                        T.C. Memo. 2012-160



                  UNITED STATES TAX COURT



     JAMES MAGUIRE AND JOY MAGUIRE, Petitioners v.
    COMMISSIONER OF INTERNAL REVENUE, Respondent

  MARC MAGUIRE AND PAMELA MAGUIRE, Petitioners v.
    COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket Nos. 11049-10, 11050-10.             Filed June 6, 2012.



       Ps owned two S corporations whose businesses were related:
one an auto dealership, the other, a finance company that purchases
customer notes from the auto dealership. During the years in issue the
finance company operated at a profit and the dealership operated at a
loss. Ps did not have sufficient bases in the dealership to deduct its
losses. Ps had substantial bases in the finance company.

        At the end of each year the finance company owned substantial
accounts receivable due from the dealership. At the end of each year
Ps received distributions of the accounts receivable from the finance
company and then contributed them to the related dealership in order to
increase their bases in the dealership enough to allow for the deduction
of its losses. R disallowed the claimed loss deductions on the basis of
R’s determination that Ps’ actions were insufficient to increase their
                                         -2-

      bases in the dealership because the transactions between Ps and their
      related S corporations did not amount to Ps’ making an economic
      outlay.

             Held: Shareholders in two related S corporations are not
      prohibited from receiving a distribution of assets from one of their S
      corporations and then contributing those assets into another of their S
      corporations in order to increase their bases in the latter. The effect is
      to decrease the shareholders’ bases in the S corporation making the
      distribution and thereby reducing the shareholders’ ability to get future
      tax-free distributions from the distributing S corporation, while
      increasing the shareholders’ bases in the S corporation to which the
      contributions are made. The fact that the two S corporations have a
      synergistic business relationship and are owned by the same
      shareholders does not preclude accomplishing Ps’ goal, so long as the
      underlying distributions and contributions actually occurred. We find
      that these transactions did actually occur.



      F. Larkin Fore, for petitioners.

      Mark D. Eblen, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      RUWE, Judge: In these consolidated cases, respondent determined

deficiencies and penalties as follows:
                                         -3-

                              James and Joy Maguire
                               docket No. 11049-10

                                             Accuracy-related penalty
               Year        Deficiency            Sec. 6662(a)

               2004         $765,923               $153,184.60
               2005          162,868                 32,573.60
               2006          378,510                 75,702.00

                              Marc and Pamela Maguire
                                docket No. 11050-10

                                               Accuracy-related penalty
               Year        Deficiency              Sec. 6662(a)

               2004         $315,071                 $63,014.20
               2005          176,330                  35,266.00
               2006          376,123                  75,224.60

After concessions,1 the issues for decision are: (1) whether petitioners James and


      1
        In the notice of deficiency relating to petitioners Marc and Pamela Maguire,
respondent recharacterized Marc Maguire’s income from CNAC, Inc. (CNAC), for
the 2004 and 2005 tax years as nonpassive and disallowed his rental real estate
passive activity losses. Respondent now concedes that Marc Maguire’s income
from CNAC for the 2004 and 2005 tax years was passive. Therefore, respondent
concedes that Marc and Pamela Maguire’s passive real estate losses for 2004 and
2005 may be used to offset Marc Maguire’s passive income from CNAC for those
years. In the notice of deficiency respondent also determined, and Marc and Pamela
Maguire have not contested, that they had: (1) unreported interest income of
$14,485 from CNAC for the 2004 tax year; (2) unreported compensation income in
the form of fringe benefits of $10,952 for the 2004 tax year; (3) unreported
compensation income in the form of fringe benefits of $12,810 for the 2005 tax
year; (4) unreported compensation income in the form of fringe benefits of $2,160
for the 2006 tax year; (5) a $3,000 decrease of their deduction for advertising
                                                                         (continued...)
                                         -4-

Joy Maguire are entitled to deduct S corporation losses of Auto Acceptance, Inc.

(Auto Acceptance), for the years 2004, 2005 and 2006 and a net operating loss

carryback of Auto Acceptance from 2006 to 2004; (2) whether Marc and Pamela

Maguire are entitled to deduct S corporation losses of Auto Acceptance for the

years 2005 and 2006 and a net operating loss carryback of Auto Acceptance from

2006 to 2004; (3) whether Marc and Pamela Maguire are entitled to a $25,000

deduction for passive losses from real estate rental activity for 2006; and (4)

whether petitioners are liable for accuracy-related penalties under section 6662(a).2

      At the time the petitions were filed, petitioners resided in Kentucky.




      1
       (...continued)
expenses for the 2004 tax year; and (6) a $4,788 decrease of their charitable
contribution deduction for the 2004 tax year.

       With regard to petitioners James and Joy Maguire, in the notice of deficiency
respondent determined, and they have not contested, that they had: (1) unreported
interest income of $15,106 from CNAC for the 2004 tax year; (2) unreported
compensation income in the form of fringe benefits of $28,333 for the 2004 tax
year; (3) unreported compensation income in the form of fringe benefits of $28,333
for the 2005 tax year; (4) unreported compensation income in the form of fringe
benefits of $27,333 for the 2006 tax year; and (5) a $3,232 decrease in their
charitable contribution deduction for the 2004 tax year.
      2
       Unless otherwise indicated, all section references are to the Internal Revenue
Code as amended and in effect for the years in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure.
                                        -5-

                               FINDINGS OF FACT

I. James and Joy Maguire

      Petitioners James and Joy Maguire are husband and wife with the filing status

of married filing jointly for the tax years 2004, 2005, and 2006. During the years at

issue James and Joy Maguire owned a majority interest in CNAC and James owned

a majority interest in Auto Acceptance. CNAC and Auto Acceptance were both S

corporations. S corporations are passthrough entities that generally do not pay

income tax. Rather, the income and losses of S corporations are passed through to

their shareholders, who must include the income or losses on their individual income

tax returns.

      In the notice of deficiency issued to James and Joy Maguire, respondent

disallowed losses that they claimed from Auto Acceptance for the taxable years

2004, 2005, and 2006 of $1,446,442, $423,449, and $1,978,539, respectively,

because respondent determined that those losses were in excess of James Maguire’s

adjusted basis in Auto Acceptance.3 For the same reason, respondent also

disallowed a net operating loss carryback of $792,893 from Auto Acceptance’s


      3
       The deductibility of a shareholder’s loss from an S corporation is limited to
the sum of the shareholder’s adjusted basis in the shareholder’s stock in the S
corporation and the adjusted basis of any indebtedness of the S corporation to the
shareholder. Sec. 1366(d)(1).
                                         -6-

2006 tax year that James and Joy Maguire claimed on their 2004 Form 1040X,

Amended U.S. Individual Income Tax Return. James and Joy Maguire received a

refund and tax credit of $229,292 on the basis of their amended return. The refund

claim for the 2004 tax year was processed and paid by respondent’s service center

before the examination for the tax years in issue.

II. Marc and Pamela Maguire

      Petitioners Marc and Pamela Maguire are husband and wife with the filing

status of married filing jointly. Marc is the son of James and Joy Maguire. During

the years at issue Marc Maguire owned a minority interest in CNAC, and during

2005 and 2006 he owned a minority interest in Auto Acceptance. In the notice of

deficiency issued to Marc and Pamela Maguire, respondent disallowed losses

claimed from Auto Acceptance for 2005 and 2006 of $406,844 and $1,900,950,

respectively, because respondent determined that those losses are in excess of Marc

Maguire’s adjusted basis in Auto Acceptance. For the same reason, respondent also

disallowed a 2004 net operating loss carryback of $768,710 from Auto

Acceptance’s 2006 tax year that Marc and Pamela Maguire claimed on an amended

return for 2004. Marc and Pamela Maguire received a refund and tax credit totaling

$277,121, on the basis of their amended return for 2004.
                                        -7-

III. The S Corporations

      Auto Acceptance is a car dealership, and CNAC is a finance company that

deals exclusively with Auto Acceptance’s customers. Auto Acceptance is primarily

engaged in the purchase of used vehicles at auction and the resale of those vehicles.

CNAC purchases retail installment notes related to the vehicles that Auto

Acceptance sells. For the tax years at issue Auto Acceptance and CNAC both

elected to be taxed as S corporations under section 1361.

      A. Ownership

      As of December 31, 2004, James Maguire owned 100% of Auto Acceptance.

During 2005 James Maguire made a gift of 49% of his interest in Auto Acceptance

to Marc Maguire. As of December 31, 2005 and 2006, James Maguire owned 51%

of Auto Acceptance and Marc Maguire owned 49%. James Maguire was an officer

of Auto Acceptance for the 2004, 2005, and 2006 tax years, and Marc Maguire was

an officer for the 2005 and 2006 tax years.

      As of December 31, 2004, 2005, and 2006, James Maguire owned 49.05% of

CNAC, Joy Maguire owned 2%, and Marc Maguire owned 48.95%. For the tax

years 2004, 2005, and 2006 James Maguire was an officer of CNAC. For the tax

years 2005 and 2006 Marc Maguire was an officer of CNAC.
                                         -8-

      B. Basis

      In 2004, 2005, and 2006 CNAC operated at a profit and Auto Acceptance

operated at a loss. Before the end of 2004 petitioners were advised by their

accountants at Katz, Sapper & Miller, LLP (Katz, Sapper & Miller), that James did

not have sufficient basis in Auto Acceptance to deduct its losses on his individual

income tax return.

      As a result, Katz, Sapper & Miller advised James that he could increase his

basis in Auto Acceptance by receiving distributions of $1,682,373 from CNAC,

which he could then contribute to Auto Acceptance. The effect would be to

increase James’ basis in Auto Acceptance so that he could deduct Auto

Acceptance’s losses on his individual return. Since James and Joy Maguire owned

51.05% of CNAC and Marc owned the other 48.95%, it was necessary for James to

borrow Marc’s portion of the distribution. James executed a note to Marc for his

share of the distribution. An initial attempt to carry out Katz, Sapper & Miller’s

plan involved the issuance of checks totaling $1,682,373 from CNAC to James and

Marc Maguire, which James could then contribute to Auto Acceptance. James, Joy,

and Marc had an adjusted basis in CNAC of at least $1,682,373; however, CNAC

did not have sufficient funds in its bank account to make a cash distribution of

$1,682,373 to its owners.
                                         -9-

      After learning of their clients’ inability to make a cash contribution to Auto

Acceptance, Katz, Sapper & Miller advised them to pursue an alternative method of

increasing James’ basis in Auto Acceptance which would not require CNAC to

make a cash distribution to its owners. Katz, Sapper & Miller advised petitioners

that an identical result would be reached if a distribution of accounts receivable

owed to CNAC by Auto Acceptance was made from CNAC to James, Joy, and

Marc. Marc would lend his portion of the accounts receivable to James, who would

then contribute the accounts receivable to Auto Acceptance, increasing James’ basis

in Auto Acceptance enough to allow for the deduction of Auto Acceptance’s losses

on his 2004 Federal income tax return. This advice was followed.

      CNAC distributed $1,682,373 in accounts receivable to James, Joy, and

Marc Maguire on or before December 31, 2004. Auto Acceptance owed at least

this amount to CNAC before the distribution. Marc lent his share of accounts

receivable to James, who then contributed them to Auto Acceptance. James

executed a note to Marc for the amount of the loan.

      The advice of Katz, Sapper & Miller was followed in subsequent years. In

2005 CNAC distributed $1,500,000 in accounts receivable to its shareholders on

December 31, 2005, and the receivables were then contributed by petitioners to
                                        - 10 -

Auto Acceptance. In 2006 CNAC distributed $3,500,000 in accounts receivable to

its shareholders on December 31, 2006, and the accounts receivable were then

contributed to Auto Acceptance. Auto Acceptance owed at least these amounts to

CNAC before the distributions in 2005 and 2006. The respective distributions from

CNAC and the respective contributions to Auto Acceptance were apportioned

according to James’, Joy’s, and Marc’s ownership interests.4

      The distributions and contributions of the accounts receivable were carried

out by the execution of separate written shareholder resolutions regarding the

distributions and contributions, which were signed at the end of 2004, 2005, and

2006, respectively. Adjusting journal entries were made to the corporate books in

the year following the taxable year to which they related, at the time Auto

Acceptance’s and CNAC’s yearly audit was conducted. In 2005 and 2006 James

was a 51% shareholder and Marc was a 49% shareholder in Auto Acceptance.

      At the end of each of the tax years 2004, 2005, and 2006, petitioners’

respective bases in CNAC equaled or exceeded the amounts of distributions from

CNAC to petitioners.



      4
        There were very slight differences in petitioners’ respective ownership
percentages of CNAC and Auto Acceptance. Neither party made any argument that
this difference has any significance to the outcome of these cases.
                                         - 11 -

                                      OPINION

      Pursuant to section 1366, a shareholder of an S corporation is liable for the

tax on his pro rata share of the corporation’s gross income. A shareholder is also

entitled to deduct his pro rata share of an S corporation’s losses. See sec. 1366(a);

Broz v. Commissioner, 137 T.C. 46, 60 (2011). Losses deductible by a shareholder

are limited to the shareholder’s basis in the corporation. See sec. 1366(d); Bergman

v. United States, 174 F.3d 928, 931 (8th Cir. 1999). As a result, losses cannot

exceed the sum of the shareholder’s adjusted basis in his or her stock in the S

corporation and the shareholder’s adjusted basis in any indebtedness of the S

corporation to the shareholder. Sec. 1366(d)(1)(A) and (B). A shareholder’s basis

in his stock is increased by his contributions of capital to the corporation. See secs.

1012, 351(a), 358(a)(1).

Economic Outlay

      In determining whether a particular transaction qualifies as a shareholder

investment, a taxpayer must make an actual “economic outlay”. Underwood v.

Commissioner, 63 T.C. 468, 477 (1975), aff’d, 535 F.2d 309 (5th Cir. 1976); Perry

v. Commissioner, 54 T.C. 1293, 1296 (1970), aff’d, 27 A.F.T.R.2d 71-1464 (8th

Cir. 1971); Oren v. Commissioner, T.C. Memo. 2002-172, aff’d, 357 F.3d 854 (8th

Cir. 2004). A taxpayer makes an “economic outlay” when he incurs a cost or is left
                                         - 12 -

poorer in a material sense after the transaction. Putnam v. Commissioner, 352 U.S.

82, 85 (1956); Ruckriegel v. Commissioner, T.C. Memo. 2006-78; Oren v.

Commissioner, T.C. Memo. 2002-172; see Estate of Bean v. Commissioner, 268

F.3d 553, 558 (8th Cir. 2001), aff’g T.C. Memo. 2000-355; Bergman, 174 F.3d at

932.

       In order for petitioners to have sufficient bases in Auto Acceptance to deduct

the losses claimed for the years in issue, they must have made an actual “economic

outlay” when they contributed the accounts receivable to Auto Acceptance. We

find petitioners did make the required economic outlay.

       Respondent contends that the written yearend resolutions and the subsequent

adjusting corporate journal entries are insufficient to increase petitioners’ bases in

Auto Acceptance under section 1366(d). Much of respondent’s position is rooted in

his factual conclusion that the distributions and contributions of accounts receivable

never actually took place. However, the record sufficiently establishes that

petitioners were advised by their team of accountants and attorneys, before the end

of each year in issue, to use the distributions and contributions of the accounts

receivable in order to increase their bases in Auto Acceptance for the years in issue

and that this advice was actually followed. Petitioners James and Marc Maguire

both testified that Katz, Sapper & Miller advised them to effectuate the accounts
                                        - 13 -

receivable transaction at the end of each year in issue and that they followed this

advice. In addition, Jeffrey Taylor, a certified public accountant (C.P.A.) and

partner with Katz, Sapper & Miller, and Kevin Sullivan, a tax attorney, C.P.A., and

tax partner with Katz, Sapper & Miller,5 testified that they advised petitioners to

make the distributions and contributions of accounts receivable before the end of

each of the taxable years in issue and that they determined the best way to

implement their plan was to have petitioners execute the corporate resolutions and

make adjusting journal entries on the corporate books. The resolutions dated

December 31, 2004, 2005, and 2006, and the adjusting journal entries, coupled with

the relevant testimony and the pattern of following this procedure for three straight

years, is persuasive evidence that petitioners followed Katz, Sapper & Miller’s

advice and effected the distributions and contributions at the end of each year in

issue.


         5
        Mr. Taylor has been a C.P.A. since 1980 and concentrates his practice in the
retail automotive industry. Mr. Sullivan has been an attorney and a C.P.A. since
1993. Mr. Sullivan has worked in C.P.A. firms as an accountant and in a law firm
as a tax attorney. As a tax partner, Mr. Sullivan is engaged as a technical tax
resource by other members of his firm, as well as by its clients. We include
information regarding Messrs. Taylor and Sullivan’s backgrounds only to
demonstrate that they were individuals whose advice petitioners sought regarding
their income tax situation, on the basis of their experience and qualifications. We
have not relied on their legal conclusions in reaching our decision.
                                         - 14 -

      Respondent also argues that no economic outlay was made, because the

resolutions and adjusting journal entries made to the books of the related companies

were devoid of any economic reality and did not alter the economic positions of the

parties. We find that the distributions and contributions did have real consequences

that altered the positions of petitioners individually and those of their businesses.

As petitioners point out, the distributions and contributions created actual economic

consequences for the parties, because the accounts receivable had real value in that

they were legitimate debts that Auto Acceptance owed to CNAC and thus were

legitimate assets of CNAC.6 Petitioners’ contribution of the accounts receivable

resulted in their being poorer in a material sense in that the accounts receivable were

no longer collectible by them individually.

      When petitioners received the accounts receivable from CNAC, as they had

every right to do, and contributed them to Auto Acceptance, that transaction

reduced the liabilities of Auto Acceptance; made Auto Acceptance solvent in terms

of its assets exceeding its liabilities; and increased the net worth of Auto




      6
       These “accounts receivable” that Auto Acceptance owed to CNAC are to be
distinguished from the interest-bearing notes that Auto Acceptance received from
car buyers and sold to CNAC.
                                        - 15 -

Acceptance, exposing a greater amount of its assets to its general creditors.7 At the

same time, petitioners’ bases in CNAC were reduced by the amounts of the

accounts receivable that CNAC had distributed to them, thereby reducing their

ability to receive future tax-free distributions from CNAC. See sec. 1368.8




      7
        Petitioners stress that the risk involved in exposing more of Auto
Acceptance’s assets to its creditors was more than hypothetical, because by mid-
2004 the Kentucky attorney general had instituted a lawsuit against petitioners and
their businesses claiming millions of dollars on the basis of consumer fraud claims.
Petitioners contend that the risk of the loss to Auto Acceptance’s creditors,
including vendors that it alone dealt with, when viewed in consideration of the
attorney general’s lawsuit, was very real and the additional net worth in Auto
Acceptance created by the capital contribution was put at greater risk, making them
poorer in a material sense.
      8
        In general, a shareholder’s basis in the stock of an S corporation is increased
by the shareholder’s pro rata share of the corporation’s income, decreased by the
shareholder’s pro rata share of the corporation’s losses and deductions, and also
decreased by the amounts of distributions not includable in income. See sec. 1367.
Sec. 1368(a) provides that a “distribution of property made by an S corporation with
respect to its stock to which (but for this subsection) section 301(c) would apply
shall be treated in the manner provided in subsection (b) or (c), whichever applies.”
Sec. 1368(c) generally provides that if such a distribution is made by an S
corporation out of previously taxed undistributed earnings and profits it shall not be
included in income to the extent it does not exceed the adjusted basis of the stock.
If the distribution is made by an S corporation which has no accumulated earnings
and profits, pursuant to sec. 1368(b) the distribution shall not be included in gross
income to the extent that it does not exceed the adjusted basis of the stock, and the
amount of the distribution which exceeds the adjusted basis of the stock shall be
treated as gain from the sale or exchange of property.
                                        - 16 -

      The fact that the CNAC accounts receivable were distributed to petitioners

and then contributed to a related entity does not require a finding that there was no

economic outlay. We have previously considered this issue and have held that “the

fact that funds lent to an S corporation originate with another entity owned or

controlled by the shareholder of the S corporation does not preclude a finding that

the loan to the S corporation constitutes an ‘actual economic outlay’ by the

shareholder.” Ruckriegel v. Commissioner, T.C. Memo. 2006-78; see also Yates v.

Commissioner, T.C. Memo. 2001-280; Culnen v. Commissioner, T.C. Memo.

2000-139, rev’d and remanded on another issue, 28 Fed. Appx. 116 (3d Cir. 2002).

The fact that petitioners contributed intangible assets to Auto Acceptance, rather

than cash, does not preclude increases in their bases. The tax basis of an S

corporation may be increased through the contribution of cash, tangible assets, or

intangible assets (such as accounts receivable). See secs. 1012, 351(a), 358(a)(1);

see also Estate of Leavitt v. Commissioner, 90 T.C. 206 (1988), aff’d, 875 F.2d 420

(4th Cir. 1989).

      As a result of the transactions, the values of petitioners’ investments in

CNAC were diminished by the amounts of the receivables distributed to them.

When petitioners contributed the accounts receivable to Auto Acceptance, the

contributions increased their bases in Auto Acceptance and made them poorer
                                         - 17 -

individually because they no longer owned the receivables in their individual

capacities.

      Respondent argues that the close relationships between the shareholders and

the two S corporations warrants disregarding petitioners’ attempt to increase their

bases in Auto Acceptance. While it is appropriate to scrutinize the validity of

transactions between related parties, we see no reason why shareholders in two

related S corporations should be prohibited from taking distributions of assets from

one of their S corporations and investing those assets into another of their S

corporations, in order to increase their bases in the latter. The effect is to decrease

the shareholders’ bases in the S corporation making the distribution, thereby

reducing the shareholders’ potential future tax-free distributions from the

distributing S corporation, while increasing the shareholders’ bases in the S

corporation to which the contribution is made. The fact that the two S corporations

have a synergistic business relationship and are owned by the same shareholders

should make no difference so long as the underlying distributions and contributions

actually occurred. “[T]he existence of * * * [a close relationship between the

parties] is not necessarily fatal if other elements are present which clearly establish

the bona fides of the transactions and their economic impact.” Bhatia v.

Commissioner, T.C. Memo. 1996-429. As previously stated, we have found that
                                         - 18 -

these transactions did actually occur. The fact that petitioners were motivated by

tax considerations is not fatal. “Any one may so arrange his affairs that his taxes

shall be as low as possible”. Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir.

1934), aff’d, 293 U.S. 465 (1935).

      We find that petitioners made an actual economic outlay when they

contributed the accounts receivable to Auto Acceptance. We hold that petitioners

are entitled to their claimed bases increases in Auto Acceptance and their claimed S

corporation losses for the years 2004, 2005, and 2006.

Marc and Pamela Maguire’s Passive Real Estate Losses

      In the notice of deficiency respondent disallowed $25,000 of Marc and

Pamela Maguire’s passive rental losses for the tax year 2006.

      Section 469 generally disallows for the taxable year any passive activity loss.

Sec. 469(a). A passive activity loss is defined as the excess of the aggregate losses

from all passive activities for the taxable year over the aggregate income from all

passive activities for that year. Sec. 469(d)(1). A passive activity is any trade or

business in which the taxpayer does not materially participate, sec. 469(c)(1), or to

the extent provided in regulations, any activity with respect to which expenses are

allowable as a deduction under section 212, sec. 469(c)(6)(B).
                                          - 19 -

Rental activity is generally treated as a per se passive activity regardless of whether

the taxpayer materially participates. Sec. 469(c)(2), (4).

       There are two principal exceptions to the general rule that rental activities are

per se passive activities.

       (1) Real Estate Professional

       The first exception to the general rule is found in section 469(c)(7). Under

that section, the rental activities of taxpayers in real property trades or businesses

are not treated as per se passive activities but rather as trade or business activities,

subject to the material participation requirements of section 469(c)(1). Sec.

469(c)(7); see also sec. 1.469-9(e)(1), Income Tax Regs. Petitioner Marc Maguire

does not contend that he is a real estate professional, and the record does not

establish that he is.

       (2) Offset for Rental Real Estate Activities

       The second exception to the general rule that rental real estate activities are

per se passive activities (and therefore subject to the disallowance rule of section

469(a)) is found in section 469(i). That section provides that a taxpayer who

“actively” participates in a rental real estate activity may deduct a maximum loss of

$25,000 per year related to the activity. See sec. 469(i)(1) and (2). This exception
                                         - 20 -

is subject to phaseout when the taxpayer’s adjusted gross income (AGI) (determined

without regard to any passive activity loss) exceeds $100,000. Sec. 469(i)(3).

      The active participation standard can be satisfied without regular, continuous,

and substantial involvement in an activity; the standard is satisfied if the taxpayer

participates in a significant and bona fide sense in making management decisions

(such as approving new tenants, deciding on rental terms, approving capital

expenditures) or arranging for others to provide services such as repairs. Madler v.

Commissioner, T.C. Memo. 1998-112.

      On his 2006 Federal income tax return, Marc Maguire took the position that

he was active in the management of his real estate activities and claimed the

maximum deduction of $25,000. Respondent has not contested Marc Maguire’s

contention that he was active in the real estate management, and the record does not

indicate otherwise. As a result, the claimed deduction should be disallowed only if

Marc Maguire’s AGI for 2006 is high enough that the phaseout rule applies. Sec.

469(i)(3).

      Marc and Pamela Maguire reported a net operating loss for 2006 of

$738,992. However, respondent disallowed $1,900,950 in claimed losses from

Auto Acceptance and increased their AGI because he determined that they lacked

the necessary basis in Auto Acceptance. As a result, respondent determined that
                                        - 21 -

Marc and Pamela Maguire’s AGI for 2006 exceeded $150,000, making them

ineligible for the deduction.

      Because we have decided the adjusted basis issue in petitioners’ favor, Marc

and Pamela Maguire will have negative AGI for purposes of their 2006 return. As a

result, Marc and Pamela Maguire are not subject to the section 469(i)(3) phaseout

limitation. We therefore find that petitioners Marc and Pamela Maguire are entitled

to their claimed deduction of $25,000 for passive losses from real estate rental

activity for 2006.

Section 6662(a) Accuracy-Related Penalties

      Respondent determined accuracy-related penalties against James and Joy

Maguire for the taxable years 2004, 2005, and 2006 of $153,184.60, $32,573.60,

and $75,702, respectively. Respondent also determined accuracy-related penalties

against Marc and Pamela Maguire for the 2004, 2005, and 2006 tax years of

$63,014.20, $35,266, and $75,224.60, respectively.

      Because of our holding in petitioners’ favor on the adjusted basis issue and

because of the parties’ various concessions, respondent’s section 6662(a) penalty

computations must be adjusted accordingly in the event that petitioners are found

liable for the penalties. We must decide whether petitioners are liable for the

section 6662(a) penalties with respect to items not related to respondent’s
                                        - 22 -

determinations of their bases in Auto Acceptance, which include various

determinations involving their receipt of unreported interest income and unreported

fringe benefit income and the reduction of advertising expense and charitable

contribution deductions.

      Pursuant to section 6662(a) and (b)(1), a taxpayer may be liable for a penalty

of 20% of the portion of an underpayment of tax due to negligence or disregard of

rules or regulations. “Negligence” is defined as any failure to make a reasonable

attempt to comply with the provisions of the Internal Revenue Code; this includes a

failure to keep adequate books and records or to substantiate items properly. Sec.

6662(c); sec. 1.6662-3(b)(1), Income Tax Regs. Negligence has also been defined

as the failure to exercise due care or the failure to do what a reasonable person

would do under the circumstances. See Allen v. Commissioner, 92 T.C. 1, 12

(1989), aff’d, 925 F.2d 348, 353 (9th Cir. 1991); Neely v. Commissioner, 85 T.C.

934, 947 (1985). “Disregard” means any careless, reckless, or intentional

disregard. Sec. 6662(c).

      Petitioners have not contested several of the adjustments respondent

determined in the notice of deficiency. For their 2004 tax year James and Joy

Maguire agree that they had unreported interest income from CNAC of $15,106

because they failed to impute interest income at the applicable Federal rate on
                                       - 23 -

loans CNAC made to related parties. Marc and Pamela Maguire do not contest that

they also had unreported interest income of $14,485 from CNAC for 2004.

      Petitioners have also conceded that they had unreported fringe benefit income

for the personal use of company-owned vehicles.9 Petitioners were unable to

provide records to respondent to substantiate the business purpose of the automobile

use and indicated that such records had not been maintained. As a result,

respondent’s revenue agent determined that petitioners had used company

automobiles for personal reasons.

      Additionally, Marc and Pamela Maguire have not contested that they failed to

substantiate advertising expenses for 2004 of $3,000.

      Petitioners have also conceded that they claimed deductions for charitable

contributions which they could not substantiate. James and Joy Maguire conceded

that their charitable contribution deduction for 2004 be decreased by $3,232, while

Marc and Pamela Maguire conceded that their charitable contribution for 2004 be

decreased by $4,788.

      9
      For the taxable years 2004, 2005, and 2006, James and Joy Maguire
conceded that they had $28,333, $28,333, and $27,333 in unreported fringe benefit
income from CNAC, respectively, for their personal use of company automobiles.

     Marc and Pamela Maguire conceded that they had unreported fringe benefit
income of $10,952, $12,810, and $2,160 for their personal use of company
automobiles for the 2004, 2005, and 2006 taxable years, respectively.
                                         - 24 -

      Because petitioners failed to keep adequate books and records and to

substantiate properly the items in question on their returns, we find that they were

negligent and, therefore liable for the accuracy-related penalties with respect to the

conceded adjustments.

      To reflect the foregoing,


                                                            Decisions will be entered

                                                      under Rule 155.
