                         T.C. Memo. 2002-35



                      UNITED STATES TAX COURT



                  SIDNEY C. SHAW, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 2799-00.                Filed February 6, 2002.



     H. Craig Pitts, for petitioner.

     Edith F. Moates, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     COHEN, Judge:   Respondent determined deficiencies and

accuracy-related penalties with respect to petitioner’s Federal

income tax as follows:

                                        Penalty, I.R.C.
          Year           Deficiency       Sec. 6662(a)

          1995             $75,255            $15,051
          1996             103,514             20,703
                                - 2 -

The issues presented are:    (1) Whether losses claimed by

petitioner are subject to the passive activity loss limitations

under section 469 and (2) whether petitioner is liable for the

accuracy-related penalty under section 6662(a).    Unless otherwise

indicated, all section references are to the Internal Revenue

Code in effect for the years in issue.

                          FINDINGS OF FACT

     Some of the facts have been stipulated, and the stipulated

facts are incorporated in our findings by this reference.

Petitioner resided in Stillwater, Oklahoma, at the time of filing

the petition.   He owned real estate investment properties,

interests in various business entities, gasoline-hauling

trailers, and an airplane.

     Petitioner researched properties and operational businesses.

He developed a business model and consulted with his banker,

construction supervisor, and operations managers.    He either

purchased the property individually or purchased the property

indirectly through an entity in which he held an ownership

interest.   Petitioner then developed the land, renovated the

existing building, or inventoried the property for future

development.    Petitioner leased many of his properties to Shaw’s

Gulf, Inc. (Shaw’s Gulf), or its affiliates, and Shaw’s Gulf

managed the day-to-day business operations.
                                - 3 -

Shaw’s Gulf

     Petitioner was a 44.9-percent shareholder of Shaw’s Gulf and

was its president during the years in issue.     As president,

petitioner reviewed the monthly financial statements, approved

the annual budget, approved the remodeling projects, and signed

the checks.    Shaw’s Gulf paid petitioner compensation of

$64,883.62 and $64,884.00 for 1995 and 1996, respectively, for

his services related to Shaw’s Gulf.

     Shaw’s Gulf was in the business of operating convenience

stores, gas stations, carwashes, and Western Sizzlin’

restaurants.    During the years in issue, Shaw’s Gulf leased

properties from petitioner and managed the operations of the

businesses located on those properties.      The convenience stores

that were leased from petitioner and operated by Shaw’s Gulf

were:   Buy N Bye #2, Buy N Bye #6, Buy N Bye #7, Buy N Bye #12,

Buy N Bye #13, and Conoco Cmart #16.     Shaw’s Gulf also rented an

office building located in Stillwater from petitioner that was

used as Shaw’s Gulf’s headquarters.     In 1996, Shaw’s Gulf also

leased from petitioner and operated a Western Sizzlin’ restaurant

located in Ponca City, Oklahoma (Western Sizzlin’ PC), and a

convenience store with a large carwash located in Ponca City.

Shaw’s Gulf paid gross rents to petitioner of $739,875 and

$976,954 for 1995 and 1996, respectively.
                               - 4 -

     In addition to the real estate that Shaw’s Gulf leased from

petitioner, Shaw’s Gulf also leased properties from entities in

which petitioner held an ownership interest.   During the years in

issue, Shaw’s Gulf operated Texaco Food Mart #5, a gas station

and convenience store, that was leased from RS&M Properties II

(RS&M).   Petitioner was a 55-percent partner and the designated

tax matters partner of RS&M during the years in issue.

     Shaw’s Gulf leased Buy N Bye #10, a convenience store, from

R&S Partnership (R&S).   Petitioner was a 50-percent partner of

R&S during the years in issue, and petitioner contributed the

Bye N Bye #10 convenience store to R&S sometime prior to the

years in issue.

     In 1996, Shaw’s Gulf leased the Western Sizzlin’ restaurant

located in Stillwater (Western Sizzlin’ SW) from S.C. Shaw, Ltd.

(Shaw Ltd.), an S corporation of which petitioner was the sole

shareholder.

     Shaw’s Gulf operated a convenience store at a truck stop

located in Billings, Oklahoma, that was owned by Luttrell Oil

Company (Luttrell).   Petitioner was a shareholder and president

of Luttrell during the years in issue.   He reviewed the financial

statements and tax bills of Luttrell, but he did not have much

involvement in the day-to-day operations of Luttrell.
                                - 5 -

Petitioner’s compensation from Luttrell was $34,718.30 and

$34,872.00 for 1995 and 1996, respectively.

       Shaw’s Gulf also leased and operated four other convenience

stores in which petitioner held no direct nor indirect ownership

interest in the property.

       Barden Kellum (Kellum), vice president of operations,

managed the day-to-day operations of Shaw’s Gulf and its

affiliates and was responsible for the maintenance of the

properties leased by Shaw’s Gulf.    Kellum consulted with

petitioner either by telephone or in person approximately 3 to

5 hours a week.

       Shaw’s Gulf also leased a house located in Stillwater from

R&S.    Petitioner contributed the house to R&S sometime prior to

the years in issue.    Kellum was not responsible for any of the

residential rentals because petitioner hired an agency to manage

the residential rentals.

C&A Trucking

       C&A Trucking was a subsidiary of Shaw’s Gulf.   C&A Trucking

was in the transportation business; on a call-and-carry basis, it

delivered petroleum products.    About 25 to 35 percent of C&A

Trucking’s business was from Shaw’s Gulf.    Stephen Shaw, general

manager of C&A Trucking, managed the day-to-day business

operations, dispatch, and billing.
                                - 6 -

     Petitioner was a shareholder and the president of C&A

Trucking during the years in issue.     Petitioner was not involved

in the day-to-day operations of C&A Trucking but did meet with

Stephen Shaw for about 3 hours three times a month to review the

numbers, sign the checks, and review the business volume.    C&A

Trucking paid petitioner compensation of $16,180.50 and

$16,221.00 in 1995 and 1996, respectively, for his services

related to C&A Trucking.

     C&A Trucking rented gasoline-hauling trailers (Over the Road

Trailers) and a warehouse located in Stillwater from petitioner.

C&A Trucking paid petitioner gross rents of $172,251 and $313,657

in 1995 and 1996, respectively.

Shaw Ltd.

     Petitioner was the sole shareholder of Shaw Ltd., which was

an S corporation, during the years in issue.    During the years in

issue, Shaw Ltd. was in the business of operating a Dairy Queen

restaurant.   In 1995, Shaw Ltd. owned and operated the Western

Sizzlin’ SW restaurant that was later leased to and operated by

Shaw’s Gulf in 1996.

     The Dairy Queen restaurant was built and opened for business

in 1994.    Shaw Ltd. owned the building and the equipment of the

Dairy Queen restaurant, but the land on which the Dairy Queen

restaurant stood was leased from SDQ LLC.    Petitioner was a
                                - 7 -

33.33-percent member and the designated tax matters partner of

SDQ LLC during the years in issue.      The day-to-day operations of

the Dairy Queen restaurant were managed by Kent Russell

(Russell).

     Petitioner renovated the Dairy Queen restaurant in 1995.

Petitioner purchased a new cash register system and added a salad

display case.    The renovations consisted of relocating the

fountain area to create a separate area for customers to get

their drinks, installing new tile, and adding a mop sink closet.

The renovation work was done at night so that the restaurant

could remain open.

     During the first 14 weeks of 1995, petitioner was involved

in the renovation project and operations of the Dairy Queen

restaurant.    He spent about 7 hours a week at the restaurant

busing tables, cooking hamburgers, and fixing the balls in the

playroom.    Petitioner met with Russell every morning to review

the food and labor costs.    After the first 14 weeks of 1995,

petitioner spent about 3 hours a day at the restaurant observing

operations.    In 1996, petitioner spent about 3 hours a week at

the Dairy Queen restaurant.

     Petitioner contributed Western Sizzlin’ SW to Shaw Ltd. in

May 1995.    In 1996, Shaw Ltd. leased Western Sizzlin’ SW to

Shaw’s Gulf, and Shaw’s Gulf took over the business operations of
                                - 8 -

Western Sizzlin’ SW.    Bob Palmer (Palmer), manager of Western

Sizzlin’ SW, continuously managed the day-to-day operations of

the Western Sizzlin’ SW restaurant during the years in issue.

       In 1995, Shaw Ltd. made renovations to Western Sizzlin’ SW.

The renovations consisted of expanding the seating area,

extending the entry to create a cashier area, relocating the

restrooms, adding a cleaning closet, and expanding the parking

lot.    The renovation work was done at night so that the

restaurant could remain open.

       Petitioner met with Palmer regularly, about 14 hours a week

during the 15-week construction period, to discuss the

renovations and business operations of the Western Sizzlin’ SW

restaurant.    Petitioner made the final decisions on the

operations and policy of the Western Sizzlin’ SW restaurant,

including the type of food served, the meat quality, the

seasoning used on the steaks, the use of a vacuum tumbler to

marinate the steaks, the baking of fresh bread, the addition of

scatter bars throughout the restaurant, and the addition of a

cotton candy machine and desserts to the buffet.    After the

renovations were completed in August 1995, petitioner met with

Palmer occasionally, about 3 hours a week, to review and discuss

the financial statements.    In 1996, petitioner ate dinner at the

restaurant 3 nights a week.
                                - 9 -

     Gregory Webb (Webb), an employee of Shaw’s Gulf, was the

construction supervisor responsible for overseeing the day-to-day

construction of the Dairy Queen and Western Sizzlin’ SW

remodeling projects.   Webb worked with petitioner on the design,

drawings, and cost of the projects.     Petitioner approved all of

the details of the renovation projects, set up lines of credit

with vendors, found subcontractors, set up the bank account, and

signed the checks for the cost of construction.    During

construction, Webb met with petitioner for about an hour on a

daily basis to discuss the progress and problems encountered on

the remodeling projects.

     Petitioner took trips for the purpose of improving his

business operations.   He attended conventions, observed the

operations and facilities of other restaurants, and met with

other franchise owners.    The trips he took in his airplane are

documented in his airplane flight log.    The airplane flight log

recorded the dates of travel, points of departure and arrival,

hours of flight duration, and remarks on the purpose of the

trips.   Petitioner’s flight and travel time that related to Shaw

Ltd. was 110 hours in 1995.    Petitioner kept calendars for the

years in issue, but they were discarded at the end of each

calendar year.
                              - 10 -

Lease Agreements

     Petitioner usually represented both sides of the lease

transactions between himself and Shaw’s Gulf.   Petitioner signed

the lease agreements as the legal owner of the property, as

lessor, and as the legal representative of Shaw’s Gulf, as

lessee, for the following properties:   Buy N Bye #2, Buy N

Buy #6, Buy N Buy #7, Buy N Bye #12, Buy N Bye #13, Western

Sizzlin’ PC, and the airplane.   Kellum signed as the legal

representative of Shaw’s Gulf, as lessee, on the leases for

Western Sizzlin’ SW, Conoco Cmart #16, and the office building

located in Stillwater.

     Petitioner had an appraisal done for each property he owned

and used the appraisal to determine the rental price.   He

generally set the rental price based on the appraisal value and

added a 12-percent return.   Kellum and Webb calculated the

numbers that assisted petitioner in determining whether he could

own, develop, and lease a particular property to Shaw’s Gulf.

Kellum typed some of the lease documents but did not research

what the fair rental value of properties would have been.

     The lease agreements included the land, building, fixtures,

and equipment at the specified location.   The lease agreements

also provided that Shaw’s Gulf would be responsible for the

repairs and maintenance of each property and that improvements

made by the lessee would revert to the lessor upon termination of

the lease.   The lease agreements for Buy N Bye #2, Buy N Bye #6,
                              - 11 -

Buy N Bye #7, Buy N Bye #12, Buy N Bye #13, Conoco Cmart #16, and

the office building located in Stillwater provide:

     Lessee covenants and agrees to carry and maintain the
     buildings, equipment, and improvements upon the said
     premises in the same conditions as they now are and to
     deliver the same to the Lessor upon the termination of
     this lease in the same condition in which they are now,
     normal and usual wear and tear alone expected. Lessee
     may construct additions and improvements upon the
     premises, which said additions and improvements are to
     be maintained at Lessee’s expense to the termination of
     the lease when they become property of the Lessor.

The lease agreement for Western Sizzlin’ PC provides:

     REPAIRS. The LESSEE shall, at its own expense, make
     all necessary repairs and replacements to the Leased
     Premises * * * fixtures and all other appliances and
     their appurtenant equipment * * *

     ALTERATIONS AND IMPROVEMENTS. * * * All additions,
     alterations and improvements made in or to the leased
     premises by either the LESSOR or the LESSEE, shall
     become property of the LESSOR and be surrendered with
     the Leased Premises at the termination of the Lease.
     * * *

Airplane Lease Activity

     Petitioner purchased a new TBM 700, single engine, propeller

airplane in 1993.   Petitioner leased the airplane to Shaw’s Gulf

during the years in issue.   Petitioner signed the lease

agreement, as lessor, and as the president of Shaw’s Gulf, as

lessee.   The lease agreement provided that “Shaw Gulf, Inc. shall

keep the airplane in good condition and shall make all repairs

necessary for its good operation at * * * [its] own expense” and

required monthly rental payments of $7,000.   The lease agreement

also required Shaw’s Gulf to insure the airplane against loss.
                             - 12 -

Shaw’s Gulf deducted the rental expense and all the repairs and

maintenance expense relating to the airplane.   Petitioner

included the rental income and deducted the mortgage interest and

depreciation expense related to the airplane.

Tax Reporting

     Petitioner’s individual tax return and the tax returns of

petitioner’s business entities were prepared by petitioner’s

accountant, who was a certified public accountant, tax

practitioner, and had a real estate background.   Petitioner met

with his accountant regularly and discussed his business

activities.

     On petitioner’s Schedule E, Supplemental Income and Loss, he

reported income and losses from his ownership interests as

nonpassive:

     Entity                              1995        1996

     RS&M                              $29,814     $29,814
     R&S                                27,869      25,236
     SDQ LLC                            21,981      19,247
     Shaw, Ltd.                       (139,623)   (108,691)
       Net nonpassive income/(loss)   $(59,959)   $(34,394)

     Based on petitioner’s assumption that he qualified as a real

estate professional under section 469(c)(7), petitioner reported

his net income and loss from his rental property on Schedule E as

nonpassive:
                               - 13 -

     Property                               1995       1996

     Over the Road Trailers               $22,357   $16,489
     Warehouse (Stillwater)                   600       600
     Buy N Bye #7                          32,128    34,791
     Buy N Bye #6, #12, #13               306,272   330,688
     Conoco Cmart #16                      52,644    87,868
     Office building (Stillwater)          (6,838)   20,688
     Carwash (Ponca City)                      --    21,000
     Buy N Bye #2                         (24,856) (14,446)
     Western Sizzlin’ PC                       -- (114,811)
     Airplane                            (355,147) (255,096)
       Total nonpassive income/(loss)     $27,160 $127,771

     Petitioner did not attach to his 1995 or 1996 tax return an

election to treat all interests in rental real estate as a single

rental real estate activity.

Notice of Deficiency

     Respondent’s examination of petitioner’s tax liability

commenced on May 13, 1997.   A statutory notice of deficiency for

1995 and 1996 was mailed to petitioner on December 8, 1999.    In

the notice of deficiency, respondent disallowed petitioner’s

losses for 1995 and 1996.

                               OPINION

     Respondent reclassified petitioner’s Schedule E activities

from nonpassive to passive activities and disallowed the losses

claimed by petitioner based on the passive loss limitations under

section 469.    In deciding whether petitioner is allowed to deduct

his losses, we must address multiple issues.   The deductibility

of the losses from petitioner’s ownership interest in Shaw Ltd.

depends on whether petitioner materially participated in Shaw
                               - 14 -

Ltd.    The deductibility of the losses from his rental properties

depends on:    (1) Whether petitioner had net income from self-

rented property under section 1.469-2(f)(6), Income Tax Regs.;

(2) whether petitioner qualifies as a real estate professional

under section 469(c)(7); and (3) whether petitioner’s airplane

lease activity was a passive activity under section 469(c)(2).

       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).   Rental activity is

treated as a per se passive activity regardless of whether the

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

section 469(c)(7)(B), the rental activities of a taxpayer in the

real property business (real estate professional) are not per se

passive activities under section 469(c)(2) but are treated as a

trade or business and subject to the material participation

requirements of section 469(c)(1).

       Petitioner contends, for the first time in his posttrial

brief, that he is entitled to deduct his losses in 1995 and 1996

because Shaw’s Gulf, Shaw Ltd., petitioner’s real estate rental

activities, and petitioner’s airplane lease activity constitute a
                              - 15 -

single trade or business activity in which petitioner materially

participated.

     Respondent argues that petitioner’s desire to combine his

various activities into a single trade or business activity under

section 1.469-4(c), Income Tax Regs., represents a new issue that

cannot be raised for the first time on brief.   Respondent asserts

that to permit petitioner to raise this new issue on brief would

result in unfairness, surprise, and prejudice to respondent.

     We have held that issues raised for the first time on brief

will not be considered by the Court when surprise and prejudice

are found to exist.   See Seligman v. Commissioner, 84 T.C. 191,

198-199 (1985), affd. 796 F.2d 116 (5th Cir. 1986).   Petitioner

had numerous opportunities to raise his new theory, and the

failure to raise this issue when he could have done so waives the

argument.   See Aero Rental v. Commissioner, 64 T.C. 331, 338

(1975).   Petitioner’s attempt to regroup his activities is

belated and will not be accepted.   In any event, his argument is

factually and legally flawed under section 1.469-4(e)(1), Income

Tax Regs., and section 1.469-4(d)(2), Income Tax Regs.

     Respondent alternatively argues that petitioner’s proposed

grouping of activities is inconsistent with petitioner’s actual

grouping of activities as reported in 1994, 1995, and 1996.

Section 1.469-4(e)(1), Income Tax Regs., states, in general, that

“once a taxpayer has grouped activities under this section, the
                               - 16 -

taxpayer may not regroup those activities in subsequent taxable

years”.    Respondent also explains that petitioner is unable to

group his real estate rental activities with his airplane

activity because, under section 1.469-4(d)(2), Income Tax Regs.,

an “activity involving the rental of real property and an

activity involving the rental of personal property * * * may not

be treated as a single activity”.    We agree with respondent.

Material Participation in Shaw Ltd.

       Respondent reclassified the income and loss from

petitioner’s Schedule E ownership interests from nonpassive to

passive activities and disallowed the net passive loss of $59,959

and $34,394 in 1995 and 1996, respectively, pursuant to section

469:

       Entity                           1995         1996

       RS&M                           $29,814      $29,814
       R&S                             27,869       25,236
       SDQ LLC                         21,981       19,247
       Shaw Ltd.                     (139,623)    (108,691)
         Net passive income/(loss)   $(59,959)    $(34,394)

       The effect of respondent’s reclassification was to disallow

a portion of the losses from Shaw Ltd.    Petitioner can deduct the

losses from his ownership interest in Shaw Ltd. of $139,623 and

$108,691 in 1995 and 1996, respectively, if petitioner can

demonstrate that he materially participated in Shaw Ltd. during

1995 or 1996.
                                 - 17 -

     Material participation is defined as involvement in the

operations of an activity that is regular, continuous, and

substantial.   Sec. 469(h)(1).    As explained in section 1.469-

5T(a), Temporary Income Tax Regs., 53 Fed. Reg. 5725 (Feb. 25,

1988), a taxpayer can satisfy the material participation

requirement if the individual meets any one of the seven

regulatory tests:

     (1) The individual participates in the activity for
     more than 500 hours during such year;

                *    *    *      *    *     *    *

     (4) The activity is a significant participation
     activity * * * for the taxable year, and the
     individual’s aggregate participation in all significant
     participation activities during such year exceeds 500
     hours;

                *    *    *      *    *     *    *

     (7) Based on all of the facts and circumstances * * *,
     the individual participates in the activity on a
     regular, continuous, and substantial basis during such
     year.

     “Participation” generally means any work done in an activity

by an individual who owns an interest in the activity.

Sec. 1.469-5(f)(1), Income Tax Regs.      Work done by the individual

is not treated as participation in the activity if such work is

not of a type that is customarily done by an owner of such

activity and one of the principal purposes for performing such

work is to avoid the passive activity limitations of section 469.
                                - 18 -

Sec. 1.469-5T(f)(2)(i), Temporary Income Tax Regs., 53 Fed. Reg.

5726 (Feb. 25, 1988).

     Work done by an individual in the individual’s capacity as

an investor in an activity is not treated as participation in the

activity for purposes of this section unless the individual is

directly involved in the day-to-day management or operations of

the activity.   Sec. 1.469-5T(f)(2)(ii)(A), Temporary Income Tax

Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988).    Work done as an

investor includes:   (1) Studying and reviewing financial

statements or reports on operations of the activity;

(2) preparing or compiling summaries or analyses of the finances

or operations of the activity for the individual’s own use;

and (3) monitoring the finances or operations of the activity in

a nonmanagerial capacity.     Sec. 1.469-5T(f)(2)(ii)(B), Temporary

Income Tax Regs., supra.

     Petitioner contends that in 1995 he met the 500-hour

requirement under section 1.469-5T(a)(1), Temporary Income Tax

Regs., supra, and in 1996 his participation in significant

participation activities exceeded 500 hours under section 1.469-

5T(a)(4), Temporary Income Tax Regs., 53 Fed. Reg. 5726 (Feb. 25,

1988).   Respondent argues:   (1) Petitioner failed to establish by

reasonable means the hours he devoted to Shaw Ltd. and

(2) petitioner’s activities that were related to Shaw Ltd.
                                - 19 -

consisted of investor type activities that are not treated as

participation in an activity.

     With respect to the evidence that may be used to establish

hours of participation, section 1.469-5T(f)(4), Temporary Income

Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988), provides:

     The extent of an individual’s participation in an
     activity may be established by any reasonable means.
     Contemporaneous daily time reports, logs, or similar
     documents are not required if the extent of such
     participation may be established by other reasonable
     means. Reasonable means for purposes of this paragraph
     may include but are not limited to the identification
     of services performed over a period of time and the
     approximate number of hours spent performing such
     services during such period, based on appointment
     books, calendars, or narrative summaries.

     While the regulations are somewhat ambiguous concerning the

records to be maintained by taxpayers, they do not allow a

postevent “ballpark guesstimate”.    Carlstedt v. Commissioner,

T.C. Memo. 1997-331; Speer v. Commissioner, T.C. Memo. 1996-323;

Goshorn v. Commissioner, T.C. Memo. 1993-578.   Petitioner’s

recollection and estimate of the hours that he participated in

Shaw Ltd. are reasonable and are corroborated by the testimony of

Webb and Palmer.   However, based on the description of the

activities that petitioner performed, the hours that are related

to investor type activities such as monitoring the operations and

reviewing financial statements are not treated as participation

because petitioner was not involved in the day-to-day operations

of the restaurants.   Rather, the day-to-day operations of the
                               - 20 -

Dairy Queen restaurant were managed by Russell and the day-to-day

operations of Western Sizzlin’ SW were managed by Palmer.      The

activities that will be considered as participation in Shaw Ltd.

are petitioner’s involvement in the renovations and initial

operations of his restaurants in 1995.    Petitioner spent about 7

hours a week during the 14-week construction period on activities

related to the Dairy Queen restaurant, or 98 hours, and he spent

about 14 hours a week during a 15-week construction period on

activities related to the Western Sizzlin’ SW restaurant, or 210

hours.    Petitioner’s flight and travel time related to Shaw Ltd.

was 110 hours in 1995.    Petitioner’s 418 hours of participation

in Shaw Ltd. do not meet the material participation test for

1995.    Petitioner has conceded that he did not participate in

Shaw Ltd. for 500 hours in 1996.

     Petitioner’s argument that he spent more than 500 hours in

significant participation activities in 1996 impermissibly

combines his hours of participation in Shaw Ltd. with his hours

of participation in his rental activities.    Section 1.469-

5T(c)(1)(i), Temporary Income Tax Regs., 53 Fed. Reg. 5726

(Feb. 25, 1988), provides that a significant participation

activity must be a trade or business activity, not a rental

activity.
                              - 21 -

Rental Activities

     Petitioner reported his property rentals as nonpassive

activities during the years in issue based on the assumption that

he qualified as a real estate professional under section

469(c)(7).   Respondent determined that petitioner was not a real

estate professional and reclassified petitioner’s rental

activities as passive activities.

     Respondent also determined that the properties leased to

Shaw’s Gulf and C&A Trucking were self-rented properties pursuant

to section 1.469-2(f)(6), Income Tax Regs.    The self-rented

property rule contained in section 1.469-2(f)(6), Income Tax

Regs., states:

     Property rented to a nonpassive activity. An amount of
     the taxpayer’s gross rental activity income for the
     taxable year from an item of property equal to the net
     rental activity income for the year from that item of
     property is treated as not from a passive activity if
     the property–-

          (i) Is rented for use in a trade or business
     activity * * * in which the taxpayer materially
     participates * * * for the taxable year * * * [Emphasis
     added.]

Under the self-rented property rule, the net rental income from

self-rented property is treated as nonpassive income and the net

rental losses are treated as passive losses, even though the

rental activities are passive activities.    Respondent

reclassified the net rental income from the following properties

as nonpassive:
                              - 22 -

     Property                             1995        1996

     Over the Road Trailers             $22,357    $16,489
     Warehouse (Stillwater)                 600        600
     Buy N Bye #7                        32,128     34,791
     Buy N Bye #6, #12, #13             306,272    330,688
     Conoco Cmart #16                    52,644     87,868
     Office building (Stillwater)            --     20,688
     Carwash (Ponca City)                    --     21,000
       Total nonpassive income         $414,001   $512,124

The result to petitioner is that his passive losses from his

other rental properties are subject to the passive loss

limitations under section 469.   The following rental losses were

disallowed by respondent:

       Property                          1995        1996

       Buy N Bye #2                     $24,856   $14,446
       Office building (Stillwater)       6,838         -–
       Western Sizzlin’ PC                   –-   114,811
       Airplane                         355,147   255,096
         Total passive losses          $386,841   $384,353

     Petitioner contends that the application of section 1.469-

2(f)(6), Income Tax Regs., is arbitrary, capricious, and contrary

to the Code because similarly situated properties are treated

differently solely on the basis of whether they show a profit or

loss for the year.   Petitioner argues that the regulations

produce an inequitable result and are not appropriate where

multiple properties are leased to a single business enterprise.

     This Court has previously addressed the validity of section

1.469-2(f)(6), Income Tax Regs., and held that the

recharacterization of net income from self-rented property was
                              - 23 -

not arbitrary, capricious, or manifestly contrary to the statute.

Krukowski v. Commissioner, 114 T.C. 366, 369-370 (2000);

Schwalbach v. Commissioner, 111 T.C. 215, 219-224 (1998); see

also Sidell v. Commissioner, T.C. Memo. 1999-301, affd. 225 F.3d

103 (1st Cir. 2000).   Congress granted the Secretary of the

Treasury the authority to prescribe regulations as may be

necessary or appropriate to carry out the provisions of section

469, including regulations “which specify what constitutes an

activity, material participation, or active participation for

purposes of this section, * * * [and] requiring net income or

gain from a limited partnership or other passive activity to be

treated as not from a passive activity”.   Sec. 469(l)(1), (3).

In Krukowski v. Commissioner, supra at 369, the Court stated:

          We disagree with petitioner that the
     recharacterization rule is invalid. The
     recharacterization rule is a legislative regulation,
     see Schwalbach v. Commissioner, 111 T.C. 215, 220
     (1998) (the Secretary had to comply with the
     Administrative Procedure Act (APA), 5 U.S.C. sec.
     553(b) and (c) (1994), when he prescribed sec. 1.469-
     2(f)(6), Income Tax Regs., because the rules contained
     therein are legislative rather than interpretive); see
     also Fransen v. United States, 191 F.3d 599, 600 (5th
     Cir. 1999); thus, it is invalid only if it is
     arbitrary, capricious, or manifestly contrary to the
     statute, see Chevron, U.S.A., Inc. v. Natural Resources
     Defense Council, Inc., 467 U.S. 837, 844 (1984); see
     also McKnight v. Commissioner, 99 T.C. 180, 183 (1992)
     [affd. 7 F.3d 182 (5th Cir. 1993)].

          The recharacterization rule is not arbitrary,
     capricious, or manifestly contrary to the statute. It
     was prescribed by the Secretary pursuant in part to the
     specific grant of authority stated in section 469(l)
                              - 24 -

     that allows him to prescribe all necessary or
     appropriate regulations to carry out the provisions of
     section 469 * * * [Fn. ref. omitted.]

The Court cited the following passage from the legislative

history to support its holding:

     The conferees intend that this authority be exercised
     to protect the underlying purpose of the passive loss
     provision, i.e., preventing the sheltering of positive
     income sources through the use of tax losses derived
     from passive business activities.

          Examples where the exercise of such authority may
     (if the Secretary so determines) be appropriate include
     the following * * * (2) related party leases or sub-
     leases, with respect to property used in a business
     activity, that have the effect of reducing active
     business income and creating passive income * * *.
     [H. Conf. Rept. 99-841, at 147 (1986), 1986-3 C.B.
     (Vol. 4) 147.]

     Petitioner argues that the Court has not previously

considered the inequity of recharacterizing net income from

self-rented properties where self-rented properties with losses

are not recharacterized.   We disagree.   The taxpayers in Sidell

v. Commissioner, supra, faced a similar situation where one self-

rented property generated a net loss and the other self-rented

properties generated net income.   The taxpayers argued that the

properties were either contiguous to or located across the street

from each other and that the ownership of the properties was

separate from the business for valid business reasons.     The Court

held that section 1.469-2(f)(6), Income Tax Regs., was valid
                              - 25 -

pursuant to the Secretary’s delegated regulation-making

authority.

     Without the application of section 1.469-2(f)(6), Income Tax

Regs., taxpayers would be able to substitute passive income from

self-rented properties for nonpassive income, such as wages or

dividends from a personal service or closely held corporation, in

order to offset their passive losses from other activities.

Where the taxpayer controls both sides of the transaction, such

arrangements require special scrutiny.

     We do not agree with petitioner that section 1.469-2(f)(6),

Income Tax Regs., has produced an inequitable result.    Petitioner

is a sophisticated businessperson who owned multiple properties,

held ownership interests in several businesses, and served as the

president of Shaw’s Gulf and C&A Trucking.    Petitioner controlled

both sides of the rental transactions between himself,

individually, as lessor, and as an officer of the respective

businesses, as lessee.   As lessor, he knew the appraised value,

the mortgage interest expense, and the depreciation expense on

each property.   He had control over establishing the amount of

rent and chose a 12-percent return.    Petitioner had nontax

business reasons for retaining ownership of the rental properties

individually and outside of his businesses.

     Petitioner must accept the tax consequences of his business

decisions and the manner in which he chose to structure his
                                - 26 -

business transactions.    The Supreme Court has observed that

“while a taxpayer is free to organize his affairs as he chooses,

nevertheless, once having done so, he must accept the tax

consequences of his choice, whether contemplated or not and may

not enjoy the benefit of some other route he might have chosen to

follow but did not.”     Commissioner v. Natl. Alfalfa Dehydrating &

Milling Co., 417 U.S. 134, 148-149 (1974) (citations omitted).

     We sustain respondent’s determination that the net rental

income from the real estate properties rented to Shaw’s Gulf and

C&A Trucking should be reclassified as nonpassive income.

     Petitioner argues, in the alternative, that his real estate

activities were nonpassive activities because he qualifies as a

real estate professional under section 469(c)(7) and his real

estate rental activities are a trade or business in which he

materially participated.

     Respondent disallowed the following real estate rental

losses based on the passive loss limitations under section 469:

       Property                          1995     1996

       Buy N Bye #2                 $24,856      $14,446
       Office building (Stillwater) 6,838             -–
       Western Sizzlin’ PC               –-      114,811
         Total passive losses       $31,694     $129,257

Respondent maintains that the real estate rental activities

generating a net loss are per se passive activities under section

469(c)(2) because petitioner has not presented adequate evidence
                              - 27 -

to support his assertion that he was a real estate professional

pursuant to section 469(c)(7) in either 1995 or 1996 or to

support a finding that he materially participated in each of the

real estate properties.

     Under section 469(c)(7)(B), a taxpayer qualifies as a real

estate professional and is not engaged in a passive activity

under section 469(c)(2) if:

          (i) more than one-half of the personal services
     performed in trades or businesses by the taxpayer
     during such taxable year are performed in real property
     trades or businesses in which the taxpayer materially
     participates, and

          (ii) such taxpayer performs more than 750 hours of
     services during the taxable year in real property
     trades or businesses in which the taxpayer materially
     participates.


     Thus, if the taxpayer qualifies as a real estate

professional, the rental activities of the real estate

professional are exempt from classification as a passive activity

under section 469(c)(2).   Instead, the real estate professional’s

rental activities are treated as a passive activity under section

469(c)(1) unless the taxpayer materially participated in the

activity.   Sec. 1.469-9(e)(1), Income Tax Regs.   For purposes of

determining whether a taxpayer materially participated in a trade

or business, this requirement must be met with respect to each

interest in rental real estate unless the taxpayer makes an

election to treat all interests in rental real estate as a single
                               - 28 -

rental real estate activity.   Sec. 469(c)(7)(A); sec. 1.469-

9(e)(1), Income Tax Regs.   Petitioner did not make a timely

election to treat all interests in rental real estate as a single

rental real estate activity.

     Real property trades or businesses are defined in section

469(c)(7)(C) as “any real property development, redevelopment,

construction, reconstruction, acquisition, conversion, rental,

operation, management, leasing, or brokerage trade or business.”

A trade or business includes being an employee.   Putoma Corp. v.

Commissioner, 66 T.C. 652, 673 (1976), affd. 601 F.2d 734 (5th

Cir. 1979).

     Petitioner asserts that he devoted more than 750 hours to

real property trades or businesses because his “activities show a

meaningful involvement in real property trades or business” and

he bases this on the following:   (1) He was the general

contractor on three projects in 1995 and two projects in 1996;

(2) he spent a significant amount of time looking for additional

real estate to purchase; (3) he owned 20 real estate properties

in 1995 and 21 in 1996; (4) he purchased five real estate

properties in 1995 and four in 1996; (5) he sold two parcels of

real estate in 1995; and (6) he spent over $395,870 and $597,000

in construction costs in 1995 and 1996, respectively.   The number

of properties owned, sold, or purchased or the amount of money
                              - 29 -

spent on construction costs does not quantify the number of hours

that petitioner spent on real estate activities.

     Petitioner attempted to recollect his participation in his

real estate activities at trial and attempted to summarize his

estimates from trial in his brief.     Petitioner asserts that his

hours of participation in his real estate activities were 1,425.5

and 1,494.4 in 1995 and 1996, respectively.

     Respondent argues that petitioner has not established by

reasonable means that he spent more than 750 hours in real

property trades or businesses.   We agree.   Petitioner has not

recorded the number of hours spent in any activity and has

discarded his calendars.   His attempt to reconstruct or estimate

his hours through testimony such as that described above produces

a generalized description of his activities and a vague

approximation--or “ballpark guesstimate”--of his hours.    His

testimony regarding his real estate activities is inadequate and

unpersuasive under the circumstances.    His estimated hours of

participation in real estate activities are unreasonable.

     The airplane flight logs that document petitioner’s flight

time would be a credible source and reasonable means to

demonstrate petitioner’s activities and hours spent in real

estate activities; however, petitioner’s flight time that was

related to his real estate activities in 1995 and 1996 does not
                              - 30 -

provide a sufficient number of hours to meet the 750-hour

participation requirement.

     Because petitioner does not meet the 750-hour requirement of

section 469(c)(7)(B)(ii), he is not a real estate professional

for purposes of section 469(c)(7)(A), and his real estate rental

activities are treated as passive activities under section

469(c)(2).   As such, it is not necessary for us to address

whether petitioner spent more than 50 percent of his time in real

estate trades or businesses or whether he materially participated

in each real estate rental.   Even so, the lease agreements

executed by petitioner would not require much involvement by

petitioner during the lease term because the leased premises

included the land, building, fixtures, and equipment, and the

lessee was required to repair and maintain the property.

Further, Kellum was responsible for the repairs and maintenance

of the properties leased to Shaw’s Gulf, and petitioner hired an

agency to manage the residential rentals.

Airplane Lease Activity

     Respondent disallowed the airplane rental losses of $355,147

and $255,096 in 1995 and 1996, respectively, and maintains that

the leasing of personal property is a passive activity under

section 469(c)(2) and subject to the passive activity loss

limitations under section 469.
                               - 31 -

     Petitioner argues that the airplane was an essential part of

his real estate operations and that the costs he incurred should

be allowable as trade or business expenses under section 162.

Petitioner asserts that he used the airplane for the

“professional chase of properties”, such as the purchase of real

estate, research to develop his properties, and attendance at

business meetings.

     A rental activity is a per se passive activity regardless of

whether the taxpayer materially participates in the activity.

Sec. 469(c)(2), (4).   Rental activity, as defined in section

469(j)(8), is “any activity where payments are principally for

the use of tangible property.”    Here, the rental of petitioner’s

airplane to Shaw’s Gulf for monthly lease payments of $7,000 was

a rental activity under section 469(j)(8) and, thus, a passive

activity under section 469(c)(2).

     Petitioner argues that, while, in form, the agreement is a

lease, the substance of the transaction resembles an

expense-sharing agreement with Shaw’s Gulf, Shaw Ltd., and C&A

Trucking.   We disagree.   The lease agreement did not provide for

expense-sharing.   Rather, the lease provided that the lessee

would maintain and repair the airplane and insure the airplane

against loss.   Shaw’s Gulf, as lessee, deducted the repairs and

maintenance expenses related to the airplane.
                               - 32 -

     Petitioner was on both sides of the transaction and reported

the income and expense of the airplane lease activity as a rental

activity on his Schedule E.    Petitioner chose to structure and

report his airplane leasing activity as a rental activity during

the years in issue and must accept the tax consequences related

to that form.   See Commissioner v. Natl. Alfalfa Dehydrating &

Milling Co., 417 U.S. 134, 148-149 (1974).    He cannot belatedly

recharacterize it to secure greater tax benefits.     Id.   We

conclude that the airplane lease activity was a passive activity,

and the rental losses are limited to the extent of passive

activity income under section 469.

Penalties

     Section 6662(a) imposes a 20-percent accuracy-related

penalty where the taxpayer’s underpayment of tax is attributable

to negligence or disregard of rules or regulations.    See also

sec. 6662(b).

     Respondent determined that petitioner is liable for the

accuracy-related penalty under section 6662(a) because petitioner

was negligent in the preparation of his 1995 and 1996 tax

returns.    Respondent maintains that petitioner’s tax returns

contained errors, petitioner failed to maintain adequate books

and records, and petitioner ignored the self-rental rules of

section 1.469-2(f)(6), Income Tax Regs.    Petitioner argues that

he was not negligent, that he made a reasonable attempt to comply
                              - 33 -

with the provisions of the Internal Revenue Code, and that he

took a position that was well founded in law and fact.

     Good faith reliance on the advice of counsel or a qualified

accountant can, in certain circumstances, be a defense to the

accuracy-related penalty for negligence.    See Schwalbach v.

Commissioner, 111 T.C. 215, 230-231 (1998); Ewing v.

Commissioner, 91 T.C. 396, 423-424 (1988), affd. without

published opinion 940 F.2d 1534 (9th Cir. 1991).

     Petitioner consulted with his accountant who prepared his

tax returns for the years in issue.    Petitioner’s reliance on the

representations of his accountant was reasonable.    We conclude

that petitioner is not liable for the accuracy-related penalties

imposed under section 6662.

     We have considered all of the remaining arguments that have

been made by petitioner for a result contrary to that expressed

herein, and, to the extent not discussed above, they are without

merit.

     To reflect the foregoing,

                                           Decision will be entered

                                      for respondent as to the

                                      deficiencies and for

                                      petitioner as to the

                                      accuracy-related penalties.
