                         T.C. Memo. 2003-185



                       UNITED STATES TAX COURT



             PAUL AND PAULINE D. KESSLER, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 3281-02.                Filed June 26, 2003.



     Paul and Pauline D. Kessler, pro sese.

     James N. Beyer, for respondent.




                          MEMORANDUM OPINION


     RUWE, Judge:    This case was submitted fully stipulated.   The

stipulation of facts, the supplemental stipulation of facts, and

the stipulation of settled issues are incorporated herein by this

reference.
                                - 2 -

     On November 9, 2001, respondent issued a notice of

deficiency determining petitioners owed income tax deficiencies

of $17,097, $17,283, and $11,267 for the taxable years 1991,

1992, and 1993, respectively.     Additionally, respondent

determined a $2,765 accuracy-related penalty pursuant to section

6662(a) for the tax year 1991.1

     In the notice of deficiency, respondent made numerous

changes to items reported on petitioners’ returns for the

aforementioned years.   After petitioners’ concessions,2 the

issues to be decided are:   (1) Whether petitioners’ rental losses

for the taxable years 1991, 1992, and 1993 in the amounts of

$115,390, $48,974, and $21,309, respectively, are section 469

passive activity losses, and (2) whether petitioners are liable

for the section 6662(a) accuracy-related penalty for 1991.




     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
     2
      Petitioners conceded the following: (1) They had
unreported rental income in 1991 of $55,000 which should have
been included on their Schedule E, Supplemental Income and Loss;
(2) their total claimed depreciation deductions should be
decreased by $1,590, $15,005, and $22,005 for 1991, 1992, and
1993, respectively; and (3) they had additional unreported
capital gains of $1,464 for 1992.
                               - 3 -

Background

     Petitioners timely filed their joint income tax returns for

1991, 1992, and 1993.   Petitioners were owners3 and operators of

a subchapter C corporation named Pauline’s Concrete Pumping,

Inc.4 (Pauline’s Concrete).   At the time the petition was filed,

petitioners resided in Philadelphia, Pennsylvania.

     On February 15, 1987, petitioners in their individual

capacities entered into a “Master Lease Agreement” with Pauline’s

Concrete (the lease).   The lease contemplated that petitioners

would provide certain equipment to Pauline’s Concrete and that

Pauline’s Concrete was responsible for all costs, including the

costs associated with the acquisition and maintenance of the

equipment and for all the insurance costs.   The lease term was 10

years.   Attached to the lease was an exhibit which listed the

following equipment contemplated by the lease:




     3
      For the taxable years at issue, petitioners were the only
shareholders of Pauline’s Concrete Pumping, Inc.
     4
      The stipulations filed by the parties use the names
“Pauline’s Concrete Pumping, Company,” “Pauline’s Concrete
Pumping Company, Inc.,” and “Pauline’s Concrete Pumping Inc.”     It
is apparent that the stipulations refer to the same entity.
                               - 4 -

          Truck Description            Unit Number

          Mack 175K                         1
          Mack 514K                         2
          Mack 474K                         3
          Tag along                         4
          1989 Ford truck
          1993 Ford truck
          Various excavation equipment
          Office equipment

In exchange, Pauline’s Concrete covenanted to pay petitioners for

the use of the equipment.5

     For the taxable years 1991 through 1993, Pauline’s Concrete

was generally in the business of performing concrete pumping.

Pauline’s Concrete provided concrete pumping services and related

equipment at specific locations as requested by the construction

contractors.6   For the years at issue, both petitioners worked

for, and received wages from, Pauline’s Concrete.    Petitioners

each drove and operated the equipment leased by Pauline’s


     5
      The lease states:

     The lease payments (the “Annual Lease Amount”) shall be
     calculated annually by Lessor based upon the number of
     hours the trucks are in operation for the year at a
     rate of $120 per hour, however, monthly payments (the
     “Periodic Payment”) shall be paid in an amount as from
     time to time may be periodically agreed between Lessor
     and Lessee. * * *
     6
      As part of its operations, Pauline’s Concrete performed,
among other things, the following: Receiving phone calls to log
the pumping equipment on and off jobsites; deciding which pumping
equipment will be placed on which jobs; transporting the pumping
equipment to the jobsites; deciding when to replace older pumping
equipment; performing necessary maintenance on the pumping
equipment; and performing the safe operation of the pumping
equipment.
                                 - 5 -

Concrete at various jobsites.7    Petitioners were both responsible

for the management and daily operations of Pauline’s Concrete.8

     During the years at issue, petitioners were also employed by

the same construction contractors for whom Pauline’s Concrete

performed concrete pumping services.     These services consisted of

providing and operating equipment which would pump concrete to

the specific locations needed by the customers as part of the

construction process.   The parties stipulated: “This payment

arrangement was used in order for petitioners to maintain their

union membership in the union, but more importantly to the

petitioners, to get paid for the services they performed.”    The

contractors issued Forms W-2, Wage and Tax Statement, to report

payments made to petitioners in their individual capacities.9

     For 1991, 1992, and 1993, petitioners reported their lease

activities on Schedules E, Supplemental Income and Loss, attached

to their joint income tax returns, on which they reported net

losses of $171,980, $63,979, and $43,314, respectively.    For

1991, 1992, and 1993, petitioners received rental income under




     7
      Pauline’s Concrete employed approximately four to six
additional employees who also operated the leased equipment.
     8
      Additionally, petitioner Pauline Kessler performed
administrative, clerical, and secretarial duties for Pauline’s
Concrete.
     9
      Petitioners, in their individual capacities, received 20 to
30 Forms W-2, Wage and Tax Statement, each year from contractors.
                               - 6 -

the lease agreement in the amounts of $55,000,10 $108,000, and

$184,702, respectively.   With respect to the leasing activity,

for 1991 and 1992, petitioners claimed only equipment

depreciation deductions of $171,980 and $171,979, respectively.

With respect to their leasing activity, for 1993, petitioners

claimed deductions for interest expense and depreciation of

$44,538 and $183,478, respectively.

Discussion

     Determinations of the Commissioner in a notice of deficiency

are presumed correct, and the burden is on the taxpayer to show

that the determinations are erroneous.11   Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).   As a general matter,

deductions are a matter of legislative grace, and the taxpayer

bears the burden of proving entitlement to such claimed

deductions.   INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440

(1934).

     1.   Were Petitioners’ Rental Activities Passive Activities?

     Section 469(a)(1) limits the deductibility of losses from

activities which are deemed “passive” activities.   A passive


     10
      See supra note 2. On their 1991 return, petitioners
reported no lease income.
     11
      Sec. 7491, which shifts the burden of proof to respondent
in certain circumstances, does not apply because the examination
of the returns at issue commenced prior to the statute’s
effective date.
                                  - 7 -

activity is broadly defined as any activity involving the conduct

of a trade or business in which the taxpayer does not “materially

participate”.   Sec. 469(c)(1).    Rental activities are

presumptively passive activities, regardless of whether the

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

v. Commissioner, T.C. Memo. 2000-358; Frank v. Commissioner, T.C.

Memo. 1996-177.   A rental activity “means any activity where

payments are principally for the use of tangible property.”12

Sec. 469(j)(8).

     Respondent’s argument is straightforward:     Petitioners’

rental activities are passive in nature, and any losses therefrom

cannot be used to offset petitioners’ nonpassive income for the

years at issue.   Thus, it is respondent’s position that the loss

deductions claimed on petitioners’ returns are currently

unavailable and are suspended until a future date when

petitioners have passive gains.     See sec. 469(b).   Petitioners,

on the other hand, assert that they are subject to one of the

exceptions to the presumption in favor of passive classification.




     12
      It is clear that petitioners’ leasing of equipment to
Pauline’s Concrete is a rental activity within the purview of
sec. 469. See Tarakci v. Commissioner, T.C. Memo. 2000-358;
Kelly v. Commissioner, T.C. Memo. 2000-32; Welch v. Commissioner,
T.C. Memo. 1998-310.
                                - 8 -

     The temporary regulations provide six exceptions to the

definition of rental activity.13     See sec. 1.469-1T(e)(3)(ii)(A)

through (F), Temporary Income Tax Regs., 53 Fed. Reg. 5702 (Feb.

25, 1988).   Those exceptions are:     (1) The average use of the

property by customers is 7 days or less; (2) the average period

of customer use is 30 days or less, and significant personal

services are provided by or on behalf of the owner; (3)

extraordinary personal services are provided by the owner in

connection with making the property available for use by

customers; (4) the rental of the property is incidental to a

nonrental activity of the taxpayer; (5) the taxpayer customarily

makes the property available during defined business hours for

nonexclusive use by various customers; or (6) the property is

provided by a partner or S corporation shareholder to his

partnership or S corporation.    Id.    Given the stipulated record,

we glean from petitioners’ brief that their argument is trained

upon the third and fourth exceptions listed above.14




     13
      The regulations were prescribed by the Commissioner under
the broad regulatory authority delegated to him by Congress
through sec. 469(l)(1).
     14
      Clearly, since the lease agreement by and between
petitioners and Pauline’s Concrete is exclusive, for a term of 10
years, and Pauline’s Concrete was a C corporation, the other
enunciated exceptions cannot apply.
                               - 9 -

          (a) The Incidental Exception

     Although not clearly articulated in their brief, petitioners

apparently argue that their rental activity is incidental to

their nonrental activities, excepting them from the presumption

of passive characterization.   See sec. 1.469-1T(e)(3)(ii)(D),

Temporary Income Tax Regs., supra.     As it relates to this case,

the regulations “test” provides in pertinent part:

          (c) Property used in a trade or business. The
     rental of property during a taxable year shall be
     treated as incidental to a trade or business activity
     * * * if and only if--

                (1) The taxpayer owns an interest in such
          trade or business activity during the taxable
          year;

               (2) The property was predominantly used in
          such trade or business activity during the taxable
          year or during at least two or the five taxable
          years that immediately precede the taxable year;
          and

               (3) The gross rental income from such
          property for the taxable year is less than two
          percent of the lesser of--

                    (i) The unadjusted basis of such
               property; and

                    (ii) The fair market value of such
               property. [Sec. 1.469-1T(e)(3)(vi)(C),
               Temporary Income Tax Regs., 53 Fed. Reg. 5703
               (Feb. 25, 1988); emphasis added.]

Petitioners presented no evidence that the amount of the rental

income earned for the years at issue met the 2-percent test.     Cf.

Tarakci v. Commisioner, T.C. Memo. 2000-358.    The record does not

establish the fair market value or unadjusted basis of the
                             - 10 -

property leased by petitioners to Pauline’s Concrete.

Accordingly, petitioners have not shown they meet the

requirements of this exception.

          (b) The Extraordinary Personal Services Exception

     Petitioners argue in their brief that “the services * * *

[they] provide are personal in nature and not merely the rental

of concrete pumping trucks and equipment”.   For purposes of the

extraordinary personal services exception, the temporary

regulations provide:

     extraordinary personal services are provided in
     connection with making property available for use by
     customers only if the services provided in connection
     with the use of the property are performed by
     individuals, and the use by customers of the property
     is incidental to their receipt of such services. For
     example, the use by patients of a hospital’s boarding
     facilities generally is incidental to their receipt of
     the personal services provided by the hospital’s
     medical and nursing staff. Similarly, the use by
     students of a boarding school’s dormitories generally
     is incidental to their receipt of the personal services
     provided by the school’s teaching staff. [Sec. 1.469-
     1T(e)(3)(v), Temporary Income Tax Regs., 53 Fed. Reg.
     5702 (Feb. 25, 1988).]

Section 1.469-1T(e)(3)(viii), Example (3), Temporary Income Tax

Regs., 53 Fed. Reg. 5703 (Feb. 25, 1988), illustrates this

exception:

     The taxpayer is engaged in an activity of transporting
     goods for customers. In conducting the activity, the
     taxpayer provides tractor-trailers to transport goods
     for customers pursuant to arrangements under which the
     tractor-trailers are selected by the taxpayer, may be
     replaced at the sole option of the taxpayer, and are
     operated and maintained by drivers and mechanics
                               - 11 -

     employed by the taxpayer. The average period of
     customer use for the tractor-trailers exceeds 30 days.
     Under these facts, the use of the tractor-trailers by
     the taxpayer’s customers is incidental to their receipt
     of personal services provided by the taxpayer.
     Accordingly, the services performed in the activity are
     extraordinary personal services * * * and, * * *
     [thus], the activity is not a rental activity.

     In this case, petitioners are not engaged in an activity

which provides personal services to Pauline’s Concrete.

Petitioners simply own and lease cement pumping equipment to

Pauline’s Concrete.    The lease is “net of all costs” to

petitioners.15   While petitioners clearly provide personal

services in their capacity as employees of Pauline’s Concrete

and, in their individual capacity, to construction contractors,

nonetheless, with respect to leasing equipment to Pauline’s

Concrete, the record reflects no provision for services incident

to such leasing activities.    We hold that petitioners did not

provide extraordinary personal services within the meaning of

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

Reg. 5702 (Feb. 25, 1988).    Accordingly, the activity is not

excepted from the definition of a rental activity.

     Our opinion in Hairston v. Commissioner, T.C. Memo. 2000-

386, is instructive.    In Hairston, the taxpayers owned heavy

construction equipment in their own names which they leased to

     15
      Under the lease, Pauline’s Concrete “shall pay all of the
costs associated with the acquisition and maintenance of the
leased property including the cost(s) of adequate insurance
sufficient to exculpate * * * [petitioners] from any and all
liability.”
                               - 12 -

their wholly owned subchapter C corporation.    The corporation was

in the business of leasing heavy construction equipment to

third parties.   According to the lease agreement between the

taxpayers and their corporation, the corporation assumed all the

responsibility and costs for the equipment.    Similar to this

case, the taxpayers claimed ordinary net losses.    The

Commissioner determined that the taxpayers’ leasing activity was

a passive rental activity and denied the claimed deductions.

This Court analyzed the facts in light of the extraordinary

personal services exception and held that the evidence did not

establish that the taxpayers

     in their individual capacities provided either
     significant or extraordinary personal services in
     connection with making their equipment available for
     use either by * * * [taxpayers’] customer * * * [their
     corporation] or for use by * * * [the corporation’s]
     customers. * * * [Hairston v. Commissioner, supra.]

The Court explained that under the lease agreement, the taxpayers

were not obligated as owners of the equipment to provide any

services to their corporation or the end users.    “Any services

that * * * [the taxpayers] might have performed as * * *

[corporate] officers or employees were unrelated to * * * [the

taxpayers’] obligations as owners of the equipment.”      Id.   Thus,

the Court concluded that the taxpayers did not qualify for the

extraordinary personal services exception.    A similar result is

required here.
                                   - 13 -

        Moreover, we cannot attribute the services provided by

Pauline’s Concrete to petitioners’ leasing activities.         The

grouping rules are inapplicable because they only determine

whether a taxpayer materially participates in an activity, not

whether an activity is excepted from the definition of a rental

activity.

        Section 1.469-4, Income Tax Regs.,

     sets forth the rules for grouping a taxpayer’s trade or
     business activities and rental activities for purposes
     of applying the passive activity loss and credit
     limitation rules of section 469. A taxpayer’s
     activities include those conducted through C
     corporations that are subject to section 469, S
     corporations, and partnerships.” [Sec. 1.469-4(a),
     Income Tax Regs.16]

The regulations provide: “One or more trade or business

activities or rental activities may be treated as a single

activity if the activities constitute an appropriate economic

unit for the measurement of gain or loss for purposes of section

469.”        Sec. 1.469-4(c)(1), Income Tax Regs.   Whether such

activities constitute an appropriate economic unit depends upon

all the relevant facts and circumstances.        Sec. 1.469-4(c)(2),

Income Tax Regs.

     Here, however, this attribution rule does not apply.

Section 1.469-4(d)(5)(ii), Income Tax Regs., states that: “An


        16
      Sec. 1.469-4, Income Tax Regs., applies only to tax years
ending after May 10, 1992. See sec. 1.469-11(a)(1), Income Tax
Regs.
                                   - 14 -

activity that a taxpayer conducts through a C corporation subject

to section 469 may be grouped with another activity of the

taxpayer, but only for purposes of determining whether the

taxpayer materially or significantly participates in the other

activity.”     (Emphasis added.)    See sec. 1.469-5, Income Tax Regs.

(regulations on what constitutes material participation).         Since

we find that petitioners are not excepted from the general

definition of “rental activity,” we never ask the subsidiary

question of whether petitioners materially participated in such

nonrental activities.     See sec. 469(c)(1); Tarakci v.

Commissioner, T.C. Memo. 2000-358; Welch v. Commissioner, T.C.

Memo. 1998-310 (“If petitioner establishes that the activity was

not a rental activity, he then must establish that he materially

participated in the activity to avoid the proscription of section

469.").

     2.     Accuracy-Related Penalty

     Respondent determined an accuracy-related penalty of $2,765

for 1991 based solely upon petitioners’ failure to report rental

income.17    Prior to submission, petitioners conceded that they

had unreported rental income of $55,000 in 1991 which should have

been included on their Schedule E.          Respondent’s determination is

presumed correct, and the burden lies with petitioners to


     17
      On brief, respondent states that he does not seek an
increase in the amount of the penalty determined.
                                  - 15 -

demonstrate that respondent’s penalty determination was in

error.18    Rule 142(a).

     Section 6662(a) imposes a 20-percent penalty on the portion

of an underpayment of tax attributable to, inter alia, any

substantial understatement of income tax.      There is a

“substantial understatement” of tax if “the amount of the

understatement for the taxable year exceeds the greater of” (1)

10 percent of the tax required to be shown on the return or (2)

$5,000.     Sec. 6662(d)(1)(A).   An “understatement” means the

excess of the amount of tax required to be shown on the return

for the year over the amount of tax shown on the return.        Sec.

6662(d)(2)(A).

     Section 6664(c) provides an exception to the penalty imposed

under section 6662(a).     “No penalty shall be imposed under this

part with respect to any portion of an underpayment if it is

shown that there was a reasonable cause for such portion and that

the taxpayer acted in good faith with respect to such portion.”

Sec. 6664(c)(1).     “Underpayment” is defined as the amount by

which the tax imposed exceeds the excess of the sum of the amount

shown by the taxpayer on his return plus the amounts not shown

previously assessed over the amount of rebates made.        Sec.

6664(a).     The determination of whether the taxpayer acted with

reasonable cause and in good faith is made on a case-by-case

     18
          See supra note 11.
                              - 16 -

basis, contemplating all the relevant facts and circumstances.

Sec. 1.6664-4(b)(1), Income Tax Regs.

     Here, there is a substantial understatement of tax

attributable to petitioners’ failure to report rental income in

1991.   The total understatement and the amount required to be

shown on the return was $17,097.   The amount of the

understatement attributable to the unreported rental income was

$13,823.

     There is no evidence in the record that respondent was

erroneous in the application and computation of the accuracy-

related penalty.   Petitioners offered no argument or excuse for

their failure to report the rental income.   Accordingly, we hold

that respondent was not erroneous in his determination of a

penalty.   See Esposito v. Commissioner, T.C. Memo. 2001-131.



                                         Decision will be

                                    entered for respondent.
