                        T.C. Memo. 1998-287



                      UNITED STATES TAX COURT



            ASSOCIATED DENTISTS OF RIVER FALLS, f.k.a.
       RIVER FALLS DENTAL ASSOCIATES, LTD., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 17503-97.                     Filed August 5, 1998.


     Jay B. Kelly, for petitioner.

     Blaine C. Holiday, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:   Petitioner petitioned the Court to redetermine

respondent's determination of deficiencies of $12,630 and $11,606

in its 1993 and 1994 Federal income taxes, respectively.    We must

decide whether petitioner may deduct the rent that it paid to a

shareholder in 1993 and 1994.   We hold it may.   We must also
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decide whether petitioner may deduct the net operating loss (NOL)

claimed on its 1993 tax return.    We hold it may not.   Section

references are to the Internal Revenue Code in effect for the

subject years.    Rule references are to the Tax Court Rules of

Practice and Procedure.    Dollar amounts are rounded to the

nearest dollar.

                          FINDINGS OF FACT

     Some facts have been stipulated.    The stipulations of fact

and the exhibits submitted therewith are incorporated herein by

this reference.    Petitioner is a personal service corporation

that provides dental services.    Its principal place of business

at the time of the petition was in River Falls, Wisconsin.

     Petitioner's stock is owned equally by two of its full-time

employees, Stephen Schwalbach (Dr. Schwalbach) and Timothy Knotek

(Dr. Knotek).    Dr. Schwalbach is a dentist who has practiced

dentistry through petitioner since he graduated from dental

school in 1972.    He and a classmate formed petitioner upon

graduation, and, following the classmate's departure from the

business, Dr. Schwalbach remains the only dentist to be

continually associated with petitioner since its formation.

Dr. Knotek is a dentist who has practiced dentistry through

petitioner since he graduated from dental school in 1988.

     Petitioner's operations are based in River Falls in a

two-floor, 4,800-square-foot building (the River Falls building)
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that is owned by Dr. Schwalbach and his wife (collectively, the

Schwalbachs).   The building's lower level has a suite of rooms

that has been let since 1974 to an orthodontist named David

Nelson (Dr. Nelson).   These rooms, totaling 1,200 square feet,

include a laboratory, a patient treatment room, and a doctor’s

office.   The lower level has other rooms that have been let to

petitioner since at least 1974.   These rooms, totaling 1,200

square feet, include an x-ray room, an analysis room, and a

doctor's office.   Petitioner has let the building's upper level

and the building's parking lot since at least 1974.   Rooms on the

upper level, which measures 2,400 square feet, include seven

patient treatment rooms, a laboratory, and an x-ray room.   The

parking lot holds approximately 25 to 30 cars and is accessible

to the upper level by way of a handicap ramp.

     In 1991, when Dr. Schwalbach was petitioner's sole owner and

Dr. Knotek was an associate, they discussed the possibility of

owning petitioner's business jointly.   During their discussions,

which focused primarily on the value of a 50-percent interest in

petitioner's business and the amount of rent that petitioner

would have to pay the Schwalbachs for use of the River Falls

building, Dr. Schwalbach and Dr. Knotek sought advice from a list

of people that included an attorney, an accountant, a specialist

on business valuation, and other dentists who had established

relationships similar to the relationship sought by Dr.
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Schwalbach and Dr. Knotek.   Dr. Schwalbach and Dr. Knotek also

referenced a professional publication of the American Dental

Association, looking specifically at a rent factor guideline

stated therein.   Dr. Schwalbach and Dr. Knotek's discussions

ended on or near January 1, 1992, when Dr. Knotek purchased from

Dr. Schwalbach 50-percent interests in petitioner and its office

equipment.

     Contemporaneously therewith, on January 1, 1992,

Dr. Schwalbach and Dr. Knotek, in their capacities as officers of

petitioner, signed a lease with the Schwalbachs under which the

Schwalbachs relet to petitioner the building's parking lot and

the 3,600-square-foot area that it already occupied for a 5-year

term ending on December 31, 1996.   Petitioner agreed to pay the

Schwalbachs $4,500 per month, plus pay all utilities that it

used, all insurance on the building, and all real estate and

personal property taxes that were related to the building.

Real estate taxes paid in 1992 through 1994 totaled $8,777,

$9,113, and $8,153, respectively.

     In 1993, Dr. Schwalbach relet to Dr. Nelson the

1,200-square-foot space that he already occupied for a 5-year

term ending May 31, 1998, at a rate of $8,400 per year (i.e.,

$7 per square foot).   Dr. Nelson practiced full time in Hastings,

Minnesota, and he used the leased space 1 day a week; petitioner

had the right to use the space when Dr. Nelson did not. Dr.
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Nelson and Dr. Schwalbach negotiated the stated rent, but

Dr. Schwalbach's main intent during the negotiations was to

secure Dr. Nelson’s presence in the building 1 day a week in

order to further petitioner's business.   But for Dr. Nelson, the

River Falls area did not have an orthodontist before 1994.

     The Schwalbachs own a commercial building (the Hudson

building) in Hudson, Wisconsin, a city that is close to River

Falls.   The Hudson building is similar to the River Falls

building in terms of quality and available space, but the Hudson

building is dissimilar to the River Falls building in that the

former is unimproved space whereas the latter is tailored to the

needs of a dental practice.   During the subject years, Dr.

Schwalbach let 530 square feet in the Hudson building for $7,500

per year (i.e., $14.74 per square foot), and he let another

468-square-foot space in the Hudson building for $6,900 per year

(i.e., $14.15 per square foot).

     In connection with its lease of the River Falls building,

petitioner claimed deductions on its 1993 and 1994 tax returns

for the following amounts of rent and real estate taxes:

                                      1993      1994
          Rent                      $54,000   $54,000
          Real estate taxes           9,113     8,128
            Total                    63,113    62,128

Of these amounts, respondent disallowed the following:

                                      1993      1994
          Rent                      $28,800   $28,800
          Real estate taxes           9,112     8,040
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              Total                      37,912     36,840

     Petitioner also claimed a $2,184 NOL deduction on its 1993

tax return.    The return stated that petitioner had sustained a

$13,647 NOL in 1992, that it carried back $11,463 of this loss to

1989, and that it was carrying forward the rest to 1993.

Respondent disallowed this deduction because, respondent

determined, petitioner had not proven its right to it.

                               OPINION

     We must first decide whether the rent (inclusive of the real

estate taxes) that petitioner paid the Schwalbachs for the River

Falls building equaled the fair rental value of the premises.1

Respondent determined it did not.    Respondent argues that the

fair rental value of the leased premises is $7 a square foot, as

evidenced by the rental rate that the Schwalbachs charged Dr.

Nelson for a portion of the same building.        Petitioner argues

that the rent charged Dr. Nelson is not representative of fair

rental value and that it may deduct all the rent it paid the

Schwalbachs.

     We agree with petitioner.    Generally, a taxpayer may deduct

reasonable rent paid for property used in a trade or business.

Sec. 162(a)(3); Milbrew, Inc. v. Commissioner, 710 F.2d 1302,

1308 (7th Cir. 1983), affg. T.C. Memo. 1981-610; Limericks, Inc.


     1
       The parties have treated the real estate taxes paid by
petitioner as additional rent. We do likewise.
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v. Commissioner, 165 F.2d 483, 484 (5th Cir. 1948), affg. 7 T.C.

1129 (1946); Levenson & Klein, Inc. v. Commissioner, 67 T.C. 694,

715 (1977).   When the lessor and the lessee are related, however,

the lessee's deduction for rent is limited to the rent it would

have paid had the terms of the lease been reached at arm's

length; i.e., the lessee's deduction is limited to the premises'

fair rental value.   Sparks Nugget, Inc. v. Commissioner, 458 F.2d

631, 635 (9th Cir. 1972), affg. T.C. Memo. 1970-74; Levenson &

Klein, Inc. v. Commissioner, supra at 715; see also Milbrew, Inc.

v. Commissioner, supra at 1308.   Fair rental value is a factual

determination, Utter-McKinley Mortuaries v. Commissioner,

225 F.2d 870, 872-873 (9th Cir. 1955), affg. a Memorandum Opinion

of this Court, and petitioner bears the burden of proof, Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).   Close

scrutiny of the facts is appropriate here because the lessee

(petitioner) and the lessor (the Schwalbachs) are related.

Ingle Coal Corp. v. Commissioner, 174 F.2d 569, 571 (7th Cir.

1949), affg. 10 T.C. 1199 (1948); Limericks, Inc. v.

Commissioner, supra at 484; Estate of Schneider v. Commissioner,

88 T.C. 906, 938 (1987), affd. 855 F.2d 435 (7th Cir. 1988).

     We are satisfied that petitioner paid the Schwalbachs fair

rental value for the River Falls building.   In the respective

years at issue, petitioner's rental rate equaled no more than

$17.53 and $17.26 per square foot ($63,113/3,600 sq. ft. and
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$62,128/3,600 sq. ft.).2    These rental rates, which were reached

by the parties to the lease following their informed review, are

slightly higher than the square footage rates that the

Schwalbachs charged the tenants of the Hudson building.    Given

the additional fact that the Hudson building is unimproved

property, and that the River Falls building is an established

dental clinic, we believe that the market adequately supports the

rental rates that the Schwalbachs charged petitioner for the

River Falls building.

     Respondent looks to the $7 rate charged to Dr. Nelson and

argues that this rate represents the fair rental rate of space in

the River Falls building.    We do not agree.   The $7 rate charged

Dr. Nelson is not an adequate measure of fair rental value.

Dr. Schwalbach was prompted to let the premises to Dr. Nelson in

order to secure his presence in the building 1 day a week.    We do

not believe that Dr. Nelson let the premises at the price that a

lessee would have paid an unrelated lessor to use the premises

daily seeing that Dr. Nelson used the premises only 1 day a week,

and petitioner was entitled to use the space on other days.    Such

a compulsion on the part of the lessor, and such a limitation on

the part of the lessee, is contrary to the test of fair rental


     2
       We are unable   to determine the exact rental rate for the
3,600 square feet of   building space because the record does not
reveal the amount of   rent that was attributable to petitioner's
lease of the parking   lot.
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value.    Accordingly, the rate charged Dr. Nelson was not the

measure of fair rental value.

     As to the remaining issue, i.e., the deductibility of the

NOL, section 172 allows a taxpayer to deduct an NOL equal to the

sum of NOL carryovers plus NOL carrybacks to that year.     Sec.

172(a).    Petitioner, as the claimant of an NOL, must prove its

right thereto.    United States v. Olympic Radio & Television,

Inc., 349 U.S. 232, 235 (1955).    A deduction for an NOL is not a

matter of right; it is a matter of legislative grace.      Id.;

Deputy v. duPont, 308 U.S. 488, 493 (1940).

     The record does not show that petitioner incurred an NOL in

1992, or that any portion of this NOL, if in fact one was

sustained, was properly applied in 1993.    Petitioner must prove

not only that it had an NOL in 1992, but that a portion of an NOL

was properly deductible in 1993.    See Jones v. Commissioner,

25 T.C. 1100, 1104 (1956), revd. and remanded on other grounds

259 F.2d 300 (5th Cir. 1958); Vaughan v. Commissioner, 15 B.T.A.

596 (1929); see also sec. 172(b)(1)(A), (2), and (3) (absent an

election to the contrary, an NOL for any taxable year must first

be carried back 3 years and then forward 15 years).    Although

petitioner's 1993 tax return reports that petitioner incurred an

NOL in 1992, and that it carried back a portion of this loss to

1989, these representations are not enough for petitioner to meet

its burden.    See Jones v. Commissioner, supra at 1104.   We hold
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for respondent on this issue.    In reaching all our holdings

herein, we have considered all arguments by the parties for

contrary holdings, and, to the extent not discussed above, find

those arguments to be irrelevant or without merit.     To reflect

the foregoing,


                                          Decision will be entered

                                     under Rule 155.
