                          T.C. Memo. 1998-310



                        UNITED STATES TAX COURT



               MICHAEL D. AND JOAN WELCH, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent


        Docket No. 18402-96.             Filed August 24, 1998.


        Michael D. Welch and Joan Welch, pro se.


        Andrew Lee, for respondent.


                          MEMORANDUM OPINION


        NAMEROFF, Special Trial Judge:   This case was heard pursuant

to the provisions of section 7443A(b)(3) and Rules 180, 181, and

182.1    Respondent determined a deficiency in petitioners’ 1993

Federal income tax in the amount of $878 and an accuracy-related


    1
      All section references are to the Internal Revenue Code in
effect for the year at issue. All Rule references are to the Tax
Court Rules of Practice and Procedure.
                                 - 2 -


penalty under section 6662(a) in the amount of $176.     After a

concession by respondent, the issues for decision are:

(1) Whether a loss incurred by petitioner husband’s equipment

leasing activity is subject to the passive activities loss rules;

(2) in the alternative, whether unreimbursed expenditures for

that activity are employee business expenses deductible on

Schedule A; and (3) whether petitioners are liable for the

accuracy-related penalty.2

        Petitioners resided in Silverado, California, at the time of

filing their petition.

        Petitioner Michael D. Welch (petitioner) is a carpenter by

trade and is hired by movie production companies as a

construction coordinator.     As a construction coordinator,

petitioner coordinates the construction of the sets required for

the movie.     He hires other employees, arranges for purchase of

materials, and furnishes all the tools needed for the project.

In this connection, petitioner was required to purchase,

maintain, transport, and repair the tools as needed.

          When petitioner is hired by the production company, he

enters into a “deal memorandum” (or deal memo).     The deal memo

sets forth the terms of petitioner’s employment, including the


    2
      Respondent also contends that substantiation of some of
the expenses is at issue, which petitioners dispute. After
careful review of the record herein, we conclude and hold that no
substantiation issue was properly and timely raised.
                                 - 3 -


rate at which he will be paid and the rate at which he will rent

tools and equipment to the production company.    Typically

attached to the deal memo would be a list of the inventory of

petitioner’s tools and equipment.    For example, in 1993,

petitioner entered into a deal memo with Mantis Productions

providing for both a weekly and hourly salary, as well as a tool

rental for $100 per day as used and a truck rental for $125 per

week.   In 1994, as another example of a typical deal memo,

petitioner entered into an agreement with Mitchell Entertainment,

Inc. to be construction coordinator for the film “Cub Scouts”.

The deal memo, again, provided for daily, weekly, and “straight

time” rates plus “box/kit/equipment” rental at $140 per day.

     The production companies at the end of the year would send

petitioner Forms W-2 to reflect wages paid and Forms 1099 to

reflect rentals paid under the terms of the deal memos.

     Also in 1993, petitioner rented some of his tools to a third

party for $1,500, for a project in which he (petitioner) was not

involved as construction coordinator or otherwise.    However, this

transaction did not result in a loss.

     On petitioners’ joint income tax return for 1993, petitioner

reported wages in accordance with the Forms W-2 of $37,838.    On a

Schedule C, he reported gross receipts of $10,200 and expenses of

$17,247, resulting in a net loss of $7,047.    The gross receipts

were for the rentals received.    Included in the expenses are car
                                 - 4 -


and truck $928, legal and professional $1,900, office expense

$413, supplies $106, taxes and licenses $120, meals and

entertainment $346, equipment rental use $10,687, home office

$1,000, location travel $679, telephone $738, and union dues

$330.3

        Petitioners’ return was prepared by Mr. Virgil Judd.   The

determination to reflect the rental income and expenses on

Schedule C was made by Mr. Judd and petitioner jointly.     Mr. Judd

stated that he was following the procedure that had been used in

previous years, and petitioner testified that 1993 was the only

year in which he had reported a loss from this activity.

        In the notice of deficiency, respondent took alternative

positions with regard to petitioner’s Schedule C.     Initially,

respondent determined that the Schedule C loss was not allowable

because it was incurred in the pursuit of a passive activity.        In

the alternative, respondent takes the position that the $10,200,

reported as income on Schedule C, is merely reimbursement for

employee business expenses.     Therefore, respondent contends that

the petitioner should have reported his employee business

expenses on Schedule A, reduced by the $10,200.4


    3
        On Schedule A, petitioner also deducted $3,491 as Form
2106 expenses (i.e. employee business expenses) and $1,244 as
union and professional dues.
    4
        Although respondent disallowed the entire loss claimed on
Schedule C, respondent also disallowed by a separate adjustment
                                                        (continued...)
                                 - 5 -


Discussion

         Section 469 generally disallows for the taxable year any

passive activity loss that exceeds passive activity income.

Sec. 469(a)(1), (d)(1).     Passive activity is any activity which

involves the conduct of any trade or business in which the

taxpayer does not materially participate.     Sec. 469(c)(1).

Without regard to whether a taxpayer materially participates in

an activity, the term “passive activity” includes any rental

activity.     Sec. 469(c)(2), (4).

        A rental activity is any activity where payments are

principally for the use of tangible property.     Sec. 469(j)(8).

There are exceptions to the definition of “rental activity”.

Section 1.469-1T(e)(3)(ii).     Temporary Income Tax Regs., 53 Fed.

Reg. 5702 (Feb. 25, 1998), provides:

             an activity involving the use of tangible
             property is not a rental activity for a taxable year if
             for such taxable year --

             (A) The average period of customer use for such
             property is seven days or less;

             (B) The average period of customer use for such
             property is 30 days or less, and significant personal
             services (within the meaning of paragraph (e)(3)(iv) of
             this section) are provided by or on behalf of the owner
             of the property in connection with making the property
             available for use by customers;




    4
     (...continued)
$200 of the $1,900 claimed as legal expenses.     At trial,
respondent conceded the latter adjustment.
                              - 6 -


          (C) Extraordinary personal services (within the meaning
          of paragraph (e)(3)(v) of this section) are provided by
          or on behalf of the owner of the property in connection
          with making such property available for use by
          customers (without regard to the average period of
          customer use);

          (D) The rental of such property is treated as
          incidental to a non-rental activity of the taxpayer
          under paragraph (e)(3)(vi) of this section * * *.

     Section 1.469-1T(e)(3)(iv), Temporary Income Tax Regs., 53

Fed. Reg. 5702 (Feb. 25, 1988), provides, in part, a definition

of “significant personal services”:

In determining whether personal services provided in connection
with making property available for use by customers are
significant, all of the relevant facts and circumstances shall be
taken into account. Relevant facts and circumstances include the
frequency with which such services are provided, the type and
amount of labor required to perform such services, and the value
of such services relative to the amount charged for the use of
the property.


     Section 1.469-1T(e)(3)(v), Temporary Income Tax Regs., 53

Fed. Reg. 5702 (Feb. 25, 1988), defines “extraordinary personal

services” as follows:

          For purposes of paragraph (e)(3)(ii)(C) of this section
     extraordinary personal services are provided in connection
     with making property available for use by customers only if
     the services provided in connection with the use of the
     property are performed by individuals, and the use by
     customers of the property is incidental to their receipt of
     such services.


     Thus, petitioner must prove that the rental of equipment to

the production companies was not a passive activity.   In so

doing, he must first prove that the activity was not a “rental
                                  - 7 -


activity” as defined above, for any rental activity is a passive

activity.    If petitioner establishes that the activity was not a

rental activity, he then must establish that he materially

participated in the activity to avoid the proscription of section

469.

       On this record, we find that petitioner provided equipment

to production companies for an average period of 30 days or less

and that he performed significant personal services in connection

with making the property available for use by customers.

Petitioner acquired, maintained, transported and repaired the

tools and equipment.    We also find that petitioner provided

extraordinary personal services.     The rental of the tools and

equipment by the production companies is incidental to their

receipt of petitioner’s services as construction coordinator.

Therefore, we hold that petitioner’s activity was not a rental

activity within the meaning of section 469(j)(8).

       A taxpayer is treated as materially participating in an

activity only if the taxpayer is involved in the operations of

the activity on a basis which is regular, continuous, and

substantial.    Sec. 469(h)(1).   Petitioner’s business as

construction coordinator was regular, continuous (for each

project), and substantial.    Therefore, we hold that petitioner

materially participated in his rental activity, and the
                                - 8 -


provisions of section 469 do not apply to deny petitioner a

deduction for the full loss from this activity.

      We now examine respondent’s alternative theory that

petitioner was merely incurring employee business expenses, which

were partially reimbursed and the excess is deductible on

Schedule A.    This issue requires us to determine whether the

expenses claimed were properly attributable to a separate

activity of renting the equipment or whether the expenditures

pertained to petitioner’s activity of being an employee.    The

latter expenses are deductible on Schedule A as an itemized

deduction.    After a careful review of this record, we conclude

that the expenses claimed on Schedule C for car and truck,

equipment rental use, and location travel pertain to the rental

activity and are allowable as Schedule C deductions.    Petitioner

has not clearly shown how the other claimed expenses pertain to

the rental activity, and therefore we hold that they are only

deductible as unreimbursed employee business expenses on Schedule

A.

     In view of the above, we further hold that petitioners are

not liable for the accuracy-related penalty.    The adjustment

required by shifting some expenses from Schedule C to Schedule A

will reduce the loss claimed on Schedule C, increase adjusted

gross income by a like amount, and increase the 2-percent floor

limiting the deduction of unreimbursed business expenses.
                              - 9 -


However, the resulting deficiency will be small.    Moreover,

petitioners made a good faith attempt to report their correct tax

liability, and the deficiency, if any, results from a technical

reporting requirement change rather than from the claiming of

unallowable deductions.

     To reflect the above,



                                           Decision will be entered

                                      under Rule 155.
