                        T.C. Memo. 1998-215



                      UNITED STATES TAX COURT



            RONALD I. AND LOIS B. KOENIG, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 1468-96.                        Filed June 17, 1998.



     Patrick Derdenger, for petitioners.

     John W. Duncan, for respondent.



                         MEMORANDUM OPINION


     PARR, Judge:   Respondent determined deficiencies in,

additions to, and penalties on petitioners' Federal income taxes

as follows:

                               Additions to Tax       Penalties
     Year       Deficiency      Sec. 6651(a)(1)      Sec. 6662(a)
     1990        $167,792           $4,160             $33,558
     1991          16,536            1,445               3,307
                                   - 2 -


        All section references are to the Internal Revenue Code in

effect for the taxable years in issue, and all Rule references

are to the Tax Court Rules of Practice and Procedure, unless

otherwise indicated.       References to petitioner are to Ronald I.

Koenig.

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

Whether for 1990 petitioners are entitled to a business bad debt

deduction relating to their disposition of the Washington

Chocolate Co. (Washington Chocolate).         We hold they are not.    (2)

Whether for 1990 petitioners are entitled to deductions for

activities involving ancient artifacts.         This turns on whether

petitioners were actively engaged in a trade or business during

1990.       We hold petitioners were not engaged in a trade or

business during 1990 and are not entitled to the deductions.           (3)

Whether for 1990 petitioners' net loss for their rental real

estate activity is limited to $25,000.         We hold it is.    (4)

Whether for 1990 petitioners are liable for an addition to tax

pursuant to section 6651(a)(1) for delinquent filing of a return.

We hold they are.       (5) Whether for 1990 petitioners are liable

for a penalty pursuant to section 6662(a) for negligence or

disregard of rules or regulations.         We hold they are not.




        1
          The parties settled all issues relating to taxable year
1991 before trial.
                               - 3 -


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

The stipulated facts and the accompanying exhibits are

incorporated herein by this reference.   At the time the petition

in this case was filed, petitioners resided in Paradise Valley,

Arizona.

     For convenience, we combine our findings of fact with our

opinion under each separate issue heading.2

Issue 1.   Bad Debt

     Respondent determined that for 1990 petitioners were not

entitled to a $500,000 business bad debt deduction related to

their disposition of Washington Chocolate.

     Section 166 entitles a taxpayer to a deduction for a bad

debt that becomes worthless during the taxable year.   A business

bad debt can be deducted from ordinary income if it is either

partially or totally worthless.   Sec. 166(a).   Only a bona fide

debt is deductible.   Sec. 1.166-1(c), Income Tax Regs.

Petitioners bear the burden of proving that a bona fide business

debt exists and that the debt became worthless during the taxable

year in issue.   Rule 142(a); Crown v. Commissioner, 77 T.C. 582,

598 (1981); Rude v. Commissioner, 48 T.C. 165, 172 (1967).

     From July 25, 1986, until May 26, 1989, petitioners were the

sole shareholders of Washington Chocolate, a subchapter S

     2
          We have considered each of the parties' arguments and,
to the extent that they are not discussed herein, find them to be
unconvincing.
                               - 4 -


corporation.   Washington Chocolate was in the business of

providing bulk food products which would be placed in and sold

from bins located in supermarkets and other retail

establishments.   Washington Chocolate manufactured and

distributed various snack foods and confectionary goods,

including trail mixes, coated nuts, dried fruits, and chocolate,

yogurt, and carob products.

     Before petitioners acquired Washington Chocolate, the

company was close to bankruptcy.   Before purchasing Washington

Chocolate, petitioner created a new business plan for the company

and renegotiated credit and loan terms with the company's major

creditors.

     At the time petitioners purchased Washington Chocolate, the

company had only one significant customer and a downward annual

sales trend.   Petitioner increased the value of Washington

Chocolate by creating and patenting a new product dispensing

system which distinguished Washington Chocolate from its

competitors.   Under petitioners' ownership and management,

Washington Chocolate's customer base expanded and annual sales

increased substantially.

     A primary competitor of Washington Chocolate was Harmony

Foods, Inc. (Harmony Foods), whose president was Robert Lynch

(Lynch).   On May 26, 1989, Washington Chocolate entered into an

asset purchase agreement (purchase agreement) with Harmony Foods,
                               - 5 -


under which Harmony Foods purchased all of the assets of

Washington Chocolate and certain other specified assets of

petitioner.   Harmony Foods' primary interest in this transaction

was obtaining Washington Chocolate's customer base.

     Pursuant to paragraph 2.1 of the purchase agreement, Harmony

Foods paid $600,000 to Washington Chocolate for its assets and an

additional $71,000 to petitioner for those assets he owned

personally.   Paragraph 10.4 of the purchase agreement provided

that as a condition precedent, petitioner was to execute an

employment agreement with Harmony Foods.   Consistent with the

requirements of paragraph 10.4 of the purchase agreement,

petitioner entered into an employment agreement with Harmony

Foods on May 26, 1989, which provided for the employment of

petitioner by Harmony Foods.

     Paragraph 2 of the employment agreement defined petitioner

as an at-will employee.   Paragraph 3 of the employment agreement

defined the term of employment as commencing on the date of

signing the employment agreement and continuing until either

party terminated the employment agreement with 30 days' written

notice.

     Paragraph 4.A of the employment agreement provided

petitioner with an annual base salary of at least $100,000.    As

additional compensation, paragraph 4.B of the employment

agreement provided petitioner with a commission over a 7-year
                               - 6 -


period beginning May 1, 1989, based on a percentage of net sales.

The employment agreement stated that the aggregate commission for

that period would be a minimum of $200,000 and a maximum of

$900,000.   In addition, paragraph 5 of the employment agreement

set forth a noncompete agreement, under which Harmony Foods

agreed to pay petitioner $500,000.

     Paragraph 12.E of the employment agreement provided that it

would be construed and enforced in accordance with the laws of

the State of Washington.   Petitioner participated in the

negotiation of the purchase agreement and employment agreement

and personally executed these documents.   Lynch was not involved

in the drafting of these documents.

     After Harmony Foods and petitioner executed the employment

agreement, petitioner began serving as an employee of Harmony

Foods.   Petitioners subsequently changed the name of Washington

Chocolate to RLK Management, Inc., and in August 1989 liquidated

that corporation.

     On May 31, 1990, MEI Diversified, Inc. (MEI), the parent

corporation of Harmony Foods, sold Harmony Foods to Glico Harmony

Foods Corp. (Glico).   In connection with this sale, Glico,

Harmony Foods, and Glico U.S.A., Inc., the parent corporation of

Glico, entered into an assumption agreement under which Glico

assumed all of Harmony Foods' obligations under the employment

agreement, except for those relating to the noncompete agreement.
                               - 7 -


     In connection with the sale of Harmony Foods to Glico,

petitioner, Harmony Foods, and MEI entered into an agreement

accelerating the amounts due as minimum commission and noncompete

payments.   Before the sale of Harmony Foods to Glico, petitioner

received $200,000 as commissions pursuant to paragraph 4.B of the

employment agreement and $500,000 in noncompete payments.

     During June, July, and August 1990, petitioner attempted to

collect additional commissions.   When he contacted MEI he was

told to speak with Glico, and when he contacted Glico, he was

told to speak with MEI.   In mid-December 1990, petitioner was

informed during a meeting with Yasuaki Aoki, the Chief Executive

Officer of Glico, that Glico would not make any further payments

to him pursuant to paragraph 4.B of the employment agreement.

Petitioner's employment with Glico was terminated shortly after

this meeting.

     Petitioners claimed a $500,000 bad debt deduction on a

Schedule C attached to their 1990 Federal income tax return based

on petitioner's failure to receive any more than $200,000

pursuant to paragraph 4.B of the employment agreement.3

Respondent disallowed the deduction.   We agree with respondent.




     3
          Petitioner did not claim the entire $700,000 difference
between the minimum payment received and the maximum payment
allowable because at that time he believed he might be able to
collect additional commission payments.
                               - 8 -


     Petitioners ask the Court to ignore the plain meaning of the

language chosen by the parties to the purchase agreement and the

employment agreement.   Petitioners argue that, in form, part of

the sale price of Washington Chocolate was allocated among a

noncompete payment and commissions; however, they argue that the

substance of the deal was that all payments received by

petitioner were for the assets of Washington Chocolate.

Therefore, petitioners claim the asset sale price should be read

as follows:   $600,000 in cash, $500,000 for a noncompete payment,

and $900,000 for commissions payable for 7 years, for a total

sale price of $2 million.

     Petitioners argued at trial and on brief that although the

purchase price was allocated as outlined above, the intent of the

parties was an asset sale.   At trial, Lynch, the former president

of Harmony Foods, testified that the sale of Washington Chocolate

to Harmony Foods was understood to be an asset sale.    Lynch was

interested primarily in one asset, which was Washington

Chocolate's customer list.

     If this transaction was merely as asset sale, as petitioners

claim, we fail to see why the payments were structured as

outlined above.   The logical explanation is that the payments

were not just for the assets of Washington Chocolate.   Both

petitioner and Lynch testified that the industry in which they

were involved was extremely competitive, and the two had
                               - 9 -


continually bid against each other for contracts with

supermarkets and other retailers.   Lynch also testified that a

major reason Harmony Foods acquired Washington Chocolate was to

consolidate the industry and eliminate competition.   With this in

mind, it is very clear that the $500,000 allocated to the

noncompete clause was intended for that purpose and not as

payment for the assets of Washington Chocolate.

     Petitioner became an employee of Harmony Foods after he sold

Washington Chocolate, and subsequently an employee of Glico.

Lynch testified that he intended to work with petitioner after

Washington Chocolate was sold to Harmony Foods.   The purpose of

petitioner's employment with Harmony Foods was to assist in

distributing some of Harmony Foods' products to petitioner's

customers, and some of petitioner's products to Harmony Foods'

customers.   Lynch testified that petitioner's presence after the

sale of Washington Chocolate helped with the transition of

customers.   The commission payments petitioner received pursuant

to paragraph 4.B of the employment agreement were in connection

with his status as an at-will employee and his assistance with

the customer transition.   Paragraph 4.B provided that the

commissions were based on a percentage of net sales, and that

petitioner was entitled to the commissions whether or not he was

responsible for generating the sales.   The minimum and maximum

aggregate commissions payable for the 7-year period pursuant to
                               - 10 -


the employment agreement were $200,000 and $900,000,

respectively.   Petitioner received payment of $200,000 before his

status as an at-will employee was terminated.    Any amount above

the $200,000 minimum was to be based on net sales.4    A valid debt

did not exist for the remaining $700,000.

     Moreover, respondent claims that even if petitioners were

owed an additional amount under paragraph 4.B of the employment

agreement, they still would not be entitled to a bad debt

deduction.   We agree.   The regulations state that

     Worthless debts arising from unpaid wages, salaries,
     fees, rents, and similar items of taxable income shall
     not be allowed as a deduction under section 166 unless
     the income such items represent has been included in
     the return of income for the year for which the
     deduction as a bad debt is claimed or for a prior
     taxable year. [Sec. 1.166-1(e), Income Tax Regs.]

     The commissions received pursuant to the employment

agreement, like wages or salary, were ordinary income.    Thus,

since petitioners did not report any of the commissions alleged

to be owed as income in 1990 or in a prior year, they cannot

claim these unpaid commissions as a bad debt deduction for 1990.


     4
          Pursuant to par. 6.B of the employment agreement, the
commissions payable to petitioner under par. 4.B were to survive
the termination of his employment. Petitioner argues that this
means he is entitled to the full $900,000. By the terms of the
employment agreement, $900,000 is the maximum commission payable,
not the amount required to be paid. As stated previously, any
amount received over the $200,000 minimum was to be based on a
percentage of net sales. Petitioners did not provide any
information regarding net sales by which to determine whether an
additional commission payment was due.
                                 - 11 -


       Accordingly, respondent is sustained on this issue.

Issue 2.      Ancient Artifacts Business

       Respondent determined that the claimed deductions for

petitioner's ancient artifacts activities were startup expenses

pursuant to section 195 and therefore not deductible since they

were not related to an active trade or business.        Petitioner

asserts that he was in the business of dealing in ancient

artifacts during 1990.

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

expenses of carrying on a trade or business.        In order for

expenses to be deductible under section 162, they must relate to

a trade or business functioning at the time they are incurred.

Hardy v. Commissioner, 93 T.C. 684, 687 (1989).        Startup or

preopening expenses are not currently deductible under section

162.    Id.

       Section 195(a) generally disallows all deductions for

startup expenditures.      Startup expenditures are defined as

amounts paid or incurred in connection with:        (1) Investigating

the creation or acquisition of an active trade or business, (2)

creating an active trade or business, or (3) any activity engaged

in for profit in anticipation of the activity's becoming an

active trade or business.      Sec. 195(c)(1)(A).    Second, these

costs must be the type of costs that would be currently

deductible if paid or incurred in connection with the operation
                                - 12 -


of an existing trade or business in the same field as that

entered into by the taxpayer.    Sec. 195(c)(1)(B).

     After petitioner sold Washington Chocolate, he decided he

wanted to become an ancient artifacts dealer.     Petitioner had

developed an interest in ancient artifacts during childhood and

had built a substantial personal collection.

     In the fall of 1989, petitioner traveled to Sedona, Arizona,

and purchased his first artifact for his commercial inventory

from Donald Corsette (Corsette).    Throughout 1990, petitioner

made frequent trips to Sedona and made several purchases from

Corsette.   In December 1990, petitioner traveled with Corsette to

Geneva, Switzerland, where he purchased additional artifacts from

Phoenix Ancient Art.

     Petitioner testified that when dealing in ancient artifacts,

having a gallery bolsters a dealer's credibility.     Therefore,

during 1990 petitioner began to look for retail space in and

around the Union Square area of San Francisco in which he could

operate a gallery for his ancient artifacts.     Petitioner located

acceptable retail space in San Francisco, negotiated a lease,

received drawings, and met with contractors who would construct

leasehold improvements on the space.     The plan for a San

Francisco gallery was abandoned, however, because petitioner did

not have sufficient inventory for the gallery space.     Instead,

petitioner decided he would operate his gallery from his personal
                                - 13 -


residence, which at that time was located in Santa Cruz,

California.

     Petitioner claims that his ancient artifacts activities were

an active trade or business during 1990.    We disagree.

Petitioner testified that his inventory was available for sale

during 1990.    The mere fact that petitioner would have sold items

in his inventory if approached by a buyer, however, does not mean

that the activity rose to the level of an active trade or

business.     Kennedy v. Commissioner, T.C. Memo. 1973-15 ("the

ability to transact business does not satisfy the 'carrying on'

requirement of [section 162]"); see also Richmond Television

Corp. v. United States, 345 F.2d 901, 907 (4th Cir. 1965),

vacated and remanded per curiam on other grounds 382 U.S. 68

(1965).

     Petitioner also testified that he had a business plan for

his ancient artifacts activities.    According to this business

plan, during 1990, petitioner testified that "I wasn't out

beating on doors, * * * I was doing what I had planned to do

which was to build up [the] inventory."    Furthermore, petitioner

testified that starting a business like this requires a

tremendous amount of preparation work, including locating buying

sources and other general business considerations, and that he

spent longer than a year accumulating his inventory.
                              - 14 -


     In addition, despite the fact that selecting a name for his

business was "very important", petitioner did not file his

fictitious business name statement with the State of California,

indicating the name under which he planned to conduct his ancient

artifacts business, until May 7, 1991.   Petitioner testified that

it was not until that time that he satisfied the criteria for his

business plan, which included accumulating a certain amount of

inventory.

     Petitioner was not actively involved in an ancient artifacts

trade or business during 1990.   Instead, he was accumulating the

necessary inventory and developing the reputation he would need

to conduct the business.   At trial, petitioner stressed the

amount of preparation required to conduct this type of business,

yet he acquired his first piece of inventory only in the fall of

1989.   Although lack of sales is not dispositive, petitioner made

no sales of ancient artifacts in 1990.   The rational explanation

for his failure to make any sales is that he was not conducting

an active trade or business during 1990, as he did not yet have

sufficient inventory or a commercial gallery.   Furthermore,

according to petitioner's testimony, he was not conducting any

type of sales activity.

     Accordingly, respondent is sustained on this issue.

Petitioner's 1990 expenses related to ancient artifacts are

startup expenses pursuant to section 195.
                              - 15 -


Issue 3.   Net Loss for Rental Real Property

     Respondent determined that petitioners' net loss for rental

real property in 1990 is limited to $25,000.   Petitioners assert

that they are not limited by the $25,000 rental loss allowance

and that they are entitled to deduct $57,975, the full amount of

their loss.

     During 1990, petitioners owned five separate parcels of

rental real property.   Four of the properties were located in

Scottsdale, Arizona (the Scottsdale properties), and one was

located in Sumner, Washington (the Sumner property).   The

Scottsdale properties, which comprised two townhomes and two

condominiums, were upscale, resort-oriented properties with

numerous amenities.   The Sumner property was a lakefront single-

family dwelling with an unobstructed view of Mt. Rainier.

     Lois B. Koenig (Mrs. Koenig) personally conducted the

leasing activities for the Sumner property.    Petitioners engaged

Racquet Club Realty to act as a rental broker to locate tenants

for the Scottsdale properties.

     Mrs. Koenig was responsible for the management, maintenance,

and operation of the rental properties.   Her responsibilities

included collecting rents and arranging for necessary repairs.

In addition, when tenants moved out, it was necessary to clean

and sometimes paint the rental properties before new tenants
                                - 16 -


arrived.     Mrs. Koenig would sometimes perform these tasks herself

or would make arrangements for the services to be performed.

     Petitioners assert that they are entitled to the full amount

of the rental loss because they were actively engaged in the

trade or business of renting real property.    Accordingly, they

argue their loss is fully deductible under section 162 because

the expenses were incurred in their rental property trade or

business.5

     Section 162(a) provides in relevant part that "There shall

be allowed as a deduction all the ordinary and necessary expenses

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

or business".    The regulations promulgated thereunder state that

only those ordinary and necessary business expenses "directly

connected with or pertaining to the taxpayer's trade or business"

may be deducted.    Sec. 1.162-1(a), Income Tax Regs.

     Section 469(a) generally disallows all passive activity

losses.    The term "passive activity" includes any rental

activity.    Sec. 469(c)(2).   Section 469(i) provides an exception,

however, to this complete disallowance.    Section 469(i) allows a

taxpayer who "actively participates" in a rental activity to


     5
          Petitioners originally argued that they were entitled
to the full amount of the claimed loss pursuant to sec.
469(c)(7). The year in issue is 1990. Sec. 469(c)(7) did not
become effective until taxable years beginning after Dec. 31,
1993. See Omnibus Budget Reconciliation Act of 1993, Pub. L.
103-66, sec. 13143(a), 107 Stat. 312, 440.
                              - 17 -


claim a maximum loss of $25,000 per year related to the rental

real estate.6

     The general provisions for deductibility of ordinary and

necessary business expenses under section 162 must be read in

conjunction with the passive activity loss rules of section 469.

These sections must be construed together with more specific

provisions prevailing over general ones.   Cf. United States v.

Estate of Romani, 523 U.S.__, 118 S. Ct. 1478 (1998).

Petitioners cannot completely circumvent the passive activity

loss rules merely by asserting that they are in the trade or

business of renting real estate.

     Accordingly, respondent is sustained on this issue, and

petitioners' net loss for rental real property for 1990 is

limited to $25,000.

Issue 4.   Addition to Tax Under Section 6651(a)

     Respondent determined an addition to tax under section

6651(a) for delinquent filing of a return.

     Petitioners were required to file their 1990 Federal income

tax return by October 15, 1991.    Petitioners provided a certified

mail receipt indicating that their return was mailed on October




     6
          This exemption provided in sec. 469(i) is phased out
for taxpayers whose adjusted gross income is greater than
$100,000. Sec. 469(i)(3)(A). Respondent did not seek to invoke
the phaseout, and so we do not address the issue.
                               - 18 -


15, 1992.   Therefore, petitiioners' return is deemed timely

mailed/timely filed.   Sec. 7502.   Respondent concedes this issue.

Issue 5.    Penalty Under Section 6662(a)

     Respondent determined that petitioners' underpayment of tax

for 1990 was due to negligence or disregard of rules or

regulations, subjecting them to the accuracy-related penalty of

section 6662(a).

     Section 6662 provides for an accuracy-related penalty equal

to 20 percent of the portion of the underpayment due to

negligence or disregard of rules or regulations.      For purposes of

section 6662, negligence "includes any failure to make a

reasonable attempt to comply with the * * * [income tax laws]"

and disregard "includes any careless, reckless, or intentional

disregard."    Sec. 6662(c).

     When petitioners acquired Washington Chocolate, the company

was performing poorly and close to bankruptcy.      Through his

business plan and innovation, petitioner increased both the

company's sales and its value.    We accept that as a result of his

efforts petitioner had a good faith belief that he was entitled

to additional commission payments.      We also accept that

petitioner was sent back and forth between Glico and MEI when he

attempted to open discussions about additional payments.      This,

however, does not change the fact that petitioners are not

entitled to a bad debt deduction.
                              - 19 -


     Petitioners relied on advice from Philip Silbering

(Silbering), a certified public accountant, in connection with

the preparation of their 1990 Federal income tax return.

Petitioner had telephone conversations with Silbering and

explained the circumstances of the sale of Washington Chocolate.

Silbering advised petitioner that it would be appropriate to take

a bad debt deduction for the unpaid commissions.

     Silbering also advised petitioner to prepare an explanation

of the bad debt deduction and include it with his return.

Petitioner prepared this explanation and attached it to

petitioners' 1990 Federal income tax return.

     When an accountant provides advice to a taxpayer on a matter

of tax law, it may be reasonable for the taxpayer to rely on that

advice.   United States v. Boyle, 469 U.S. 241, 251 (1985); Betson

v. Commissioner, 802 F.2d 365, 372 (9th Cir. 1986), affg. in part

and revg. in part T.C. Memo. 1984-264.   Petitioners' reliance on

Silbering's advice regarding the bad debt was reasonable.

Moreover, the circumstances were disclosed.    In addition, we find

the other issues resulting in petitioners' deficiency to be good

faith misinterpretations of the Internal Revenue Code.

     Accordingly, petitioners are not liable for the accuracy-

related penalty pursuant to section 6662(a).

     For the foregoing reasons,
- 20 -


          Decision will be entered

     under Rule 155.
