                          T.C. Memo. 2011-29



                        UNITED STATES TAX COURT



         DKD ENTERPRISES a.k.a. DKD ENTERPRISES, INC., ET AL.,1
                             Petitioners v.
              COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 24403-07, 24404-07,      Filed January 31, 2011.
                 10818-08, 10819-08.



     James R. Monroe, for petitioners.

     Catherine S. Tyson, for respondent.




     1
      Cases of the following petitioners are consolidated here-
with: Debra K. Dursky, docket Nos. 24404-07 and 10819-08; and
DKD Enterprises a.k.a. DKD Enterprises, Inc., docket No. 10818-
08.
                                      - 2 -

                 MEMORANDUM FINDINGS OF FACT AND OPINION


        CHIECHI, Judge:     Respondent determined the following defi-

ciencies in, additions under section 6651(a)(1)2 to, and

accuracy-related penalties under section 6662(a) on each peti-

tioner’s Federal income tax (tax):

                                                           Accuracy-Related
                                    Addition to Tax             Penalty
Petitioner    Year   Deficiency   Under Sec. 6651(a)(1)   Under Sec. 6662(a)
    DKD       2003   $23,458.61        $2,345.86                 --
              2004   47,740.00          4,774.00              $9,548.00
              2005   42,376.00             --                  8,475.00


Ms. Dursky    2003   17,476.00             --                    --
              2004   16,403.00             --                  3,280.60
              2005   12,604.00             --                  2,520.80

        The issues remaining for decision for the years at issue

are:3

        (1)   Is DKD Enterprises, Inc. (DKD), entitled to deduct

under section 162(a) certain respective amounts relating to its

cattery activity that it (a) reimbursed to Debra K. Dursky (Ms.

Dursky) and her personal partner, Elizabeth Watkins (Ms.


        2
      All section references are to the Internal Revenue Code in
effect for the years at issue. All Rule references are to the
Tax Court Rules of Practice and Procedure.
        3
      In addition to the issues remaining for decision that are
listed in the text, there are other questions relating to certain
determinations in the respective notices of deficiency with
respect to those years that respondent issued to Ms. Dursky and
DKD which are computational in that their resolution flows from
our resolution of certain of the issues that we address herein.
                                    - 3 -

Watkins), (b) paid to Ms. Watkins, (c) paid for certain “taxes

and licenses”, and (d) paid to Ms. Dursky?       We hold that it is

not.

       (2)   Is Ms. Dursky required to include in gross income as

constructive dividends the certain respective amounts that we

have held with respect to issue (1) DKD is not entitled to

deduct?      We hold that she is.

       (3)   In the light of our holdings with respect to issues

(1) and (2), is Ms. Dursky entitled to deduct under section

162(a) the certain respective amounts that we have held DKD is

not entitled to deduct?      We hold that she is not.

       (4)   In the light of our holding with respect to issue (1),

is Ms. Dursky entitled to deduct in Schedule E, Supplemental

Income and Loss (Schedule E), certain respective amounts of home

mortgage interest and real estate taxes that she paid?         We hold

that she is not.

       (5)   Is DKD a qualified personal service corporation, as

defined in section 448(d)(2), that is subject to the 35-percent

tax rate prescribed in section 11(b)(2)?       We hold that it is not.

       (6)   Is DKD entitled to deduct under section 162(a) certain

amounts that it paid into a certain account that Fidelity

Investments maintained for it?       We hold that it is not.

       (7)   Is Ms. Dursky required to include in gross income as

constructive dividends certain amounts that we have held with
                                 - 4 -

respect to issue (6) DKD is not entitled to deduct?    We hold that

she is.

       (8)   Is DKD entitled to deduct under section 162(a) certain

amounts of premiums that it paid with respect to a health

insurance policy that Ms. Dursky purchased for herself?    We hold

that it is not.

       (9)   Is Ms. Dursky entitled to exclude from gross income the

certain amounts of premiums that that we have held with respect

to issue (8) DKD is not entitled to deduct?    We hold that she is

not.

                           FINDINGS OF FACT

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

       At all relevant times, including throughout 2003 through

2005 (the years at issue) and at the times Ms. Dursky filed the

respective petitions in the cases at docket Nos. 24404-07 and

10819-08, Ms. Dursky resided in a house that she owned (Ms.

Dursky’s residence) in West Des Moines, Iowa (West Des Moines).

For an undisclosed period starting before the years at issue to

at least the time of the trial in these cases, Ms. Dursky’s

personal partner, Ms. Watkins, resided with Ms. Dursky in Ms.

Dursky’s residence.

       At all relevant times, including throughout the years at

issue and at the times DKD filed the respective petitions in the
                               - 5 -

cases at docket Nos. 24403-07 and 10818-08, DKD maintained its

place of operation at Ms. Dursky’s residence.

     At all relevant times, Ms. Dursky was the sole owner of Ms.

Dursky’s residence, which had approximately 2,100 square feet of

space.   During each of the years at issue, the monthly fair

rental value of Ms. Dursky’s residence was $1,600.

     Dallas County, Iowa (Dallas County), the county in which Ms.

Dursky’s residence was located, assessed the following real

property tax on that residence for the real property tax year

indicated:

                  Real Property         Real Property Tax
                   Tax Assessed        Year Ended March 31
                      $3,976                   2003
                       3,966                   2004
                       3,708                   2005
                       3,630                   2006

     At all relevant times, Ms. Dursky’s residence was subject to

a home mortgage loan on which Ms. Dursky paid an undisclosed

amount of interest (home mortgage interest) during each of the

years at issue.

     For an undisclosed period starting before 1997 through at

least the years at issue, Ms. Dursky was an information

technology (IT) consultant.   On May 28, 1997, Ms. Dursky

incorporated DKD to provide IT consulting services.
                                - 6 -

       At all relevant times, including throughout the years at

issue, DKD employed Ms. Dursky, who was the sole stockholder and

the sole officer of DKD, to perform IT consulting services for

it.4

       At all relevant times, including throughout the years at

issue, DKD provided IT consulting services to a company known as

Octagon.    At those times, Octagon, in turn, provided IT

consulting services to other companies such as Wells Fargo.

Octagon paid DKD on an hourly basis for the IT consulting

services that DKD performed for it.     During the years at issue,

Ms. Dursky was the only person whom DKD employed to work on

matters relating to DKD’s IT consulting business.

       Ms. Dursky spent approximately 2,000 hours during 2003 and

approximately 2,200 hours during each of the years 2004 and 2005

working for DKD in its IT consulting business.    DKD paid Ms.

Dursky $80,400 annually as compensation for the IT consulting

work that she performed for DKD during each of the years 2003,

2004, and 2005.5

       For each of the years 2003 through 2005, DKD issued to Ms.

Dursky Form W-2, Wage and Tax Statement (Form W-2), in which it


       4
      At least during the years at issue, Ms. Dursky did not have
a written employment agreement with DKD.
       5
      DKD also paid Ms. Dursky $80,400 annually as compensation
for the IT consulting work that she performed for DKD during each
of the years 2001 and 2002.
                              - 7 -

reported that it had paid her wages of $80,400.   In each of those

Forms W-2, DKD also reported certain respective amounts of

“Federal income tax withheld”, “Social security wages”, “Social

security tax withheld”, “Medicare wages and tips”, “Medicare tax

withheld”, “State wages, tips, etc.”, and “State income tax”.

DKD did not report any other amounts in each of those forms.

     Throughout the years at issue, Ms. Dursky’s personal assets

consisted primarily of Ms. Dursky’s residence, certain retirement

accounts, certain automobiles, certain stocks, including her 100-

percent stock interest in DKD, a joint checking account that Ms.

Dursky maintained with Ms. Watkins, and certain cats, kittens,

and equipment (e.g., cat trees, feeding bowls, litter boxes)

relating to a cattery.

Cattery Activity of Ms. Dursky and Ms. Watkins

     Since at least 1989 Ms. Watkins, and since at least 1994 Ms.

Dursky, each was engaged in the hobby of operating a cattery from

which each derived significant personal pleasure.   That cattery

operation included breeding, raising, and offering for sale

certain cats and certain kittens, attending certain cat shows,

and entering in some of those shows some of those cats and

kittens (cattery activity).

     At a time not disclosed by the record before the years at

issue, Ms. Dursky and Ms. Watkins became engaged in the hobby of

jointly operating a cattery (cattery activity of Ms. Dursky and
                               - 8 -

Ms. Watkins) from which they continued to derive significant

personal pleasure.   Ms. Dursky and Ms. Watkins had at least the

following two breeds of cats in the cattery activity of Ms.

Dursky and Ms. Watkins:   The Maine Coon breed (Maine Coons) and

the Norwegian Forest breed (Norwegian Forest cats).6

     The cattery activity of Ms. Dursky and Ms. Watkins took

place in Ms. Dursky’s residence, except for attending cat shows

and visiting veterinarians.   The cattery activity of Ms. Dursky

and Ms. Watkins required them to spend substantial time and

substantial money in operating that activity.   As part of the

cattery activity of Ms. Dursky and Ms. Watkins, they traveled

extensively to certain cat shows in the United States.   The money

that Ms. Dursky and Ms. Watkins spent in operating that activity

was for, inter alia, cat food, cat litter, veterinarians, cat

show entrance fees, and transportation, meals, and lodging

relating to the attendance by Ms. Dursky and/or Ms. Watkins at

certain cat shows.

     At a time not disclosed by the record before the years at

issue, Ms. Dursky and Ms. Watkins created a Web site (cattery

activity Web site) that they maintained for the cattery activity


     6
      In 1989, a person or persons not identified by the record
operated a cattery for Maine Coons. In 1994, Ms. Dursky was
operating a cattery for Norwegian Forest cats. In 1997, Ms.
Dursky and Ms. Watkins were jointly operating a cattery for
Norwegian Forest cats. At a time not disclosed by the record,
Ms. Dursky and Ms. Watkins were jointly operating a cattery for
Maine Coons.
                                 - 9 -

of Ms. Dursky and Ms. Watkins.    At the time of the trial in these

cases, the general public was able to access that Web site,

although it had not been updated since 2002.

     The cattery activity Web site stated:     “We treat our cats as

members of our family”, and “we have invested too much love in

our wonderful kittens to risk exposing them to an uncertain and

risky environment.”   The cattery activity Web site also indicated

that kittens were born in one of the bedrooms in Ms. Dursky’s

residence, that the kittens stayed in the bedroom for five to

eight weeks after birth, and that after the kittens were older

and well socialized “they are then allowed to run the house with

the other cats.”   The cattery activity Web site stated that “Our

goal * * * is to breed healthy, well-socialized Wegies [Norwegian

Forest cats] who are at home--whether in the show ring or simply

as a beloved member of the family.”      That Web site further stated

that “Our goal is to breed healthy, large, shaggy coated Maine

Coons with a gentle, loving personality.”

     As part of the cattery activity of Ms. Dursky and Ms.

Watkins, Ms. Dursky and Ms. Watkins participated in certain

competitions, clubs, and associations and attended cat shows over

much of the United States and developed relationships with cat

breeders around the world.   In this regard, the cattery activity

Web site stated:
                               - 10 -

     We currently show exclusively in the Cat Fanciers
     Association (CFA). We have shown five of our cats to
     Regional Wins and two of our female NFC’s [Norwegian
     Forest cats] have produced such outstanding offspring
     that they achieved the coveted title of CFA
     Distinguished Merit. Currently less than 10 Norwegian
     Forest Cats throughout the world have been awarded the
     title of Distinguished Merit--it is the highest award
     that CFA presents to a breeding pedigreed cat and we
     are very proud to [be] the owners of TWO NFC DM’s
     [Distinguished Merits]! We are currently members of
     two CFA clubs, the Hawkeye Cat Club and the Lucky
     Tomcat Club. In addition, we are also members of the
     CFA Norwegian Forest Cat Breed Council and Deb [Ms.
     Dursky] is a Breeder Member of the Norwegian Forest Cat
     Fanciers Association. By attending shows over much of
     the United States we have developed friendships with
     breeders and exhibitors from around the world. Our
     success is built on the trust of those breeders who
     have sold us our cats, permitted us to use their studs,
     and to all those breeders who came before them. * * *

     The cattery activity Web site also indicated that the Cat

Fanciers’ Association (CFA), the largest association for owners

of cats in the United States,7 had designated the cattery

activity of Ms. Dursky and Ms. Watkins as a “CFA Approved Cattery

of Excellence”.    The cattery activity Web site advertised for

sale a cat for $75, a cat for $150, a kitten for $200, and a

kitten for $400.

Cattery Activity During the Years at Issue

     During each of the years at issue, DKD had two activities:

A consulting activity and a cattery activity (DKD’s cattery




     7
      CFA imposed ethical standards and practices for catteries.
                                - 11 -

activity).8    Ms. Dursky and Ms. Watkins operated DKD’s cattery

activity.     DKD’s cattery activity was the cattery activity in

which Ms. Dursky and Ms. Watkins had engaged before the years at

issue.    While operating DKD’s cattery activity during each of the

years at issue, Ms. Dursky and Ms. Watkins continued to breed,

raise, and offer for sale certain cats and certain kittens at Ms.

Dursky’s residence9 and to attend certain cat shows in some of

which they entered some of those cats and kittens.10    As was true

while they were operating the cattery activity of Ms. Dursky and

Ms. Watkins before the years at issue, Ms. Dursky and Ms. Watkins

continued to derive significant personal pleasure while operating

DKD’s cattery activity during the years at issue.

     During each of the years at issue, DKD used, without

purchasing, in DKD’s cattery activity the assets (e.g., cats,

kittens, cat trees, feeding bowls, litter boxes) that Ms. Dursky




     8
      By referring to the cattery activity of DKD as “DKD’s
cattery activity”, we are in no way implying or suggesting that
during any of the years at issue DKD’s cattery activity
constituted a trade or business of DKD within the meaning of sec.
162(a).
     9
      Of the approximately 2,100 square feet of space at Ms.
Dursky’s residence, Ms. Dursky and Ms. Watkins used approximately
474 square feet in operating DKD’s cattery activity during each
of the years at issue.
     10
      During each of the years at issue, Ms. Dursky and Ms.
Watkins did not attend all of the cat shows in which they entered
certain cats and/or kittens while operating DKD’s cattery
activity.
                              - 12 -

and Ms. Watkins had used before those years in the cattery

activity of Ms. Dursky and Ms. Watkins.

     During each of the years at issue, Ms. Dursky spent

approximately 800 hours in operating DKD’s cattery activity.    As

discussed above, during each of those years, DKD continued to pay

to Ms. Dursky the same amount of wages (i.e., $80,400) that it

had paid to her in 2001 and 2002.   The wages that DKD paid to Ms.

Dursky also remained unchanged in 2006, the year in which DKD

discontinued DKD’s cattery activity.

     During each of the years at issue, Ms. Watkins spent more

hours than Ms. Dursky in operating DKD’s cattery activity.

During each of those years, DKD made payments to Ms. Watkins

totaling $7,700.   (We shall refer to any, some, or all of those

payments as DKD’s payments to Ms. Watkins.)   For each of the

years at issue, DKD withheld Social Security tax and Medicare tax

from DKD’s payments to Ms. Watkins.

     For each of the years at issue, DKD issued Form W-2 to Ms.

Watkins in which it reported that it had paid her wages of

$7,700.   For each of those years, Ms. Watkins filed a tax return

in which she included in gross income the $7,700 that she had

received from DKD during each such year.

     For each of the taxable years at issue, DKD filed Form 940,

Employer’s Annual Federal Unemployment (FUTA) Tax Return, and for

each quarter during each of those years, DKD filed Form 941,
                               - 13 -

Employer’s Quarterly Federal Tax Return.   In each of those forms,

DKD reported DKD’s payments to Ms. Watkins and paid any Federal

tax shown due in each such form.

     During the years at issue, while operating DKD’s cattery

activity Ms. Dursky and Ms. Watkins desired to expand on the

national reputation of the cattery activity of Ms. Dursky and Ms.

Watkins that they had developed before those years.   In order to

do so, Ms. Dursky and Ms. Watkins relied on their respective

years of cattery activity experience and their respective

reputations in the so-called cattery world.

     While operating DKD’s cattery activity during the years at

issue, Ms. Dursky and Ms. Watkins bred, raised, and offered for

sale Norwegian Forest cats and entered certain of those cats in

certain cat shows.11   Starting at an undisclosed time in 2004,

they bred, raised, and offered for sale Abyssinian cats and

entered certain of those cats in certain cat shows.

     While operating DKD’s cattery activity during 2003, Ms.

Dursky and Ms. Watkins produced approximately seven to nine

kittens from approximately five to seven litters.   While

operating DKD’s cattery activity during each of the years 2004




     11
      The number of breeders that bred Norwegian Forest cats in
the Midwest region of the United States increased from
approximately three at the beginning of 2003 to approximately 10
to 15 by 2005.
                                - 14 -

and 2005, Ms. Dursky and Ms. Watkins produced approximately nine

kittens from approximately three litters.

       While operating DKD’s cattery activity during the years at

issue, Ms. Dursky and Ms. Watkins entered at least 62 cats,

49 cats, and 45 cats, respectively, in various cat shows that

were typically held on the east coast or the west coast of the

United States.    In order to enter a cat in any such show, the

owner of the cat was required to prepay a nonrefundable entrance

fee.    Ms. Dursky and Ms. Watkins did not attend all the cat shows

in which they entered cats.     During the years at issue, Ms.

Watkins typically attended cat shows without Ms. Dursky, although

Ms. Dursky attended some cat shows with Ms. Watkins.12

       While operating DKD’s cattery activity during 2003, 2004,

and 2005 Ms. Watkins attended 30 cat shows, 31 cat shows, and

28 cat shows, respectively, and Ms. Dursky attended a relatively

small number of those shows with Ms. Watkins.    When one or both

of them attended a cat show, one or both made arrangements for

travel and lodging.    If Ms. Dursky and/or Ms. Watkins attended a

cat show that was not within driving distance of West Des Moines,

it took approximately 40 hours in order to travel to and from,

and participate in, the show.    If Ms. Dursky and/or Ms. Watkins

attended a cat show that was within driving distance of West Des


       12
      The record does not establish how many cat shows during
each of the years at issue Ms. Watkins attended with Ms. Dursky
and without Ms. Dursky.
                             - 15 -

Moines, it took approximately 32 hours in order to travel to and

from, and participate in, the show.

     As was true of the cattery activity of Ms. Dursky and Ms.

Watkins before the years at issue, DKD’s cattery activity was

designated by the CFA during the years at issue as a “Cattery of

Excellence”.

     As was true of their beliefs while operating the cattery

activity of Ms. Dursky and Ms. Watkins before the years at issue,

while Ms. Dursky and Ms. Watkins were operating DKD’s cattery

activity during the years at issue they believed that the price

of any cat or kitten offered for sale would increase if the cats

and kittens that they bred won national cat shows.   While

operating DKD’s cattery activity during the years at issue, Ms.

Dursky and Ms. Watkins produced a total of four cats that won

national championships.13

     During each of the years at issue, the monthly fair rental

value of Ms. Dursky’s residence was $1,600.   During none of those



     13
      National championship winners were determined on the basis
of the total number of points earned by a cat during cat show
season. Cats earned points by winning cat shows; the number of
points earned depended on the number of cats competing in a show.
The number of cats competing in a cat show typically was not
determined until shortly before the show. Ms. Dursky and Ms.
Watkins often waited until the number of cats competing in a cat
show was determined before deciding whether to attend the show.
Because they waited until shortly before a cat show was scheduled
to take place to decide whether to attend it, Ms. Dursky and Ms.
Watkins paid a premium for any air transportation costs incurred
to attend the show.
                              - 16 -

years was there a written rental agreement between Ms. Dursky and

DKD with respect to Ms. Dursky’s residence.   Nonetheless, during

each of the years at issue, DKD paid Ms. Dursky $1,000 monthly,

or $12,000 annually (DKD’s purported rent), for its claimed

partial use of Ms. Dursky’s residence for DKD’s cattery activity.

In arriving at that amount, neither Ms. Dursky nor DKD obtained

an appraisal to determine the fair rental value of (1) Ms.

Dursky’s residence or (2) the portion of that residence used in a

cattery activity during each of the years at issue.   Instead, Ms.

Dursky, DKD, and Howard Musin (Mr. Musin), the tax return

preparer of Ms. Dursky and DKD for at least each of the years

2003 and 2004,14 agreed that DKD should pay each month to Ms.

Dursky $1,000 for the use of Ms. Dursky’s residence for a cattery

activity.   Ms. Dursky, DKD, and Mr. Musin also agreed that DKD

should pay to Ms. Dursky 10 percent of certain expenses (e.g.,

utilities, repairs) relating to Ms. Dursky’s residence as

allocable to a cattery activity.15


     14
      Mr. Musin’s colleague, Jill Schwartz (Ms. Schwartz), the
tax return preparer of DKD for the year 2001, also advised Ms.
Dursky and DKD regarding the amount that DKD should pay Ms.
Dursky for the use of Ms. Dursky’s residence for a cattery
activity.
     15
      Ms. Schwartz also advised Ms. Dursky and DKD regarding
DKD’s paying Ms. Dursky 10 percent of certain expenses (e.g.,
utilities, repairs) relating to Ms. Dursky’s residence as
allocable to a cattery activity.

     The record does not establish whether DKD paid to Ms. Dursky
                                                   (continued...)
                                - 17 -

     As was true while they were operating the cattery activity

of Ms. Dursky and Ms. Watkins before the years at issue, while

Ms. Dursky and Ms. Watkins were operating DKD’s cattery activity

during the years at issue they continued to incur and pay

substantial expenses.   As discussed below, at least during each

of the years at issue, DKD reimbursed Ms. Dursky and Ms. Watkins

for those expenses16 and also paid directly a very small amount

of expenses relating to the operation of DKD’s cattery activity.

     During each of the years at issue, Ms. Watkins used certain

computer software in order to record for each of those years the

substantial amounts expended and the insubstantial amounts

received while Ms. Dursky and Ms. Watkins were operating DKD’s

cattery activity during each of those years.

     During 2003, DKD reimbursed Ms. Dursky and Ms. Watkins

$60,968 for the following amounts (2003 reimbursed cattery

expenses) that they had paid:




     15
      (...continued)
10 percent of any such expenses.
     16
      During each of the years at issue, DKD reimbursed Ms.
Dursky and Ms. Watkins for certain amounts that they had expended
as shown on certain receipts by issuing checks drawn on DKD’s
bank account over which only Ms. Dursky had signature authority.
                                - 18 -

                    Type of Expense       Amount
                 Mileage to cat shows     $4,277
                 Motels                    5,669
                 Meals (50 percent)        1,151
                 Entry fees                6,786
                 Airfares                 13,953
                 Pet sitters               2,566
                 Rental cars               2,107
                 Cattery cleaning          1,761
                 Veterinarian bills       13,576
                 Postage                     150
                 Litter and food           5,993
                 Grooming products         1,212
                 Advertising               1,767
                   Total                  60,968

     During 2003, in addition to DKD’s payments to Ms. Watkins of

$7,700 and DKD’s purported rent of $12,000 that DKD paid to Ms.

Dursky, DKD paid directly $588 of unidentified “taxes and

licenses”.

     During 2004, DKD reimbursed Ms. Dursky and Ms. Watkins

$66,734 for the following amounts (2004 reimbursed cattery

expenses) that they had paid:
                                - 19 -

                    Type of Expense       Amount
                 Mileage to cat shows     $4,643
                 Motels                    8,385
                 Meals (50 percent)        1,814
                 Entry fees                6,338
                 Airfares                  7,652
                 Pet sitters               2,095
                 Rental cars               1,994
                 Cattery cleaning          5,080
                 Veterinarian bills       14,759
                 Postage                     167
                 Litter and food           7,029
                 Photos                      817
                 Grooming and misc.
                   supplies                3,004
                 Advertising               1,580
                 Long-distance
                   telephone               1,327
                 Misc. travel                 50
                   Total                  66,734

     During 2004, in addition to DKD’s payments to Ms. Watkins of

$7,700 and DKD’s purported rent of $12,000 that DKD paid to Ms.

Dursky, DKD paid directly $588 of unidentified “taxes and

licenses”.

     During 2005, DKD reimbursed Ms. Dursky and Ms. Watkins

$68,329 for the following amounts (2005 reimbursed cattery

expenses) that they had paid:
                             - 20 -

                    Type of Expense         Amount
                 Mileage to cat shows      $6,350
                 Motels                     8,121
                 Meals (50 percent)         1,659
                 Entry fees                 2,848
                 Airfares                  16,885
                 Rental cars                2,618
                 Veterinarian bills        13,860
                 Postage                       42
                 Litter                     1,664
                 Cat food                   8,613
                 Photos                        78
                 Grooming and misc.
                   supplies                 4,190
                 Advertising                1,401
                   Total                   68,329

     During 2005, in addition to DKD’s payments to Ms. Watkins of

$7,700 and DKD’s purported rent of $12,000 that DKD paid to Ms.

Dursky, DKD paid directly $588 of unidentified “taxes and

licenses”.

     In addition to reimbursing Ms. Dursky and Ms. Watkins for

the amounts described above that they paid during each of the

years at issue, DKD reimbursed them (1) $297.84 in 2003 for

lodging and food that they had paid in that year for the mother

of Ms. Watkins who had attended a banquet honoring them for

winning a national cat show, (2) $88.97 in 2003 for restaurant

food that Ms. Watkins’ mother had paid in that year, and (3) $412

in 2004 for entry tickets to Walt Disney World that Ms. Dursky

and Ms. Watkins had paid in that year.   (We shall refer to the

reimbursements described in (1) and (2) as DKD’s 2003 reimburse-
                              - 21 -

ments for lodging and food relating to Ms. Watkins’ mother.     We

shall refer to the reimbursements described in (3) as DKD’s 2004

reimbursements for entry tickets for Ms. Dursky and Ms. Watkins

to Walt Disney World.)

     During 2003, Ms. Dursky and Ms. Watkins did not sell any

cats or kittens while operating DKD’s cattery activity.    During

2004, Ms. Dursky and Ms. Watkins did not sell any cats or kittens

while operating DKD’s cattery activity except for three cats

and/or kittens that they sold in December of that year for a

total of $250.   During 2005, Ms. Dursky and Ms. Watkins did not

sell any cats or kittens while operating DKD’s cattery activity

except for a total of eight cats and/or kittens that they sold in

June, July, August, October, and November of that year for a

total of $1,525.17

     In 2006, at an undisclosed time in or before August, Mr.

Musin and Ms. Schwartz informed petitioners that the Internal

Revenue Service (IRS) was investigating Mr. Musin and Ms.

Schwartz and intended to commence an examination of petitioners’

respective tax returns for 2003 and 2004.   As a result, around

August 2006, (1) Ms. Dursky and Ms. Watkins discontinued



     17
      During 2005, while operating DKD’s cattery activity Ms.
Dursky and Ms. Watkins sold (1) a total of three cats and/or
kittens in June for a total of $200, (2) a total of two cats
and/or kittens in July for a total of $200, (3) one cat or kitten
in August for $100, (4) one kitten in October for $575, and
(5) one kitten in November for $450.
                              - 22 -

operating DKD’s cattery activity,18 (2) Ms. Dursky and Ms.

Watkins continued operating that cattery activity as the cattery

activity of Ms. Dursky and Ms. Watkins, and (3) Ms. Dursky and

DKD retained James R. Monroe (Mr. Monroe).19

Certain Retirement Accounts

     Vanguard

     In December 1995, Ms. Dursky executed a document entitled

“VANGUARD PROFIT-SHARING PLAN SIMPLIFIED ADOPTION AGREEMENT

(006)” (Vanguard plan document) that by its terms was effective

on January 1, 1995.   The Vanguard plan document stated that Debra

K. Dursky was the employer and that the employer was a “Sole

Proprietor/Self-Employed Individual”.   That document also stated

that Debra K. Dursky was the plan administrator and that Vanguard

Fiduciary Trust Company (Vanguard) was the plan trustee.     The

Vanguard plan document did not identify a beneficiary.   The

Vanguard plan document also stated:

     the Employer [Debra K. Dursky] shall make contributions
     to the Trust for each Plan Year in an amount determined
     by the Employer in its sole discretion by resolution
     duly adopted on or before the last day for filing its
     federal income tax return, including extensions, for


     18
      Although Ms. Dursky and Ms. Watkins did not discontinue
operating DKD’s cattery activity until around August 2006, as
discussed below, DKD did not claim any deductions relating to
DKD’s cattery activity in the tax return that it filed for its
taxable year 2006.
     19
      Mr. Monroe prepared petitioners’ respective tax returns
for 2005 and is the lead attorney representing petitioners in
these cases.
                               - 23 -

     the taxable year with or within which such Plan Year
     ends.

     Pursuant to the Vanguard plan document, on certain dates in

2003 and 2006 Ms. Dursky sent the following checks to Vanguard

that she intended to be contributions under that plan document.

On December 30, 2003, Ms. Dursky sent a $10,000 check to Vanguard

for her benefit that was drawn on DKD’s bank account maintained

at Bankers Trust (DKD’s bank account).      In the so-called memo

portion of that check, Ms. Dursky wrote, inter alia, “2003

Keogh”.   On April 10, 2006, Ms. Dursky sent a $10,000 check to

Vanguard for her benefit that was drawn on DKD’s bank account.

     During none of the years 2003 through 2005 did Ms. Dursky

make any contributions under the Vanguard plan document for the

benefit of Ms. Watkins.

     Fidelity

     On December 28, 2001, Ms. Dursky executed on behalf of DKD a

document that was entitled “Profit Sharing Plan Application”

(Fidelity application document) in order to open an account for a

profit-sharing plan at Fidelity (DKD Fidelity profit-sharing

plan).    Ms. Dursky completed and signed that document on behalf

of DKD.    The Fidelity application document indicated that the

employer was DKD Enterprises, Inc.      Nonetheless, Ms. Dursky

checked the box in that document marked “Self-Employed” and did

not check the box marked “Incorporated”.      In response to the

question in the Fidelity application document “Do you currently
                                - 24 -

have or have you ever maintained another qualified plan?”, Ms.

Dursky stated:   “Vanguard - 15% Fidelity - 85%”.

     On December 28, 2001, Ms. Dursky also executed on behalf of

DKD a document that was entitled “Profit Sharing Plan

Contribution Form” (Fidelity contribution document).    The

Fidelity contribution document indicated that the only

participant under the DKD Fidelity profit-sharing plan was Ms.

Dursky.

     On certain dates in 2004, 2005, and 2006 DKD sent the

following checks to Fidelity that were intended to be

contributions under the DKD Fidelity profit-sharing plan.     On

April 14, 2004, DKD sent a $10,000 check to Fidelity for the

benefit of Ms. Dursky that was drawn on DKD’s bank account.      In

the so-called memo portion of that check, Ms. Dursky wrote, inter

alia, “Fidelity Profit Sharing Keogh * * * for 2003”.    On

December 27, 2004, DKD sent a $10,000 check to Fidelity for the

benefit of Ms. Dursky that was drawn on DKD’s bank account.      In

the so-called memo portion of that check, Ms. Dursky wrote, inter

alia, “Keogh * * * for 2004”.    On April 11, 2005, DKD sent a

$10,000 check to Fidelity for the benefit of Ms. Dursky that was

drawn on DKD’s bank account.    In the so-called memo portion of

that check, Ms. Dursky wrote, inter alia, “2004 Keogh”.    On April

10, 2006, DKD sent a $5,000 check to Fidelity for the benefit of

Ms. Dursky that was drawn on DKD’s bank account.    In the so-
                             - 25 -

called memo portion of that check, Ms. Dursky wrote, inter alia,

“2005”.

     During none of the years 2003 through 2005 did DKD send any

checks to Fidelity that were intended to be contributions under

the DKD Fidelity profit-sharing plan for the benefit of Ms.

Watkins.

Ms. Dursky’s Health Insurance Policy

     At a time not disclosed by the record, Ms. Dursky purchased

a health insurance policy in her name (Ms. Dursky’s health

insurance policy) that was in effect at least during each of the

years 2003 and 2004 and that required her to pay certain

quarterly premiums to the company (health insurance provider)

that issued that policy to her.   During 2003 and 2004, DKD paid

to Ms. Dursky’s health insurance provider the following premiums

on the dates indicated for Ms. Dursky’s health insurance policy:

     2003
                   Date             Amount
                 Mar. 30          $1,687.50
                 July 14           1,687.50
                 Sept. 14          1,687.50
                 Dec. 30           1,887.60
                   Total           6,950.10

     2004
                 Apr. 5           $1,887.60
                 June 16           1,887.60
                 Oct. 4            1,887.60
                 Dec. 27           1,988.70
                   Total           7,651.50
                                - 26 -

DKD’s Tax Returns

     2001

     DKD filed Form 1120, U.S. Corporation Income Tax Return

(Form 1120), for 2001 (DKD’s 2001 return) that Ms. Schwartz

signed as return preparer and that Ms. Dursky signed as the sole

officer of DKD.     In Schedule K, Other Information (Schedule K),

of DKD’s 2001 return, DKD indicated that it was on the cash

method of accounting.

     In DKD’s 2001 return, DKD reported (1) “Gross receipts or

sales” of $2,770,20 (2) “returns and allowances” of zero,

(3) “Cost of goods sold” of zero, (4) “Other income” of

$226,923,21 and (5) “Total income” of $229,693.

     In DKD’s 2001 return, DKD claimed, inter alia, the following

deductions:   (1) “Compensation of officers” of $80,400,

(2) “Salaries and wages” of zero, (3) “Rents” of $19,150,

(4) “Taxes and licenses” of $6,307,22 (5) “Pension, profit-

sharing, etc., plans” of $30,000, and (6) “Employee benefit

programs” of $8,852.    In that return, DKD also claimed “Other



     20
      The record does not establish the nature of the “Gross
receipts or sales” that DKD reported in DKD’s 2001 return.
     21
      DKD included a schedule with DKD’s 2001 return in which
DKD indicated that the “Other income” of $226,923 reported
consisted of (1) consulting revenue of $223,796 and (2) an Iowa
State tax refund of $3,127.
     22
      DKD included a statement with DKD’s 2001 return in which
it described the “Taxes and licenses” claimed as “payroll taxes”.
                              - 27 -

deductions” of $55,210.   DKD included a schedule with DKD’s 2001

return in which it indicated that the “Other deductions” claimed

consisted of the following types and amounts of deductions:

                 Claimed Deduction          Amount
                                1
               Cattery expenses            $19,391
                         1
               Show fees                     4,076
               Promotional labor             1,850
               Accounting                    1,100
               Postage                         541
               Insurance                     1,966
               Insurance - workman’s
                 compensation                  213
               Licenses and permits             50
               Meals                         1,772
               Supplies                      9,034
               Telephone                     2,183
               Travel1                      12,680
               Utilities                       354
                 Total                      55,210
     1
       DKD’s claimed deductions for “Cattery expenses”, “Show
fees”, and “Travel” were for amounts that Ms. Dursky and Ms.
Watkins paid during 2001 in operating the cattery activity of Ms.
Dursky and Ms. Watkins.

     DKD attached to DKD’s 2001 return Schedule L, Balance Sheets

per Books (Schedule L), for 2001 (2001 Schedule L).   In that

schedule, DKD showed the following assets:   “Cash”, “Trade notes

and accounts receivable”, and “Buildings and other depreciable

assets”.   DKD did not show any other assets in the 2001 Schedule

L, such as cats, kittens, cat trees, feeding bowls, litter boxes,

or other assets relating to a cattery activity.
                              - 28 -

     2002

     DKD filed Form 1120 for 2002 (DKD’s 2002 return) that Mr.

Musin signed as return preparer and that Ms. Dursky signed as the

sole officer of DKD.   In Schedule K of DKD’s 2002 return, DKD

indicated that it was on the cash method of accounting.

     In DKD’s 2002 return, DKD reported (1) “Gross receipts or

sales” of $800,23 (2) “returns and allowances” of zero, (3) “Cost

of goods sold” of zero, (4) “Other income” of $198,608,24 and

(5) “Total income” of $199,408.

     In DKD’s 2002 return, DKD claimed, inter alia, the following

deductions:   (1) “Compensation of officers” of $80,400,

(2) “Salaries and wages” of $7,350, (3) “Rents” of $19,800,

(4) “Taxes and licenses” of $7,354,25 (5) “Pension, profit-

sharing, etc., plans” of $10,000, and (6) “Employee benefit

programs” of $6,931.   In that return, DKD also claimed “Other

deductions” of $58,424.   DKD included a schedule with DKD’s 2002

return in which it indicated that the “Other deductions” claimed

consisted of the following types and amounts of deductions:



     23
      The record does not establish the nature of the “Gross
receipts or sales” that DKD reported in DKD’s 2002 return.
     24
      DKD included a schedule with DKD’s 2002 return in which
DKD indicated that the “Other income” of $198,608 reported
consisted of (1) consulting revenue of $197,466 and (2) an Iowa
State tax refund of $1,142.
     25
      DKD included a statement with DKD’s 2002 return in which
it described the “Taxes and licenses” claimed as “payroll taxes”.
                                - 29 -

                   Claimed Deduction        Amount
                                1
               Cattery expenses            $26,784
                         1
               Show fees                     4,485
               Labor                         1,245
               Accounting                      550
               Automobile                    5,170
               Postage                         261
               Licenses and permits             45
               Office                          557
               Supplies                      1,550
               Telephone                     2,805
                                        1
               Travel and entertainment     14,571
               Utilities                       401
                 Total                      58,424
     1
       DKD’s claimed deductions for “Cattery expenses”, “Show
fees”, and “Travel and entertainment” were for amounts that Ms.
Dursky and Ms. Watkins paid during 2002 in operating the cattery
activity of Ms. Dursky and Ms. Watkins.

       DKD attached to DKD’s 2002 return Schedule L for 2002.   In

that schedule, DKD did not show any assets.

       2003

       DKD filed late Form 1120 for 2003 (DKD’s 2003 return), the

first year at issue in these cases, that Mr. Musin signed as

return preparer and that Ms. Dursky signed as the sole officer of

DKD.    In Schedule K of DKD’s 2003 return, DKD indicated that it

was on a “MODIFIED ACCRUAL” method of accounting but did not

indicate what that meant.

       In DKD’s 2003 return, DKD reported (1) “Gross receipts or

sales” of $197,582.     None of that amount was from DKD’s cattery

activity.     In DKD’s 2003 return, DKD also reported (1) “returns

and allowances” of zero, (2) “Cost of goods sold” of zero,
                               - 30 -

(3) “Other income” consisting of an “IOWA TAX REFUND” of $675,

and (4) “Total income” of $198,257.

     In DKD’s 2003 return, DKD claimed, inter alia, the following

deductions:    (1) “Compensation of officers” of $80,400,

(2) “Salaries and wages” of $7,700, (3) “Rents” of $19,400,

(4) “Taxes and licenses” of $6,861,26 (5) “Pension, profit-

sharing, etc., plans” of $20,000, and (6) “Employee benefit

programs” of $10,274.   In that return, DKD also claimed “Other

deductions” of $75,000.   DKD included a schedule with DKD’s 2003

return in which it indicated that the “Other deductions” claimed

consisted of the following types and amounts of deductions:

                  Claimed Deduction         Amount
                                1
               Cattery expenses            $69,515
               Accounting                    2,025
               Dues and subscriptions          286
               Insurance                     1,687
               Insurance - workman’s
                 compensation                  363
               Office                           26
               Travel and entertainment      1,098
                 Total                      75,000
     1
       DKD’s claimed deduction for “Cattery expenses” of $69,515
included the 2003 reimbursed cattery expenses of $60,968. A
portion of the claimed deduction for “Cattery expenses” (i.e.,
$386.81) was for DKD’s 2003 reimbursements for lodging and food
relating to Ms. Watkins’ mother.

     DKD attached to DKD’s 2003 return Schedule L for 2003 (2003

Schedule L).    In that schedule, DKD showed the following assets:



     26
      DKD included a statement with DKD’s 2003 return in which
it described the “Taxes and licenses” claimed as “payroll taxes”.
                              - 31 -

“Cash”, “Trade notes and accounts receivable”, and “Buildings and

other depreciable assets”.   DKD did not show any other assets in

the 2003 Schedule L, such as cats, kittens, cat trees, feeding

bowls, litter boxes, or other assets relating to a cattery

activity.

     2004

     DKD filed late Form 1120 for 2004 (DKD’s 2004 return).27    In

Schedule K of DKD’s 2004 return, DKD indicated that it was on a

“MODIFIED ACCRUAL” method of accounting but did not indicate what

that meant.

     In DKD’s 2004 return, DKD reported (1) “Gross receipts or

sales” of $233,556,28 (2) “returns and allowances” of zero,

(3) “Cost of goods sold” of zero, (4) “Other income” consisting

of an “IOWA TAX REFUND” of $1,000, and (5) “Total income” of

$234,556.

     In DKD’s 2004 return, DKD claimed, inter alia, the following

deductions:   (1) “Compensation of officers” of $80,400,

(2) “Salaries and wages” of $7,700, (3) “Rents” of $24,700,




     27
      The copy of DKD’s 2004 return that is in the record is not
signed by a return preparer or by an officer of DKD.
     28
      The record does not establish whether the $250 that we
have found DKD received in 2004 for the sale of certain cats
and/or kittens in December of that year was included in the
“Gross receipts or sales” of $233,556 that DKD reported in DKD’s
2004 return.
                              - 32 -

(4) “Taxes and licenses” of $6,861,29 (5) “Pension, profit-

sharing, etc., plans” of zero, and (6) “Employee benefit

programs” of $5,763.   In that return, DKD also claimed “Other

deductions” of $105,414.   DKD included a schedule with DKD’s 2004

return in which it indicated that the “Other deductions” claimed

consisted of the following types and amounts of deductions:

                   Claimed Deduction         Amount
               Cattery expenses1            $75,091
               Accounting                      1,750
               Bank charges                      143
               Conventions and meetings        1,500
               Disability insurance            1,145
               Dues and subscriptions         20,000
               Insurance                       3,373
               Office                            189
               Meals                           1,367
               Telephone                         697
               Travel                            159
                 Total                      105,414
     1
       DKD’s claimed deduction for “Cattery expenses” of $75,091
included the 2004 reimbursed cattery expenses of $66,734. A
portion of the claimed deduction for “Cattery expenses” (i.e.,
$412) was for DKD’s 2004 reimbursements for entry tickets for Ms.
Dursky and Ms. Watkins to Walt Disney World.

     DKD attached to DKD’s 2004 return Schedule L for 2004 (2004

Schedule L).   In that schedule, DKD showed the following assets:

“Cash”, “Trade notes and accounts receivable”, and “Buildings and

other depreciable assets”.   DKD did not show any other assets in

the 2004 Schedule L, such as cats, kittens, cat trees, feeding



     29
      DKD included a statement with DKD’s 2004 return in which
it described the “Taxes and licenses” claimed as “payroll taxes”.
                                - 33 -

bowls, litter boxes, or other assets relating to a cattery

activity.

     2005

     DKD filed Form 1120 for 2005 (DKD’s 2005 return) that Mr.

Monroe,30 whom, as discussed above, DKD retained around August

2006, signed as return preparer and that Ms. Dursky signed as the

sole officer of DKD.     In Schedule K of DKD’s 2005 return, DKD

indicated that it was on a “MOD ACC” method of accounting but did

not indicate what that meant.

     In DKD’s return, DKD reported (1) “Gross receipts or sales”

of $212,970,31 (2) “returns & allowances” of zero, (3) “Cost of

goods sold” of zero, (4) “Other income” consisting of “State tax

refunds” of $1,000, and (5) “Total income” of $213,970.

     In DKD’s 2005 return, DKD claimed, inter alia, the following

deductions:     (1) “Compensation of officers” of $80,400,

(2) “Salaries and wages” of $7,700, (3) “Rents” of $22,800,

(4) “Taxes and licenses” of $6,740,32 (5) “Pension, profit-

sharing, etc., plans” of zero, (6) “Employee benefit programs” of


     30
          See supra note 19.
     31
      The record does not establish whether the $1,525 that we
have found DKD received in 2005 for the sale of certain cats
and/or kittens, see supra note 17, was included in the “Gross
receipts or sales” of $212,970 reported in DKD’s 2005 return.
     32
      Unlike DKD’s 2001 return, 2002 return, 2003 return, and
2004 return, DKD did not include a statement with DKD’s 2005
return or otherwise provide a description of the nature of the
“Taxes and licenses” of $6,740 claimed in DKD’s 2005 return.
                              - 34 -

zero, and (7) “Advertising” of $1,240.33   In that return, DKD

also claimed “Other deductions” of $62,942.   DKD included a

schedule with DKD’s 2005 return, in which it indicated that the

“Other deductions” claimed consisted of the following types and

amounts of deductions:34




     33
      We have found that during 2005 DKD reimbursed Ms. Dursky
and Ms. Watkins $1,401 for advertising.
     34
      Most of the “Other deductions” were for the 2005
reimbursed cattery expenses of $68,329. However, DKD did not
claim a deduction for the $8,121 for which we have found DKD
reimbursed Ms. Dursky and Ms. Watkins in 2005 for motels.
                             - 35 -

                   Claimed Deduction1           Amount
               Automobiles                      $6,350
               Bank charges                            38
               Legal and professional             1,175
                                                2
               Meals and entertainment            1,878
                                                3
               Miscellaneous                      5,188
               Office                                  52
                                                     4
               Postage                                 41
               Telephone                            710
                                              5
               Travel                           15,730
               Utilities                            377
               Annual report                           50
                                                6
               Entry fees                         5,363
                                                7
               Rental car                         1,214
                                              8
               Veterinarian                     13,986
                                                9
               Litter                             1,923
                                               10
               Cat food                           8,014
                                                    11
               Photos                                  53
               Stud service                         800
                 Total                          62,942
     1
       The deductions for automobiles, meals, miscellaneous, post-
age, travel, entry fees, rental cars, veterinarian, litter, cat
food, photos, and stud service related to DKD’s cattery activity.
We shall refer to those deductions as “cattery expenses”.
     2
       We have found that during 2005 DKD reimbursed Ms. Dursky
and Ms. Watkins $1,659 for meals.
     3
       We have found that during 2005 DKD reimbursed Ms. Dursky
and Ms. Watkins $4,190 for grooming and miscellaneous supplies.
     4
       We have found that during 2005 DKD reimbursed Ms. Dursky
and Ms. Watkins $42 for postage.
     5
       We have found that during 2005 DKD reimbursed Ms. Dursky
and Ms. Watkins $16,885 for airfares.
     6
       We have found that during 2005 DKD reimbursed Ms. Dursky
and Ms. Watkins $2,848 for entry fees.
     7
       We have found that during 2005 DKD reimbursed Ms. Dursky
and Ms. Watkins $2,618 for rental cars.
     8
       We have found that during 2005 DKD reimbursed Ms. Dursky
and Ms. Watkins $13,860 for veterinarian bills.
     9
       We have found that during 2005 DKD reimbursed Ms. Dursky
and Ms. Watkins $1,664 for litter.
     10
        We have found that during 2005 DKD reimbursed Ms. Dursky
and Ms. Watkins $8,613 for cat food.
     11
        We have found that during 2005 DKD reimbursed Ms. Dursky
and Ms. Watkins $78 for photos.
                                  - 36 -

       DKD attached to DKD’s 2005 return Schedule L for 2005.    In

that schedule, DKD did not show any assets.

       2006

       DKD filed Form 1120 for 2006, the year during which DKD

discontinued DKD’s cattery activity, that Mr. Monroe signed as

return preparer and that Ms. Dursky signed as the sole officer of

DKD.    In Schedule K of DKD’s Form 1120 for 2006 (DKD’s 2006

return), DKD indicated that it was on a “MOD ACC” method of

accounting but did not indicate what that meant.

       In DKD’s 2006 return, DKD reported (1) “Gross receipts or

sales” of $177,519,35 (2) “returns & allowances” of zero,

(3) “Cost of goods sold” of zero, and (4) “Total income” of

$177,519.

       In DKD’s 2006 return, DKD claimed, inter alia, the following

deductions:      (1) “Compensation of officers” of $80,400,

(2) “Salaries and wages” of zero, (3) “Rents” of zero, (4) “Taxes

and licenses” of $6,740,36 (5) “Pension, profit-sharing, etc.,

plans” of $15,000, and (6) “Employee benefit programs” of

$13,458.      In that return, DKD also claimed “Other deductions” of

$1,759.       DKD included a schedule with DKD’s 2006 return in which


       35
      The record does not establish the nature of the “Gross
receipts or sales” reported in DKD’s 2006 return.
       36
      Unlike DKD’s 2001 return, 2002 return, 2003 return, and
2004 return, DKD did not include a statement with DKD’s 2006
return or otherwise provide a description of the nature of the
“Taxes and licenses” of $6,740 claimed in DKD’s 2006 return.
                              - 37 -

it indicated that the “Other deductions” claimed consisted of the

following types and amounts of deductions:

                Claimed Deduction        Amount
             Dues and subscriptions         $35
             Legal and professional       1,550
             Miscellaneous                  124
             Annual report                   50
               Total                      1,759

     DKD did not claim any deductions in DKD’s 2006 return with

respect to DKD’s cattery activity.37

     DKD attached to DKD’s 2006 return Schedule L for 2006.    In

that schedule, DKD did not show any assets.

     Summary of DKD’s Returns for 2001 Through 2006

     The following chart summarizes DKD’s tax return treatment of

all income and certain deductions claimed for each of the years

2001 through 2006:




     37
      We have found that Ms. Dursky and Ms. Watkins operated
DKD’s cattery activity until around August 2006.
                                          - 38 -

Income                          2001      2002      2003         2004      2005        2006
  “Gross receipts or
    sales”                     $2,770      $800    $197,582    $233,556   $212,970   $177,519
  “Other income”              226,923   198,608         675       1,000      1,000       --
Deductions Claimed
  Deductions claimed
    relating to DKD’s
    cattery activity
      “Cattery expenses”      55,210     58,424      69,515      75,091     60,540       --
      “Salaries and wages”      --        7,350       7,700       7,700      7,700       --
       “Taxes and licenses”      588        588         588         588        588       --
      “Rent”                  12,000     12,000      12,000      12,000     12,000       --
  “Compensation of
    officers”                  80,400    80,400      80,400      80,400     80,400     80,400
  “Pension, profit-
    sharing, etc., plans”      30,000    10,000      20,000       --         --        15,000
  “Employee benefit
    programs”                   8,852     6,931      10,274       5,763       --       13,458
  Income (loss)                42,643    23,715      (2,220)     53,014     52,742     68,661
                              - 39 -

Ms. Dursky’s Returns

     2003

     Ms. Dursky filed Form 1040, U.S. Individual Income Tax

Return (Form 1040), for 2003 (Ms. Dursky’s 2003 return) that Mr.

Musin signed as return preparer and that she signed.   In that

return, Ms. Dursky reported “Wages, salaries, tips, etc.” of

$80,400 that she received during 2003 from DKD as compensation

for the IT consulting work that she performed for DKD during that

year.

     In Schedule A--Itemized Deductions (Schedule A) attached to

Ms. Dursky’s 2003 return, Ms. Dursky deducted “Real estate taxes”

of $3,458 and “Home mortgage interest and points” of $5,204.

     Ms. Dursky included with Ms. Dursky’s 2003 return Schedule E

for 2003 (2003 Schedule E).   In the 2003 Schedule E, Ms. Dursky

described the “rental real estate property” to which that

schedule pertained as “OFFICE SPACE WEST DES MOINE [sic] IA”.      In

that schedule, Ms. Dursky responded in the negative to the

following question:

     For each rental real estate property listed on line 1,
     did you or your family use it during the tax year for
     personal purposes for more than the greater of:

     • 14 days or

     • 10% of the total days rented at fair rental value?
                                - 40 -

     In the 2003 Schedule E, Ms. Dursky reported “Rents received”

of $19,40038 and claimed deductions for “Mortgage interest paid

to banks, etc.” of $1,555 and for “Taxes” of $610.

     2004

     Ms. Dursky filed Form 1040 for 2004 (Ms. Dursky’s 2004

return) that Mr. Musin signed as return preparer and that she

signed.     In that return, Ms. Dursky reported “Wages, salaries,

tips, etc.” of $80,400 that she received during 2004 from DKD as

compensation for the IT consulting work that she performed for

DKD during that year.

     In Schedule A attached to Ms. Dursky’s 2004 return, Ms.

Dursky deducted “Real estate taxes” of $3,098 and “Home mortgage

interest and points” of $4,302.

     Ms. Dursky included with Ms. Dursky’s 2004 return Schedule E

for 2004 (2004 Schedule E).     In the 2004 Schedule E, Ms. Dursky

described the “rental real estate property” to which that

schedule pertained as “OFFICE SPACE WEST DES MOINE [sic] IA”.        In

that schedule, Ms. Dursky responded in the negative to the

following question:

     For each rental real estate property listed on line 1,
     did you or your family use it during the tax year for
     personal purposes for more than the greater of:



     38
      As discussed above, in DKD’s 2003 return, DKD claimed a
deduction for “Rents” of $19,400.
                                - 41 -

     • 14 days or

     • 10% of the total days rented at fair rental value?

     In the 2004 Schedule E, Ms. Dursky reported “Rents received”

of $24,70039 and claimed deductions for “Mortgage interest paid

to banks, etc.” of $1,555 and for “Taxes” of $610.

     2005

     Ms. Dursky filed Form 1040 for 2005 (Ms. Dursky’s 2005

return) that Mr. Monroe, whom, as discussed above, DKD retained

around August 2006, signed as return preparer and that she

signed.     In that return, Ms. Dursky reported “Wages, salaries,

tips, etc.” of $80,400 that she received during 2005 from DKD as

compensation for the IT consulting work that she performed for

DKD during that year.

     In Schedule A attached to Ms. Dursky’s 2005 return, Ms.

Dursky deducted “Real estate taxes” of $2,287 and “Home mtg

interest and points” of $4,084.

     Ms. Dursky included with Ms. Dursky’s 2005 return Schedule E

for 2005 (2005 Schedule E).     In the 2005 Schedule E, Ms. Dursky

described the “rental real estate property” to which that

schedule pertained as “OFFICE SPACE WEST DES MOINES, IA”.     In

that schedule, Ms. Dursky responded in the negative to the

following question:



     39
      As discussed above, DKD claimed a deduction in DKD’s 2004
return for “Rents” of $24,700.
                                - 42 -

     For each rental real estate property listed on line 1,
     did you or your family use it during the tax year for
     personal purposes for more than the greater of:

     • 14 days, or

     • 10% of the total days rented at fair rental value?

     In the 2005 Schedule E, Ms. Dursky reported “Rents received”

of $12,00040 and claimed deductions for “Mortgage interest paid

to banks, etc.” of $2,398 and for “Taxes” of $1,343.

Notices of Deficiency

     DKD

     On September 26, 2007, respondent issued to DKD a notice of

deficiency (notice) for its taxable year 2003 (DKD’s 2003

notice).     On March 12, 2008, respondent issued to DKD a notice

for its taxable years 2004 and 2005 (DKD’s 2004 and 2005 notice).

     In DKD’s 2003 notice, respondent determined, inter alia,

that DKD is not entitled to the following deductions claimed for

2003:     (1) “Other expenses” of $69,515, (2) “Salaries & wages” of

$7,700, (3) “Taxes and licenses” of $588, (4) “Rents” of $19,400,

and (5) “Employee benefit programs” of $10,274.     In that notice,

respondent also determined that DKD is not entitled to a $20,000

deduction claimed for 2003 for “Pension, profit sharing plans”

because

     The corporation paid the shareholder’s expenses for the
     operation of the cat breeding business. The disallowed


     40
      As discussed above, DKD claimed a deduction in DKD’s 2005
return for “Rents” of $22,800.
                              - 43 -

     business expenses are not ordinary and necessary for
     the operation of the corporation’s business. The
     business that the shareholder operated was determined
     to be a hobby and not operated for profit. The
     corporation’s income increased, by the above amount
     [$20,000] for the tax year ending December 31, 2003
     [sic].

     In DKD’s 2004 and 2005 notice, respondent determined, inter

alia, that DKD is not entitled to the following deductions

claimed for 2004:   (1) Cattery expenses of $75,091, (2) “Salaries

& Wages” of $7,700, (3) “Taxes & Licenses” of $588, and

(4) “Rents” of $24,700, and (5) “Employee Benefit Programs” of

$1,145.   In that notice, respondent also determined, inter alia,

that DKD is not entitled to the following deductions claimed for

2005:   (1) “Meals & Entertainment” of $1,878, (2) “Telephone

Expense” of $710, (3) “Advertising” of $1,240, (4) “Auto & Truck

Expense” of $6,350, (5) “Travel Expenses” of $15,730,

(6) “Miscellaneous Expenses” of $5,188, (7) “Utility Expenses” of

$377, (8) “Entry Fees” of $5,363, (9) “Rental Cars” of $1,214,

(10) “Veterinarian Bills” of $13,986, (11) “Litter Expense” of

$1,923, (12) “Cat Food Expense” of $8,014, (13) “Photo Expenses”

of $53, (14) “Stud Service Expense” of $800, (15) “Salaries &

Wages” of $7,700, (16) “Taxes & Licenses” of $588, and

(17) “Rents” of $22,800.   In addition, respondent determined in

DKD’s 2004 and 2005 notice that DKD was a qualified personal

service corporation, as defined in section 448(d)(2), for each of

the years 2004 and 2005.   In that notice, respondent also
                              - 44 -

determined that DKD is not entitled to the $20,000 deduction

claimed for 2004 for “Pension & Profit Sharing”41 because

     It is determined that pension and profit sharing
     expense is $0.00, rather than $20,000.00 for the
     taxable year ended December 31, 2004 because it has not
     been established that more than $0.00 was for an
     ordinary and necessary business expense, and expended
     for the purpose designated. Accordingly, taxable
     income is increased $20,000.00 for the taxable year
     ended December 31, 2004.

     In DKD’s 2004 and 2005 notice, respondent also determined

that DKD is liable for its taxable years 2004 and 2005 for

accuracy-related penalties under section 6662(a) in the

respective amounts of $9,548 and $8,475.

     Ms. Dursky

     On September 26, 2007, March 12, 2008, and March 12, 2008,

respectively, respondent issued to Ms. Dursky separate notices

for her taxable year 2003 (Ms. Dursky’s 2003 notice), her taxable

year 2004 (Ms. Dursky’s 2004 notice), and her taxable year 2005

(Ms. Dursky’s 2005 notice).

     In Ms. Dursky’s 2003 notice, respondent determined that Ms.

Dursky is required to include in gross income as constructive

dividends the following deductions that DKD claimed in DKD’s 2003



     41
      As discussed above, DKD did not claim in DKD’s 2004 return
a deduction of $20,000 for “Pension, profit-sharing, etc.,
plans”. DKD claimed in DKD’s 2004 return a $20,000 deduction for
“Dues and subscriptions”. The record does not explain how
respondent determined that the $20,000 that DKD claimed as a
deduction for “Dues and subscriptions” in DKD’s 2004 return was a
$20,000 deduction for “Pension & Profit Sharing”.
                                - 45 -

return and that respondent disallowed in DKD’s 2003 notice:

(1) “Cattery expenses” of $69,515, (2) “Salaries and wages” of

$7,700, (3) “Taxes and licenses” of $588, (4) “Rents” of $19,400,

(5) “Pension, profit-sharing, etc., plans” of $20,000, and

(6) “Employee benefit programs” of $9,695.     In Ms. Dursky’s 2003

notice, respondent also determined to (1) exclude from Ms.

Dursky’s 2003 Schedule E the rental income of $19,400 that she

reported and (2) disallow the deductions of (a) “Mortgage

Expenses” of $1,555, (b) “Other Expenses” of $2,870, and

(c) “Depreciation Expense” of $641 that she claimed in the 2003

Schedule E with respect to Ms. Dursky’s residence.

     In Ms. Dursky’s 2004 notice, respondent determined that Ms.

Dursky is required to include in gross income as constructive

dividends the following deductions that DKD claimed in DKD’s 2004

return and that respondent disallowed in DKD’s 2004 and 2005

notice:     (1) “Cattery expenses” of $75,091, (2) “Salaries and

wages” of $7,700, (3) “Taxes and licenses” of $588, (4) “Rents”

of $24,700, (5) “Pension” of $20,000,42 and (6) “Employee benefit

programs” of $1,145.     In Ms. Dursky’s 2004 notice, respondent

also determined to (1) exclude from Ms. Dursky’s 2004 Schedule E

the rental income of $24,700 that she reported and (2) disallow

the deductions for (a) “Mortgage Interest” of $1,555, (b) “Taxes”

of $610, (c) “Other Expenses” of $730, and (d) “Depreciation” of


     42
          See supra note 41.
                              - 46 -

$641 that she claimed in the 2004 Schedule E with respect to Ms.

Dursky’s residence.   In that notice, respondent also determined

that Ms. Dursky is liable for her taxable year 2004 for an

accuracy-related penalty under section 6662(a) of $3,280.60.

     In Ms. Dursky’s 2005 notice, respondent determined that Ms.

Dursky is required to include in gross income as constructive

dividends the following deductions that DKD claimed in DKD’s 2005

return and that respondent disallowed in DKD’s 2004 and 2005

notice:   (1) “Meals and entertainment” of $1,878, (2) “Telephone”

of $710, (3) “Advertising” of $1,240, (4) “Automobiles” of

$6,350, (5) “Travel” of $15,730, (6) “Miscellaneous” of $5,188,

(7) “Utilities” of $377, (8) “Cat food” of $8,014, (9) “Entry

fees” of $5,363, (10) “Rental car” of $1,214, (11) “Veterinarian”

of $13,986, (12) “Litter” of $1,923, (13) “Stud Service” of $800,

(14) “Photos” of $53, (15) “Salaries and wages” of $7,700,

(16) “Taxes and licenses” of $588, and (17) “Rents” of $22,800.

In Ms. Dursky’s 2005 notice, respondent also determined to

(1) exclude from Ms. Dursky’s 2005 Schedule E the rental income

of $12,000 that she reported and (2) disallow the deductions for

(a) “Mortgage Interest” of $2,398, (b) “Taxes” of $1,343, and

(c) “Depreciation” of $641 that she claimed in the 2005 Schedule

E with respect to Ms. Dursky’s residence.   In that notice,

respondent also determined that Ms. Dursky is liable for her
                              - 47 -

taxable year 2005 for an accuracy-related penalty under section

6662(a) of $2,520.80.

                              OPINION

     DKD and Ms. Dursky bear the burden of proof with respect to

the determinations which remain at issue in the respective

notices that respondent issued to them.   See Rule 142(a); Welch

v. Helvering, 290 U.S. 111, 115 (1933).   Moreover, deductions are

strictly a matter of legislative grace, and DKD and Ms. Dursky

bear the burden of proving entitlement to any respective

deductions that they claim.   See INDOPCO, Inc. v. Commissioner,

503 U.S. 79, 84 (1992).   Respondent bears the burden of proof

with respect to any new matter.   See Rule 142(a); Achiro v.

Commissioner, 77 T.C. 881, 890 (1981).

     Before turning to the issues presented, we shall comment on

the respective testimonies of Ms. Dursky and Ms. Watkins, who

were the only witnesses at the trial in these cases.   We found

those testimonies to be in certain material respects

questionable, implausible, unpersuasive, uncorroborated, vague,

and/or conclusory.   We also found (1) the testimony of Ms. Dursky

to be in certain material respects self-serving and (2) the

testimony of Ms. Watkins to be in certain material respects

serving the interests of Ms. Dursky, her personal partner, and

DKD, the corporation that Ms. Dursky wholly owned.   We shall not

rely on the respective testimonies of Ms. Dursky and Ms. Watkins
                               - 48 -

to establish the respective positions of DKD and Ms. Dursky with

respect to the issues to which those testimonies pertained.     See,

e.g., Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

Cattery Activity

     DKD--Claimed Deductions

     It is the position of DKD that for the years at issue it is

entitled to deduct under section 162(a) the following amounts

relating to DKD’s cattery activity:     (1) Respective reimbursed

cattery expenses of $59,817, $64,920, $66,628; (2) purported

salary of $7,700 paid to Ms. Watkins; (3) certain unidentified

“taxes and licenses” of $588; and (4) purported rent of $4,333

paid to Ms. Dursky.43

     Section 162(a) provides in pertinent part:

     SEC. 162.   TRADE OR BUSINESS EXPENSES.

          (a) In General.--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 * * *

     In order to be entitled for each of the years at issue to

the deductions that it is claiming with respect to DKD’s cattery

activity, DKD must show that for each of those years that cattery

activity constituted a trade or business of DKD within the

meaning of section 162(a).   In order to establish that for each



     43
      DKD conceded certain additional amounts that it claimed as
deductions relating to DKD’s cattery activity in its respective
returns for the years at issue.
                                - 49 -

of the years at issue DKD’s cattery activity constituted a trade

or business of DKD within the meaning of section 162(a), DKD must

show that during each of those years it had the intent or motive

to make a profit from that activity.     See Am. Props., Inc. v.

Commissioner, 28 T.C. 1100 (1957), affd. per curiam 262 F.2d 150

(9th Cir. 1958).     As we explained in Am. Props., Inc., supra at

1111,

     The determination of whether the activities of a
     taxpayer constitute the carrying on of a trade or
     business requires an examination of facts in each case.
     Higgins v. Commissioner, 312 U.S. 212 [(1941)]. It has
     been held that whether an enterprise is conducted as a
     business for profit is a matter of intention and good
     faith, and all the facts in a particular case are to be
     considered. * * *

             Thus, the issues in the final analysis turn upon
        the question of whether during the years in question
        the petitioner and the corporation had the requisite
        intent or motive of making a profit. Intention is a
        question of fact to be determined not only from the
        direct testimony as to intent, but a consideration of
        all the evidence, including the conduct of the parties.
        The statement of an interested party of his intention
        and purpose is not necessarily conclusive. * * *

        DKD contends that for each of the years at issue DKD’s

cattery activity constituted a trade or business within the

meaning of section 162(a) because it conducted that activity

during each of those years “In order to produce more income and a

profit”.     On the record before us, we reject DKD’s contention.

        Since at least 1989 Ms. Watkins, and since at least 1994 Ms.

Dursky, each was engaged in the hobby of operating a cattery from

which each derived significant personal pleasure.     At a time not
                              - 50 -

disclosed by the record before the years at issue, Ms. Dursky and

Ms. Watkins became engaged in the hobby of jointly operating a

cattery from which they continued to derive significant personal

pleasure.   The cattery activity of Ms. Dursky and Ms. Watkins

took place in Ms. Dursky’s residence, except for attending cat

shows and visiting veterinarians.   That cattery activity required

them to spend substantial time and substantial money, including

substantial time and substantial money spent by one or both of

them in participating in certain competitions, clubs, and

associations and traveling extensively to attend certain CFA44

cat shows over much of the United States.   At least five of the

cats of Ms. Dursky and Ms. Watkins won awards during certain

competitions, at least two of their Norwegian Forest cats

produced such outstanding offspring that they achieved the

coveted title of CFA Distinguished Merit,45 and the CFA

designated the cattery activity of Ms. Dursky and Ms. Watkins as

a “CFA Approved Cattery of Excellence.”

     At a time not disclosed by the record before the years at

issue, Ms. Dursky and Ms. Watkins created a Web site that they



     44
      The CFA is the largest association for owners of cats in
the United States.
     45
      The title of CFA Distinguished Merit was the highest award
that the CFA presented to a breeding pedigreed cat. At the time
the CFA awarded the title of CFA Distinguished Merit to each of
the two Norwegian Forest cats of Ms. Dursky and Ms. Watkins,
fewer than ten Norwegian Forest cats throughout the world had
been awarded that title.
                              - 51 -

maintained for their cattery activity.   At the time of the trial

in these cases, the general public was able to access that Web

site, although it had not been updated since 2002.   The cattery

activity Web site stated:   “We treat our cats as members of our

family” and “we have invested too much love in our wonderful

kittens to risk exposing them to an uncertain and risky

environment.”   The cattery activity Web site advertised for sale

two cats for $75 and $150, respectively, and two kittens for $200

and $400, respectively.

     During the years at issue, DKD had a cattery activity, which

was the cattery activity in which Ms. Dursky and Ms. Watkins had

engaged before those years.   While operating DKD’s cattery

activity during the years at issue, Ms. Dursky and Ms. Watkins

continued to engage in the same kinds of activities in which they

had engaged before those years while operating the cattery

activity of Ms. Dursky and Ms. Watkins.46   As was true while they

were operating the cattery activity of Ms. Dursky and Ms. Watkins

before the years at issue, Ms. Dursky and Ms. Watkins each

continued to derive significant personal pleasure while operating

DKD’s cattery activity during the years at issue.


     46
      During each of the years at issue, DKD used, without
purchasing, the assets (e.g., cats, kittens, cat trees, feeding
bowls, litter boxes) that Ms. Dursky and Ms. Watkins had used
before those years in the cattery activity of Ms. Dursky and Ms.
Watkins. Starting sometime in 2004, while Ms. Dursky and Ms.
Watkins were operating DKD’s cattery activity they began
breeding, raising, offering for sale, and showing Abyssinian cats
in addition to Norwegian Forest cats.
                              - 52 -

     During the years at issue, while operating DKD’s cattery

activity Ms. Dursky and Ms. Watkins desired to expand on the

national reputation that they had developed before those years

while operating the cattery activity of Ms. Dursky and Ms.

Watkins.   In order to do so, they relied on their respective

years of cattery activity experience and their respective

reputations in the so-called cattery world.

     As was true of the cattery activity of Ms. Dursky and Ms.

Watkins before the years at issue, DKD’s cattery activity was

designated by the CFA during the years at issue as a “Cattery of

Excellence”.

     As was true of their beliefs while operating the cattery

activity of Ms. Dursky and Ms. Watkins before the years at issue,

while Ms. Dursky and Ms. Watkins were operating DKD’s cattery

activity during the years at issue they believed that the price

of any cat or kitten offered for sale would increase if the cats

and kittens that they bred won national cat shows.   While

operating DKD’s activity during the years at issue, Ms. Dursky

and Ms. Watkins produced a total of four cats that won national

championships.

     As was true while they were operating the cattery activity

of Ms. Dursky and Ms. Watkins before the years at issue, while

Ms. Dursky and Ms. Watkins were operating DKD’s cattery activity

during the years at issue they continued to incur and pay
                              - 53 -

substantial expenses.   During the years at issue, DKD reimbursed

Ms. Dursky and Ms. Watkins for those substantial expenses and

claimed deductions for those reimbursed expenses and for certain

other claimed expenses in its respective tax returns for those

years.47

     While operating DKD’s cattery activity during 2003, Ms.

Dursky and Ms. Watkins produced approximately seven to nine

kittens from approximately five to seven litters.   While

operating DKD’s activities during each of the years 2004 and

2005, Ms. Dursky and Ms. Watkins produced approximately nine

kittens from approximately three litters.

     During 2003, Ms. Dursky and Ms. Watkins did not sell any

cats or kittens while operating DKD’s cattery activity.     During

2004, Ms. Dursky and Ms. Watkins did not sell any cats or kittens

while operating DKD’s cattery activity except for three cats

and/or kittens that they sold in December of that year for a

total of $250.   During 2005, Ms. Dursky and Ms. Watkins did not

sell any cats or kittens while operating DKD’s cattery activity


     47
      In DKD’s 2003 return, DKD claimed deductions for cattery
expenses of $69,515 and for purported salary of $7,700, “Taxes
and licenses” of $588, and purported rent of $12,000 relating to
DKD’s cattery activity. In DKD’s 2004 return, DKD claimed
deductions for cattery expenses of $75,091 and for purported
salary of $7,700, “Taxes and licenses” of $588, and purported
rent of $12,000 relating to DKD’s cattery activity. In DKD’s
2005 return, DKD claimed deductions for cattery expenses of
$60,540 and for purported salary of $7,700, “Taxes and licenses”
of $588, and purported rent of $12,000 relating to DKD’s cattery
activity. See supra note 43.
                               - 54 -

except for a total of eight cats and/or kittens that they sold in

June, July, August, October, and November of that year for a

total of $1,525.

     In 2006, at an undisclosed time in or before August, Mr.

Musin and Ms. Schwartz, the tax return preparers for DKD and/or

Ms. Dursky,48 informed them that the IRS was investigating Mr.

Musin and Ms. Schwartz and intended to commence an examination of

petitioners’ respective tax returns for 2003 and 2004.   As a

result, around August 2006, (1) Ms. Dursky and Ms. Watkins

discontinued operating DKD’s cattery activity,49 (2) Ms. Dursky

and Ms. Watkins continued operating that cattery activity as the

cattery activity of Ms. Dursky and Ms. Watkins, and (3) Ms.

Dursky and DKD retained Mr. Monroe.50

     Except for the respective testimonies of Ms. Dursky and Ms.

Watkins, on which we are unwilling to rely, there is no reliable

evidence in the record to support our finding that during each of




     48
          See supra note 14.
     49
      Although Ms. Dursky and Ms. Watkins did not discontinue
operating DKD’s cattery activity until around August 2006, DKD
did not claim any deductions relating to DKD’s cattery activity
in the tax return that it filed for its taxable year 2006.
     50
       See supra note 19.
                              - 55 -

the years at issue DKD intended to make a profit from DKD’s

cattery activity.51

     Based upon our examination of the entire record before us,

we find that DKD has failed to carry its burden of establishing

that during each of the years at issue it intended to make a

profit from DKD’s cattery activity.    On that record, we find that

during each of the years at issue DKD expended substantial

amounts in DKD’s cattery activity for the personal pleasure of

Ms. Dursky, its sole stockholder, and with the expectation that

it would be able to deduct those substantial amounts for each of

those years.   On the record before us, we further find that

during each of the years at issue DKD’s cattery activity was

incident to the personal hobby of Ms. Dursky, DKD’s sole

stockholder, who before, during, and after those years derived

significant personal pleasure from the cattery activity in which

she was involved.

     Based upon our examination of the entire record before us,

we find that DKD has failed to carry its burden of establishing

that for each of the years at issue DKD’s cattery activity

constituted a trade or business of DKD within the meaning of



     51
      For example, the record does not contain reliable evidence
of a business plan for DKD that described specifically what steps
Ms. Dursky, DKD’s sole stockholder and sole officer, intended to
take during the years at issue in an attempt to increase
significantly revenues and/or to reduce significantly expenses in
order to generate a profit for DKD from DKD’s cattery activity.
                                - 56 -

section 162(a).   On that record, we further find that DKD has

failed to carry its burden of establishing that for each of the

years at issue it is entitled under section 162(a) to deduct with

respect to DKD’s cattery:   (1) Amounts reimbursed to Ms. Dursky

and Ms. Watkins, (2) amounts paid to Ms. Watkins as purported

salary, (3) amounts paid for certain “taxes and licenses”, and

(4) amounts paid to Ms. Dursky as purported rent.

     Ms. Dursky--Claimed Constructive Dividends

     We have found that during each of the years at issue DKD

expended substantial amounts in DKD’s cattery activity for the

personal pleasure of Ms. Dursky, its sole stockholder, and that

during each of those years that activity was incident to the

personal hobby of Ms. Dursky.    On the record before us, we find

that for each of the years at issue Ms. Dursky is required to

include in gross income as constructive dividends the amounts of

deductions relating to DKD’s cattery activity that DKD claimed

for each of those years and that we have disallowed.52

     Ms. Dursky--Claimed Cattery Activity Deductions

     It is the alternative position of Ms. Dursky that

          If this Court finds that the cattery operation was
     operated by Debra Dursky and not DKD Enterprises, which
     is contrary to the stipulation between the parties,
     then Debra Dursky should be allowed to deduct the


     52
      Petitioners do not dispute that for each of the years at
issue DKD had earnings and profits that were at least equal to
the amount of constructive dividends that we have found Ms.
Dursky has for each of those years.
                              - 57 -

     cattery expenses under I.R.C. §162, since the cattery
     was operated for a profit.

     In holding that DKD is not entitled for each of the years at

issue to deduct under section 162(a) the various deductions that

it is claiming with respect to DKD’s cattery activity, we did not

find that “the cattery operation was operated by Debra Dursky and

not DKD Enterprises”.   Instead, we found that DKD failed to carry

its burden of establishing (1) that during each of the years at

issue DKD intended to make a profit from DKD’s cattery activity

and (2) that for each of those years DKD’s cattery activity

constituted a trade or business of DKD within the meaning of

section 162(a).   Thus, the premise on which Ms. Dursky advances

her alternative position is not valid.53

     On the record before us, we find that for each of the years

at issue Ms. Dursky is not entitled to deduct under section

162(a) the deductions relating to DKD’s cattery activity that DKD

is claiming for each of those years and that we have disallowed.

     Ms. Dursky--Claimed Schedule E Deductions

     It is the position of Ms. Dursky that she is entitled for

each of the years at issue to deduct in Schedule E the respective


     53
      Even if the premise on which Ms. Dursky advances her
alternative position were valid, on the record before us, we
would nonetheless reject that position. If that premise were
valid, on the record before us, we would find under sec. 183 and
the regulations thereunder that for each of the years at issue
Ms. Dursky is not entitled to deduct the amounts that DKD is
claiming as deductions for each of those years with respect to
DKD’s cattery activity and that we have disallowed.
                             - 58 -

portions of the mortgage interest and real estate tax that she

paid with respect to Ms. Dursky’s residence that are allocable to

DKD’s purported rental of a portion of that residence for DKD’s

cattery activity.

     We have found that DKD failed to carry its burden of

establishing (1) that for each of the years at issue DKD’s

cattery activity constituted a trade or business of DKD within

the meaning of section 162(a) and (2) that for each of those

years DKD is entitled to deduct under that section any amounts

that it claimed as rent for the portion of Ms. Dursky’s residence

where Ms. Dursky and Ms. Watkins operated DKD’s cattery

activity.54

     On the record before us, we find that Ms. Dursky has failed

to carry her burden of establishing that for each of the years at

issue she is entitled to deduct in Schedule E the respective

portions of mortgage interest and real estate tax that she paid

with respect to Ms. Dursky’s residence that are allocable to




     54
      Although respondent determined that Ms. Dursky does not
have rental income for each of the years at issue attributable to
the purported rent that DKD is claiming as a deduction for each
of those years and that we have disallowed, we have held that for
each of the years at issue Ms. Dursky is required to include in
gross income as constructive dividends that disallowed purported
rent.
                                - 59 -

DKD’s purported rental of that residence for DKD’s cattery

activity.55

Qualified Personal Service Corporation

     It is the position of DKD that it is not a qualified

personal service corporation, as defined in section 448(d)(2),

for each of the years 2004 and 2005 that is subject to the 35-

percent tax rate prescribed in section 11(b)(2).56

     Section 448(d)(2) defines the term “qualified personal

service corporation” to mean:

          SEC. 448(d). Definitions and Special Rules.--For
     purposes of this section--

     *        *        *       *         *     *       *

               (2) Qualified personal service corporation.--
          The term “qualified personal service corporation”
          means any corporation--

                       (A) substantially all of the activities
                  of which involve the performance of services
                  in the fields of health, law, engineering,
                  architecture, accounting, actuarial science,
                  performing arts, or consulting, and



     55
      Respondent determined that   for each of the years at issue
Ms. Dursky is entitled to deduct   in Schedule A the respective
amounts of mortgage interest and   real estate tax that she paid
and that she claimed in Schedule   E for each of those years and
that we have disallowed.
     56
      Respondent determined in DKD’s 2004 and 2005 notice that
DKD is a qualified personal service corporation for each of the
years 2004 and 2005. Respondent did not make any such
determination in DKD’s 2003 notice. Respondent argues on brief
that DKD also is a qualified personal service corporation for
2003. Therefore, respondent has the burden of establishing that
DKD is a qualified personal service corporation for 2003.
                             - 60 -

                    (B) substantially all of the stock of
               which (by value) is held directly (or
               indirectly through 1 or more partnerships, S
               corporations, or qualified personal service
               corporations not described in paragraph (2)
               or (3) of subsection (a)) by--

                         (i) employees performing services
                    for such corporation in connection with
                    the activities involving a field
                    referred to in subparagraph (A),

     Section 1.448-1T(e)(3), Temporary Income Tax Regs., 52 Fed.

Reg. 22768 (June 16, 1987), provides in pertinent part:

          (3) Meaning of qualified personal service
     corporation. For purposes of this section, the term
     “qualified personal service corporation” means any
     corporation that meets--

          (i) The function test of paragraph (e)(4) of this
     section, and

          (ii) The ownership test of paragraph (e)(5) of
     this section.

     Section 1.448-1T(e)(4), Temporary Income Tax Regs., supra,

provides in pertinent part that the function test is met “if 95

percent or more of the time spent by employees of the

corporation, serving in their capacity as such, is devoted to the

performance of services” in, inter alia, consulting.    Section

1.448-1T(e)(5)(i)(A), Temporary Income Tax Regs., 52 Fed. Reg.

22770 (June 16, 1987), provides in pertinent part that a

corporation “meets the ownership test, if at all times during the

taxable year, substantially all the corporation’s stock, by

value, is held, directly or indirectly, by” employees who perform
                               - 61 -

services for the corporation in connection with activities

involving the performance of services in, inter alia, consulting.

     We have found that Ms. Dursky, the only stockholder of DKD

and the only employee of DKD who performed consulting services

for it, spent approximately 2,000 hours during the year 2003 and

approximately 2,200 hours during each of the years 2004 and 2005

working for DKD in its IT consulting business.   We have also

found that during each of the years 2003, 2004, and 2005 Ms.

Dursky spent approximately 800 hours operating DKD’s cattery

activity.57

     On the record before us, we find that during each of the

years 2003, 2004, and 2005 Ms. Dursky did not spend 95 percent or

more of her time while working for DKD performing consulting

services for it.   On that record, we further find that for each

of the years at issue DKD is not a qualified personal service

corporation, as defined in section 448(d)(2), that is subject to

the 35-percent tax rate prescribed in section 11(b)(2).

DKD Fidelity Profit-Sharing Plan

     DKD--Claimed Deductions




     57
      We have found that during each of the years at issue Ms.
Watkins spent more hours than Ms. Dursky operating DKD’s cattery
activity. We have not found the precise number of hours that Ms.
Watkins spent during each of those years operating that activity
because we are unwilling to rely on her testimony in that
respect.
                              - 62 -

     It is the position of DKD that it is entitled to deduct

(1) for 2003 a $10,000 contribution under the DKD Fidelity

profit-sharing plan that it made on April 14, 2004, by sending a

$10,000 check to Fidelity; (2) for 2004 a total of $20,000 of

contributions that it made under that profit-sharing plan by

sending a $10,000 check to Fidelity on December 27, 2004, and a

$10,000 check to Fidelity on April 11, 2005; and (3) for 2005 a

$5,000 contribution that it made under that profit-sharing plan

by sending a $5,000 check to Fidelity on April 10, 2006.58

     It is the position of respondent that for each of the years

at issue DKD is not entitled to the deduction that DKD is

claiming for DKD’s contributions under the DKD Fidelity profit-

sharing plan.   In support of respondent’s position, respondent

asserts in pertinent part:




     58
      In DKD’s 2003 return, DKD claimed a deduction for the
$10,000 contribution under the DKD Fidelity profit-sharing plan
that it is claiming here. In DKD’s 2004 return, DKD did not
claim a deduction of $20,000 for contributions under that plan.
It did, however, claim in that return a $20,000 deduction for
“Dues and subscriptions”. Respondent determined that the $20,000
that DKD claimed in DKD’s 2004 return for “Dues and
subscriptions” was a $20,000 deduction claimed for contributions
under the DKD Fidelity profit-sharing plan. The record does not
explain how respondent made that determination, see supra note
41, but DKD does not dispute it. In DKD’s 2005 return, DKD did
not claim a deduction for a $5,000 contribution under the DKD
Fidelity profit-sharing plan. DKD claims for the first time here
a deduction for 2005 for a $5,000 contribution that it made under
the DKD Fidelity profit-sharing plan by sending a $5,000 check to
Fidelity on Apr. 10, 2006. Thus, DKD has the burden of proof
with respect to that claimed deduction for 2005.
                              - 63 -

          If [Ms.] Watkins is determined to have been an
     employee of the cattery, then the failure to include
     [Ms.] Watkins in DKD’s pension plan is a fatal flaw. A
     qualified pension plan cannot discriminate in favor of
     highly compensated employees. I.R.C. § 401(a)(4).
     “Highly compensated employee” is defined in I.R.C. §
     414(q) as a [sic] employee who was a 5 percent owner at
     any time during the year or preceding year or was in
     the top-paid group of employees. As the sole
     shareholder of DKD, [Ms.] Dursky qualifies as a “highly
     compensated employee.” [Ms.] Dursky and [Ms.] Watkins
     were both employees. DKD did not offer, or pay, [Ms.]
     Watkins any pension benefits. The purported pension
     plan is not, therefore, a qualified pension plan and no
     pension contributions should be allowed.

     DKD counters that the reason stated in DKD’s 2003 notice and

in DKD’s 2004 and 2005 notice for respondent’s determinations

that DKD is not entitled for the years 2003 and 2004 to the

deductions that it claimed in its respective tax returns for

those years for contributions under the DKD Fidelity profit-

sharing plan was that those contributions are not “ordinary and

necessary” expenses.   As a result, DKD argues that respondent has

the burden of proving that the DKD Fidelity profit-sharing plan

did not include Ms. Watkins as a participant.   According to DKD,

“Respondent presented no evidence, at trial or otherwise,

regarding who were the participants in the [DKD] Fidelity pension

[sic] plan.”

     We reject DKD’s contention about what the record establishes

“regarding who were the participants in the [DKD] Fidelity

pension [sic] plan.”   The Fidelity contribution document that Ms.

Dursky executed on behalf of DKD on December 28, 2001, indicated
                              - 64 -

that the only participant under the DKD Fidelity profit-sharing

plan was Ms. Dursky.   Moreover, petitioners have taken the

position at trial and on brief that Ms. Dursky was an employee of

DKD during each of the years at issue.59

     On the record before us, we find that for each of the years

at issue the DKD Fidelity profit-sharing plan discriminated in

favor of Ms. Dursky, DKD’s sole stockholder, who was a “highly

compensated employee” as defined in section 414(q).   On that

record, we further find that for each of the years at issue the

DKD Fidelity profit-sharing plan did not constitute a qualified

profit-sharing plan under section 401(a).   On the record before

us, we find that for each of the years at issue DKD is not

entitled to a deduction for any contributions made under the DKD

Fidelity profit-sharing plan.60

     Ms. Dursky--Claimed Constructive Dividends

     We have found that for each of the years at issue DKD is not

entitled to deduct any contributions made under the DKD Fidelity



     59
      For each of the years at issue, DKD issued Form W-2 to Ms.
Watkins, in which it reported that it paid her wages of $7,700.
For each of those years, Ms. Watkins filed Form 1040, in which
she included in gross income the $7,700 that she had received
from DKD during each such year.
     60
      In the light of our holding, we need not address
respondent’s alternative argument that if the DKD Fidelity
profit-sharing plan were to constitute a qualified profit-sharing
plan under sec. 401(a), DKD would be entitled to deduct for each
year at issue only the contributions that it made under that plan
during each such year.
                                 - 65 -

profit-sharing plan.     On the record before us, we find that any

respective contributions that DKD made under that plan and

claimed as deductions in its respective tax returns for the years

at issue and that we have disallowed are required to be included

in Ms. Dursky’s income as constructive dividends for her

respective taxable years at issue in which DKD made those

contributions.61

Ms. Dursky’s Health Insurance Policy

     DKD--Claimed Deductions

     It is DKD’s position that for each of the years at issue it

is entitled to deduct certain premiums that it paid on a health

insurance policy issued in Ms. Dursky’s name that she had

purchased.62     In support of DKD’s position, DKD asserts:

          An employer is entitled to deduct, as ordinary and
     necessary trade or business expense, medical insurance
     premiums it paid for its employees. I.R.C. § 162(a).

            *       *       *          *    *       *         *



     61
          See supra notes 52 and 58.
     62
      In petitioners’ opening brief, petitioners state that DKD
paid in 2003 and 2004, respectively, and is entitled to deduct
for those years the respective premiums of $6,950 and $7,651 on
Ms. Dursky’s health insurance policy. In petitioners’ reply
brief, petitioners claim that, in addition to those claimed
respective deductions for 2003 and 2004, it is entitled to deduct
for 2005 $7,651 of health insurance premiums that it paid in that
year on Ms. Dursky’s health insurance policy. We have found that
during 2003 and 2004 DKD paid premiums on Ms. Dursky’s health
insurance policy totaling $6,950.10 and $7,651.50, respectively.
We have not found that DKD paid any premiums on that policy
during 2005.
                              - 66 -

          Since DKD Enterprises paid medical insurance
     premiums on a medical insurance policy for its
     employee, Debra Dursky, DKD Enterprises is entitled to
     deduct the medical insurance premiums as ordinary and
     necessary business expenses under I.R.C. § 162(a).

     It is respondent’s position that DKD is not entitled to the

deductions that it is claiming for the premiums that it paid on

Ms. Dursky’s health insurance policy.63   In support of

respondent’s position, respondent asserts in respondent’s reply

brief:

     the medical insurance premiums paid by DKD [on Ms.
     Dursky’s health insurance policy] were not made
     pursuant to an accident or health plan as required by
     I.R.C. § 106(a). DKD never had an accident or health
     insurance plan. DKD simply wrote checks to a health
     insurer, allegedly on behalf of [Ms.] Dursky.

          Also, I.R.C. § 105 states that amounts received by
     an employee through accident or health insurance for
     personal injuries or sickness shall be included in
     gross income to the extent such amounts (1) are
     attributed to contributions by the employer which were
     not includible in the gross income of the employee or
     (2) are paid by the employer. [Ms.] Dursky did not
     include the health insurance premiums as compensation.

     Section 162(a) permits a taxpayer to deduct all the ordinary



     63
      In petitioners’ reply brief, petitioners argue that
respondent conceded in respondent’s opening brief that DKD is
entitled to deduct for the years at issue any respective premiums
that it paid on Ms. Dursky’s health insurance policy. We
disagree. Although respondent did not offer any reason in
respondent’s opening brief in support of respondent’s position
that DKD is not entitled to deduct those premiums, we conclude
that respondent did not concede that issue in that brief.
Respondent explained in respondent’s reply brief, which we quote
in pertinent part in the text, why respondent believes that DKD
is not entitled to deduct for each of the years at issue any
premiums that it paid on Ms. Dursky’s health insurance policy.
                              - 67 -

and necessary expenses paid or incurred during the taxable year

in carrying on any trade or business, including a reasonable

allowance for salaries or other compensation for personal

services actually rendered.   Sec. 162(a)(1).   Section 1.162-10,

Income Tax Regs., provides in pertinent part with respect to

“Certain employee benefits” as follows:

     Amounts paid or accrued within the taxable year for
     * * * a sickness, accident, hospitalization, medical
     expense, * * * or similar benefit plan, are deductible
     under section 162(a) if they are ordinary and necessary
     expenses of the trade or business. * * *

     In Waterfall Farms, Inc. v. Commissioner, T.C. Memo. 2003-

327, we held:

          When payments for medical care are properly
     excludable from an employee’s income [under section 105
     and/or 106] because they are made under a “plan for
     employees,” they are deductible by the employer as
     ordinary and necessary business expenses under section
     162(a). * * *

     Based upon our examination of the entire record before us,

we find that DKD has failed to carry its burden of establishing

that it had in effect during any of the years at issue a

sickness, hospitalization, medical expense, or similar benefit

plan for employees.   On that record, we find that DKD has failed

to carry its burden of establishing that for each of the years at

issue it is entitled to deduct any premiums that it paid on Ms.

Dursky’s health insurance policy.
                                 - 68 -

     Ms. Dursky--Claimed Exclusion from Income

     It is the position of Ms. Dursky that she is entitled to

exclude under section 105 or 106 the premiums that she claims DKD

paid during each of the years at issue on Ms. Dursky’s health

insurance policy.64     We have found that DKD has failed to carry

DKD’s burden of establishing that during each of the years at

issue it had in effect a sickness, hospitalization, medical

expense, or similar plan for employees.      On the record before us,

we find that Ms. Dursky is not entitled for any of the years at

issue to exclude from gross income under section 105 or 106 the

amount of any premiums that DKD paid on Ms. Dursky’s health

insurance policy.

     We have considered all of the contentions and arguments of

the parties that are not discussed herein, and we find them to be

without merit, irrelevant, and/or moot.

     To reflect the foregoing, the concessions of respondent, and

the concessions of petitioners,


                                          Decisions will be entered

                                    under Rule 155.




     64
          See supra note 62.
