                               T.C. Memo. 2012-358



                         UNITED STATES TAX COURT



          DONALD R. FITCH AND BRENDA T. FITCH, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket Nos.     157-10, 27401-10,             Filed December 26, 2012.
                    27417-10.



      Kevan P. McLaughlin and Richard A. Carpenter, for petitioners.

      Michael S. Hensley, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      VASQUEZ, Judge: In these consolidated cases, respondent determined

deficiencies in and penalties on petitioners’ Federal income tax as follows:
                                           -2-

[*2]                                                            Penalty
             Year                 Deficiency                  Sec. 6662(a)

             2005                   $75,258                      $15,052
             2006                   107,085                       21,417
             2007                   124,041                       24,808

       After concessions,1 the issues remaining for decision as to all years in issue


       1
          Respondent conceded the adjustments related to petitioners’ failure to
report income for all years in issue, except for their failure to report interest income
for 2006. Petitioners admitted, and respondent accepted, that their actual interest
income for 2006 is $47,617, an amount $4,382 greater than respondent determined
in the notice of deficiency.
       Petitioners conceded the following expenses they reported on Schedule C,
Profit or Loss from Business, related to their accounting practice: (1) $1,161 of car
and truck expenses, $1,937 of depreciation, $418 of insurance expenses, and $85 of
travel expenses for 2005; (2) $1,461 of car and truck expenses, $1,156 of
depreciation, and $3,987 of office expenses for 2006; and (3) $1,710 of car and
truck expenses, $731 of contract labor expenses, $818 of depreciation, and $669 of
insurance expenses for 2007. Petitioners conceded the following expenses they
reported on Schedule C related to their real estate activity: (1) $4,202 of car and
truck expenses and $1,644 of depreciation for 2005; (2) $1,978 of car and truck
expenses and $641 of depreciation for 2006; and (3) $1,332 of car and truck
expenses and $377 of depreciation for 2007. Respondent conceded the remaining
adjustments on the Schedules C, other than the adjustments to amortization
expenses on Schedules C related to the accounting practice for 2005 to 2007 and the
adjustments to meal and entertainment expenses on Schedule C related to the
accounting practice for 2005 to 2007 and Schedule C related to the real estate
activity for 2005 and 2007.
       Respondent conceded the adjustments to the rental real estate expenses
petitioners reported on Schedule E, Supplemental Income and Loss, other than the
adjustments for the “E Street” property for all years in issue; however, respondent
contends that all of petitioners’ rental real estate losses are limited by sec. 469.
       Petitioners petitioned the Court for redetermination of a $3,000 long-term
capital loss adjustment for 2007, but they did not raise this issue at trial or on brief;
                                                                             (continued...)
                                           -3-

[*3] are: (1) whether petitioners are entitled to amortize the purchase price of an

accounting practice; (2) whether petitioners are entitled to deduct rental real estate

losses for the “E Street” property, and whether these and other rental real estate

losses are limited by the passive activity loss rules of section 469;2 (3) whether

petitioners are entitled to deduct meal and entertainment expenses beyond the

amounts allowed by respondent; (4) whether petitioners are entitled to deduct net

operating loss carryovers from 2003 and 2004; and (5) whether petitioners are liable

for accuracy-related penalties under section 6662(a).

                                 FINDINGS OF FACT

       Some of the facts have been stipulated and are so found. The stipulation of

facts and accompanying exhibits are incorporated herein by this reference. At the

time they filed their petition, petitioners resided in California.




       1
       (...continued)
therefore, we find that they have abandoned it. See Petzoldt v. Commissioner, 92
T.C. 661, 683 (1989); Money v. Commissioner, 89 T.C. 46, 48 (1987). The
remaining adjustments are computational and will be resolved under Rule 155.
       2
         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. All amounts are rounded to the
nearest dollar.
                                           -4-

[*4] I.       Background of Petitioners

          Brenda T. Fitch has been a licensed real estate agent under California law

since November 2001. She works full time as an independent contractor with

Remax, performing duties typical of real estate agents and brokers, including

reviewing buyer criteria, soliciting listings, going on caravans,3 and showing,

leasing, and selling real property. While she has no set schedule, she generally

wakes up at 6 a.m. to review business emails, new real estate listings, and buyer

criteria for her clients, and she works six days a week, taking either Saturday or

Sunday off.

          Donald R. Fitch has been a licensed certified public accountant (C.P.A.) in

California since February 1993. Upon receiving his license, he started an

accounting practice (C.P.A. practice) as a sole proprietor in San Francisco. He

spent nearly a decade developing the C.P.A. practice, until he suffered a brain

aneurysm in May 2003. He was hospitalized for a week, underwent surgery, and

slowly recuperated.




          3
         A caravan is typically a tour of new real estate listings designed for real
estate agents and brokers.
                                            -5-

[*5] II.     The Sale and Repurchase of the C.P.A. Practice

           On June 14, 2003, Mr. Fitch sold the C.P.A. practice (sale transaction) for

$900,000 to Mark Gronke, a C.P.A. licensed in Massachusetts who worked for Mr.

Fitch as an independent contractor sporadically from 1996 through 2003. They duly

executed an agreement (sale agreement) providing that the $900,000 was “due and

payable in full within 1 year at the applicable federal interest rates.” The agreement

stated that “Mr. Fitch has incurred recent brain surgery, Mr. Fitch understands the

need to transfer the business based on health issues.” Petitioners reported the

$900,000 as a capital gain on their 2003 tax return.

       Mr. Fitch performed a small amount of work for the C.P.A. practice after the

sale transaction to help ensure a smooth transition. On October 31, 2003,

approximately 4-1/2 months after the sale transaction, Mr. Gronke suffered a

seizure and was rushed to the hospital. Five days later, on November 5, 2003, Mr.

Gronke sold the C.P.A. practice back to Mr. Fitch for $900,000 (repurchase

transaction). They duly executed another agreement (repurchase agreement)

containing the same payment terms as the sale agreement. The repurchase

agreement stated that “Mark Gronke has incurred recent severe medical problems

* * *. Mr. Gronke understands the need to sell the business based on his health

issues.” As a result of the repurchase transaction, petitioners claimed a $900,000
                                          -6-

[*6] cost basis in the C.P.A. practice, and they claimed an amortization deduction of

$45,000 for each of the years in issue.

III.   Petitioners’ Rental Real Estate

       Petitioners owned eight rental real estate properties in California during the

years in issue. They chose to keep their properties separate. Mr. Fitch owned

properties on Edgewood Road, Auburn (Edgewood property); Amelia Way, Palm

Springs (Amelia property); Sterling Road, Cathedral City (Sterling property);

Ridgeway Ave., Cathedral City (Ridgeway property); and E Street, Sacramento (E

Street property).4 Mrs. Fitch owned properties on Cook Street, Palm Desert (Cook

Street property); Esplanade, Redondo Beach (Esplanade property); and Island Ave.,

San Diego (Island property).5

       Petitioners were actively involved in the day-to-day management of their

rental properties. They performed almost all of the tasks themselves, including,

inter alia, bookkeeping, making repairs, executing contracts, screening tenants,

advertising, paying taxes and utilities, procuring insurance, and dealing with the


       4
          Mr. Fitch owned a two-thirds interest in the E Street property. He inherited
a one-third interest from his mother in early 2005, and he purchased a second one-
third interest from one of his brothers in late 2005. His other brother owned the
remaining one-third interest.
       5
           Mrs. Fitch purchased the Island property in 2006.
                                         -7-

[*7] homeowners’ associations. They occasionally hired a contractor (such as an

engineer or electrician) to perform a technical task. Petitioners incurred losses on

the Edgewood property, Cook Street property, Esplanade property, and E Street

property in 2005; the Edgewood property, Ridgeway property, Cook Street

property, Esplanade property, and E Street property in 2006; and the Amelia

property, Cook Street property, Esplanade property, E Street property, and Island

property in 2007. Although the aggregate losses petitioners incurred in each of the

years at issue exceeded $25,000, they limited the losses they claimed (in excess of

their income from the rental real estate) to $25,000 each year.

IV.   Business Discussions Over Meals

      Petitioners frequently discussed their respective businesses and rental real

estate properties together over meals at restaurants. They occasionally dined with

clients (client meals), but the vast majority of the meals were solely between

themselves (spousal meals). For each meal, they recorded on general ledgers the

name of the restaurant, an associated date,6 the business purpose, the names of the

people dining, and the amount spent. The general ledgers list the business purpose

of almost every spousal meal as “Schedule C” and/or “Schedule E”. The


      6
         The general ledgers do not contain the individual date that each meal took
place--the associated dates appear to correspond to the dates of petitioners’ monthly
credit card statements.
                                          -8-

[*8] discussions during the spousal meals resulted in successful client referrals

between petitioners’ businesses on occasion. Petitioners claimed business expense

deductions for a small number of client meals and hundreds of spousal meals.

V.    Petitioners’ Tax Returns

      Mr. Fitch prepared petitioners’ tax returns for 2003 to 2007, among other

years. Petitioners reported net operating losses (NOLs) for 2003 and 2004 and

elected to carry the NOLs forward. They reported zero tax for each of the years in

issue. Respondent audited petitioners’ tax returns for 2005 to 2007 and disallowed,

inter alia, the amortization of the C.P.A. practice, the losses on the rental real estate

properties, the deductions for the client meals and spousal meals, and the NOL

carryovers from 2003 and 2004.7 Petitioners timely petitioned the Court for

redetermination.




      7
          Respondent made several other adjustments in the notices of deficiency for
2005 to 2007. As stated supra note 2, the other adjustments have been conceded,
settled, or are computational in nature.
                                         -9-

[*9]                                  OPINION

I.     General Rules

       The Commissioner’s determinations are generally presumed correct, and the

taxpayer bears the burden of proving the determinations erroneous.8 Rule 142(a);

New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). The taxpayer bears

the burden of proving that he or she is entitled to the deductions claimed, and this

includes the burden of substantiation. Hradesky v. Commissioner, 65 T.C. 87, 90

(1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976). A taxpayer must

substantiate amounts claimed as deductions by maintaining the records necessary to

establish that he or she is entitled to the deductions. Sec. 6001; sec. 1.6001-1(a),

Income Tax Regs.

       Taxpayers are allowed a deduction for ordinary and necessary expenses paid

or incurred in carrying on a trade or business. Sec. 162(a). Whether an

expenditure is ordinary and necessary is generally a question of fact.

Commissioner v. Heininger, 320 U.S. 467, 475 (1943). Generally, for an

expenditure to be an ordinary and necessary business expense, the taxpayer must

show a bona fide business purpose for the expenditure; there must be a proximate


       8
        Petitioners have neither claimed nor established that they satisfy the
requirements of sec. 7491(a) for any of the issues remaining for decision.
Accordingly, the burden of proof does not shift to respondent.
                                       - 10 -

[*10] relationship between the expenditure and the business of the taxpayer.

Challenge Mfg. Co. v. Commissioner, 37 T.C. 650 (1962); Henry v. Commissioner,

36 T.C. 879 (1961). To be “necessary” within the meaning of section 162, an

expense needs to be “appropriate and helpful” to the taxpayer’s business. Welch v.

Helvering, 290 U.S. 111, 113 (1933). The requirement that an expense be

“ordinary” connotes that “the transaction which gives rise to it must be of common

or frequent occurrence in the type of business involved.” Deputy v. du Pont, 308

U.S. 488, 495 (1940) (citing Welch v. Helvering, 290 U.S. at 114).

      When taxpayers establish that they have incurred deductible expenses but

are unable to substantiate the exact amounts, we can estimate the deductible

amount in some circumstances, but only if the taxpayers present sufficient

evidence to establish a rational basis for making the estimate. See Cohan v.

Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930); Vanicek v. Commissioner,

85 T.C. 731, 742-743 (1985). In estimating the amount allowable, we bear heavily

against taxpayers whose inexactitude is of their own making. See Cohan v.

Commissioner, 39 F.2d at 544. There must be sufficient evidence in the record,

however, to permit us to conclude that a deductible expense was paid or incurred.

Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957). Furthermore, we

may not use the Cohan doctrine to estimate expenses subject to the strict
                                          - 11 -

[*11] substantiation requirements of section 274(d). See Sanford v.

Commissioner, 50 T.C. 823, 827 (1968), aff’d, 412 F.2d 201 (2d Cir. 1969).

II.   Amortization of the C.P.A. Practice

      A taxpayer is entitled to an amortization deduction with respect to any

amortizable section 197 intangible, the amount of which is determined by

amortizing the adjusted basis of the intangible ratably over a 15-year period

beginning with the month in which it was acquired. Sec. 197(a). An amortizable

section 197 intangible is any section 197 intangible9 acquired by a taxpayer after

August 10, 1993, and held in connection with the conduct of a trade or business.

Sec. 197(c)(1). For purposes of depreciation and amortization, a taxpayer’s basis

in purchased property is the cost, including any valid liabilities incurred in

acquiring the property. Crane v. Commissioner, 331 U.S. 1 (1947). Petitioners

claimed a $900,000 cost basis in the C.P.A. practice as a result of the repurchase

transaction, and they claimed an amortization deduction of $45,000 in each of the

years in issue on their tax return.10 Respondent principally argues that “the alleged


      9
        Sec. 197 intangibles include, inter alia, goodwill, going-concern value,
business books and records, trade names, and covenants not to compete entered into
in connection with the acquisition of an interest in a trade or business. Sec. 197(d).
      10
           It appears that petitioners miscalculated their amortization deductions.

                                                                           (continued...)
                                         - 12 -

[*12] sales agreements petitioners submitted are untrustworthy and the alleged sales

did not take place”. Alternatively, respondent argues the sale and repurchase

transactions were rescinded or that petitioners reacquired self-created intangibles of

the C.P.A. practice in a series of related transactions.11 We address each of

respondent’s arguments in turn.

      Respondent contends that petitioners presented false testimony and fabricated

documents in an attempt to prove that the transactions took place. We disagree.

We find petitioners’ testimony to be credible and persuasive. See Diaz v.

Commissioner, 58 T.C. 560, 564 (1972) (stating that the process of distilling truth

from the testimony of witnesses, whose demeanor we observe and whose credibility

we evaluate, is the daily grist of judicial life). Furthermore, we find the sale and

repurchase agreements to be genuine and trustworthy.




      10
        (...continued)
Under sec. 197, petitioners’ $900,000 basis is ratably amortized over a 15-year
period, which comes out to $60,000 per year. Respondent has not argued that the
C.P.A. practice consisted of any class of assets other than intangibles to which part
of the $900,000 purchase price should be allocated. See sec. 1060(a).
      11
          Respondent also questions Mr. Fitch’s wisdom in repurchasing the C.P.A.
practice. However, it is beyond this Court’s purview to second-guess Mr. Fitch’s
business judgment or the manner of operations of his business. See, e.g., Rozzano
v. Commissioner, T.C. Memo. 2007-177; Greenbaum v. Commissioner, T.C.
Memo. 1987-222.
                                         - 13 -

[*13] Respondent attacks the agreements for their brevity, arguing that they lack

“details that would certainly be present on an authentic sales contract of nearly one

million dollars.”12 However, the circumstances surrounding the sale and repurchase

transactions present a different story. Mr. Fitch was recovering from an aneurysm

at the time he sold the C.P.A. practice to Mr. Gronke. They had a working

relationship dating back to 1996, and they understood the need to effect a quick sale

on account of Mr. Fitch’s medical condition. They put the basic elements of their

agreement into writing and left the details to be sorted out later. Likewise, when

Mr. Gronke suffered a seizure, they signed a similar agreement to effect a quick

repurchase. In these circumstances, we find it hard to believe that a lack of details

somehow suggests the agreements were fabricated. Respondent does not argue that

the sale and repurchase agreements are invalid or unenforceable under State law.

Accordingly, we find that petitioners have proven that the sale and repurchase

transactions actually took place.

      Next, respondent argues that the sale and repurchase transactions were

rescinded. Rev. Rul. 80-58, 1980-1 C.B. 181, defines rescission as “the

abrogation, canceling, or voiding of a contract that has the effect of releasing the


      12
        Respondent takes issue with, among other things, the length of the
agreements and the lack of provisions addressing breach or default.
                                        - 14 -

[*14] contracting parties from further obligations to each other and restoring the

parties to the relative positions that they would have occupied had no contract been

made.” “For the rescission to be effective, both buyer and seller must be put back

in their original positions.” Hutcheson v. Commissioner, T.C. Memo. 1996-127

(citing Rev. Rul. 80-58, 1980-1 C.B. at 181). “A rescission may be effected by

mutual agreement of the parties, by one of the parties declaring a rescission of the

contract without the consent of the other if sufficient grounds exist, or by applying

to the court for a decree of rescission.” Rev. Rul. 80-58, 1980-1 C.B. at 181-182.

      The repurchase agreement, by its own terms, effected a sale of the C.P.A.

practice from Mr. Gronke to Mr. Fitch and not an unwinding of the earlier sale.

There is no evidence that Mr. Fitch and Mr. Gronke intended to abrogate, cancel, or

void the sale agreement. Furthermore, we do not believe that the repurchase

agreement returned them to their original positions. The C.P.A. practice continued

as a dynamic, ongoing enterprise for approximately 4-1/2 months after the sale

transaction, and we cannot say that Mr. Fitch received the C.P.A. practice back in

the exact same condition in which he had sold it. Accordingly, we find that the sale

and repurchase transactions were not rescinded.
                                         - 15 -

[*15] Respondent cursorily cites section 1.197-2(d)(2)(iii)(C), Income Tax Regs.,

in support of the position that “no amortization is available under I.R.C. § 197 for

self-created intangibles that are repurchased as part of a series of related

transactions”. Self-created intangibles generally are not amortizable. Sec.

197(c)(2). However, an exception is provided if a taxpayer disposes of a self-

created intangible and subsequently reacquires the intangible from a seller (in whose

hands the intangible is amortizable) in an unrelated transaction. Sec. 1.197-

2(d)(2)(iii)(C), Income Tax Regs.

      Almost all of the intangibles that Mr. Fitch reacquired in the repurchase

transaction were originally created by him. The issue therefore turns on whether the

sale and repurchase transactions were related transactions. We find that the

transactions were impelled by separate business exigencies, namely Mr. Fitch’s

anuerysm and Mr. Gronke’s seizure. It is hard to believe these medical conditions

could have been predicted or the transactions necessitated by them preplanned. We

find that the sale and repurchase transactions are not related transactions, and

therefore the rules generally disallowing the amortization of self-created intangibles

do not apply.13


      13
         Likewise, the antichurning rules of sec. 197(f)(9) do not apply. See sec.
1.197-2(h)(5)(ii), Income Tax Regs.
                                        - 16 -

[*16] Accordingly, petitioners are entitled to an amortization deduction of $60,000

for each of the years in issue.

III.   Deductibility of the Rental Real Estate Losses

       A.    The E Street Property

       Section 212 allows as a deduction all the ordinary and necessary expenses

paid during the year for the production or collection of income, sec. 212(1), or for

the management, conservation, or maintenance of property “held for the

production of income”, sec. 212(2). Section 167(a)(2) allows as a deduction a

reasonable allowance for depreciation of property “held for the production of

income.” The phrase “held for the production of income” has the same meaning in

section 212 and section 167. Mitchell v. Commissioner, 47 T.C. 120, 129 (1966).

Expenses and depreciation may be deducted only if the property is held for

production of income during the taxable year at issue. Meredith v. Commissioner,

65 T.C. 34, 41 (1975). Section 1.212-1(b), Income Tax Regs., provides:

“ordinary and necessary expenses paid or incurred in the management,

conservation, or maintenance of a building devoted to rental purposes are

deductible notwithstanding that there is actually no income therefrom in the

taxable year, and regardless of the manner in which or the purpose for which the

property in question was acquired.” Furthermore, expenses paid or incurred in
                                            - 17 -

[*17] connection with investment property may be deductible under this regulation,

“even though the property is not currently productive and there is no likelihood that

the property will be sold at a profit or will otherwise be productive of income and

even though the property is held merely to minimize a loss with respect thereto.”

Sec. 1.212-1(b), Income Tax Regs. Whether property is held for the production of

income is a question of fact to be determined from all the facts and circumstances.

Johnson v. Commissioner, 59 T.C. 791 (1973), aff’d, 495 F.2d 1079 (6th Cir.

1974).

         Mr. Fitch and his two brothers each inherited a one-third interest in the E

Street property in early 2005 when their mother passed away. They immediately

tried to sell the property but did not receive a satisfactory offer. Toward the end of

2005 Mr. Fitch purchased an additional one-third interest from one of his brothers

and as of the time of trial owned a two-thirds tenancy in common with his other

brother.

         While Mr. Fitch did not succeed in renting the E Street property in 2005 to

2007, we find that he held the property for the production of income.14 He

credibly testified that he intended to make the property into a rental when he


         14
              The record reflects that Mr. Fitch succeeded in renting the property in
2009.
                                         - 18 -

[*18] purchased the one-third interest from his brother. To that effect, he posted a

“for rent” sign on the property, placed an advertisement on Craigslist, and secured

bids with insurance companies for a landlord protection policy. He further credibly

testified that he performed property management services at least weekly in 2005

and continued performing those services in 2006 and 2007. Accordingly, he

incurred expenses for the management, conservation, or maintenance of property

held for the production of income, and he is entitled to deduct those expenses under

section 212.

      B.       Passive Activity Loss Limitation Rules

      Deductions for certain business and investment expenses pursuant to

sections 162 and 212 may be limited under section 469, which generally disallows

any passive activity loss for the tax year. A passive activity is any trade or

business in which the taxpayer does not materially participate. Sec. 469(c)(1). A

passive activity loss is defined as the excess of the aggregate losses from all

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

for such year. Sec. 469(d)(1). A rental activity is generally treated as a per se
                                         - 19 -

[*19] passive activity regardless of whether the taxpayer materially participates.15

Sec. 469(c)(2).

      Pursuant to section 469(c)(7), the rental activities of a taxpayer who is in the

real property business (real estate professional) are not per se passive activities but

are treated as a trade or business subject to the material participation requirements

of section 469(c)(1). Sec. 1.469-9(e)(1), Income Tax Regs. 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.

Sec. 469(c)(7)(B). A real property trade or business is 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.” In the case of a joint return, the foregoing


      15
          A rental activity is “any activity where payments are principally for the use
of tangible property.” Sec. 469(j)(8).
                                         - 20 -

[*20] requirements for qualification as a real estate professional are satisfied if, and

only if, either spouse separately satisfies the requirements. Sec. 469(c)(7)(B). All

of a taxpayer’s real estate activities are taken into account to determine whether the

750-hour requirement is satisfied. See Fowler v. Commissioner, T.C. Memo.

2002-223; Bailey v. Commissioner, T.C. Memo. 2001-296.

      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.

We have held that the regulations do not allow a postevent “ballpark guesstimate”.

Bailey v. Commissioner, T.C. Memo. 2001-296; Goshorn v. Commissioner, T.C.

Memo. 1993-578.

      Mrs. Fitch works full time as a licensed real estate agent. She credibly

testified that she works weekdays and many weekends, and typically wakes up at 6

a.m. to review business emails, new real estate listings, and buyer criteria for her

clients. She credibly testified that in addition to the time she spent managing her
                                         - 21 -

[*21] rental real estate, she spent more than 750 hours each year in 2005 to 2007

performing real estate related activities as an independent contractor with Remax,

which we find qualifies as a real property trade or business under section

469(c)(7)(C). She further credibly testified that she was not involved in any

activities besides real estate. We find Mrs. Fitch has established that she separately

satisfies the requirements to qualify as a real estate professional under section

469(c)(7), and therefore petitioners’ rental activities are subject to the material

participation requirements of section 469(c)(1).

      Material participation is defined as involvement in the operations of the

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. 5696 (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;

             (2) The individual’s participation in the activity for the taxable
      year constitutes substantially all of the participation in such activity of
      all individuals (including individuals who are not owners of interests in
      the activity) for such year;

             (3) The individual participates in the activity for more than
      100 hours during the taxable year, and such individual’s participation
      in the activity for the taxable year is not less than the participation in
                                          - 22 -

[*22] the activity of any other individual (including individuals who
       are not owners of interests in the activity) for 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 the year exceeds 500 hours;

             (5) The individual materially participated in the activity * * * for
      any five taxable years (whether or not consecutive) during the ten
      taxable years that immediately precede the taxable year;

             (6) The activity is a personal service activity * * *, and the
      individual materially participated in the activity for any three tax years
      (whether or not consecutive) preceding the taxable year; or

             (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 all work done in an activity by an individual who

owns an interest in the activity. Sec. 1.469-5(f), Income Tax Regs. Work done by

an individual in the individual’s capacity as an investor in an activity is not treated

as participation in the activity 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).

      In determining whether a taxpayer materially participates, the participation

of the spouse of the taxpayer shall be taken into account. Sec. 469(h)(5). We

therefore treat petitioners as one unit for the purpose of determining their
                                          - 23 -

[*23] participation in an activity. However, petitioners did not make the election to

treat all of their interests in real property as one activity pursuant to section

469(c)(7)(A) and section 1.469-9(g)(1), Income Tax Regs., and must therefore

satisfy the material participation requirements with respect to each of their rental

properties separately. See Shaw v. Commissioner, T.C. Memo. 2002-35.

       We find that petitioners satisfy the second enumerated test for material

participation: their participation in the rental real estate constituted substantially all

of the participation. Mr. Fitch testified extensively as to the activities he performed

with respect to his rental properties,16 including, inter alia, advertising, bookkeeping,

accounting, dealing with contractors, decorating, resolving fence disputes, making

repairs, paying taxes, and procuring insurance. He further testified that no one else

performed any services for his properties. Mrs. Fitch similarly testified as to the

activities she performed in managing her rental properties, including, inter alia,

advertising, decorating, dealing with contractors and the homeowners’ associations,

screening tenants, filling out paperwork, making repairs, and handling the lockbox

and keys. She further testified that no one other than she and Mr. Fitch performed

any services for her properties.

       16
          Mr. Fitch did not testify about the activities he performed in regard to the
Sterling property. However, the Sterling property did not generate a loss for any of
the years in issue.
                                          - 24 -

[*24] Respondent argues that we should disregard petitioners’ testimony as self-

serving; however, we find their testimony credible and persuasive. We do not

believe that petitioners’ decision to occasionally hire a contractor to perform

technical tasks disqualifies their substantial day-to-day management of their rental

properties from constituting “substantially all of the participation”.17 See sec.

1.469-5T(a)(2), Temporary Income Tax Regs, supra. Accordingly, petitioners’

losses attributable to their rental real estate in 2005 to 2007 are not limited by the

passive activity loss limitation rules of section 469.18

IV.   Meal and Entertainment Expenses

      Meal and entertainment expenses may be deducted under section 162 if they

are ordinary, necessary, and reasonable expenses incurred by a taxpayer in his or




      17
           Mr. Fitch testified that in 2005 and 2006, Mrs. Fitch would ask the wife of
a client to show the Esplanade property to prospective tenants. However, Mr. Fitch
was “not sure exactly when and where or how often.” Given the extensive activities
petitioners performed with respect to the Esplanade property, we likewise do not
believe this would preclude a finding that petitioners performed substantially all of
the activities.
      18
           We reach this conclusion notwithstanding that petitioners reported rental
real estate losses of only $25,000 in excess of their rental income on Schedules E of
their tax returns for 2005 to 2007 and now argue that their losses should not be
limited by sec. 469. We have long held that “A taxpayer is not bound on an issue
by a position taken on their tax returns, although that is a factor to be considered.”
Casey v. Commissioner, 38 T.C. 357, 384 (1962).
                                         - 25 -

[*25] her trade or business.19 See Tyson v. Commissioner, T.C. Memo. 2009-176.

However, section 262 disallows any deduction with respect to personal, living, or

family expenses. Petitioners claimed deductions for a small number of client meals

and hundreds of spousal meals as business expenses on Schedules C related to their

accounting practice and real estate activity for 2005 to 2007.20 Respondent

contends that the spousal meals are nondeductible personal expenses and not

ordinary and necessary business expenses.21


      19
         This category of expenses is also subject to the limitations of sec. 274(a)
and (n) and the strict substantiation requirements of sec. 274(d).
      20
          Petitioners claimed deductions for meal and entertainment expenses on
Schedules C related to their accounting practice of $6,414 for 2005, $5,695 for
2006, and $7,972 for 2007 and Schedules C related to their real estate activity of
$859 for 2005, $42 for 2006, and $1,214 for 2007. Respondent disallowed all of
the deductions in the notices of deficiency, except for the $42 for 2006. Respondent
subsequently stipulated that petitioners are entitled to a deduction of $1,000 each
year (in addition to the $42 allowed for 2006) because “respondent assumes
petitioners likely had some deductible meal and entertainment expenses during the
years at issue”. Neither party provided the Court with an explanation of how
respondent arrived at this figure. We attribute the $1,000 to the deductions
petitioners would be entitled to for the client meals. We attribute the deductions
respondent disallowed in excess of $1,000 to petitioners’ expenditures for their
spousal meals. The Court will not sift through the voluminous documents
petitioners provided to attempt to match the evidence to respondent’s adjustments.
See, e.g., Hale v. Commissioner, T.C. Memo. 2010-229.
      21
          Respondent contends for the first time in his reply brief that petitioners’
general ledgers “simply do not meet the strict substantiation requirements set forth
in section 274(d).” Our resolution of the first issue makes it unnecessary for us to
                                                                          (continued...)
                                        - 26 -

[*26] Petitioners testified that on occasion their discussions during the spousal

meals led to client referrals between their businesses; however, petitioners’

testimony was general, vague, and conclusory. They did not recount the specific

business purpose of any spousal meal nor the specific business discussions that

took place. Quite to the contrary, Mrs. Fitch testified: “[M]ostly I vented with him

[Mr. Fitch] regarding my real estate clients”. Likewise, the general ledgers

petitioners introduced into evidence contain vague and inadequate descriptions of

the purported business purposes of the spousal meals.22 Petitioners have not met

their burden of proving that the spousal meals are ordinary and necessary business

expenses. See Moss v. Commissioner, 80 T.C. 1073, 1078 (1983) (“Daily meals

are an inherently personal expense, and a taxpayer bears a heavy burden in proving

they are routinely deductible.”), aff’d, 758 F.2d 211 (7th Cir. 1985). Accordingly,

petitioners are not entitled to a deduction for meal and entertainment expenses in

excess of the $1,000 respondent allowed for each year.




      21
        (...continued)
consider this issue.
      22
         The general ledgers list the business purpose of almost every spousal meal
as “Schedule C” and/or “Schedule E”.
                                         - 27 -

[*27] V.     NOL Carryover

      An NOL is defined in section 172(c) to mean the excess of allowable

deductions over gross income. Section 172(a) allows an NOL deduction for the

aggregate of the NOL carrybacks and carryovers to the taxable year. Section

172(b)(1)(A) generally provides that the period for an NOL carryback is 2 years and

that the period for an NOL carryover is 20 years. A taxpayer claiming an NOL

deduction for a taxable year must file with the tax return for that year a concise

statement setting forth the amount of the NOL deduction claimed and all material

and pertinent facts, including a detailed schedule showing the computation of the

NOL deduction. Sec. 1.172-1(c), Income Tax Regs. The taxpayer bears the burden

of establishing both the actual existence of NOLs in the prior years and the amount

of such losses that may be carried to the years at issue. Keith v. Commissioner, 115

T.C. 605, 621 (2000). We have jurisdiction to consider such facts related to years

not in issue as may be necessary for redetermination of tax liability for the period

before the Court. See sec. 6214(b).

      Petitioners claimed deductions for NOLs of $57,139 and $44,260 on their

2003 and 2004 tax returns, respectively. Thereafter petitioners attempted to carry

the NOLs forward and claim them as deductions for the years in issue.

Respondent disallowed the NOL carryovers for lack of substantiation. The only
                                         - 28 -

[*28] evidence petitioners provided to the Court to substantiate the NOL carryovers

is their 2003 and 2004 tax returns and the NOL worksheets contained therein.

However, a tax return is merely a statement of a taxpayer’s claim and does not

establish the correctness of the facts stated therein. See Wilkinson v.

Commissioner, 71 T.C. 633, 639 (1979); Roberts v. Commissioner, 62 T.C. 834,

837-839 (1974). We find that petitioners have not substantiated the NOL

carryovers. Accordingly, they are not entitled to deduct the NOL carryovers from

2003 or 2004.

VI.   Accuracy-Related Penalties

      Section 7491(c) provides that the Commissioner bears the burden of

production with respect to the liability of any individual for additions to tax and

penalties. “The Commissioner’s burden of production under section 7491(c) is to

produce evidence that it is appropriate to impose the relevant penalty, addition to

tax, or additional amount”. Swain v. Commissioner, 118 T.C. 358, 363 (2002);

see Higbee v. Commissioner, 116 T.C. 438, 446 (2001). The Commissioner,

however, does not have the obligation to introduce evidence regarding reasonable

cause or substantial authority. Higbee v. Commissioner, 116 T.C. at 446-447.

Once the Commissioner has met his burden of production, the taxpayer must come
                                        - 29 -

[*29] forward with evidence sufficient to persuade a court that the Commissioner’s

determination is incorrect. Id.

      Respondent determined that petitioners are liable for section 6662(a)

accuracy-related penalties for 2005 to 2007.23 Pursuant to section 6662(a) and

(b)(1), a taxpayer may be liable for a penalty of 20% on the portion of an

underpayment of tax due to negligence or disregard of rules or regulations. The

term “negligence” in section 6662(b)(1) includes any failure to make a reasonable

attempt to comply with the Code and any failure to keep adequate books and

records or to substantiate items properly. Sec. 6662(c); sec. 1.6662-3(b)(1),

Income Tax Regs. Negligence is “strongly indicated” where the taxpayer “fails to

make a reasonable attempt to ascertain the correctness of a deduction, credit or

exclusion on a return which would seem to a reasonable and prudent person to be

‘too good to be true’ under the circumstances”. Sec. 1.6662-3(b)(1)(ii), Income

Tax Regs. “Disregard” means any careless, reckless, or intentional disregard.




      23
          Respondent determined that petitioners have underpayments for 2005 to
2007 attributable to (1) negligence or disregard of rules and regulations and (2)
substantial understatements of income tax.
                                        - 30 -

[*30] Sec. 6662(c); sec. 1.6662-3(b)(2), Income Tax Regs. We find that respondent

has met his burden of production.24

      Section 6662(a) and (b)(2) imposes a 20% accuracy-related penalty on any

portion of a tax underpayment that is attributable to any substantial understatement

of income tax, defined in section 6662(d)(1)(A) as an understatement that exceeds

the greater of 10% of the tax required to be shown on the return or $5,000. The

exact amounts of petitioners’ underpayments, if any, will depend upon the Rule 155

computations, taking into account respondent’s concessions and in accordance with

our findings and conclusions. To the extent that those computations establish that

petitioners have substantial understatements of income tax, respondent will have

also met his burden of production in this regard. See Jarman v. Commissioner, T.C.

Memo. 2010-285.

      The accuracy-related penalty is not imposed with respect to any portion of

the underpayment as to which the taxpayer shows that he acted with reasonable

cause and in good faith. Sec. 6664(c)(1); Higbee v. Commissioner, 116 T.C. at

448. The determination of whether a taxpayer acted with reasonable cause and in



      24
         Petitioners failed to substantiate the NOL carryovers and the Schedule C
expenses they conceded as set forth supra note 2. Furthermore, petitioners did not
present any evidence of any attempt they made to ascertain the correctness of the
deductions they claimed for the spousal meals--deductions that would seem to a
reasonable and prudent person to be “too good to be true”.
                                          - 31 -

[*31] good faith depends on the pertinent facts and circumstances. Sec.

1.6664-4(b)(1), Income Tax Regs. Petitioners argue that Mr. Fitch, who prepared

their tax returns for the years in issue, suffered an aneurysm in 2003 and the

aneurysm was a serious illness outside his control that supports a reasonable cause

defense to the accuracy-related penalties. While we sympathize with Mr. Fitch’s

circumstances, we do not find petitioners’ argument persuasive because Mr. Fitch

continued to work as a C.P.A. in the C.P.A. practice during the years in issue. See,

e.g., Stewart v. Commissioner, T.C. Memo. 2010-184, 2010 Tax Ct. Memo LEXIS

220, at *29 (finding that the taxpayer’s illness did not support a reasonable cause or

good faith defense because her testimony about the illness was uncorroborated, and

she continued to work for the IRS and to participate in her investment activity

during the years in issue).

         Accordingly, we find that petitioners are liable for an accuracy-related

penalty on the amounts of their underpayments of tax, if any, for the years in issue.

That determination must await the Rule 155 computations.

         In reaching our holdings herein, we have considered all arguments made, and,

to the extent not mentioned above, we conclude they are moot, irrelevant, or without

merit.
                                        - 32 -

[*32] To reflect the foregoing and the parties’ concessions,


                                                       Decisions will be entered

                                                 under Rule 155.
