies any one of seven tests. Sec. 1.469-5T(a),

Temporary Income Tax Regs., 53 Fed. Reg. 5725-5726 (Feb. 25, 1988). These

tests inquire (for example) whether the individual “participate[d] in the activity for

more than 500 hours” during the tax year or “materially participated” in the activi-

ty during certain prior years. Id. para. (a)(1), (5), (6).

      Petitioner does not contend that he devoted more than 500 hours to N444SS

during 2007. Nor does he contend that he materially participated in N444SS in

any prior year. He contends that he satisfies only one of the seven regulatory tests

for “material participation,” namely, the “significant participation” test specified in

paragraph (a)(4). It provides that a taxpayer will be treated as “materially partici-

pating” in an activity if:

      The activity is a significant participation activity (within the meaning
      of paragraph (c) of this section) for the taxable year, and the individ-
      ual’s aggregate participation in all significant participation activities
      during such year exceeds 500 hours * * *

      An activity qualifies as a “significant participation activity” under paragraph

(a)(4) if two tests are met. First, the activity must be a “trade or business activity”

in which the individual “participates * * * for more than 100 hours during such
                                        - 16 -

[*16] year.” Id. para. (c)(1)(i), (2). Second, the activity must be one in which the

taxpayer would not be treated as materially participating “if material participation

for such year were determined without regard to paragraph (a)(4) of this section.”

Id. subpara. (1)(ii). Although this regulation is something of a word soup, its

meaning and intent seem clear. It enables a taxpayer who does not devote 500+

hours to any one activity during the year to satisfy the “material participation” test

by cobbling together several smaller activities, to each of which he devotes 100+

hours during the year. See generally Lamas v. Commissioner, T.C. Memo. 2015-

59, 109 T.C.M. (CCH) 1299, 1305; Estate of Stangeland v. Commissioner, T.C.

Memo. 2010-185, 100 T.C.M. (CCH) 156, 163; Scheiner v. Commissioner, T.C.

Memo. 1996-554, 72 T.C.M. (CCH) 1532, 1539.

      We conclude that petitioner does not satisfy either prong of the “significant

participation” test. A taxpayer may substantiate the required hours of participation

by any reasonable means, but a mere “ballpark guesstimate” will not suffice.

Moss v. Commissioner, 135 T.C. 365, 369 (2010); Goshorn v. Commissioner, T.C.

Memo. 1993-578, 66 T.C.M. (CCH) 1499, 1501. In the absence of “[c]ontempor-

aneous daily time reports, logs, or similar documents,” the extent of a taxpayer’s

participation may be established by “the identification of services performed over

a period of time and the approximate number of hours spent performing such serv-
                                        - 17 -

[*17] ices * * * based on appointment books, calendars, or narrative summaries.”

Sec. 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25,

1988).

      Petitioner contends that he participated in N444SS’ activities for at least

100 hours during 2007. He testified that he reviewed flight logs and charter in-

voices; marketed the Premier jet to potential customers; considered various main-

tenance issues; and contacted Raytheon, the aircraft’s manufacturer, to demand

compensation for the peeling paint problem. He also testified that he had re-

searched the feasibility of a class action lawsuit against Raytheon; researched the

feasibility of acquiring a new jet; and helped negotiate the acquisition of the Gulf-

stream jet that was placed in service the following year.

      Petitioner presented no documentary evidence of any kind to substantiate

these efforts or to quantify the hours they actually consumed. He supplied no con-

temporaneous time logs, appointment books, calendars, or narrative summaries.

Sec. 1.469-5T(f)(4), Temporary Income Tax Regs., supra. Although he testified

that these tasks consumed at least 100 hours, his testimony reflects the sort of

“post-event ballpark guesstimate” that we have found unpersuasive on prior occa-

sions. See Lee v. Commissioner, T.C. Memo. 2006-193, 92 T.C.M. (CCH) 263,

265-266; Goshorn, 66 T.C.M. (CCH) at 1501. We accordingly find that petitioner
                                         - 18 -

[*18] has not carried his burden of proving that he participated in N444SS “for

more than 100 hours during * * * [the taxable] year.” Sec. 1.469-5T(c)(2),

Temporary Income Tax Regs., supra.4

       Even if petitioner had proven that he devoted the required 100+ hours to

N444SS, he does not meet the second prong of the “significant participation” test,

which requires that the taxpayer devote 500+ hours in the aggregate to “significant

participation activities.” An activity qualifies as such only if it is an activity in

which the taxpayer would not be treated as materially participating “if material

participation for such year were determined without regard to paragraph (a)(4) of

this section,” i.e., were determined without regard to the “significant participation”

test. Id. subpara. (1)(ii).

       Seeking to accomplish “grouping” in a different way, petitioner urges that

he satisfies the “significant participation” test by adding his N444SS-related hours


       4
        Apart from lack of substantiation, certain tasks petitioner allegedly per-
formed for N444SS related to management of the activity or were performed in his
capacity as an investor. Under the management agreement, KMR had complete
responsibility for day-to-day management of the Premier jet. Because petitioner
was not directly involved in the day-to-day operations, and because KMR devoted
many more hours to management than he did, hours he may have logged in con-
nection with management or in his capacity as an investor would not count toward
satisfying the material participation requirement. See Serenbetz v. Commissioner,
T.C. Memo. 1996-510, 72 T.C.M. (CCH) 1264, 1266; Goshorn, 66 T.C.M. (CCH)
at 1501; sec. 1.469-5T(b)(2)(ii), (f)(2)(ii), Temporary Income Tax Regs., supra.
                                        - 19 -

[*19] to his BLH-related hours. But assuming arguendo that N444SS was a

“significant participation activity,” BLH clearly was not. That is because

petitioner during 2007 devoted well in excess of 500 hours to BLH. He would

thus qualify as “materially participating” in BLH under section 1.469-5T(a)(1),

Temporary Income Tax Regs., supra. Since petitioner would be treated as

materially participating in BLH without regard to the “significant participation”

test of paragraph (a)(4), his BLH activity is not a “significant participation”

activity. See id. para. (c)(1)(ii).

       Petitioner has not identified any other activity that could possibly qualify as

a “significant participation activity.” His only “significant participation activity,”

assuming he could substantiate the required 100+ hours, would be N444SS. He

therefore has not shown that his “aggregate participation in all significant partici-

pation activities during such year exceeds 500 hours.” See id. para. (a)(4).

       In sum, petitioner has failed to meet his burden of proving that he “materi-

ally participated” in N444SS during 2007. The IRS thus correctly recharacterized,

as a passive loss under section 469, the $348,347 flow-through loss deduction that

petitioners claimed on their Schedule E.
                                        - 20 -

[*20] II.    Accuracy-Related Penalty

      The Code imposes a 20% penalty upon the portion of any underpayment of

tax attributable to “[n]egligence or disregard of rules or regulations” or any “sub-

stantial understatement of income tax.” Sec. 6662(a) and (b)(1) and (2). “Negli-

gence” includes “any failure to make a reasonable attempt to comply” with the in-

ternal revenue laws. Sec. 6662(c). “Negligence” also includes any failure to keep

adequate books and records or to substantiate items properly. Sec. 1.6662-3(b)(1),

Income Tax Regs.; see Olive v. Commissioner, 139 T.C. 19, 43 (2012), aff’d, F.3d

1146 (9th Cir. 2015). An understatement of income tax is “substantial” if it ex-

ceeds the greater of $5,000 or 10% of the tax required to be shown on the return.

See sec. 6662(d)(1)(A).

      Under section 7491(c) the Commissioner bears the burden of production

with respect to the liability of any individual for any penalty. See Higbee v. Com-

missioner, 116. T.C. 438, 446 (2001). Respondent has satisfied his burden of pro-

duction as to negligence by showing that petitioner failed to maintain adequate

books and records regarding his N444SS activities. See sec. 1.6662-3(b)(1), In-

come Tax Regs.

      In Graev v. Commissioner, 149 T.C. __ (Dec. 20, 2017), supplementing and

overruling in part Graev v. Commissioner, 147 T.C. __ (Nov. 30, 2016), we held
                                        - 21 -

[*21] that respondent’s burden of production under section 7491(c) also includes

establishing compliance with section 6751(b), which requires that penalties be

“personally approved (in writing) by the immediate supervisor of the individual

making such determination.” See Chai v. Commissioner, 851 F.3d 190, 221 (2d

Cir. 2017), aff’g in part, rev’g in part T.C. Memo. 2015-42. The record includes a

copy of a Civil Penalty Approval Form, approving imposition of an accuracy-

related penalty against petitioners for 2007, which was executed by the immediate

supervisor of the revenue agent who examined petitioners’ 2007 return. We ac-

cordingly conclude that respondent has met his burden of production for this pen-

alty.

        Section 6664(c)(1) provides an exception to the imposition of the accuracy-

related penalty if the taxpayer establishes that there was reasonable cause for, and

that he acted in good faith with respect to, the underpayment. The decision as to

whether the taxpayer acted with reasonable cause and in good faith is made on a

case-by-case basis, taking into account all pertinent facts and circumstances. See

sec. 1.6664-4(b)(1), Income Tax Regs. Circumstances that may signal reasonable

cause and good faith “include an honest misunderstanding of fact or law that is

reasonable in light of all of the facts and circumstances, including the experience,

knowledge, and education of the taxpayer.” Ibid.
                                        - 22 -

[*22] Petitioner is a highly sophisticated businessman. With respect to the

claimed $348,347 flow-through loss deduction, he has failed to establish that he

made a good-faith effort to determine his Federal income tax liability correctly.

He kept no contemporaneous records of his activities with respect to N444SS or

the time he devoted to those activities. His argument for grouping BLH with

N444SS as a single activity was extremely weak. Although he hired a tax return

preparer, he does not assert reliance on that person as a defense to the penalty. See

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98 (2000), aff’d, 299

F.3d 221 (3d Cir. 2002); sec. 1.6664-4(b)(1), (c), Income Tax Regs.

      We accordingly conclude that the portion of the underpayment reflecting

disallowance of the $348,347 flow-through loss deduction was attributable to neg-

ligence.5 Alternatively, if the Rule 155 computations show that the understate-

ment of income tax exceeds the greater of $5,000 or 10% of the amount required

to be shown on the 2007 return, we conclude that the underpayment is attributable

to a substantial understatement of income tax for which reasonable cause has not

been shown.


      5
        In his post-trial briefs respondent does not contend that petitioner was neg-
ligent with respect to the disallowed $163,915 mortgage interest expense deduc-
tion, an issue over which we previously determined that we lack jurisdiction. See
Brumbaugh v. Commissioner, T.C. Memo. 2015-65.
                                  - 23 -

[*23] To reflect the foregoing,


                                           Decision will be entered under

                                  Rule 155.
