                          T.C. Memo. 1997-284



                        UNITED STATES TAX COURT



         JAMES J. LENCKE AND JANENE B. LENCKE, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 8787-95.                          Filed June 24, 1997.



     Margret G. Robb and Suzanne C. Klinghammer, for

 petitioners.

     Angela J. Kennedy, for respondent.




                MEMORANDUM FINDINGS OF FACT AND OPINION

     DAWSON, Judge:1    Respondent determined deficiencies in

petitioners' Federal income taxes and penalties for the taxable

years 1990, 1991, and 1992 as follows:


     1
        With the consent of counsel for the parties, the Chief
Judge reassigned this case, after the death of Judge Irene F.
Scott, to Judge Howard A. Dawson, Jr., for disposition on the
existing record.
                                  - 2 -

                           Accuracy-Related Penalties - Sec. 6662(a)2
Year       Deficiency          Sec. 6662(b)(1)     Sec. 6662(b)(2)
1990        $14,753                   ---             $2,815
1991          4,195                  $839               ---
1992          3,956                   791               ---


       Several issues have been conceded or settled by the parties.

The issues presented for decision are:      (1) Whether petitioners

are entitled to claimed losses incurred in their model railroad

activity for 1990, 1991, and 1992, so as to allow the expenses in

excess of the income from the activity to be deducted for Federal

income tax purposes; (2) whether petitioners are entitled to a

nonbusiness bad debt deduction for 1990; (3) whether amounts

received by petitioner James J. Lencke as residual insurance

premiums and in lieu of renewal insurance commissions during 1990

and 1991 are subject to self-employment tax under sections 1401

and 1402; (4) whether petitioners are liable for an accuracy-

related penalty for an underpayment of tax attributable to a

substantial understatement for 1990; and (5) whether petitioners

are liable for accuracy-related penalties for negligence or

disregard of rules or regulations for 1991 and 1992.

                            FINDINGS OF FACT

       Some of the facts have been stipulated and are found

accordingly.      The stipulation of facts and three supplemental



       2
        All section references are to the Internal Revenue Code
in effect for the years in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
                                - 3 -

stipulations of facts, together with attached exhibits, are

incorporated herein by this reference.

     At the time they filed their petition in this case, James J.

Lencke and Janene B. Lencke (petitioners) were residents of

Lafayette, Indiana.    They timely filed their joint Federal income

tax returns for the taxable years 1990, 1991 and 1992.

Claimed Business Loss Deductions for Model Railroad Activity

     James J. Lencke (Mr. Lencke) has been collecting model

railroad equipment and memorabilia for over 50 years.    His model

railroad collection is elaborately displayed in the basement of

his home.   It includes a complete circus with a big top, 12

operating carnival rides, 12 complete circus trains, hundreds of

buildings, signals, lights, and figurines, and at least 800

locomotives, 3,000 freight cars, and 2,000 passenger cars.     Mr.

Lencke is very knowledgeable about model railroads.

     Because Mr. Lencke had become disabled in July 1989, and

needed an activity to occupy his mind and his time, petitioners

started a model railroad activity, called Red Caboose, operated

from their home in 1990.   Both Mr. Lencke and Janene B. Lencke

(Mrs. Lencke), participated in the activity during the years in

issue, and both were still engaged in the activity at the time

this case was tried.

     Before deciding to begin their operation of Red Caboose,

petitioners visited model railroad shows and sought advice from

various vendors of model railroad supplies.   Although they
                                 - 4 -

considered entering into other types of activities, such as a

craft activity, petitioners chose the model railroad activity

because they believed it would be a feasible activity for them to

pursue given Mr. Lencke's extensive model railroad knowledge and

his physical limitations.3

     Prior to forming Red Caboose, petitioners had a retail

merchant certificate for one of their former activities, a craft

activity called Kiln Classics.    In early 1990, they attempted to

have the name Red Caboose substituted for the name Kiln Classics

on their retail merchant certificate.    However, the name was not

changed by the State of Indiana until several years later.

Petitioners are not zoned to conduct a retail business in their

home.

     During 1990, after petitioners had selected Red Caboose as

the activity they would conduct, they asked various suppliers

whether they would sell model railroad merchandise to them at

wholesale prices.   However, the suppliers refused to do so until

sometime in 1991.   Petitioners also contacted credit card

companies, Visa and MasterCard, to discuss the possibility of Red

Caboose accepting their credit cards for its model railroad


     3
        During the years in issue, Mr. Lencke suffered from
glaucoma and diabetes, and previously he had had open heart
surgery. In addition, he is deaf in one ear, completely blind in
one eye and partially blind in the other eye, and must keep one
of his legs in a cast. Thus, Mrs. Lencke, along with Mr.
Lencke's brother, does most of the physical work involved in the
operation of Red Caboose, and Mr. Lencke does most of the
paperwork.
                               - 5 -

orders.   Visa and MasterCard would not allow Red Caboose to

accept their credit cards during the years in issue.

     While planning the activities to be pursued through Red

Caboose, Mr. Lencke looked through model railroad magazines to

find model railroad shows which would be convenient and feasible

for them to attend.   He investigated the cost to rent tables at

the shows for petitioners to display and sell their merchandise,

and he made arrangements for them to become vendors at the shows.

Furthermore, petitioners advertised Red Caboose in model railroad

and toy magazines, and, in 1991, they published a two-page flyer

describing Red Caboose and listing its merchandise.    The flyer

was distributed at model railroad shows.    They also created Red

Caboose business cards during 1990, and used the elaborate model

railroad display in their basement as a way to entice visitors'

interests in collecting model railroads.4   However, they did not

formulate a written business plan for Red Caboose.

     During the years in issue, petitioners did not maintain a

separate telephone line at their home for Red Caboose.    Their

home telephone number was not listed in the local telephone

directory and, although it was listed on the business cards they

distributed, it was not provided in either their advertisements


     4
        Mr. Lencke treated visitors to his house to tours of the
model railroad collection in his basement. Although he did not
charge a fee for the tours, he encouraged "donations" by placing
a "donations bucket" near his collection. Some visitors donated
as much as $20.
                               - 6 -

in the train and toy magazines or the two-page flyer distributed

to their customers.   Thus, petitioners primarily conducted a

mail-order model railroad activity from their home.   They used

the model railroad shows they attended as a way to attract mail-

order customers.

     During 1990, 1991, and 1992, petitioners attended 4, 13, and

24 model railroad shows, respectively.   The number of tables they

rented at the shows increased during that time.

     During a week in which petitioners were not preparing to

travel to a show, they surveyed their inventory, which was stored

in their two-car garage and in a 24- by 30-foot shed adjacent to

their house, to assess which items sold well, which items needed

to be reordered, and which items needed to be marked down.5     They

also discussed whether each railroad show they attended was

worthwhile, and processed orders from their mail-order customers.

     During a week in which petitioners were preparing for a

show, they made sure they had all the merchandise they would need

for the show.   After marking a price on each of the items, they

packed the merchandise in their truck to take it to the show.

Each item's price was generally based on the price for which the

item was advertised in model railroad magazines.   However, if

they realized that another vendor at a show was selling an item

     5
        At its inception Red Caboose's merchandise consisted of
cardboard signs imprinted with train logos, 50 different
railroads, and mugs and buttons. Red Caboose's merchandise
expanded during the years in issue.
                                   - 7 -

for less than the price petitioners had marked on the item, they

adjusted that item's price accordingly.      None of their

merchandise was sold below cost.

       Usually, petitioners left on Friday morning when they were

going to a Saturday show.      Once they arrived at the show, they

unloaded the merchandise and set up their tables.      The shows were

generally held on Saturday and Sunday and lasted 7 hours each

day.       On Sunday evening they packed the merchandise that was not

sold into their truck and returned home.

       Petitioners did not hire an accountant to assist with the

preparation of Red Caboose's books and records.      They did not

have a traditional bookkeeping system for the activity.      Red

Caboose's records were kept in the same way Mr. Lencke had

previously kept his insurance business records.      To keep track of

merchandise sold during a show, petitioners dictated descriptions

of the items sold into a hand-held tape recorder.      Once they

returned home, they listened to the tape and made a note of the

amount of money received and the items sold at each show.       During

1990 and 1991, petitioners recorded the amount and nature of Red

Caboose's sales in their personal appointment book.       During 1992,

they prepared a tally sheet for each show indicating which items

were sold and the amount of money received at each show.6

       6
        Petitioners testified that Red Caboose's sales were
recorded in their personal ledger during the years in issue.
However, the stipulation of facts to which the parties agreed
                                                   (continued...)
                                - 8 -

     Petitioners placed the receipts for Red Caboose's expenses,

along with some of the receipts for their personal expenses, in

manilla envelopes, but the receipts were not labeled personal or

business.    At the end of each year, working from memory, they

prepared a list of Red Caboose's expenses and attached the list

to the outside of the envelopes.    Petitioners could not have

presented a complete set of records for Red Caboose, separate

from their personal records, at any point during the years in

issue.

     Mr Lencke deposited some of the proceeds from Red Caboose

into his Tippecanoe Agency account at Valley Federal Bank, which

was the account he had maintained as an insurance agent with

United Farm Bureau Insurance Companies.    The account no longer

contained funds from his former business as an insurance agent

when the Red Caboose proceeds were deposited.    Mr. Lencke's

Social Security benefits were also deposited into the Tippecanoe

Agency account during the years in issue.    In fact, petitioners

used some of Mr. Lencke's Social Security benefits to fund Red

Caboose.    In addition, petitioners paid some of Red Caboose's

expenses with funds from their personal bank account.


     6
      (...continued)
indicated that for 1990 and 1991 the sales were recorded in their
appointment book, and for 1992 the sales were recorded on a
separate tally sheet for each show. We have resolved this
inconsistency by finding that for 1990 and 1991 the sales were
recorded in their personal appointment book, and for 1992 the
sales were recorded on a separate tally sheet for each show.
                                   - 9 -

     In connection with Red Caboose, petitioners incurred, among

other operating expenses, table rental fees, postage expenses,

advertising expenses, utility expenses, banking fees, and travel

expenses.   However, other than staying at less expensive hotels

and eating at less expensive restaurants while they were

attending shows, petitioners were unable to reduce their

operating expenses during the years in issue.

     Petitioners enjoyed their model railroad activity and never

considered abandoning it although they regularly incurred losses.

While attending the model railroad shows, they occasionally

purchased items from other vendors, but they did not sell any

part of Mr. Lencke's personal model railroad collection in

connection with their model railroad activity.

     On line 17 of their joint Federal income tax returns for

1990, 1991, and 1992, petitioners reported taxable pension income

in the amounts of $71,424, $35,524, and $33,714, respectively.

     During 1990, 1991, and 1992, the gross receipts less cost of

goods sold from petitioners' model railroad activity were $440,

$2,108, and $1,128, respectively.      Petitioners claimed losses

from the operation of their model railroad activity on the

Schedule C attached to their 1990, 1991, and 1992 Federal income

tax returns as follows:

                            1990           1991      1992

Gross Receipts            $1,100      5,271        13,012
Cost of Goods Sold           -         (364)      (12,590)
Gross Income               1,100      4,907           422
                              - 10 -

Operating Expenses     (19,620)   (14,990)   (18,474)
                       (18,520)   (10,083)   (18,052)
Depreciation           (11,298)    (7,828)    (6,006)
Income/(Loss)          (29,818)   (17,911)   (24,058)


     Although petitioners' gross income from their model railroad

activity increased to $8,577 in 1993, $16,142 in 1994, and

$14,575 in 1995, their operating expenses substantially

increased, so that their claimed losses were $23,255, $11,656,

and $14,443, respectively, for those years.    Thus, the claimed

losses for 1990 through 1995 totaled $121,141, and petitioners

anticipated no net profit for their model railroad activity in

1996.   Since 1993 petitioners' activity has been operated in the

name of Jim's House of Trains because they were informed that the

name Red Caboose is a trademark.

     In the notice of deficiency respondent determined that

petitioners' model railroad activity was not engaged in for

profit and therefore disallowed the claimed loss deductions.

Claimed Nonbusiness Bad Debt Deduction

     On January 30, 1990, petitioners lent Dale and Gloria

Christopher $6,000 to enable them to purchase a flower shop in

Monticello, Indiana.   They had known the Christophers for 4 or 5

years prior to lending them the $6,000, and they had become

friends through church and other social activities.     At that time

both couples lived in Battleground, Indiana, which is a small

community with less than 1,000 residents.
                                - 11 -

     On February 14, 1990, the Christophers signed a promissory

note obligating them to repay the $6,000 to petitioners, at ten

percent interest, in monthly payments of $127.49.   On February 9,

1990, the Christophers became the owners of Main Street Floral.

The Christophers allowed petitioners to place some candy on

consignment at their flower shop.

     Petitioners felt that Main Street Floral was not prospering

during 1990.   They visited the flower shop several times during

1990, and on each visit they noticed very few customers and very

little inventory in the shop.    Although the Christophers sold the

candy petitioners placed on consignment at the flower shop, they

told them that they could not pay them their share of the

proceeds from the sales.

     Petitioners received three checks from the Christophers

during 1990, which represented four of the monthly payments

required under the terms of the promissory note.    However, Mrs.

Christopher requested that the checks not be cashed.

Nonetheless, in November 1990, petitioners took the checks to the

bank to cash them, but were told by the bank teller that the

Christophers did not have enough money in their account to cover

the checks, and that petitioners should not attempt to cash them.

In addition, petitioners heard rumors that the Christophers were

experiencing financial problems and had sought help through

various local charities.   After 1990, petitioners learned that
                               - 12 -

the Christophers' home was foreclosed, and in 1993 the

Christophers filed for divorce.

     During December 1990, Mr. Lencke contacted the Christophers

to discuss repayment of the $6,000 loan.    He was informed that

Mr. Christopher was currently "out of work", and the Christophers

would therefore not be able to repay the loan.    Petitioners then

decided not to pursue further collection of the debt.

     Mr. Christopher told petitioners that Main Street Floral had

been sold by the Christophers in December 1990.    However, the

Christophers did not enter into a contract to sell the floral

shop until January 19, 1991.   Main Street Floral was sold for

$18,000, and the Christophers received the initial installment in

the amount of $3,000 on January 19, 1991.    In December 1990, the

Christophers informed petitioners that any money they received

from the sale of their business would be used to repay their

obligation to the bank and would not be used to repay the $6,000

the Christophers owed to petitioners.   In March 1994, Mr.

Christopher was employed by Wabash National Corporation.

     Because of the Christophers' failure to repay petitioners

the $6,000 loaned to them, petitioners claimed a nonbusiness bad

debt deduction on their 1990 Federal income tax return.    In the

notice of deficiency respondent disallowed petitioners' claimed

bad debt deduction because they failed to establish that the debt

became worthless in 1990.
                              - 13 -

Self-Employment Taxes on Residual and Renewal Insurance
Commissions


     From 1973 to July 1989, Mr. Lencke was an insurance agent of

United Farm Bureau Family Life Insurance Company and United Farm

Bureau Mutual Insurance Company (Farm Bureau).   He and Farm

Bureau considered their association to be an independent

contractor relationship.   While he worked as Farm Bureau's agent,

Mr. Lencke had his own clients, who could not be assigned to a

different agent.   He received a 5-percent renewal commission on

the life insurance policies he sold.   Throughout his career as an

agent with Farm Bureau, Mr. Lencke maintained his insurance

office in his home.   During July 1989, Mr. Lencke became disabled

and decided that he could not continue to work as Farm Bureau's

agent.   The relationship was terminated.

     In general, when one of its insurance agents becomes

disabled and terminates his or her agency relationship, Farm

Bureau pays the agent a 5-percent renewal commission for a

limited period on the life insurance policies sold by him.

However, Mr. Lencke was concerned that some of his clients would

not renew their Farm Bureau life insurance policies once they

learned that he would no longer be working for Farm Bureau.

Thus, to provide him with a fixed amount of income during the 6

months following his separation from service, and to enable Farm

Bureau to assign his clients to other agents, he and Farm Bureau

agreed, after negotiations, that his previously executed
                              - 14 -

agreement to sell insurance on behalf of Farm Bureau would be

amended.

     An Amendment to Contract Between James J. Lencke and United

Farm Bureau Family Life Insurance Company, United Farm Bureau

Mutual Insurance Company, and Their Subsidiaries (contract

amendment), executed in September 1989, provided that Mr. Lencke

would not earn any new commissions (other than first writings on

policies previously written), and would receive, in lieu of

renewal commissions, five monthly payments of $5,000.     Petitioner

received two of the monthly payments in 1990 which totaled

$10,225.

      Mr. Lencke also received $874 in residual premiums in 1990,

and $684 in residual premiums in 1991.     In 1990, Mr. Lencke had

premium returns totaling $1,359.

     Petitioners reported the amounts Mr. Lencke received as

residual premiums in 1990 and 1991 as other income on line 22 of

their joint Federal income tax returns for 1990 and 1991,

respectively.   However, they did not report the $10,225 Mr.

Lencke received in lieu of renewal commissions in 1990 as income

on their tax return for that year.     Petitioners have conceded

that the $10,225, less the premium returns for 1990, should have

been reported as income on their 1990 return.     But they allege in

their petition that the residual premiums received by Mr. Lencke

in 1990 and 1991, and the amount received by him in lieu of
                               - 15 -

renewal commissions in 1990, are not subject to self-employment

tax.

       In the notice of deficiency respondent determined that the

amounts Mr. Lencke received as residual premiums and in lieu of

renewal commissions constitute income from self-employment within

the meaning of section 1401 and, therefore, were subject to self-

employment tax.

Accuracy-Related Penalties

       Petitioners' Federal income tax returns for 1990, 1991, and

1992 were prepared by an attorney.

       Petitioners reported a tax liability of only $392 on their

1990 Federal income tax return.    They failed to report net income

received in lieu of renewal commissions for 1990.    Their tax

liability was substantially understated for that year.

       Petitioners claimed depreciation deductions on the Schedule

C attached to their 1991 and 1992 Federal income tax returns for

several items for which they have conceded they were not entitled

to depreciation deductions.    The items for which petitioners

claimed depreciation deductions included a boat, lawn mower, and

sprinkler, which were personal assets.    They failed to maintain

or present adequate substantiation to support some deductions

claimed on their tax returns for 1991 and 1992.

       Respondent determined in the notice of deficiency that

petitioners are liable for accuracy-related penalties under
                             - 16 -

section 6662(b)(2) for 1990 and section 6662(b)(1) for 1991 and 1992.

                             OPINION

     We begin by noting that respondent's determinations are

presumed correct, and petitioners bear the burden of proving that

those determinations are erroneous.    Rule 142(a); Welch v.

Helvering, 290 U.S. 111 (1933).   Deductions are a matter of

legislative grace, and petitioners have the burden of proving

that they are entitled to any claimed deductions.    INDOPCO, Inc.

v. Commissioner, 503 U.S. 79, 84 (1992).

I.   Claimed Business Loss Deductions for Model Railroad Activity

Section 1837 provides, in general, that an individual will not be


     7
        SEC. 183. ACTIVITIES NOT ENGAGED IN FOR PROFIT.
     (a) GENERAL RULE.--In the case of an activity engaged in by
an individual or an S corporation, if such activity is not
engaged in for profit, no deduction attributable to such activity
shall be allowed under this chapter except as provided in this
section.
     (b) DEDUCTIONS ALLOWABLE.--In the case of an activity not
engaged in for profit to which subsection (a) applies, there
shall be allowed--

          (1) the deductions which would be allowable under this
     chapter for the taxable year without regard to whether or
     not such activity is engaged in for profit, and

          (2) a deduction equal to the amount of the deductions
     which would be allowable under this chapter for the taxable
     year only if such activity were engaged in for profit, but
     only to the extent that the gross income derived from such
     activity for the taxable year exceeds the deductions
     allowable by reason of paragraph (1).

     (c) ACTIVITY NOT ENGAGED IN FOR PROFIT DEFINED.--For
purposes of this section, the term "activity not engaged in for
profit" means any activity other than one with respect to which
deductions are allowable for the taxable year under section 162
                                                   (continued...)
                               - 17 -

allowed a deduction in excess of gross income attributable to an

activity if the activity is not engaged in for profit.      An

activity not engaged in for profit is "any activity other than

one with respect to which deductions are allowable for the

taxable year under section 162 or under paragraph (1) or (2) of

section 212."   Sec. 183(c).   Therefore, whether an activity is

engaged in for profit is determined with reference to sections

162 and 212.

     Deductions are allowed under section 162(a) for all ordinary

and necessary expenses of carrying on an activity that

constitutes a trade or business.    The Supreme Court has stated

that "to be engaged in a trade or business, the taxpayer must be

involved in the activity with continuity and regularity and * * *

the taxpayer's primary purpose for engaging in the activity must

be for income or profit.   A sporadic activity, a hobby, or an

amusement diversion does not qualify."    Commissioner v.

Groetzinger, 480 U.S. 23, 35 (1987).    To be entitled to a trade

or business expense deduction, the taxpayer must have an "actual

and honest objective of making a profit."    Dreicer v.

Commissioner, 78 T.C. 642, 645 (1982), affd. without opinion 702

F.2d 1205 (D.C. Cir. 1983).




     7
      (...continued)
or under paragraph (1) or (2) of section 212.
                               - 18 -

     Petitioners contend that Red Caboose was an activity in

which they engaged with the objective of making a profit during

the years in issue.   Respondent, on the other hand, contends that

petitioners' operation of Red Caboose was an activity "not

engaged in for profit" within the meaning of section 183(c).

     Whether the required profit objective exists is to be

determined on the basis of all the facts and circumstances of

each case.    Allen v. Commissioner, 72 T.C. 28, 33 (1979).

Section 1.183-2(b), Income Tax Regs., sets forth some of the

relevant factors to be considered in deciding whether an activity

is engaged in for profit.    No one factor is controlling.    Dunn v.

Commissioner, 70 T.C. 715, 720 (1978), affd. 615 F.2d 578 (2d

Cir. 1980).   The factors include:   (1) The manner in which the

taxpayer carries on the activity; (2) the expertise of the

taxpayer or his advisers; (3) the time and effort expended by the

taxpayer in carrying on the activity; (4) the expectation that

assets used in the activity may appreciate in value; (5) the

success of the taxpayer in carrying on other similar or

dissimilar activities; (6) the taxpayer's history of income or

losses with respect to the activity; (7) the amount of occasional

profits, if any, which are earned; (8) the financial status of

the taxpayer; and (9) whether elements of personal pleasure or

recreation are involved.    Sec. 1.183-2(b), Income Tax Regs.

While the focus of the test is on the subjective intention of the

taxpayer, greater weight is given to the objective facts than to
                                 - 19 -

the taxpayer's mere statement of his or her intent.    Dreicer v.

Commissioner, 78 T.C. at 645; sec. 1.183-2(a), Income Tax Regs.

     After considering all the facts and circumstances in this

case, it is our view that petitioners' operation of Red Caboose

was an activity not engaged in for profit during the years in

issue.   Some of the more significant factors we have weighed are

the manner in which petitioners carried on Red Caboose, Red

Caboose's loss history, the time and effort expended by them in

carrying on Red Caboose, their financial status, and their

interest in model railroads as a recreational activity.

     That a taxpayer operates an activity in a businesslike

manner and maintains complete and accurate books and records may

indicate that the activity is engaged in for profit.    Sec. 1.183-

2(b)(1), Income Tax Regs.   Respondent contends that petitioners

did not maintain adequate books and records for their model

railroad activity.   We agree.

     Petitioners commingled their records for Red Caboose with

their personal records.   For 1990 and 1991, they recorded Red

Caboose's sales in their personal appointment book.    During 1990,

1991, and 1992, they commingled the receipts for Red Caboose's

expenses with their personal receipts.    They could not have

presented a complete set of records for Red Caboose, separate

from their personal records, at any time during the years in

issue.   Furthermore, they conducted some of Red Caboose's banking
                              - 20 -

transactions through their personal bank account and Mr. Lencke's

former insurance bank account.

     Petitioners argue that their record-keeping system for Red

Caboose was complete and accurate, and thus evidence of their

profit motive, because Mr. Lencke used the same system for his

insurance activity.   We do not find their reasoning persuasive.

Even if the record-keeping system used by petitioners for Red

Caboose was an adequate record-keeping system for Mr. Lencke's

insurance activity, which is an issue we do not address, it does

not follow that such a system was a complete and accurate record-

keeping system for a model railroad activity.

     It is significant that petitioners did not have a concrete

plan for improving the profitability potential of Red Caboose.

During each year in issue, and in later years, they sustained

sizeable losses in connection with Red Caboose.   In 1990 they

reported a loss of $29,818; in 1991 they reported a loss of

$17,911; and in 1992 they reported a loss of $24,058.   However,

in spite of these large losses, they failed to substantially

change their method of operating Red Caboose.   Other than staying

at less expensive hotels and eating at less expensive restaurants

while they were attending model railroad shows, they did little,

if anything, to reduce Red Caboose's operating expenses.

Moreover, they were not successful in implementing remedial

measures to increase Red Caboose's revenues.    For example, they

did not consider installing a separate telephone line for Red
                              - 21 -

Caboose so they could profit from telephone orders.   In fact,

petitioners' record-keeping system for Red Caboose was in such a

disorganized state that we doubt they could have constructively

analyzed Red Caboose's expenses and revenues and formulated a

plan for increasing its profitability.

     As we stated in Bessenyey v. Commissioner, 45 T.C. 261, 274

(1965), affd. 379 F.2d 252 (2d Cir. 1967), the presence of losses

in the formative years of a business "is not inconsistent with an

intention to achieve a later profitable level of operation,

bearing in mind, however, that the goal must be to realize a

profit on the entire operation, which presupposes not only future

net earnings but also sufficient net earnings to recoup the

losses which have meanwhile been sustained in the intervening

years".   See also sec. 1.183-2(b)(6), Income Tax Regs.

Petitioners assert that they expected to incur losses from Red

Caboose operations in its early years, but that eventually, as

Red Caboose's sales increased, they expected to realize a profit.

If Mr. Lencke were to die, they point out, his Social Security

benefits would cease, and Mrs. Lencke would have to support

herself with the proceeds from Red Caboose.   We are not persuaded

by these assertions.   Petitioners have not formulated a concrete

business plan to reverse the substantial losses sustained by them

in operating Red Caboose.   Thus, we are not convinced that Red

Caboose (now Jim's House of Trains) will ever show a profit, let

alone recoup the present history of losses.
                                - 22 -

     A taxpayer who devotes much of his personal time and effort

to carrying on an activity, particularly if the activity does not

have substantial personal or recreational aspects, may have an

intention to derive a profit.    Sec. 1.183-2(b)(3), Income Tax

Regs.   Here, however, the record shows that petitioners failed to

devote much of their personal time and effort to Red Caboose

during the years in issue.

     The relatively small amounts of gross receipts reported by

petitioners from Red Caboose during 1990, 1991, and 1992, which

were $1,100, $5,271, and $13,012, respectively, and the

relatively few model railroad shows they attended during 1991,

1992, and 1993, which were 4, 13, and 24, respectively, show that

petitioners did not devote much of their personal time and effort

to Red Caboose, particularly in light of the recreational aspects

involved in its operation.   Therefore, based on the testimonial

and documentary evidence in this record, we think petitioners did

not devote sufficient personal time and effort to Red Caboose

during 1990, 1991, and 1992 to establish that they engaged in

their model railroad activity with an actual and honest objective

of making a profit.

     In our opinion petitioners' primary motivation in operating

Red Caboose was other than to earn a profit.    Respondent suggests

that their motive was to use the losses it generated to offset

income they received during 1990, 1991, and 1992.    This seems

probable.   Substantial income from sources other than the
                              - 23 -

activity (particularly if the losses from the activity generate

substantial tax benefits) may indicate that an activity is not

engaged in for profit, especially if there are personal or

recreational elements involved.    Sec. 1.183-2(b)(8), Income Tax

Regs.

     On their 1990, 1991, and 1992 Federal income tax returns,

petitioners reported taxable pension income in the amounts of

$71,424, $35,524, and $33,714, respectively.    The losses claimed

by them from the operation of Red Caboose for 1990, 1991, and

1992 were $29,818, $17,911, and $24,058, respectively.

Consequently, the losses that petitioners sustained in the

operation of Red Caboose resulted in appreciable tax savings for

them.   The operation of Red Caboose, it appears to us, provided a

method for attempting to achieve these tax savings while enabling

Mr. Lencke to pursue his lifelong hobby of collecting model

railroad equipment and memorabilia.

     Respondent further contends that petitioners may have viewed

Red Caboose as a recreational activity.    The presence of personal

or recreational motives in carrying on an activity may indicate

that the activity is not engaged in for profit.    Sec. 1.183-

2(b)(9), Income Tax Regs.   Both petitioners enjoy their model

railroad activity and have never considered abandoning it.    Mr

Lencke has been collecting model railroad equipment and

memorabilia for over 50 years.    One reason petitioners started

Red Caboose was to provide Mr. Lencke with an activity to occupy
                              - 24 -

his mind and his time after his retirement as an insurance agent.

Thus, we think Red Caboose allowed Mr. Lencke to pursue, upon his

retirement, his interest in and the pleasures of collecting model

railroad equipment and memorabilia.    Although its operation

extended petitioners' interest in model railroading into a more

formal pursuit, it does not necessarily follow that they were

primarily motivated by an intention to make Red Caboose a

profitable venture.   While it is not required that a taxpayer

dislike an activity before it will be considered a business and

not a hobby, Jackson v. Commissioner, 59 T.C. 312, 317 (1972),

petitioners have not shown a profit objective with respect to

their model railroad activity.   Consequently, their interest in

operating Red Caboose has strong recreational and personal

elements.

     In reaching our conclusion that Red Caboose's operation was

not an activity engaged in by petitioners for profit, we have

considered that, before starting Red Caboose, they planned and

coordinated the activities to be pursued through Red Caboose,

visited model railroad shows, and sought advice from various

vendors of model railroad supplies, and that they promoted Red

Caboose by advertising in model railroad and toy magazines,

publishing and distributing a two-page flyer listing Red

Caboose's merchandise, creating business cards, and allowing

visitors to tour the model railroad collection displayed in the

basement of their home.   We have also considered that petitioners
                               - 25 -

persuaded suppliers to sell to them at wholesale prices during

and after 1991; that they later obtained a retail merchant

certificate for Red Caboose; and that they attempted to persuade

credit card companies, Visa and MasterCard, to allow Red Caboose

to accept their credit cards for its model railroad orders during

the years in issue.   However, in weighing these facts along with

all the other facts in this record, we have concluded, on

balance, that petitioners' objective in operating Red Caboose was

not the actual and honest intention of making a profit during the

years in issue.   Accordingly, we sustain respondent's

determination.    Having decided that petitioners are not entitled

to the loss deductions resulting from their model railroad

activity in 1990, 1991, and 1992, it is unnecessary to address

respondent's alternative position that petitioners are not

entitled to additional depreciation deductions claimed for 1991

and 1992.

II.   Claimed Nonbusiness Bad Debt Deduction

      Section 166(d) allows a deduction for a nonbusiness debt

that becomes worthless within the taxable year, but provides that

the loss shall be treated as a short-term capital loss to a

taxpayer other than a corporation.      To qualify for a deduction

for a worthless debt, the taxpayer must show that the debt became

totally worthless within the taxable year in which the deduction

is claimed because no deduction is "allowed for a nonbusiness

debt which is recoverable in part during the taxable year."      Sec.
                                - 26 -

1.166-5(a)(2), Income Tax Regs; Andrew v. Commissioner, 54 T.C.

239, 245 (1970).   Whether a debt has become worthless within a

particular year is a question of fact, Perry v. Commissioner, 22

T.C. 968, 973 (1954), to be determined on the basis of objective

factors, not on the taxpayer's subjective judgment as to the

worthlessness of the debt.     Fox v. Commissioner, 50 T.C. 813, 823

(1968), affd. per curiam without published opinion 25 AFTR 2d 70-

891, 70-1 USTC par. 9373 (9th Cir. 1970).    Generally, the year of

worthlessness must be fixed by identifiable events which form the

basis of reasonable grounds for abandoning any hope of recovery.

Crown v. Commissioner, 77 T.C. 582, 598 (1981).

      The Court of Appeals for the Seventh Circuit has set forth

some of the relevant factors to be considered in determining

whether a debt is worthless.    These factors include the debtor's

serious financial reverses, insolvency, lack of assets,

persistent refusals to pay on demand, ill health, death,

disappearance, abandonment of business, bankruptcy, and

receivership, as well as the debt's unsecured and subordinated

status and expiration of the statute of limitations.     Cole v.

Commissioner, 871 F.2d 64, 67 (7th Cir. 1989), affg. T.C. Memo.

1987-228.   Some of the factors indicating that a debt is not

worthless are the creditor's failure to pursue payment

(especially if the debtor is a relative or friend), willingness

to make further advances, availability of collateral or

guarantees by third parties, the debtor's earning capacity, minor
                              - 27 -

defaults, payment of interest, and sluggish business conditions.

Id.

      Petitioners rely on the Christophers' poor financial

condition as proof that the debt became worthless during 1990.

But the evidence of worthlessness upon which they rely is tenuous

at best.   For example, some of the factors which caused them to

consider the debt worthless in 1990 are:    (1) They heard rumors

the Christophers were experiencing financial problems in 1990 and

had sought help through various local charities; (2) they

believed Mr. Christopher was "out of work" in 1990; (3) the

Christophers sold their flower shop in 1991; (4) the

Christophers' home was foreclosed after 1990; (5) the

Christophers asked petitioners not to cash their checks; and (6)

the Christophers said they could not repay the debt.    However,

the test for worthlessness is objective, not subjective.     Redman

v. Commissioner, 155 F.2d 319, 320 (1st Cir 1946), affg. a

Memorandum Opinion of this Court.   Petitioners' belief that the

Christophers were unable to pay their debt was based on

subjective concerns rather than the objective view of the

Christophers' financial inability to pay.      An examination of

the facts shows that petitioners had a significant hope for

recovery of at least a portion of the amount loaned to the

Christophers.   Although they discussed repayment of the $6,000

loan with the Christophers in December 1990, they did not

persistently press them for payment.   The Christophers sold their
                                - 28 -

flower shop for $18,000 in 1991, yet petitioners failed to make

any attempt to recover some of the proceeds received from the

sale.     Petitioners failed to persuade us that their friendship

with the Christophers was not the main reason for the refusal to

press them for payment.     Petitioners also failed to show, among

other things, whether the Christophers lacked assets, were in ill

health, had filed for bankruptcy, were insolvent, or were

incapable of paying their debt for some other reason.     In short,

petitioners have not shown that collection efforts would have

been futile.     Their belief that the debt was worthless and their

choice not to pursue reasonable collection efforts are

insufficient to establish worthlessness.

       Accordingly, we hold that petitioners have failed to prove

that the debt which the Christophers owed them became worthless

in 1990.     Therefore, they are not entitled to a nonbusiness bad

debt deduction in that year.

III.    Self-Employment Taxes on Residual and Renewal Insurance
        Premiums

        Section 1401 imposes a tax upon each individual's "self-

employment income".     "Self-employment income" is defined in

section 1402(b) as "net earnings from self-employment" with

certain exceptions not relevant to this case.     Net earnings from

self-employment are defined in section 1402(a) as "gross income

derived by an individual from any trade or business carried on by

such individual, less the deductions allowed by this subtitle
                              - 29 -

which are attributable to such trade or business".   It is well

established that the earnings of an insurance agent who is an

independent contractor are "self-employment income" subject to

self-employment tax.   Simpson v. Commissioner, 64 T.C. 974

(1975).

     In Newberry v. Commissioner, 76 T.C. 441, 444 (1981), this

Court held that, for income to be taxable as self-employment

income, "there must be a nexus between the income received and a

trade or business that is, or was, actually carried on."      Under

our interpretation of the "nexus" standard, any income must arise

from some actual (whether present, past, or future) income-

producing activity of the taxpayer before such income becomes

subject to self-employment tax.   Id. at 446.   And section

1.1402(a)-1(c), Income Tax Regs., provides that gross income

derived from an individual's trade or business may be subject to

self-employment tax even when it is attributable in whole or in

part to services rendered in a prior taxable year.

     First, we must decide whether the residual premiums received

by Mr. Lencke in 1990 and 1991 from Farm Bureau are subject to

self-employment tax.   Respondent contends that section 1401

imposes self-employment tax upon this type of income.   We agree.

Petitioners have the burden of proving that the residual premiums

received by them are not subject to self-employment tax.      Because

they have chosen not to pursue this issue in either their opening

brief or reply brief, we consider it to have been conceded.
                               - 30 -

Rule 151(e); Remuzzi v. Commissioner, T.C. Memo 1988-8, affd.

without published opinion 867 F.2d 609 (4th Cir. 1989).

     Second, we must decide whether the payments in lieu of

renewal commissions received by petitioners in 1990 are subject

to self-employment tax.   Petitioners contend that these payments

are analogous to the "termination payments" received by the

taxpayer in Milligan v. Commissioner, 38 F.3d 1094 (9th Cir.

1994), revg. T.C. Memo 1992-655, and are, therefore, not subject

to self-employment tax.   To the contrary, respondent contends the

payments merely provided a uniform manner of payment of renewal

commissions and retained the characteristics of renewal

commissions.   Thus, respondent concludes that the payments are

subject to self-employment tax just as renewal commissions are

subject to self-employment tax.   We agree with respondent.

     The courts which have examined the issue of whether payments

made in lieu of renewal commissions are subject to self-

employment tax agree that the payments are of the same character

as renewal commissions and are, therefore, subject to self-

employment tax.   See Becker v. Tomlinson, 9 AFTR 2d 1408, 62-1

USTC par. 9,446 (S.D. Fla. 1962); Erickson v. Commissioner, T.C.

Memo. 1992-585, affd. without published opinion 1 F.3d 1231 (1st

Cir. 1993).    In the Becker case, the taxpayer, an insurance

agent, was entitled to receive renewal commissions after the

termination of his contract.   An amendment to his original

contract, however, allowed the taxpayer to choose to receive
                              - 31 -

uniform, regularly scheduled payments in lieu of his renewal

commissions.   Upon his retirement as an insurance agent, the

taxpayer elected to receive the uniform, regularly scheduled

payments rather than the renewal commissions to which he was

entitled.   The District Court reasoned that the payments made to

the taxpayer in lieu of renewal commissions merely provided for a

uniform manner of payment of renewal commissions and did not

alter the nature of the payments.   Because renewal commissions

are subject to self-employment tax, the District Court held that

the payments made in lieu of the renewal commissions are also

subject to self-employment tax.

     Similarly, in the Erickson case, this Court held that

payments made under a Settlement Agreement that replaced the

taxpayer insurance agent's former agreement governing the payment

of renewal commissions were subject to self-employment tax.     The

taxpayer in the Erickson case, who had recently separated from

service as an insurance agent, was entitled to receive renewal

commissions pursuant to a Leveling Agreement that provided for

monthly payments over a 180-month period.   However, as a result

of disputes between the taxpayer and the insurance company, the

insurance company entered into a Settlement Agreement with the

taxpayer.   The Settlement Agreement nullified the Leveling

Agreement and provided that the taxpayer was to receive uniform,

monthly payments over a 240-month period, and then smaller

uniform, monthly payments for the remainder of his life.
                              - 32 -

Reasoning that the payments under the Settlement Agreement had

the same character as the renewal commissions, we concluded that

the payments were subject to self-employment tax.

     Like the payments received by the taxpayers in the Becker

and Erickson cases, the payments received by Mr. Lencke in lieu

of renewal commissions retained the character of the renewal

commissions they replaced.   Petitioners cite Gump v. United

States, 86 F.3d 1126 (Fed. Cir. 1996), and Milligan v.

Commissioner, 38 F.3d 1094 (9th Cir. 1994), revg. T.C. Memo.

1992-655 to support their position that the payments received by

Mr. Lencke in lieu of renewal commissions were analogous to

"termination payments" and therefore not subject to self-

employment tax.   However, the payments in the Gump and Milligan

cases were not payments made in lieu of renewal commissions.    The

right to the payments in those cases arose from the cancellation

of the insurance agents' business arrangements.   They were

payments specifically designated as "termination payments" or

"extended earnings", and, under certain circumstances, the agents

could have lost their right to receive the payments.8    Milligan



     8
        In Milligan v. Commissioner, 38 F.3d 1094, 1096-1097 (9th
Cir. 1994), revg. T.C. Memo. 1992-655, the agent's right to
receive termination payments would have been canceled if all of
his former customers had canceled their non-life insurance
policies during the first post-termination year. In Gump v.
United States, 86 F.3d 1126, 1128 (Fed. Cir. 1996), the agent
would not have received his extended earnings if he had attempted
to induce his agency's policyholders to lapse, cancel, or replace
their insurance contracts.
                                - 33 -

v. Commissioner, 38 F.3d at 1096-97; Gump v. United States, 86

F.3d at 1127-28.    Thus, the Milligan and Gump cases are not

factually similar to the situation confronting us here.

Moreover, the Court of Appeals for the Ninth Circuit specifically

noted that renewal commissions are subject to self-employment

tax.    Milligan v. Commissioner, 38 F.3d at 1098 (citing Erickson

with approval).    The Court of Appeals for the Federal Circuit

also recognized the distinction between renewal commissions and

"extended earnings".    Gump v. United States, 86 F.3d at 1130.

Likewise, our recent opinion in Jackson v. Commissioner, 108 T.C.

130 (1997), following the decision of the Court of Appeals in

Milligan, which dealt only with "termination payments", is

distinguishable from the renewal commissions involved in this

case.

       Accordingly, we hold that the payments received by Mr.

Lencke in lieu of renewal commissions are subject to self-

employment tax because they retained the character of the renewal

commissions they replaced.

IV.    Accuracy-Related Penalties

       Section 6662(a) imposes a penalty equal to 20 percent of the

portion of the underpayment due to any substantial understatement

of income tax.    Section 6662(d) defines both "understatement" and

"substantial understatement".    Pursuant to section 6662(d)(2),

when the amount of tax required to be shown on a return exceeds

the amount actually shown (less any rebates provided in section
                              - 34 -

6211(b)(2)), then there is an understatement of tax.    This

understatement is "substantial" if the excess amount exceeds the

greater of $5,000 or 10 percent of the amount of tax required to

be shown on the return.   Sec. 6662(d)(1).   However, section

6662(d)(2)(B) provides that the understatement is reduced to the

extent that (1) the tax treatment of an item shown on the return

was supported by substantial authority or (2) the facts affecting

the item's tax treatment are adequately disclosed and there is a

reasonable basis for such treatment.

     Petitioners' 1990 Federal income tax return reported a tax

liability of $392.   Based upon concessions made by petitioners in

the stipulations of facts, without accounting for the contested

adjustments, there appears to exist an understatement of tax,

which exceeds the greater of $5,000 or 10 percent of the amount

of tax required to be shown on the return.

     Section 6662(a) imposes a penalty equal to 20 percent of the

portion of the underpayment due to negligence or disregard of

rules or regulations.   The term "negligence" includes any failure

to make a reasonable attempt to comply with the provisions of the

Internal Revenue Code and "disregard" includes any careless,

reckless, or intentional disregard.    Sec. 6662(c).

     On their 1991 and 1992 Federal income tax returns,

petitioners admittedly claimed a depreciation deduction for a

boat which they now concede is not properly deductible.    Mr.

Lencke purchased the boat with no business purpose.    Petitioners
                              - 35 -

also claimed a depreciation deduction for their lawn mower and a

sprinkler which had no apparent business purpose, for an

answering machine when they did not have a business telephone

line (they now concede that the answering machine was not

depreciable), and for 100 percent of a shed which they now

concede was only 25 percent depreciable during 1991 and 50

percent depreciable during 1992.   Petitioners have also conceded

some deductions they claimed because they were either improper or

unsubstantiated.   Therefore, we hold that they are liable for the

negligence penalty for the above items.

     We conclude, however, that petitioners made a reasonable

attempt to comply with the Code provisions with respect to their

model railroad activity, and therefore are not liable for a

penalty on that portion of the underpayment for 1990, 1991 or

1992.   Sec. 6664(c)(1).

     In reaching all of our conclusions herein, we have

considered all arguments made by petitioners and, to the extent

not discussed above, find them to be without merit.

     To reflect conceded and settled issues and our conclusions

with respect to the disputed issues,



                                    Decision will be entered

                               under Rule 155.
