                       T.C. Memo. 1998-398



                     UNITED STATES TAX COURT



         BENJAMIN B. AND DORINA MICORESCU, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 24964-96.               Filed November 10, 1998.



     Douglas G. Miller, for petitioners.

     Ann M. Murphy, for respondent.



                        MEMORANDUM OPINION

     DEAN, Special Trial Judge:   This case was heard pursuant to

section 7443A(b)(3) and Rules 180, 181, and 182.1   Respondent

determined deficiencies in petitioners' Federal income taxes for



     1
      Unless otherwise indicated, 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.
                                   - 2 -


the years 1992, 1993, and 1994 in the amounts of $2,222, $4,392,

and $5,906, respectively.

       After concessions by the parties,2 the issues for decision

are:       (1) Whether petitioners are entitled to exclude from income

the receipt of certain payments for adult foster home care; and

(2) whether adult foster home care business expenses were

correctly allocated by respondent to nonexempt adult foster home

care income.

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

The stipulation of facts and the attached exhibits are

incorporated herein by reference.      Petitioners resided in

Portland, Oregon, at the time they filed their petition in this

case.

                                Background

       During the years 1992, 1993, and 1994, petitioners were in

the trade or business of providing adult foster home care for

individuals in Portland, Oregon.

       Petitioners were licensed by the Multnomah County Aging

Services Division (ASD) as Level III adult foster home providers

and were subject to Multnomah County Administrative Rules.      ASD

is an instrumentality of the State of Oregon that acts as a


       2
      The parties agree on the amount of "other expenses" that is
deductible by petitioners. The parties agree that certain of
petitioners' claimed expenses related to their adult foster home
are subject to the rules of sec. 280A.
                               - 3 -


social service agency responsible for providing various services

to individuals including determining eligibility for, and case

management in, medicaid3 for elderly persons.

     The State of Oregon has applied for and received "waivers"

from the Federal Health Care Financing Administration that allow

it to use medicaid funds intended for nursing facility care, to

provide community-based care services to nursing facility

eligible individuals.

     The State of Oregon provides health care for elderly

medicaid-eligible individuals, including long-term adult foster

care services.   The State also contracts with health care

providers to supply a variety of necessary services, including

adult foster care.   During the years at issue, ASD was a party to

an Interagency Partnership Agreement (partnership agreement) with

Providence ElderPlace, A Division of Shared Services of the

Sisters of Providence (ElderPlace).

     ElderPlace is not an agency of a State or of a political

subdivision of a State.   It is a State of Oregon medicaid service


     3
      Medicaid is a State-administered program jointly funded by
State and Federal Governments under tit. XIX of the Social
Security Act Amendments of 1965 (SSA), Pub. L. 89-97, sec. 122,
79 Stat. 286, 343, current version at 42 U.S.C. secs. 1396-1396v
(1994). It provides medical assistance for certain low-income
people who meet specific eligibility criteria.
     Medicare is Federal health insurance for the aged and
disabled under tit. XVIII of the SSA, secs. 1801-1815, 79 Stat.
291-297, current version at 42 U.S.C. secs. 1395-1395ggg (1994 &
Supp. III 1997).
                               - 4 -


provider, a section 501(c)(3) health maintenance organization

providing long-term care to the elderly funded through medicaid

and medicare payments.   ElderPlace is part of a demonstration

project the purpose of which is to determine whether a private

concern can provide the same services as medicaid and medicare at

less cost in Government funds.4   Although about 94 percent of

ElderPlace enrollees are medicaid eligible, ElderPlace also has

clients who are not medicaid eligible and clients who are not

referred by the State.

     Under the partnership agreement, ASD and ElderPlace "[work]

together to address the needs of older adults in Multnomah

County."

     The partnership agreement provides that persons who elect to

participate in the ElderPlace program must agree to receive all

their health and long-term care services exclusively from

     4
      The ElderPlace program operates under provisions that allow
States at their option to seek a Federal waiver of certain
medicaid and medicare requirements in order to underwrite adult
foster home care at a rate cheaper than that for the
institutional care that they would otherwise need. The
provisions had their inception with the "On LOK" program. See
Social Security Amendments of 1983, Pub. L. 98-21, sec. 603(c),
97 Stat. 65, 168, amended by: (a) Consolidated Omnibus Budget
Reconciliation Act of 1985, Pub. L. 99-272, sec. 9220, 100 Stat.
82, 183; (b) Omnibus Budget Reconciliation Act of 1986, Pub. L.
99-509, sec. 9412(b), 100 Stat. 1874, 2063; (c) Omnibus Budget
Reconciliation Act of 1987, Pub. L. 100-203, sec. 4118(b), (g),
101 Stat. 1330, 1330-155 and 1330-156; and (d) Balanced Budget
Act of 1997, Pub. L. 105-33, sec. 4801, 111 Stat. 251, 528,
codified at 42 U.S.C. sec. 1395eee (1994 & Supp. III 1997) as the
Programs of All-Inclusive Care for the Elderly (PACE).
                                - 5 -


ElderPlace.   ElderPlace assumes the full cost for all services

provided.    In return, ElderPlace receives a payment monthly from

medicare and medicaid for providing the full range of medical,

social, and long-term care services that the participants need.

The amount of such payments is based on the number of

participants served.

     Under the partnership agreement, ASD retains responsibility

for "screening and intake" of elderly individuals.   As part of

its screening and intake of older adults for long-term care

services, ASD agrees to "consider ElderPlace as one of the

options available to the older adult."   ASD will continue to

determine eligibility for medicaid services and will screen

persons for medicaid-waivered services to determine whether they

are eligible for the ElderPlace program.   Under the partnership

agreement, ASD also remains responsible for "protective services"

(protecting the elderly against abuse, neglect, exploitation, and

abandonment).

     But for the above-named purposes, individuals choosing to

enroll in the ElderPlace program are removed from the ASD case

management system and put into the ElderPlace system.   ElderPlace

case management activities include developing a "care plan" for

the enrollee that takes into consideration the enrollee's need of

transportation, medical equipment, supplies, medications, and

therapies.
                               - 6 -


     The State of Oregon and ElderPlace entered into a series of

contracts between 1990 and 1994 in order to carry out the

objectives of the partnership agreement.

     Pursuant to the contracts with the State of Oregon,

ElderPlace provided health services and, to those in need,

personal services like assistance with bathing, grooming, and

eating.   These services were supplied through adult foster care

home providers, such as petitioners, with whom ElderPlace

contracted in turn.   ElderPlace paid adult foster care home

operators out of the funds paid to it by the State of Oregon.

     Adult foster home operators who elected to care for

residents enrolled in the ElderPlace program received payments

negotiated separately with each homeowner, based on the level of

service each would provide.   ElderPlace did not, however, pay for

room and board at adult foster homes.   Room and board payments

were the responsibility of the enrollee or the enrollee's

representative and were paid at a rate determined by a schedule

set by the State of Oregon.

     If an elderly person chose to enroll in the ElderPlace

program, and foster care was appropriate, ElderPlace assisted in

"locating adult foster care homes that have the capacity to meet

their care needs and also have vacancies".   ElderPlace supplied

transportation to the enrollee or his representative to look at

different foster homes.   ElderPlace advised the enrollee or his
                               - 7 -


representative as to whether one foster home would be better than

another for the particular enrollee, based upon that enrollee's

needs.   Once a decision was made identifying the foster home in

which the enrollee wanted to live, ElderPlace negotiated the

enrollee's payment rate with the foster home operator of the

selected home.

     During each of the years 1992, 1993, and 1994, petitioners

provided adult foster care to several persons in their home.    All

of the residents had attained the age of 19.   Petitioners

received adult foster care payments for the individuals from

various sources, from their residents or their representatives,

in some cases from the State of Oregon and in other cases from

ElderPlace.

     On their Federal income tax returns for 1992 through 1994,

petitioners reported certain income and deductions from "ADULT

FOSTER CARE" on Schedule C.   Petitioners did not report as income

amounts received from the State of Oregon or from ElderPlace.    On

their return for 1994, petitioners reported exclusions of State

and ElderPlace payments from income and made a separate

adjustment for expenses attributable to nontaxable income.

     Respondent examined petitioners' returns and determined that

petitioners improperly excluded self-employment income received

from ElderPlace in the amounts of $13,167, $22,750, and $32,366

for the years 1992, 1993, and 1994, respectively, and are
                               - 8 -


entitled to claim additional business expenses associated with

the income that was allocated under section 265.

                            Discussion

     The parties agree that payments petitioners received

directly from residents, or their representatives, are taxable

and that payments petitioners received for residents placed in

their home directly by the State of Oregon are tax exempt under

section 131.   The parties disagree about whether payments

petitioners received from ElderPlace are exempt from tax under

section 131 and the proper allocation of expenses to exempt and

nonexempt income under section 265.

Section 131 Foster Care Payments

     Section 131(a) provides that gross income shall not include

"qualified foster care payments".   A "qualified foster care

payment" as described in section 131(b)(1) is any amount:

          (A) which is paid by a State or political
     subdivision thereof or by a placement agency which is
     described in section 501(c)(3) and exempt from tax
     under section 501(a), and

          (B) which is--

               (i) paid to the foster care provider for
          caring for a qualified foster individual in the
          foster care provider's home, or

                (ii) a difficulty of care payment.[5]



     5
      Difficulty of care payments as described in sec. 131(c) are
not at issue in this case.
                               - 9 -


     A "qualified foster individual" is described in section

131(b)(2) as any individual living in a foster family home in

which the individual was "placed by":

          (A) an agency of a State or political subdivision
     thereof, or

          (B) in the case of an individual who has not
     attained age 19, an organization which is licensed by a
     State (or political subdivision thereof) as a placement
     agency and which is described in section 501(c)(3) and
     exempt from tax under section 501(a).

     Petitioners argue that the payments to them by ElderPlace

are excluded from income under section 131 because they are

qualified foster care payments.   Even "though the check to the

petitioners is made by Providence ElderPlace", petitioners

contend that the payments, indirectly, are from the State of

Oregon.   Petitioners argue further that the legislative history

of section 131 and the intent of Congress in enacting it was that

a payment by an "intermediary" such as ElderPlace, made out of

State funds "that a state has an obligation to provide", meets

the requirements of section 131(b)(1)(A).

     Respondent contends that the ElderPlace payments to

petitioners are includable in gross income because the payments

are not qualified foster care payments.   They are not qualified

foster care payments, maintains respondent, because the

ElderPlace payments were not paid to petitioners for caring for

"qualified foster [individuals]".   Respondent points to the

definition of a qualified foster individual in section 131(b)(2)
                               - 10 -


as an individual living in a foster family home who was "placed

[there] by" an agency of a State or political subdivision

thereof.   Since ElderPlace, not an agency of a State or political

subdivision thereof, "placed" its enrollees with petitioners, the

enrollees are not qualified foster individuals, argues

respondent.    Respondent concludes that the ElderPlace payments to

petitioners do not meet the stated requirements.

Qualified Foster Individual

     The amounts in question can be qualified foster care

payments only if they were paid to petitioners as foster care

providers for qualified foster individuals.     Sec.

131(b)(1)(B)(i); see supra note 5.      Therefore, the focus of our

analysis will be to decide whether ElderPlace enrollees in

petitioners' home were qualified foster individuals.

     To be a qualified foster individual, an individual in a

foster home who has attained age 19 must have been "placed by" an

agency of a State or political subdivision thereof.     Sec.

131(b)(2)(A).    If ElderPlace enrollees were not "placed by" an

agency of a State or political subdivision thereof into

petitioners' foster home, they are not qualified foster

individuals.

"Placed by" a State Agency

     Petitioners deny that ElderPlace enrollees were "placed by"

ElderPlace in their care.    According to petitioners, none of the
                             - 11 -


witnesses at trial gave any testimony that the ElderPlace program

"placed" individuals in foster homes.

     Petitioners further contend that the phrase "placed by" in

section 131(b)(2) has no definition in the Internal Revenue Code

or regulations, no legal definition in case law, and no

definition in Oregon State statutes, administrative rules, or

local county rules or ordinances.   The words "place" or

"placement" have, petitioners allege, no "customary meaning to

those who are closely involved in adult foster care."

     Without a working definition of the word, petitioners

nonetheless argue that the elderly enrollees of the ElderPlace

program were "placed" in their care, not by ElderPlace, but by

the "actions" of a government agency, albeit indirectly.

Petitioners urge us to examine the legislative history of section

131 to confirm their view.

     Respondent replies that to be a "qualified foster

individual", the plain language of section 131(b)(2) requires

that individuals who have attained the age of 19 must be "placed

by" an agency of a State or political subdivision thereof.   Since

ElderPlace, and not an agency of the State or political

subdivision thereof, "placed", in the common usage of the term,

its enrollees with petitioners, respondent maintains that the

requirements of section 131(b)(2) were not met in petitioners'

case.
                              - 12 -


Plain Meaning

     The starting point for the interpretation of a statute is

the language itself.   Consumer Prod. Safety Commn. v. GTE

Sylvania, Inc., 447 U.S. 102, 108 (1980); Dyer v. United States,

832 F.2d 1062, 1066 (9th Cir. 1987).   If the language of the

statute is plain, clear, and unambiguous, "'the sole function of

the courts is to enforce it according to its terms.'"    United

States v. Ron Pair Enters., Inc., 489 U.S. 235, 241 (1989)

(quoting Caminetti v. United States, 242 U.S. 470, 485 (1917)).

     The Court must assume that the legislative purpose of the

statute is expressed in the ordinary meaning of the words used.

American Tobacco Co. v. Patterson, 456 U.S. 63, 68 (1982);

Richards v. United States, 369 U.S. 1, 9 (1962); Florida Hosp.

Trust Fund v. Commissioner, 103 T.C. 140, 152 (1994), affd. 71

F.3d 808 (11th Cir. 1996).   Where there is a conflict in

inferences between the language of the statute and the

legislative history, the language of the statute generally

prevails.   In re Stringer, 847 F.2d 549, 551 (9th Cir. 1988);

Huntsberry v. Commissioner, 83 T.C. 742, 747-748 (1984).

     The common meaning of the verb "to place" is:

     1: to distribute in an orderly manner: ARRANGE 2 a: to
     put in or as if in a particular place: SET b: to
     present for consideration (a question placed before the
     group) c: to put in a particular state (~ a performer
     under contract) d: to direct to a desired spot * * * 4:
     to find a place (as a home or employment) for * * * *
     [Webster's Ninth New Collegiate Dictionary 897 (1990).]
                              - 13 -


Examining the record in light of the common meaning of the verb

"to place", we find that ElderPlace indeed placed elderly

individuals in petitioners' foster home.

     Petitioners called as a witness Mr. Donald M. Keister,

director of ElderPlace and former deputy director of ASD.

Mr. Keister testified that an individual who decided to enroll in

the ElderPlace program would undergo an "assessment" to determine

his or her needs.   ElderPlace, for appropriate individuals, would

then assist in locating adult foster homes, provide

transportation to view the homes, provide advice as to which home

might be best for the individual, and negotiate with the foster

home a price to be paid for the care of the individual.     On the

basis of the latter fact, we assume that if a rate satisfactory

to ElderPlace could not be negotiated, another home would be

located or the individual would terminate enrollment in the

ElderPlace program and attempt to be "placed" by the State.

     In cross-examination, respondent's counsel asked whether

ElderPlace enrollees might ask to move from one foster home to

another, and Mr. Keister replied that such a situation may arise

for a number of reasons.   He continued to explain:

     So, in essence, when that happens, we go through the
     same process that I described before.

          Placements--you know, movement also occurs
     through, you know, residential care facilities, they
     also occur to nursing facilities, depending upon what
     the care needs of the individual are.
                               - 14 -


     Respondent called Mr. Jeffrey Miller to testify.    Mr. Miller

is employed by the State of Oregon as a medicaid policy analyst

for the State Senior and Disabled Services Division.     His

position involves helping State field offices determine medicaid

eligibility for individuals.    Mr. Miller is familiar with the

ElderPlace program.    During his testimony the following exchange

took place:

     Q    To your knowledge, if a person chooses the
     ElderPlace waiver --

     A   Uh-huh.

     Q    -- is the State ever consulted as to where that
     person resides, in what adult foster care home?

     A    We would have taken an application on that
     individual, and in such, we would have had the
     address of the person.

     Q    Okay. But does the State at that point decide--if
     someone is enrolled in ElderPlace, does the State
     decide where that person resides?

     A    No. The case management responsibilities would be
     with ElderPlace to do that.

     Q    Okay. So ElderPlace would be the placing agency,
     is that correct?

     A    They would be the ones making that decision.

     There is additional evidence in the record on the issue of

placement.    During the years at issue, ElderPlace had a form

"Adult Foster Care Contract" (contract) that it used to retain

the services of adult foster home care providers.    ElderPlace and

petitioners used the contract for every ElderPlace program
                               - 15 -


participant who was referred to petitioners in 1992, 1993, and

1994.    Part III of the contract, Compensation and Billing,

states that the "Provider" (petitioners) agrees to accept as full

compensation the amounts set forth in an attached exhibit to the

agreement.    It is also agreed that "Each Participant placed with

the Provider shall have his/her rate based on his/her individual

Service Plan".6   In part VIII of the agreement, Term and

Termination, the parties agree that the "placement" may be

terminated by either the Participant, the Provider, or ElderPlace

upon 2 weeks' notice.    "After the first two weeks of the

Participant's placement," the service plan may be terminated by

the Provider under circumstances enumerated in the agreement.    No

agency of the State or a political subdivision thereof was a

party to the contract between ElderPlace and petitioners.




     6
      Under the contract, a "Participant" is defined as a person
enrolled in the ElderPlace program. The term "Service Plan" is
defined as the plan determined for "each Participant placed with
the Provider." (Emphasis added.)
                             - 16 -


Legislative History

     Petitioners insist, however, that individuals placed by

ElderPlace were placed by an entity that had contracted with a

State agency responsible for such matters.   Therefore, the

individuals placed by ElderPlace were placed by the State within

the meaning of section 131(b)(2), petitioners conclude.   They

base their argument on the legislative history of section 131,

which, they claim, shows that the use of the phrase "placed by"

in section 131(b)(2) merely requires some indirect "State action"

of a government agency.

     For taxable years beginning before January 1, 1986, section

131 provided an exclusion from gross income for certain payments

received by "foster parents" for caring for foster children.     The

Tax Reform Act of 1986, Pub. L. 99-514, section 1707, 100 Stat.

2085, 2781-2782, amended section 131 to extend to certain adult

foster care payments the exclusion from gross income.

Petitioners point to the language of H. Conf. Rept. 99-841 (Vol.

II), at II-838 through II-839 (1986), 1986-3 C.B. (Vol. 4) 1,

838-839, which says:

     The conferees intend that this extension of the
     exclusion to adult foster care is limited to cases of
     individuals who provide foster care within their own
     homes to adults who have been placed in their care by
     an agency of the State or political subdivision thereof
     specifically designated as responsible for such
     function. The exclusion does not apply to payments to
     operators of boarding homes who provide room and board
     to adults who have not been placed in their care
                                - 17 -


     through the actions of a governmental agency
     responsible for adult foster care.

Petitioners focus on the second sentence of the quoted language,

specifically that part that says "through the actions of a

governmental agency responsible for adult foster care."

(Emphasis added.)    Because the second sentence does not say "by

an agency of the State or political subdivision thereof",

petitioners conclude that "State action" includes their

situation, an indirect, contractual relationship with the State

through the entity with which they contracted.

     Petitioners fail, however, to address the first sentence of

the above excerpt that expresses the intent of Congress that

section 131 apply only in the case of "adults who have been

placed in their care by an agency of the State or political

subdivision thereof specifically designated as responsible for

such function."     (Emphasis added.)    What petitioners want is to

interpret one sentence out of context.      But words and phrases

must be interpreted in context.    Rules of statutory construction

appropriate to interpreting the language at issue suggest that

words are understood by the words associated with them and that a

general term following specific terms takes its meaning from the

kinds of things denoted by the specific terms.       Jarecki v. G.D.

Searle & Co., 367 U.S. 303, 307 (1961); F.W. Fitch Co. v. United

States, 323 U.S. 582, 585-586 (1945); United States v. Lacy, 119

F.3d 742, 748 (9th Cir. 1997).
                                - 18 -


     We interpret the phrase "State action" in the second

sentence of the above excerpt to refer to the intent of the first

sentence that adults must have been "placed by" a State agency

specifically designated as responsible for that function.

     Our interpretation is further reinforced by referring to

section 131(b)(2).   A qualified foster individual is not only one

placed by "an agency of a State or political subdivision thereof"

but may be one also placed by:

          (B) in the case of an individual who has not
     attained age 19, an organization which is licensed by a
     State (or political subdivision thereof) as a placement
     agency and which is described in section 501(c)(3) and
     exempt from tax under section 501(a). [Sec.
     131(b)(2)(B).]

If Congress had intended the phrase "[placed by] an agency of a

State or political subdivision thereof" contained in section

131(b)(2)(A) to include section 501(c)(3) entities such as

ElderPlace, it could have used language similar to that used in

section 131(b)(2)(B).

     Petitioners counter with the argument that section

131(b)(2)(B) operates to exclude section 501(c)(3) organizations

from the benefit of section 131 where "there is no state

involvement"; that is, where the section 501(c)(3) organization

does not receive State funds.    While we are not sure how this

bolsters their position, we note that the Court has already

observed that petitioners' interpretation of section 131(b)(2)(B)

is unsupported.   See Cato v. Commissioner, 99 T.C. 633, 643
                                - 19 -


(1992), where the Court said:    "There is no indication in any of

the House or Senate hearings on the bill or in the reports of

either congressional branch that would indicate that a

distinction should be made that section 131 only applies if a

tax-exempt agency is State funded."

     We find that the intent of Congress as expressed in the

pertinent legislative history comports with the plain meaning of

the language in section 131.    The record in this case makes it

clear that enrollees in the ElderPlace program who were in

petitioners' foster home were "placed by" ElderPlace in the home

according to the ordinary use and plain meaning of the verb "to

place".

     The individuals placed in petitioners' home by ElderPlace

were not qualified foster individuals because they were not

placed by an agency of the State or a political subdivision

thereof.   Because the ElderPlace enrollees were not qualified

foster individuals, amounts paid to petitioners for providing

care for them cannot be qualified foster care payments.

Medicaid Policy

     Petitioners further argue that a finding by the Court that

section 131 does not cover their payments from ElderPlace would

produce "absurd results" and that the future of this experimental

program would be imperiled.    The example of "absurd results"

cited by petitioners is the case where a foster home resident
                                - 20 -


elects in and out of the ElderPlace program, thereby rendering

payments to the foster care provider taxable, or nontaxable,

depending only upon who is making the payment, the State or

ElderPlace.

     Petitioners' analysis leads them to an incorrect conclusion.

In the situation where an individual eligible for adult foster

home care elects in and then out of the ElderPlace program, the

placement by ElderPlace is terminated, with notice to the

provider according to the contract.      If the State assumes

responsibility for care of the individual, the State will then

place the individual; it is placement, not payment, that would

determine the taxability of the payments in petitioners' example.

We find the example cited by petitioners not to be "absurd" but

merely the intended result of the statute as written by Congress.

See Tele-Communications, Inc. & Subs. v. Commissioner, 95 T.C.

495, 507 (1990), affd. 12 F.3d 1005 (10th Cir. 1993).

     Although petitioners assert that tax consequences may

negatively affect the medicaid waiver or PACE program by placing

an additional financial burden on ElderPlace and petitioners, or

those similarly situated, we are not at liberty to ignore the

plain wording of section 131.    The purpose of medicaid is not to

financially benefit health care providers but to aid patients.

Baptist Hosp. E. v. Secretary of HHS, 802 F.2d 860, 868-869
                               - 21 -


(6th Cir. 1986), revd. on other grounds sub nom. Bethesda Hosp.

Association v. Bowen, 485 U.S. 399 (1988); Green v. Cashman, 605

F.2d 945, 946 (6th Cir. 1979).   In any event, petitioners' policy

arguments do not override the terms of an unambiguous statute.

See In re Transcon Lines, 58 F.3d 1432, 1437-1438 (9th Cir.

1995); In re Kelly, 841 F.2d 908, 913 (9th Cir. 1988).

     We find that amounts received by petitioners from ElderPlace

for adult foster home care are not qualified foster care payments

under section 131(b) and are includable in gross income in each

of the years at issue in this case.

Expense Allocation Under Section 265

     The parties agree that petitioners incurred and paid certain

expenses related to their operation of an adult foster home for

all the years involved here.   The parties also agree that

petitioners received payments for providing adult foster home

care for individuals, some of which are not includable in income.

     Pertinent to these facts is section 265, which provides in

part:

          SEC. 265(a). General Rule.--No deduction shall be
     allowed for--

               (1) Expenses.--Any amount otherwise allowable
          as a deduction which is allocable to one or more
          classes of income other than interest (whether or
          not any amount of income of that class or classes
          is received or accrued) wholly exempt from the
          taxes imposed by this subtitle, or any amount
          otherwise allowable under section 212 (relating to
          expenses for production of income) which is
          allocable to interest (whether or not any amount
                                - 22 -


            of such interest is received or accrued) wholly
            exempt from the taxes imposed by this subtitle.

Respondent determined that some of the adult foster home care

expenses claimed by petitioners are expenses that are allocable

to petitioner's tax-exempt income and are therefore

nondeductible.   Petitioner's position is that respondent's method

of allocation is wrong.

     Having determined that petitioners must include in income

the payments received from ElderPlace, respondent argues that

petitioners may deduct foster home care expenses only in the same

ratio as the ratio of taxable income to total income.

     Petitioners, rather than a pro rata allocation based on

taxable and nontaxable income, would allocate expenses to three

income categories:     (a) To adult foster care "service" income,

some of which is tax exempt; (b) to "room and board" income,

almost all of which is taxable;7 and (c) to income related to

both "service" and "room and board".     Petitioners characterize

mortgage interest, real estate taxes and insurance, repairs,

maintenance, depreciation, and food expense as "room and board"

expenses.   Petitioners want the Court to allocate most "room and

board" expenses to "room and board" income and almost none of it

to "service" income.

     7
      The parties agree that petitioners had a resident,
Mr. Authur (sic) Armstrong, whose room and board was paid by the
Oregon Department of Veterans' Affairs in 1993 and 1994 and is
tax exempt.
                                - 23 -


     Under section 1.265-1(b)(1), Income Tax Regs., the term

"class of exempt income", as that term is used in section 265,

means any class of income wholly excluded from gross income or

wholly exempt from tax.    Allowable expenses directly allocable to

any class of exempt income shall be allocated thereto and

expenses directly allocable to any class of nonexempt income

shall be likewise allocated thereto.     Where an expense is

indirectly allocable to both a class of nonexempt income and a

class of exempt income, "a reasonable proportion thereof

determined in the light of all the facts and circumstances in

each case shall be allocated to each."     Sec. 1.265-1(c), Income

Tax Regs.

     The class of gross income for which petitioners' deductions

are denied under section 265 is section 131 qualified foster care

payments.   In the case of petitioners, such payments are for

"caring for a qualified foster individual in the foster care

provider's home".     Sec. 131(b)(1)(B) (emphasis supplied).

     Under Oregon State law the term "adult foster home" means a

"family home or facility in which residential care is provided

for five or fewer adults who are not related to the provider by

blood or marriage."    Ore. Rev. Stat. sec. 443.705(1) (1992)

(emphasis supplied).    The term "residential care" means providing

"room and board and services that assist the resident in
                               - 24 -


activities of daily living".   Ore. Rev. Stat. sec. 443.705(6)

(1992) (emphasis supplied).

     Although petitioners were separately paid for room and board

for most residents,8 petitioners' exempt and nonexempt foster

care income was based on their home ownership.   In order to

qualify as having an adult foster home petitioners must under

Federal and State law provide the appropriate services in their

home, and they in fact did so in the years under consideration.

The expenses for mortgage interest, real estate taxes, insurance,

repairs and maintenance, utilities, depreciation, and "other"

home expenses were incurred as a result of or incident to their

adult foster home activity, and their income was derived from the

use of their home as an adult foster home.   There is a direct

factual relationship between those expenses and all petitioners'

adult foster home care income, both taxable and nontaxable.

     We find that petitioners' business expenses that they have

characterized as "service" expenses, "room and board" expenses

and other expenses are related to all of petitioners' adult,

foster home care income and must be allocated between exempt

foster home care income and nonexempt foster home care income.

We further find that under the facts and circumstances of this

case, respondent's method of proportional allocation of expenses


     8
      We note that there is no separately stated room and board
amount for petitioners' "private pay" residents.
                             - 25 -


between taxable and nontaxable income is correct.    See

Mallinckrodt v. Commissioner, 2 T.C. 1128, 1148 (1943), affd. 146

F.2d 1 (8th Cir. 1945); McFarland v. Commissioner, T.C. Memo.

1992-440.

     To reflect the foregoing,

                                      Decision will be entered

                                 under Rule 155.
