                              T.C. Memo. 2012-207



                         UNITED STATES TAX COURT



         LOGENE L. FOSTER AND AGNES M. FOSTER, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 3576-10.                          Filed July 23, 2012.



      Kenneth Alan Love, for petitioners.

      Benjamin J. Peeler and Lewis A. Booth, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      COHEN, Judge: Respondent determined deficiencies in the Federal income

tax of Logene L. Foster (petitioner) and Agnes M. Foster and penalties as follows:
                                         -2-

                                                       Penalty
                    Year         Deficiency          Sec. 6662(a)

                    2004           $32,061             $6,412.20
                    2005            24,865              4,973.00
                    2006            22,383              4,476.60

By amended answer, respondent asserts increased deficiencies as follows:

                                                       Penalty
                    Year         Deficiency          Sec. 6662(a)

                    2004           $53,240            $10,648.00
                    2005            43,772              8,754.40
                    2006            41,123              8,224.60

      The issues for decision are: (1) whether petitioners engaged in a horse

racing, training, and breeding activity (horse activity) with the objective of making a

profit within the meaning of section 183; (2) whether petitioners are entitled to

certain deductions pursuant to section 162 with respect to petitioner’s law firm; and

(3) whether petitioners are liable for accuracy-related penalties under section

6662(a). Unless otherwise indicated, all section references are to the Internal

Revenue Code (Code) in effect for the years in issue, and all Rule references are to

the Tax Court Rules of Practice and Procedure.
                                         -3-

                               FINDINGS OF FACT

      Some of the facts have been stipulated, and the stipulated facts are

incorporated in our findings by this reference. Petitioners resided in Texas at the

time the petition was filed.

      Petitioner is a lawyer who has profitably headed his own firm, the Foster Law

Firm, for more than three decades. Since 1984 petitioners also have operated a

horse racing, training, and breeding activity, first as L&A Quarter Horses and later

as L&A Racing (L&A). Petitioner Agnes Foster keeps the books for the law firm

and the horse activity. Two of petitioners’ sons, Lynn Foster and Lonnie Foster, are

lawyers and work at petitioner’s law firm. Another son, Lawrence Foster, is a

professional horse trainer.

Petitioners’ Horse Activity

      When petitioner was growing up his family had horses, and from a young age

he rode and trained horses. In 1984 one of petitioners’ friends, who owned and

raced quarter horses, convinced petitioners to buy a quarter horse from him to race.

Shortly thereafter, petitioners sought business and tax advice from a certified public

accountant with respect to pursuing their horse activity.

      In 1984 petitioners also bought a home with approximately 12 acres of land

and a barn for $375,000 to accommodate their horse activity. They made a number
                                         -4-

of improvements to the property, including building stalls in the barn, adding fences,

building an exercise track and a round pen for breaking and training horses, and

installing a horse walker. Many of the improvements to their property to

accommodate the horses were made by petitioners and their three sons. A 2010

appraisal, which included the residential portion of the property, indicated that this

property had appreciated in value to $550,000.

      Petitioners and their three sons attended races in which their horses ran,

helped when their mares foaled; mucked stalls; and fed, galloped, walked, and bred

the horses. Petitioners themselves spent more than 20 hours during the week and on

weekends working with and caring for the horses. Two of their sons, Lonnie and

Lawrence, learned to break and train horses and obtained their trainer’s licenses.

Petitioners eventually primarily employed Lawrence to care for and train their

horses.

      Through the years petitioners continued to buy and race quarter horses and

consult with professional trainers and veterinarians regarding their horses. They

bought some broodmares and began breeding horses, both for their own racing

activity and to sell. Petitioners eventually began racing thoroughbred horses in

addition to quarter horses.
                                         -5-

      Petitioners maintained a separate checking account for L&A and during the

years in issue used QuickBooks software to track income and expenses. Beyond

that, however, petitioners maintained few business records. Their business plan

consisted of little more than generalized goals for the horse activity and a narrative

account of significant events that occurred in the operation.

      To reduce expenses, petitioners sometimes fed the horses mule feed instead

of horse feed; performed some of their own veterinary work such as worming; had

Lawrence, rather than a farrier, shoe the horses; and sold horses when the horses

were no longer able to race. However, there were no records that substantiated the

cost-reducing effects these measures had on the horse operation.

      Petitioners experienced some setbacks with their horse activity. Some of

their horses became ill, were injured, or died. Also, the State of Texas failed to pass

much-hoped-for legislation allowing video gambling at the State’s horseracing

tracks, causing Texas horseracing purses to be less than those of surrounding States.

      In 1996 petitioners’ returns were audited by the Internal Revenue Service

(IRS) in relation to the horse activity for 1992, 1993, and 1994. The IRS contended

that petitioners were not engaged in the horse activity for profit within the meaning
                                         -6-

of section 183. Petitioners requested review by the IRS Office of Appeals, and the

IRS eventually conceded the section 183 issue.

      By 2004 petitioners were considering ending the horse activity. The activity

had sustained substantial losses every year of its operation and Lawrence, who by

this time was training only for petitioners, was thinking about starting a hauling

business. However, petitioners decided to try pinhooking horses because they knew

of some people “who had done real good” with pinhooking. Pinhooking involves

buying a young horse and training it to the point it can begin racing, then selling the

horse to someone else who will actually race it. They began pinhooking around

2005 but also continued with their previously unprofitable activities of racing and

breeding.

      Although petitioners have reported losses for the horse activity every year

from 1984 through 2009, they do not know the total amount of their losses because

they did not retain records of losses for years before 2002. However, considering

only years 2002 through 2009, petitioners’ losses have been substantial:
                                           -7-

                                          Net loss from
                            Year          horse activity

                            2002           ($166,447)
                            2003            (118,486)
                            2004             (88,221)
                            2005             (79,108)
                            2006             (71,987)
                            2007             (76,213)
                            2008             (54,204)
                            2009             (69,078)
                              Total         (723,744)

Petitioner’s Law Firm

        In contrast to the horse activity, petitioner’s law firm has been profitable

through the years. Until 2003 petitioners owned the building in which the law firm

is located. In 2003 petitioners sold the building to the Foster Law Firm, P.C., an S

corporation owned by petitioners’ sons, Lynn and Lonnie, both of whom are

lawyers who work as independent contractors for petitioner’s law firm. Petitioner

did not want to deal with tenants and maintenance of the building any longer, and

his sons viewed the sale as a natural step in their father’s transition to eventual

retirement from practicing law. Lynn and Lonnie obtained bank financing for the

purchase, and the bank required that they and petitioners personally guarantee the

loan.
                                           -8-

         The law firm remained in the same building after the sale, and petitioners

claimed deductions reported on the law firm’s Schedules C, Profit or Loss From

Business, for rent payments to their sons’ S corporation in the following amounts for

the years in issue: $30,000 for 2004, $24,500 for 2005, and $28,600 for 2006.

Additionally, the law firm made payments of $3,155 (rounded to the nearest whole

number) to the building’s mortgage lender in 2005 which petitioners treated as lease

payments, bringing the total payment amount for 2005 to $27,655. Petitioner’s law

firm and the S corporation had no written rent or lease agreement during the years in

issue.

         Petitioners also made payments from the law firm to their three sons during

the years in issue. Payments of $98,074.52, $89,900.64, and $88,361.15 were made

to Lonnie for contract legal services for 2004, 2005, and 2006, respectively. Lynn

was paid $106,475.92, $108,591.84, and $102,931.08 for contract legal services for

2004, 2005, and 2006, respectively. Lawrence was paid $26,000, $25,500, and

$22,000 for 2004, 2005, and 2006, respectively, for performing various tasks at the

law firm. Petitioners did not claim deductions for these payments on their tax

returns.

         In addition to their substantial income from the law firm, petitioners receive

other income, such as Social Security benefits and distributions from a Keogh
                                         -9-

account. The following table shows petitioners’ total income reported for 2002

through 2006:

                          Law firm
             Year          income       Other income        Total income

             2002         $261,225         $23,364             $284,589
             2003          213,587          23,902              237,489
             2004          203,502          84,761              288,263
             2005          161,340          60,173              221,513
             2006          178,634          67,042              245,676

      The IRS commenced an examination of petitioners’ joint tax returns for 2004,

2005, and 2006. On November 12, 2009, respondent sent petitioners a notice of

deficiency disallowing the loss deductions with respect to their horse activity.

Petitioners filed a petition for redetermination with this Court on February 12, 2010.

      In an amended answer to the petition filed on January 11, 2011, respondent

asserted increased deficiencies and penalties based on allegations that the law firm’s

rent payments to petitioners’ sons’ S corporation should be disallowed and that

petitioners underreported the income of the law firm on their Schedules C for the

years in issue. Respondent alleged, and petitioners have conceded, that the amounts

of unreported income for the law firm were $233,889 for 2004, $229,000 for 2005,

and $217,898 for 2006. As an offset, however, the parties have agreed
                                           - 10 -

that petitioners are entitled to additional deductions with respect to the law firm for

amounts paid to Lynn and Lonnie for contract legal services for the years in

issue.

                                        OPINION

Horse Activity

         Respondent determined that petitioners’ horse activity was not an activity

engaged in for profit within the meaning of section 183 and disallowed loss

deductions they claimed on Schedule F, Profit or Loss From Farming, for the years

in issue. Petitioners counter that they engaged in the horse activity with an intent to

realize a profit.

         Under section 183(a), if an activity is not engaged in for profit, no deduction

attributable to that activity is allowed except to the extent provided by section

183(b). In relevant part, section 183(b) allows those deductions that would have

been allowable had the activity been engaged in for profit only to the extent of gross

income derived from the activity (reduced by deductions attributable to the activity

that are allowable without regard to whether the activity was engaged in for profit).

         Section 183(c) defines an activity not engaged in for profit as “any activity

other than one with respect to which deductions are allowable for the taxable year
                                        - 11 -

under section 162 or under paragraph (1) or (2) of section 212.” For expenses to be

deductible under section 162, Trade or Business Expenses, or section 212, Expenses

for Production of Income, and not subject to the limitations of section 183,

taxpayers must show that they engaged in the activity with the primary objective of

making a profit. Westbrook v. Commissioner, 68 F.3d 868, 875 (5th Cir. 1995),

aff’g T.C. Memo. 1993-634.

      Under section 183(d), in the case of an activity consisting in major part of the

breeding, training, showing, or racing of horses, if the gross income derived from

the activity exceeds the deductions for any two of seven consecutive taxable years,

then the activity shall be presumed to be engaged in for profit, unless the

Commissioner establishes to the contrary. See Golanty v. Commissioner, 72 T.C.

411, 425 (1979), aff’d without published opinion, 647 F.2d 170 (9th Cir. 1981).

Petitioners have reported losses for L&A for every year from 1984 through 2009;

therefore, the presumption does not apply in this case.

      The expectation of a profit need not be reasonable, but the taxpayer must

conduct the activity with the actual and honest objective of making a profit. Keanini

v. Commissioner, 94 T.C. 41, 46 (1990). Greater weight is given to objective facts

than to a taxpayer’s self-serving statement of intent. King v. Commissioner, 116

T.C. 198, 205 (2001); sec. 1.183-2(a) and (b), Income Tax Regs. Evidence from
                                          - 12 -

years subsequent to the years in issue is relevant to the extent it creates inferences

regarding a taxpayer’s requisite profit objective in earlier years. See Hoyle v.

Commissioner, T.C. Memo. 1994-592; Smith v. Commissioner, T.C. Memo. 1993-

140.

       Generally, taxpayers bear the burden of proving that the requisite profit

objective exists. Rule 142(a); Westbrook v. Commissioner, 68 F.3d at 876. The

burden of proof may shift to the Commissioner if the taxpayers establish that they

complied with the requirements of section 7491(a)(2)(A) and (B) to substantiate

items, to maintain required records, and to cooperate fully with the Commissioner’s

reasonable requests. However, we decide this issue on the preponderance of the

evidence and, therefore, the burden of proof is not relevant. See Estate of Black v.

Commissioner, 133 T.C. 340, 359 (2009); Knudsen v. Commissioner, 131 T.C. 185,

189 (2008).

       Section 1.183-2(b), Income Tax Regs., provides a nonexclusive list of factors

to be weighed when considering whether a taxpayer is engaged in an activity for

profit. These factors are: (1) the manner in which the taxpayer carried on the

activity; (2) the expertise of the taxpayer or his advisers; (3) the time and effort

expended by the taxpayer in carrying on the activity; (4) the expectation that the

assets used in the activity may appreciate in value; (5) the success of the taxpayer in
                                         - 13 -

carrying on other similar or dissimilar activities; (6) the taxpayer’s history of income

or losses with respect to the activity; (7) the amount of occasional profits, if any,

that are earned from the activity; (8) the financial status of the taxpayer; and (9)

whether elements of personal pleasure or recreation are involved in the activity. All

facts and circumstances are to be taken into account, and no single factor or

mathematical preponderance of factors is determinative. Westbrook v.

Commissioner, 68 F.3d at 876. We address the most relevant factors in determining

petitioners’ intent objectively.

      Carrying on the activity in a businesslike manner, such as by maintaining

complete and accurate books and records, conducting the activity in a manner

similar to other activities of the same nature which are profitable, and making

changes in operations to adopt new techniques or abandon unprofitable methods are

factors that may indicate a profit objective. Sec. 1.183-2(b)(1), Income Tax Regs.

Businesslike conduct is characterized by careful and thorough investigation of the

profitability of a proposed venture, monitoring of a venture in progress, and

attention to problems that arise over time. See Ronnen v. Commissioner, 90 T.C.

74, 93 (1988); Taube v. Commissioner, 88 T.C. 464, 481-482 (1987).

      Petitioners contend that they maintained complete and accurate books and

records. However, other than income and expense statements prepared with
                                        - 14 -

QuickBooks software and a “business plan” that included only generalized goals for

the operation and a year-by-year narrative account of notable events occurring in the

horse activity, petitioners produced virtually no business records. The business plan

created by petitioners does not include budgets, economic forecasts or other

analyses demonstrating financial management or planning of the activity and

appears intended only to comply with regulations under section 183 in anticipation

of tax benefits. Petitioners also did not retain any business records for years before

2002 and, consequently, are unable to determine with any accuracy the total losses

they have incurred in the horse activity since its beginning in 1984.

      The absence of accurate books and records does not conclusively establish

the lack of a profit objective, see De Boer v. Commissioner, T.C. Memo. 1996-174,

but there was scant evidence that petitioners used the few records that they did

maintain for the important purposes of “cutting expenses, increasing profits, and

evaluating the overall performance of the operation”, see Golanty v. Commissioner,

72 T.C. at 430. They appear to have maintained income and expense statements in

order to memorialize transactions for tax reporting purposes, rather than to analyze

expenses or determine profitability. See Keating v. Commissioner, T.C. Memo.

2007-309, aff’d, 544 F.3d 900 (8th Cir. 2008); Dodge v. Commissioner, T.C.

Memo. 1998-89, aff’d without published opinion, 188 F.3d 507 (6th Cir. 1999).
                                        - 15 -

This conclusion is supported by petitioner’s testimony that he “really wasn’t

keeping up [with] the losses particularly.”

      Petitioners’ recordkeeping fell short of being businesslike in other respects

that this Court has deemed important in determining whether taxpayers have the

requisite profit objective. They did not produce separate records for each of their

horses to demonstrate that they tracked breeding results and racing performance.

See Dodge v. Commissioner, T.C. Memo. 1998-89. They also did not produce any

records that showed that they reviewed each of their specific horse-related activities

of quarter horse racing, thoroughbred racing, breeding, and pinhooking to assess

which were more profitable. See Ballich v. Commissioner, T.C. Memo. 1978-497.

      Perhaps the most important indication of whether an activity is being

performed in a businesslike manner is whether the taxpayer implements methods for

controlling losses, including efforts to reduce expenses and generate income. See

Dodge v. Commissioner, T.C. Memo. 1998-89. Petitioners argue that they worked

to reduce their expenses, including at times feeding the horses mule feed instead of

horse feed; doing some of their own veterinary work; and having their trainer son

Lawrence, rather than a farrier, shoe the horses. However, they provided no

evidence regarding how much they reduced their expenses, if any, by implementing
                                        - 16 -

these measures. See Dennis v. Commissioner, T.C. Memo. 2010-216 (the taxpayer

demonstrated a profit objective with respect to reducing expenses where he

provided calculations showing the cost-reducing effects of performing certain

veterinary and horse care services himself).

      Petitioners’ failure to produce any significant income was a key factor in their

failure to earn a profit. See Dodge v. Commissioner, T.C. Memo. 1998-89.

Petitioners contend that they made changes in their operations over the years in an

effort to increase their income. Those changes involved adding quarter horse

breeding, thoroughbred racing, and pinhooking to their initial activity of quarter

horse racing. There was little in the record, however, that established that these

changes were implemented for the purpose of making the activity profitable rather

than for other noneconomic reasons, and petitioners did not produce any evidence

demonstrating that they made a careful and thorough investigation of the potential

profitability of any of these changes before making them. See Taube v.

Commissioner, 88 T.C. at 481.

      Furthermore, specific activities that had proven unprofitable were not

expeditiously abandoned. See Wesinger v. Commissioner, T.C. Memo. 1999-372

(the lack of a profit objective was indicated where the taxpayer failed to

expeditiously abandon a business technique that had not been profitable). As of
                                         - 17 -

2004, the first year in issue here, petitioners considered abandoning the horse

activity altogether but instead continued with a new speculative venture. After

petitioners began pinhooking, they still were racing and breeding horses, activities in

which they had incurred substantial losses. In fact, during 2006 their racing

expenses increased dramatically from immediately prior years. On balance, we are

not persuaded that petitioners carried on their horse activity in a businesslike

manner. This factor negates a profit objective.

      The taxpayers’ expertise, research, and study of an activity, as well as their

consultation with experts, may be indicative of a profit motive. See sec. 1.183-

2(b)(2), Income Tax Regs. Petitioners had extensive knowledge about horses and

the horse industry, partly because of petitioner’s years of breaking and training

horses, but also from their continued study of bloodlines and breeding, training, and

racing techniques. Furthermore, during the course of the horse activity, petitioners

consulted with persons who were knowledgeable about horse racing, training, and

breeding, including professional trainers and veterinarians. See Givens v.

Commissioner, T.C. Memo. 1989-529 (a profit objective was indicated where the

taxpayer sought and acquired advice in all aspects of Tennessee walking horse

breeding from experienced owners, trainers, and a veterinarian). Petitioners also

sought business and tax advice from an accountant when they began their horse
                                         - 18 -

activity. In the face of mounting losses, it would have been prudent to seek further

business advice; however, on balance we believe this factor slightly favors

petitioners.

      The taxpayers’ devotion of much of their personal time and effort to carrying

on an activity may indicate a profit motive, particularly if the activity does not

involve substantial personal or recreational aspects. Sec. 1.183-2(b)(3), Income Tax

Regs. Although both petitioners also were involved in working at the law firm, they

spent more than 20 hours during the week and on weekends working in their horse

activity, often performing manual and menial tasks such as feeding and walking the

horses and mucking stalls. See Givens v. Commissioner, T.C. Memo. 1989-529

(the taxpayer demonstrated the requisite profit objective where he spent two to four

hours daily and more time on weekends doing chores and maintenance in his horse

activity). This factor favors petitioners.

      An expectation that assets used in the activity will appreciate may indicate a

profit motive even if the taxpayers derive no profit from current operations. Sec.

1.183-2(b)(4), Income Tax Regs. Petitioners argue that they expected the horses

that they owned to appreciate because of successful racing and breeding.

Petitioners provided no records for 2004, but computer printouts provided for 2005

and 2006 indicate that during those years petitioners sold a number of horses for
                                         - 19 -

more than they had paid for them. The printouts, however, were not substantiated

with receipts, bills of sale, or other records. Petitioners also contend that they

expected the 12-acre property on which they conducted their horse activity to

appreciate, and the 2010 appraisal indicated that the property had increased in value

from $375,000 at the time of purchase to $550,000.

       However, a profit objective may be inferred from such expected appreciation

of the activity’s assets only where the appreciation exceeds operating expenses and

is sufficient to recoup the accumulated losses of prior years. See Golanty v.

Commissioner, 72 T.C. at 427-428; Hillman v. Commissioner, T.C. Memo. 1999-

255. The appreciation of petitioners’ horse activity assets does not begin to

approach the amounts of losses petitioners have reported since the beginning of their

horse activity. Furthermore, the 12-acre property also is petitioners’ principal

residence, and much of its appreciation likely is attributable to the residential

portion of the property rather than the portion used in the horse activity. This factor

is neutral.

       A history of continued losses with respect to the activity may indicate the

lack of a profit motive. See sec. 1.183-2(b)(6), Income Tax Regs. While a series of

losses during the initial or startup stage of an activity may not necessarily indicate a

lack of a profit motive, a record of large losses over many years is persuasive
                                        - 20 -

evidence that a taxpayer did not have such a motive. Golanty v. Commissioner, 72

T.C. at 426; Bessenyey v. Commissioner, 45 T.C. 261, 274 (1965), aff’d, 379 F.2d

252 (2d Cir. 1967). An activity’s cumulative losses should not be of such a

magnitude that an overall profit on the entire operation, including recoupment of

past losses, could not possibly be achieved. Bessenyey v. Commissioner, 45 T.C. at

274. If losses are sustained because of unforeseen or fortuitous circumstances

beyond the control of the taxpayer, such losses would not be an indication of the

lack of a profit motive. See sec. 1.183-2(b)(6), Income Tax Regs.

      Petitioners have realized no profits whatsoever in more than 25 years of

engaging in their horse activity. They argue, however, that their losses are not an

indication that they lack a profit objective because the losses have been caused by

factors beyond their control. Those factors include injury, illness, and death of a

number of their horses and the failure of legislation that would have allowed video

lottery terminals (slot machines) at horseracing tracks in the State of Texas. We

acknowledge that horseracing, breeding, and training are highly speculative

activities, but these events hardly account for an unbroken string of more than 25

years of losses. Furthermore, petitioners did not show that their horse activity

would have been profitable if events beyond their control had not occurred. See
                                          - 21 -

Burger v. Commissioner, 809 F.2d 355, 360 n.8 (7th Cir. 1987), aff’g T.C. Memo.

1985-523.

      Petitioners further contend that they could potentially earn a substantial profit

with one outstanding horse. The possibility of a speculative profit in a taxpayer’s

horse activity, however, is insufficient to outweigh the absence of profits for a

sustained period of years. See Chandler v. Commissioner, T.C. Memo. 2010-92

(the possibility of a speculative profit did not outweigh more than 20 years of losses

reported for the taxpayer’s horse activity); McKeever v. Commissioner, T.C.

Memo. 2000-288 (11 consecutive years of horse activity losses failed to indicate

that the taxpayer had a profit objective even though there was the possibility of a

speculative profit). This factor strongly favors respondent.

      Substantial income from sources other than the activity may indicate that the

activity is not engaged in for profit. See sec. 1.183-2(b)(8), Income Tax Regs. This

is particularly true if the losses from the activity generate substantial tax benefits.

Golanty v. Commissioner, 72 T.C. at 429. A taxpayer with substantial income

unrelated to the activity can more readily afford a hobby. See Wesley v.

Commissioner, T.C. Memo. 2007-78. Petitioners’ substantial income from the law

firm and other sources has allowed them to continue their horse activity in spite of

more than 25 years of losses, and the activity also has generated generous tax
                                         - 22 -

savings in the form of net losses that offset that income. This factor favors

respondent.

      Finally, the presence of personal motives and recreational elements in

carrying on an activity may indicate that the activity is not engaged in for profit.

Sec. 1.183-2(b)(9), Income Tax Regs. Petitioners contend that the horse activity,

particularly mucking stalls, was hard work rather than pleasure. We do not believe,

however, that petitioners and their sons would have continued the losing horse

activity for more than 25 years unless they received satisfaction from the work. It is

more likely that such satisfaction, rather than a profit objective, accounts for their

persistence. This factor does not favor petitioners but is neutral.

      After weighing all the facts and circumstances in the light of the relevant

factors, we conclude that petitioners did not engage in their horse activity for the

years in issue with the requisite profit objective. The many years of losses without a

meaningful plan for recouping them are most persuasive. Accordingly, we sustain

respondent’s disallowance of the loss deductions relating to the horse activity under

section 183.

Law Firm Deductions Under Section 162

      If the Commissioner raises new matters or asserts increased deficiencies in

his answer to the taxpayers’ petition, the Commissioner bears the burden of proof
                                        - 23 -

on those issues. See Rule 142(a); Truesdell v. Commissioner, 89 T.C. 1280, 1292-

1293 (1987). Respondent first raised the issues of the law firm’s unreported income

and the disallowance of petitioners’ claimed deductions for the law firm’s rent

payments in his amended answer; therefore, respondent has the burden of proof on

these issues.

      Payments to Petitioners’ Sons

      Inasmuch as petitioners have conceded that they underreported the law firm’s

gross income for the years in issue, respondent has carried the burden of proof with

respect to such income. Petitioners assert that the amounts of unreported income

consisted of payments for services provided by their sons that petitioners subtracted

from the law firm’s gross income before reporting that income on their tax returns.

Petitioners now argue that the unreported income should be offset by deductions for

those payments not claimed on their tax returns. Respondent, however, seeks the

increased deficiency only with respect to payments made to Lawrence; respondent

does not dispute the deductibility of payments made to Lynn and Lonnie for contract

legal services.

      Section 162(a) allows a deduction for ordinary and necessary expenses paid

or incurred by a taxpayer in carrying on any trade or business. In general, payments

made or incurred by a trade or business for personal services rendered are ordinary
                                        - 24 -

and necessary business expenses and may be deducted under section 162(a). The

burden of showing entitlement to a claimed deduction is on the taxpayer. See Rule

142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial

Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Taxpayers must maintain records

sufficient to substantiate the amounts and purposes of deductions claimed. See sec.

6001; Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), aff’d per curiam, 540

F.2d 821 (5th Cir. 1976).

      Petitioners have produced no records substantiating the work that Lawrence

performed at the law firm. In the event a taxpayer establishes that he or she

incurred a deductible expense but is unable to substantiate the precise amount, the

Court may approximate the amount of the expense. Cohan v. Commissioner, 39

F.2d 540, 543-544 (2d Cir. 1930). The Court, however, must have sufficient

evidence upon which to make a reasonable estimate to apply the Cohan rule.

Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). Petitioners’ evidence

regarding the duties Lawrence performed for the law firm consisted only of

generalized testimony that he transported boxes of documents for petitioner and

drove petitioner to work. Petitioners provided no details establishing Lawrence’s

duties, how many hours he worked, or on what basis he was paid during the years at

issue. Therefore, we have no reasonable basis for applying the Cohan rule, and we
                                           - 25 -

conclude that petitioners are not entitled to any deductions for payments made from

the law firm to their son Lawrence.

      Rent Payments

      The S corporation bought the office building in which the law firm is located

from petitioners in 2003. Subsequently, the law firm made rent payments to the S

corporation of $30,000 for 2004, $27,655 for 2005 (which included building

mortgage payments made by petitioners and treated as rent payments), and $28,600

for 2006. Petitioners claimed deductions for these payments on their Schedules C

for the law firm for the years in issue.

      Respondent contends that the sale of the building was a tax-motivated

transaction by which petitioners transferred an asset to their sons at less than fair

market value, increased the depreciable basis of a building that had previously been

fully depreciated, avoided recapture of depreciation, and allegedly entered into an

oral lease but did not comply with the terms of the lease they describe. According

to respondent, these factors indicate that the sale had no economic substance and

thus petitioners’ deductions for rent payments should be disallowed by the Court.

Petitioners assert nontax reasons for the sale of the building and actual transfer of

ownership.
                                         - 26 -

      Respondent further argues that “[i]n substance the petitioners have achieved a

significant increase in the deductions against the Schedule C income of the [law

firm], while passing a significant family owned asset to the next generation with

* * * little or no tax consequence to the petitioners’ sons.”

      A transaction may be disregarded as lacking in economic substance where

there is no legitimate business purpose and the transaction is motivated only by a

desire to minimize taxes. See W.H. Armston Co. v. Commissioner, 188 F.2d 531,

533 (5th Cir. 1951), aff’g 12 T.C. 539 (1949). Where there is a legitimate business

purpose, however, the transaction will be recognized as having economic substance

even though a tax-saving purpose is also present. See L.W. Tilden, Inc. v.

Commissioner, 192 F.2d 704, 708-709 (5th Cir. 1951), rev’g a Memorandum

Opinion of this Court dated March 16, 1950, 9 T.C.M. (CCH) 219 (1950).

      Respondent relies on W.H. Armston Co. In that case a closely held

corporation, a construction company whose majority owners were husband-and-

wife stockholders, sold some heavy equipment to the stockholder wife who then

leased the equipment back to the corporation. The Court of Appeals for the Fifth

Circuit determined that the purported sale had no legitimate business purpose other

than as a device for minimizing the corporation’s tax liability as a result of

deductions for the lease payments. The court consequently held that the lease
                                         - 27 -

payments made to the wife were constructive dividends that were not deductible as

ordinary and necessary business expenses by the corporation. In holding that the

purported sale should be disregarded for tax purposes, the court noted that the wife

was primarily a housewife with no independent income of her own who relied on

the advice of her husband in anything she did relating to the corporation.

      Here, unlike the stockholder wife in W.H. Armston Co., petitioners’ sons,

Lynn and Lonnie, have income of their own and were required to join petitioners in

personally guaranteeing the loan used to purchase the building. Except for building

payments of $3,155 made by petitioners that were treated as rent payments, the S

corporation or petitioners’ sons made the building’s mortgage payments, and their

sons also took out an additional loan to have improvements made to the building.

Furthermore, the testimony at trial established that there was a legitimate business

purpose for the sale of the building: Petitioner was tired of having to deal with

tenants and maintenance of the building, and petitioners’ sons, who were lawyers

that worked at their father’s law firm, viewed purchasing the building as a natural

step in their father’s transition to eventual retirement from his law practice.

      Whether the sale of the building was at a less-than-arm’s-length price,

whether some of the deductions that petitioners have claimed in relation to the
                                         - 28 -

building were properly deductible on the Schedules C of the law firm, and whether a

fair market rent was being charged are issues that might bear more scrutiny.

However, respondent has asserted only that the rent payments are not allowable

because the transaction was purely tax motivated. Respondent has not persuaded us

that the transaction lacked economic substance. Thus the rent deductions for

payments actually made are not disallowed.

Section 6662(a) Accuracy-Related Penalties

      Section 6662(a) and (b)(1) and (2) imposes a 20% accuracy-related penalty

on any underpayment of Federal income tax attributable to a taxpayer’s negligence

or disregard of rules or regulations or substantial understatement of income tax.

Section 6662(c) defines negligence as including any failure to make a reasonable

attempt to comply with the provisions of the Code and defines disregard as any

careless, reckless, or intentional disregard. Disregard of rules or regulations is

careless if the taxpayer does not exercise reasonable diligence to determine the

correctness of a tax return position that is contrary to the rule or regulation. Sec.

1.6662-3(b)(2), Income Tax Regs. An understatement of income tax is substantial if

it exceeds the greater of 10% of the tax required to be shown on the return or

$5,000. Sec. 6662(d)(1)(A).
                                         - 29 -

      Under section 7491(c), the Commissioner bears the burden of production

with regard to penalties and must come forward with sufficient evidence indicating

that it is appropriate to impose penalties. Higbee v. Commissioner, 116 T.C. 438,

446 (2001). Considering the substantial amounts of unreported income and

the erroneous loss deductions that petitioners claimed for the years in issue,

respondent has satisfied the burden of producing evidence that the penalties are

appropriate.

      Once the Commissioner has met the burden of production the taxpayer must

come forward with persuasive evidence that the penalties are inappropriate because

he or she acted with reasonable cause and in good faith. Sec. 6664(c)(1); Higbee v.

Commissioner, 116 T.C. at 447-448. The decision as to whether a taxpayer acted

with reasonable cause and in good faith is made on a case-by-case basis, taking into

account all of the pertinent facts and circumstances. See sec. 1.6664-4(b)(1),

Income Tax Regs.

      Petitioners have not shown reasonable cause for claiming the erroneous loss

deductions for their horse activity or underreporting the law firm’s income with

respect to amounts paid to their son Lawrence. As to the horse activity, petitioners

rely solely on the fact that the IRS conceded the section 183 issue during their first

audit for tax years 1992 through 1994.
                                         - 30 -

      A failure by the Commissioner to disallow similar deductions in a prior year’s

audit of a taxpayer’s return may be a factor to be considered with respect to the

imposition of the accuracy-related penalty. See Stewart v. Commissioner, T.C.

Memo. 2002-199; Sheehy v. Commissioner, T.C. Memo. 1996-334. However,

petitioners’ first audit was conducted more than 10 years earlier when the horse

activity arguably was still within its startup phase during which losses could be

expected. In subsequent years, petitioners continued to sustain significant losses,

but did not seek competent advice regarding whether they should have continued to

treat their horse activity as being engaged in for profit. Petitioner’s testimony

indicated only that they talked with a certified public accountant and “a few people”

at a time undisclosed in the record. Petitioners gave no details regarding what

information they provided to the accountant or what the accountant’s advice was.

The accountant did not testify. As to petitioners’ underreporting of the law firm’s

income with respect to amounts paid to their son Lawrence, they produced no

evidence proving that they sought or relied upon competent advice in relation to the

unjustified practice of omitting from gross receipts income distributed to their sons.

      Petitioners’ tax returns for the years in issue were prepared by a bookkeeping

and tax service, not a certified public accountant, and petitioners gave no details
                                        - 31 -

about the information they provided to their tax return preparer or whether their tax

return preparer was competent to prepare their tax returns. Therefore, we sustain

the penalties on the recomputed and increased deficiencies with respect to the

disallowed horse activity losses and the unreported law firm income related to

payments made to petitioners’ son Lawrence.

      In reaching our conclusions, we have considered all arguments made by the

parties and, to the extent not mentioned above, we conclude they are moot,

irrelevant, or without merit.

      To reflect the foregoing,


                                                 Decision will be entered under

                                           Rule 155.
