                  T.C. Summary Opinion 2003-96



                     UNITED STATES TAX COURT



       EUGENE J. AND KATHRYN A. SCHUMACHER, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 18776-02S.                Filed July 23, 2003.



     Paul J. Quast, for petitioners.

     Blaine C. Holiday, for respondent.



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

the provisions of section 7463 of the Internal Revenue Code in

effect at the time the petition was filed.    The decision to be

entered is not reviewable by any other court, and this opinion

should not be cited as authority.   Unless otherwise indicated,

subsequent section references are to the Internal Revenue Code in
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effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure.

     Respondent determined deficiencies in petitioners’ Federal

income taxes of $20,582 and $21,861 for the taxable years 1998

and 1999, respectively.

     The issue for decision is whether petitioner husband’s

(petitioner’s) leasing activity is “insubstantial” in relation to

his S corporation business activity, such that petitioners may

group the activities for purposes of the section 469 passive

activity loss rules pursuant to section 1.469-4(d)(1)(A), Income

Tax Regs.1

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

The stipulations of fact and the attached exhibits are

incorporated herein by this reference.   Petitioners resided in

Arlington, Minnesota, on the date the petition was filed in this

case.

     Petitioner is the majority owner of Pro Flight Center, Inc.,

(PFC), an S corporation which was incorporated in February 1996.

After acquiring the assets of the former Stensin Aviation, PFC

began its business activity at the Beaver County Airport in

Beaver Falls, Pennsylvania, on March 15, 1996.   The assets

acquired from Stensin Aviation included five airplanes, a fuel



     1
      Petitioners do not dispute any other adjustments in the
statutory notice of deficiency.
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truck, a fuel farm, tools, office equipment, parts, fuel, and

oil.    PFC’s principal business activities from the time of its

inception have been flight training, aircraft rental, charter

services, and aircraft sales.    PFC’s principal place of business

is at the Beaver County Airport.

       During the years in issue, petitioner owned 90 percent of

the shares of PFC, while Fred A. Neppach owned the remaining 10

percent.    During this time, petitioner participated in PFC on a

full-time basis as a manager, flight instructor, and mechanic,

while also holding the corporate offices of president, treasurer,

and assistant secretary.    Mr. Neppach served as PFC’s general

manager, vice president, and secretary.    Mr. Neppach, who had

received his interest in PFC in exchange for future services,

never contributed capital to PFC, and in 2000 he transferred all

of his shares to petitioner for no consideration.

       Beginning in 1997, petitioner began acquiring additional

equipment which he determined was necessary in order to continue

the operation of PFC.    Petitioner decided to purchase the

equipment himself and lease it to PFC because petitioner felt

that the company could not have afforded to make the purchases,

and because if petitioner had “let the company buy the equipment,

he [Mr. Neppach] would automatically have 10 percent of the

equipment”.    Petitioner felt this was undesirable because Mr.
                                - 4 -

Neppach had no “financial equity” in the corporation at that

time.

     Petitioner used personal retirement funds and commercial

loans to make the equipment purchases.     In 1997, petitioner

purchased an airplane at a cost of $38,000 in order to lease it

to PFC.    This plane subsequently was sold in 1998 for $48,000, at

a gain of $17,600.   In 1998, petitioner purchased two airplanes

and two airplane engines for lease to PFC.     The cost of the

airplanes totaled $279,000, and the cost of the engines totaled

$60,000.   Written leases were executed between petitioner and PFC

under which PFC was responsible for operating and maintenance

expenses, including fuel, repairs, insurance, and taxes.

Payments required under the leases ranged from $1,000 per month

to $2,000 per month per aircraft.    PFC made actual lease payments

to petitioner of $7,000 in 1997, $9,500 in 1998, and $34,940 in

1999.   These payments were significantly less than what was

required under the leases; for example, the leases required

payments totaling $40,100 in 1998.      The equipment leased to PFC

was used exclusively by PFC.   In addition to the aircraft leased

to PFC by petitioner and the five aircraft acquired from Stensin

Aviation, PFC leased five more aircraft from other parties.

     On PFC’s Federal income tax returns for the years in issue,

the following income was reported and deductions claimed:
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                                         1998             1999

     Gross receipts                     $120,156       $1,092,295
     Cost of goods sold                  235,988          359,295
     Gross profit (loss)                (115,832)         733,000
     Other income                        684,336              -0-
     Total income                        568,504          733,000
     Deductions                          701,594          801,676
     Income (loss)                      (133,090)         (68,767)

The classification of certain income as “other income” in 1998

rather than “gross receipts”, as was done in 1999, was not the

result of a change in PFC’s operations during those years.      The

“Balance Sheets per Books” filed with these returns reflected the

following year-end asset costs and values:

                                          1998                1999

     Cost of depreciable assets          503,996          510,360
     Less accumulated depreciation      (335,532)        (404,699)
     Other assets                        250,423          233,490
     Total assets                        418,887          339,151

     PFC has reported operating losses in each year since its

inception.   Petitioner’s share of these losses, as a 90 percent

owner, were as follows:    $32,789 in 1996, $202,609 in 1997,

$119,781 in 1998, and $61,808 in 1999.    Because petitioner’s

adjusted basis in his PFC stock during the years in issue was

zero, petitioner was unable to deduct these losses in full.      As

of the end of 1998, petitioner’s suspended loss was $244,179, and

as of the end of 1999, petitioner’s suspended loss was $275,987.

     Petitioners filed joint Federal income tax returns for

taxable years 1998 and 1999.    With each of these returns,

petitioners filed a Schedule C, Profit or Loss From Business, for
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petitioner’s airplane leasing activity.   On these forms,

petitioners reported the following:

                                          1998              1999

     Gross receipts                      $9,500          $34,940
     Depreciation expense                61,500           98,320
     Mortgage expense                    13,471           14,521
     Legal/professional expense             -0-              108
     Profit (loss)                      (65,471)         (78,009)

Petitioners also reported that petitioner materially participated

in the leasing activity in each year.

     In the statutory notice of deficiency, respondent determined

that petitioner’s Schedule C leasing activity was a passive

activity subject to the provisions of section 469.    Respondent

accordingly limited the losses allowable to petitioners with

respect to the activity to the extent of petitioners’ passive

income.   This resulted in the disallowance of deductions for

losses of $47,8712 in 1998 and $78,009 in 1999.

     Pursuant to section 469(a), a passive activity loss

generally is not allowed as a deduction for the year in which it

is sustained.   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).   Passive activities



     2
      Although the record is not clear, the disallowed loss in
1998--which is less than the Schedule C loss of $65,471--
apparently reflects the $17,600 gain from the sale of the
airplane which petitioner had purchased to lease to PFC.
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generally are those activities which involve the conduct of a

trade or business in which the taxpayer does not materially

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

presumptively passive, without regard to whether the taxpayer

materially participates in the activity.     Sec. 469(c)(2), (4).

Subject to statutory and regulatory exceptions not applicable

here, a rental activity is “any activity where payments are

principally for the use of tangible property”.     Sec. 469(j)(8).

     Pursuant to the regulations issued under section 469,

certain activities may be grouped into a single activity for

purposes of ascertaining whether the resulting combined activity

is a passive activity under that section.     The regulations state

the general rule that

     One or more trade or business activities or rental
     activities may be treated as a single activity if the
     activities constitute an appropriate economic unit for the
     measurement of gain or loss for purposes of section 469.

Sec. 1.469-4(c)(1), Income Tax Regs.     A taxpayer who is a

shareholder of an S corporation may group the activity of that S

corporation with an activity conducted directly by the taxpayer.

Sec. 1.469-4(d)(5)(i), Income Tax Regs.

     Whether activities constitute an “appropriate economic unit”

depends upon all the relevant facts and circumstances, giving the

greatest weight to (1) similarities and differences in the types

of trades or businesses, (2) the extent of common control, (3)

the extent of common ownership, (4) geographical location, and
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(5) interdependencies between the activities.      Sec. 1.469-

4(c)(2), Income Tax Regs.      Taxpayers may use “any reasonable

method of applying the relevant facts and circumstances in

grouping activities.”    Id.    However, there are limitations

imposed on taxpayers’ ability to group certain activities.       Sec.

1.469-4(d), Income Tax Regs.      The limitation applicable to the

case at hand provides:

          (1) Grouping rental activities with other trade or
     business activities--

                (i) Rule. A rental activity may not be
           grouped with a trade or business activity unless
           the activities being grouped together constitute
           an appropriate economic unit under paragraph (c)
           of this section and--

                     (A) The rental activity is insubstantial
                in relation to the trade or business
                activity;

                     (B) The trade or business activity is
                insubstantial in relation to the rental
                activity; or

                     (C) Each owner of the trade or business
                activity has the same proportionate ownership
                interest in the rental activity, in which
                case the portion of the rental activity that
                involves the rental of items of property for
                use in the trade or business activity may be
                grouped with the trade or business activity.

Sec. 1.469-4(d)(1), Income Tax Regs.      The regulations do not

define the term “insubstantial”.

     The dispute in this case has been narrowly drawn by the

parties:   The sole issue we must decide is whether the leasing

activity is insubstantial in relation to the PFC activity within
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the meaning of section 1.469-4(d)(1)(A), Income Tax Regs.     If it

is, petitioners may group petitioner’s leasing activity with the

PFC activity, thereby allowing petitioners to categorize as non-

passive, and therefore deduct, the losses incurred by

petitioner’s leasing activity.     Because respondent does not

dispute that the two activities are an appropriate economic unit,

we need not address the specific factors enumerated in section

1.469-4(c)(2), Income Tax Regs.

        In arguing that the leasing activity was not insubstantial

in relation to the PFC activity, respondent makes several

comparisons between them, highlighting the income, losses, cost

of depreciable assets, and basis of assets in both activities.

In arguing that the leasing activity was insubstantial in

relation to the PFC activity, petitioners focus both on

“quantitative” comparisons similar to those focused on by

respondent, as well as on other “qualitative” factors.     See

generally Glick v. United States, 96 F. Supp. 2d 850 (S.D. Ind.

2000).

     The parties’ comparison of the value of the assets of each

activity is not determinative under the particular facts of this

case.     Merely because the rental activity in this case involved

the rental of assets with high values does not make the primary

trade or business activity less substantial in relation to that

rental activity.     Most importantly, a comparison of the value of
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the assets does not take into account the value of equipment that

PFC leased from parties other than petitioner but that was

instrumental to PFC’s operations.

       We find that, in ascertaining whether the leasing activity

was insubstantial in relation to the PFC activity, the most

significant fact in this case is that petitioner created and

operated the leasing activity solely for PFC’s benefit.    In

furtherance of this goal, petitioner spent very little time

conducting the affairs of the leasing activity in comparison with

the very substantial amount of time and effort expended by

petitioner in carrying on PFC’s business.    The leasing activity

was intended to, and in fact did, provide a service solely to

PFC.    Its purpose was to enhance PFC’s ability to generate

business, maintain PFC’s viability as an ongoing concern, and

possibly enable PFC to become profitable in the future, not to

provide an income stream independently from PFC.    Consistent with

this purpose, the leasing activity had gross receipts of $9,500

in 1998 and $34,940 in 1999, compared to PFC’s gross receipts and

other income of $804,492 and $1,092,295 in each respective year.

       Based on the record in this case, we find that petitioner’s

leasing activity was insubstantial in relation to the PFC

activity.    Accordingly, we do not sustain respondent’s

determination that the leasing activity was a passive activity

subject to the provisions of section 469.
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    Reviewed and adopted as the report of the Small Tax Case

Division.

    To reflect the foregoing,

                                     Decision will be entered

                                under Rule 155.
