                        T.C. Memo. 2012-23



                      UNITED STATES TAX COURT



          L.A. AND RAYANI SAMARASINGHE, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 5082-09.                Filed January 19, 2012.



     Matthew Pollick Cavitch, for petitioners.

     Beth A. Nunnink, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     MARVEL, Judge:   Respondent determined deficiencies in

petitioners’ Federal income tax and accuracy-related penalties

under section 6662(a)1 for 2005 and 2007 as follows:

     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
                                                   (continued...)
                                - 2 -

                                            Penalty
     Year            Deficiency            Sec. 6662

     2005             $18,068               $3,614
     2007              29,803                5,961

     After concessions,2 the issues for decision are:   (1)

Whether rental income attributable to petitioners’ rental of a

commercial office building they owned to a related professional

corporation in 2005 and 2007 was passive income under the

transition rule set forth in section 1.469-11(c)(1)(ii), Income

Tax Regs., as petitioners contend, or was nonpassive income under

the self-rental rule of section 1.469-2(f)(6), Income Tax Regs.,

as respondent determined; and (2) whether petitioners are liable

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

to decide issue (1), we must decide whether a lease executed in

1980 between petitioners and petitioner husband’s wholly owned

professional corporation constituted a written binding contract

within the meaning of section 1.469-11(c)(1)(ii), Income Tax

Regs., with respect to 2005 and 2007.




     1
      (...continued)
Procedure. Monetary amounts have been rounded to the nearest
dollar.
     2
      The parties stipulated that if the self-rental rule of sec.
1.469-2(f)(6), Income Tax Regs., is applicable, then petitioners
are liable for the deficiency. If the self-rental rule is not
applicable, then petitioners are not liable for the deficiency.
The parties also stipulated that the Westwood property “was
rented for use in a business activity in which petitioner-husband
materially participates.”
                               - 3 -

                         FINDINGS OF FACT

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

The stipulation of facts is incorporated herein by this

reference.   Petitioners resided in New Jersey when they

petitioned this Court.

     Petitioners are husband and wife.   Petitioner L.A.

Samarasinghe (petitioner) graduated from medical school in 1967.

After graduation petitioner began to practice medicine.    During

the years at issue, petitioner, who specializes in internal

medicine and in critical care, was an employee of his wholly

owned professional corporation, L.A. Samarasinghe, M.D., P.A.

(medical corporation).

     In the late 1970s petitioner hired Ramesh Sarva (Mr. Sarva),

a certified public accountant (C.P.A.), to provide accounting

services to the medical corporation and to petitioners.    Over the

years, Mr. Sarva, among other things, (1) helped petitioner

incorporate his medical practice, (2) performed accounting and

bookkeeping services for the corporation and for petitioners, (3)

provided tax planning advice, including advice on tax shelters

and real estate investments, and (4) prepared tax returns for the

medical corporation and for petitioners.

     At some point before or during 1979 Mr. Sarva advised

petitioner to purchase real property for the medical

corporation’s use.   Mr. Sarva also advised petitioner to purchase
                                 - 4 -

the real property in his individual capacity rather than through

the medical corporation.   In 1979 petitioners purchased an office

building in Westwood, New Jersey (Westwood property), and titled

the property in both their names.    The Westwood property is

conveniently situated only a few blocks from Pascack Valley

Hospital, which petitioner visits frequently in connection with

his medical practice.

     After petitioners purchased the Westwood property, Mr. Sarva

prepared a lease using a standardized lease form that purported

to lease the Westwood property to the medical corporation in

exchange for monthly rent payments and other consideration.     The

lease recited that the medical corporation would use the Westwood

property as a doctor’s office.    The lease ran from July 1, 1980,

until June 30, 1981, with the term “to be renewed automatically

unless sooner terminated as hereinafter provided, at the ANNUAL

RENT of $30,000.00 with 5% increase every year all payable in

equal monthly installments in advance on the first day of each

and every calendar month”.   The lease also provided as follows:

     NINETEENTH.--The Landlord has made no representations
     or promises in respect to said building or to the
     demised premises except those contained herein, and
     those, if any, contained in some written communication
     to the Tenant, signed by the Landlord. This instrument
     may not be changed, modified, discharged or terminated
     orally.

Petitioners and the medical corporation executed the lease on

June 30, 1980 (the 1980 lease).    From June 30, 1980, when
                               - 5 -

petitioners and the medical corporation executed the 1980 lease,

through and including the years at issue, Mr. Sarva had no

knowledge of the existence of any document that formally amended

the 1980 lease or of any other written lease regarding the

Westwood property.3

     The medical corporation maintained its offices in the

Westwood property through at least 2007.    During its occupancy of

the Westwood property the medical corporation made numerous

improvements to the property, including basic renovations and the

installation of an in-house radiology system and a laboratory.

The medical corporation paid for all improvements, the aggregate

cost of which Mr. Sarva estimated to be approximately $100,000.

     The medical corporation used a fiscal year that began on

December 1 and ended on November 30 for accounting and tax

purposes.   During the course of a fiscal year the medical

corporation periodically issued checks to petitioner without

designating what the checks were for.    The checks typically

ranged in amount from $1,000 to as much as $43,000 and were made

payable to petitioner.   The checks did not contain any notation

regarding the purpose of the payments.    The medical corporation


     3
      Although Mr. Sarva testified that there were no documents
amending or modifying the 1980 lease and that there was no other
written lease involving the Westwood property, we decline to find
these statements as facts because Mr. Sarva can testify only to
what he knew through personal knowledge. Because petitioners did
not appear at trial or testify, whatever information they might
possess is not before us.
                                - 6 -

issued the checks to petitioner whenever petitioner needed or

wanted money.

     Petitioner’s office periodically sent Mr. Sarva the bank

statements and canceled checks for the medical corporation, and

Mr. Sarva’s office would summarize the data using a software

program called QuickBooks.    The checks made payable to petitioner

as well as other checks issued by the medical corporation for

petitioner’s personal expenses such as mortgage, property taxes,

and estimated tax payments were recorded in general ledger

account 241, Due Officer.    At the end of the fiscal year Mr.

Sarva made adjusting entries which allocated the payments made to

petitioner during the year to specific expense accounts, such as

salary/payroll and rent.    Mr. Sarva determined the amounts to be

allocated to salary and to rent.    In making the allocation to

rent, Mr. Sarva did not consult the 1980 lease, and he assumed

that the annual rental period coincided with the medical

corporation’s fiscal year.    With respect to the fiscal years

ending November 30, 2005 and 2007, Mr. Sarva did not calculate

what the annual rent should be under the 1980 lease, assuming it

was in effect for those years, nor did he determine the amount of

the required monthly lease payment under the lease.    The record

contains no evidence that the medical corporation made monthly

rent payments to petitioners during 2005 and 2007 as would have
                               - 7 -

been required by the 1980 lease, assuming that the lease was

still in effect for those years.

     Mr. Sarva prepared Federal income tax returns for the

medical corporation for the fiscal years ending November 30, 2004

through 2009.   At least some of those returns were filed

electronically.   The medical corporation claimed deductions for

rental expenses attributable to the Westwood property4 on those

corporate tax returns as follows:

          FYE Nov. 30          Rental expense deduction

             2004                      $100,000
             2005                       100,000
                                       1
             2006                        133,319
                                       2
             2007                        156,224
             2008                         38,621
             2009                       168,940
     1
      The parties stipulated petitioners’ retained copy of the
medical corporation’s 2006 Federal tax return. The retained copy
shows a rental expense deduction of $139,989. The parties also
stipulated a copy of the Tax Return Database electronic return
information for the medical corporation’s 2006 return. The
electronic return information summary reflects that the medical
corporation claimed a rental expense deduction of $133,319 .




     4
      The parties stipulated that the following amounts represent
the correct amounts of rent required by the 1980 lease if it was
still in effect for rental terms ending in 2004 through 2009:

     Rental term ending June 30          Rental income

                  2004                      $94,449
                  2005                       99,172
                  2006                      104,130
                  2007                      109,337
                  2008                      114,804
                  2009                      120,554
                                - 8 -
     2
      The parties stipulated petitioners’ retained copy of the
medical corporation’s 2007 Federal tax return. The retained copy
shows a rental expense deduction of $133,828. The parties also
stipulated a copy of the Tax Return Database electronic return
information for the medical corporation’s 2007 return. The
electronic return information summary reflects that the medical
corporation claimed a rental expense deduction of $156,224.

     Petitioners timely filed their joint 2004 through 2009

Federal income tax returns, which Mr. Sarva also prepared.

Petitioners reported the following rental income attributable to

the Westwood property lease:

                 Year           Rental income

                 2004              $100,000
                 2005               100,000
                 2006                 -0-
                 2007               100,000
                 2008                 -0-
                 2009               123,484

On Schedule E, Supplemental Income and Loss, of their 2005 and

2007 returns, petitioners treated the rental income of $100,000

as passive income, which was taken into account in calculating

the passive losses for those years.

     On December 3, 2008, respondent mailed petitioners a notice

of deficiency for 2005 and 2007.    Respondent determined that the

rental income attributable to the Westwood property constituted

self-rental income, which is nonpassive income that cannot be

taken into account in calculating the correct amount of a passive

loss.    Respondent also determined that petitioners were liable

for the 20-percent accuracy-related penalty under section 6662(a)

for each of the years 2005 and 2007.
                                - 9 -

     Petitioners timely petitioned this Court to redetermine

respondent’s determinations, and the case was set for trial on

June 24, 2010.   Petitioners, who were represented by counsel, did

not appear or testify at trial, and petitioners’ counsel called

only one witness, Mr. Sarva.

                               OPINION

I.   Rental Payments as Nonpassive Income

     A.   Burden of Proof

     The Commissioner’s determinations in a notice of deficiency

are presumed correct, and the taxpayer ordinarily bears the

burden of proving that those determinations are erroneous.    Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).     Section

7491(a), however, provides that the burden of proof with respect

to a disputed factual issue shifts to the Commissioner if the

taxpayer produces credible evidence with respect to the issue,

the taxpayer complied with the substantiation requirements, and

the taxpayer cooperated with the Secretary5 with regard to all

reasonable requests for information.     Sec. 7491(a)(2); see also

Higbee v. Commissioner, 116 T.C. 438, 440-441 (2001).

Petitioners do not contend that section 7491(a) applies, and the


     5
      The term “Secretary” means “the Secretary of the Treasury
or his delegate”, sec. 7701(a)(11)(B), and the term “or his
delegate” means “any officer, employee, or agency of the Treasury
Department duly authorized by the Secretary of the Treasury
directly, or indirectly by one or more redelegations of
authority, to perform the function mentioned or described in the
context”, sec. 7701(a)(12)(A)(i).
                                   - 10 -

record does not permit us to conclude that petitioners satisfied

the requirements of section 7491(a)(2).       Accordingly, petitioners

bear the burden of proving that respondent erroneously determined

that their 2005 and 2007 rental income attributable to the

Westwood property was nonpassive income.

     B.     Passive Activity Losses and the Self-Rental Rule

     Generally, a taxpayer may deduct a loss incurred in a trade

or business.     Sec. 165(c)(1).    However, a taxpayer may not deduct

a loss from a passive activity.       Sec. 469(a).   Ordinarily, a

passive activity is an activity involving the conduct of a trade

or business in which the taxpayer does not materially

participate.     Sec. 469(c)(1).    However, except as provided in

section 469(c)(7), the term “passive activity” also includes a

rental activity regardless of whether a taxpayer materially

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

     A passive activity loss is defined as the excess, if any, of

the aggregate losses from passive activities during a taxable

year over the aggregate income from passive activities for such

year.     Sec. 469(d)(1).   In order to calculate a taxpayer’s

passive activity loss for a taxable year, the taxpayer must

ascertain whether the taxpayer’s income and losses are from
                                - 11 -

passive activities in accordance with rules set forth in section

469 and related regulations.6

     Mr. Sarva characterized the rental income attributable to

petitioners’ rental of the Westwood property to the medical

corporation during 2005 and 2007 as passive income and, in

preparing petitioners’ 2005 and 2007 returns, offset that income

with passive losses to arrive at petitioners’ nondeductible

passive activity losses for 2005 and 2007.   In the notice of

deficiency, respondent recharacterized the rental income as

nonpassive income, determining that the income was self-rental

income within the meaning of section 1.469-2(f)(6), Income Tax

Regs.

     While section 469(c)(2) generally characterizes rental

activity as passive, section 1.469-2(f)(6), Income Tax Regs.,

provides that net rental income received by the taxpayer for use

of an item of the taxpayer’s property in a business in which the

taxpayer materially participates shall be treated as income not

from a passive activity.   The rule of section 1.469-2(f)(6),

Income Tax Regs., which is sometimes referred to as the self-

rental rule or the recharacterization rule, creates an exception

to the normal rule set forth in section 469(c)(2) and (4) that


        6
      Sec. 469(l)(2) authorizes the Secretary to promulgate
regulations “which provide that certain items of gross income
will not be taken into account in determining income or loss from
any activity (and the treatment of expenses allocable to such
income)”.
                                - 12 -

income from a rental activity is passive income for purposes of

section 469 regardless of whether a taxpayer materially

participates in the activity.    See Carlos v. Commissioner, 123

T.C. 275, 279-280 (2004).

     The parties stipulated that petitioners rented the Westwood

property to petitioner’s medical corporation for use in the

corporation’s business.    The parties also stipulated that

petitioner materially participated in the business activity of

the medical corporation.    Because petitioner materially

participated in the business activity and petitioners rented the

property for such use, the self-rental rule would appear to

apply.    Therefore, unless an exception to the rule applies,

petitioners must characterize the Westwood property rental income

as nonpassive income and may not offset this income against

accumulated and unused passive losses.

     C.     Written Binding Contract Exception

     Petitioners contend that the self-rental rule of section

1.469-2(f)(6), Income Tax Regs., does not apply because they are

entitled to transitional relief under section 1.469-11(c)(1)(ii),

Income Tax Regs.    Section 1.469-11(c)(1)(ii), Income Tax Regs.,

provides that, in applying section 1.469-2(f)(6), Income Tax

Regs., a taxpayer’s rental income is passive if it is

attributable to the rental of property “pursuant to a written

binding contract entered into before February 19, 1988.”      To
                               - 13 -

qualify for transitional relief under the regulation, a taxpayer

must prove that the rental income in question was paid pursuant

to a written lease that was entered into before February 19,

1988, and was still in effect; i.e., was binding and enforceable

for the year at issue.   Krukowski v. Commissioner, 279 F.3d 547,

550 (7th Cir. 2002), affg. 114 T.C. 366 (2000).      “At a minimum,

for a lease to be binding on a party, it must be enforceable

under applicable state law.”   Connor v. Commissioner, 218 F.3d

733, 740 (7th Cir. 2000), affg. T.C. Memo. 1999-185.

     Petitioners executed a written lease with respect to the

Westwood property--the 1980 lease.      Because the parties do not

dispute that the lease was entered into before February 19, 1988,

and was in writing, the sole issue remaining is whether the 1980

lease remained in force and was binding under State law for 2005

and 2007.   We examine relevant State law and the actions of the

parties to the 1980 lease during the years at issue to decide

this issue.   The parties agree that the relevant State law is the

law of the State of New Jersey.7

     Under New Jersey law, an enforceable agreement exists when

“two parties ‘agree on essential terms and manifest an intention


     7
      The 1980 lease did not specify the law governing the
interpretation of the lease. In the absence of an agreement by
the parties to a lease regarding applicable law, we apply the law
of the State where the property is located. Krukowski v.
Commissioner, 279 F.3d 547, 550 (7th Cir. 2002), affg. 114 T.C.
366 (2000); Connor v. Commissioner, 218 F.3d 733, 740 (7th Cir.
2000), affg. T.C. Memo. 1999-185.
                                 - 14 -

to be bound by those terms.’”      Barak v. Obioha, 74 Fed. Appx.

164, 166 (3d Cir. 2003).      The essential terms of a lease include

“an adequate description of the property, a definite term

(including the commencement date), the agreed rental and the

manner of payment.”    Brechman v. Adamar of N.J., Inc., 440 A.2d

480, 482 (N.J. Super. Ct. Ch. Div. 1981).     If the lease term

exceeds 3 years, the lease also must comply with the statute of

frauds.    N.J. Stat. Ann. 25:1-5 (West 1997).8   Under the statute

of frauds, the lease must be in writing and signed by both

landlord and tenant.    Id.

     Unlike some other jurisdictions, New Jersey does not

distinguish between a renewal and an extension of a lease.

Schnakenberg v. Gibraltar Sav. & Loan Association, 117 A.2d 191,

195 (N.J. Super. Ct. App. Div. 1955); see also Balsham v.

Koffler, 73 A.2d 272, 274 (N.J. Super. Ct. App. Div. 1950).       If a

lease provides for renewal, the renewal merely continues the old

lease.    Schnakenberg v. Gibraltar Sav. & Loan Association, supra

at 195.    A general covenant to renew “implies a renewal or

extension for the same term as provided in the original lease,

and is sufficiently definite and certain to be enforceable.”        Id.



     8
      The parties do not dispute that the 1980 lease complied
with the statute of frauds at the time of execution. Effective
Jan. 5, 1996, New Jersey amended its statute of frauds, repealing
N.J. Stat. Ann. 25:1-1 (1940). See P.L. 1995, c.360 (N.J. 1996).
The parties agree that the statute of frauds in effect for 1980
applies to the 1980 lease.
                               - 15 -

No new lease is required.    Jador Serv. Co. v. Werbel, 53 A.2d

182, 185 (N.J. 1947).

     The 1980 lease contained the essential terms required to

make it a binding and enforceable agreement when it was executed

in 1980.    The lease was in writing, contained an adequate legal

description of the leased premises, and included provisions that

specified the agreed term of the lease, the rent, and the manner

in which the rent should be paid.    Its renewal and rent

adjustment provisions, if followed by the parties to the lease,

enabled the parties to renew the lease as a binding contract in

years9 after the initial rental term that ran from July 1, 1980,

through June 30, 1981.

     The parties do not appear to dispute that the 1980 lease was

a binding contract that was enforceable under State law when it

was originally executed in 1980.    The parties’ disagreement

focuses on whether the 1980 lease was still a binding contract

with respect to the years 2005 and 2007.    Under New Jersey law,

parties to a contract may modify, abandon, abrogate, or rescind a

contract.   Cnty. of Morris v. Fauver, 707 A.2d 958, 965 (N.J.

1998).   We consider whether petitioners have proved by a

preponderance of credible evidence that the 1980 lease was still



     9
      Respondent would have us conclude that the ability to renew
under the 1980 lease was limited to one additional term. Neither
the lease as drafted nor any principle of New Jersey law appears
to support such a conclusion.
                                - 16 -

a binding contract in effect for taxable years ending in 2005 and

2007.

     Under New Jersey law, the parties to a contract may make

limited changes to the contract through modification, which can

be done either by express agreement or by conduct.      Id. at 967.

For example, a landlord and tenant may alter the rent if the

lease authorizes modification, the parties comply with any

provisions regarding modification, and the modification is

supported by consideration.     Oscar v. Simeonidis, 800 A.2d 271,

276 (N.J. Super. Ct. App. Div. 2002).

        Under New Jersey law, the parties may also rescind the

initial contract in favor of a subsequent contract.      Rosenberg v.

D. Kaltman & Co., 101 A.2d 94, 96 (N.J. Super. Ct. Ch. Div.

1953).     If the parties enter into a subsequent contract covering

the same subject matter and the subsequent contract contains

terms inconsistent with the initial contract, the subsequent

contract rescinds the initial contract and “becomes the only

agreement on the part of the parties on the subject matter.”      Id.

The difference in terms, however, must be so inconsistent that

the two contracts cannot stand together.      Id.

        Abandonment under New Jersey law refers to actions of

parties to a formerly binding contract that demonstrate that the

contract is no longer in effect.     A court may infer abandonment

from the surrounding circumstances.      Mossberg v. Standard Oil Co.
                              - 17 -

of N.J., 237 A.2d 508, 516 (N.J. Super. Ct. Law Div. 1967).    For

example, in Mossberg, the Superior Court of New Jersey found that

the parties had abandoned a formerly binding contract that the

parties had executed 30 years before, on the basis of evidence

that the parties had ignored the contract provisions during the

period then in dispute.   Id. at 515-516.

     With these principles in mind, we examine the very sparse

record for what it tells us about whether the 1980 lease was

still in effect for 2005 and 2007.     Regardless of the

enforceability of the 1980 lease during the initial rental term,

which the parties appear to assume, the record contains no

credible evidence regarding the history and enforceability of the

1980 lease for periods between June 30, 1981, the end of the

initial rental term, and November 30, 2004, the earliest fiscal

year as to which there is evidence in the record of an allocation

to rental expense by Mr. Sarva.   With respect to 2005 and 2007,

the record is replete with evidence demonstrating that

petitioners, the medical corporation, and Mr. Sarva did not pay

any attention to the terms of the 1980 lease.     The parties to the

lease ignored the lease provision with respect to the amount of

required rent.   The parties to the lease ignored the lease

requirement that monthly rent payments be made.     The term of the

lease, which originally ran from July 1 through June 30, appears

to have been changed to a term corresponding to the fiscal year
                              - 18 -

of the medical corporation.   Mr. Sarva, who drafted the 1980

lease and supervised its execution by petitioners and the medical

corporation, did not consult the lease in making his annual

allocation between petitioner’s salary and rental income and his

determination of the rental income included in petitioners’

income, and the rental expense deducted on the medical

corporation’s returns for the taxable years ended in 2005 and

2007 did not coincide with what should have been reported under

the 1980 lease if it were still in effect for those years.10    The

record overwhelmingly demonstrates that, during the taxable years

ending in 2004 through 2009, the 1980 lease was a meaningless

document that was simply not followed by petitioners, the medical

corporation, or Mr. Sarva, who implemented and supervised the

rental arrangement.

     Petitioners had the burden of convincing us that the 1980

lease was still a binding contract under New Jersey law in 2005

and 2007.   They failed to do so.   During the fiscal years ending

2005 and 2007, neither petitioners nor Mr. Sarva calculated the

correct amount of rent due under the 1980 lease, and the medical



     10
      In fact, Mr. Sarva did not include any rental income from
the Westwood property lease on petitioners’ 2006 and 2008 returns
even though the medical corporation claimed a rental expense
deduction on its returns for each of the related fiscal years.
Petitioners argue that their failure to report rental income on
their 2006 and 2008 returns was a mistake attributable to Mr.
Sarva and should not be treated as evidence that the 1980 lease
was no longer in effect.
                                - 19 -

corporation did not make the required monthly rental payments.

The rental arrangement during those years was completely ad hoc--

the accountant determined the rent after the fact on the basis of

his analysis of petitioner’s financial situation at the time.    On

these facts, we conclude that petitioners have not proved that

the 1980 lease was a binding contract during 2005 and 2007.

Because petitioners have not proved that the 1980 lease was a

binding contract under New Jersey law and in effect for 2005 and

2007, petitioners have failed to prove that they qualify for

transitional relief under section 1.469-11(c)(1)(ii), Income Tax

Regs., and respondent’s determination that the rental income

petitioners reported on their 2005 and 2007 returns is nonpassive

income under section 1.469-2(f)(6), Income Tax Regs., is

sustained.

II.   Accuracy-Related Penalty Under Section 6662

      Section 6662 authorizes the Commissioner to impose a penalty

on an underpayment of tax that is attributable to negligence or

disregard of rules or regulations or any substantial

understatement of income tax.    Sec. 6662(a) and (b)(1) and (2).

The Commissioner bears the initial burden of production with

respect to the taxpayer’s liability for the section 6662 penalty.

Sec. 7491(c).   At trial the Commissioner must introduce

sufficient evidence “indicating that it is appropriate to impose

the relevant penalty.”   Higbee v. Commissioner, 116 T.C. at 446.
                              - 20 -

If the Commissioner satisfies his initial burden of production,

the burden of producing evidence to refute the Commissioner’s

evidence shifts to the taxpayer, and the taxpayer must prove that

the penalty does not apply.   Id. at 447.

     Respondent contends that petitioners are liable for the

accuracy-related penalties because the underpayments of tax are

attributable to either negligence or disregard of rules or

regulations (2005 and 2007) or to a substantial understatement of

income tax (2007).   Respondent’s contentions necessarily reflect

alternative grounds for imposing the section 6662 penalty because

only one section 6662 accuracy-related penalty may be imposed

with respect to any given portion of any underpayment, even if

the underpayment is attributable to more than one of the types of

listed conduct.   New Phoenix Sunrise Corp. v. Commissioner, 132

T.C. 161, 187 (2009), affd. 408 Fed. Appx. 908 (6th Cir. 2010);

sec. 1.6662-2(c), Income Tax Regs.

     We turn first to respondent’s contention that the section

6662 penalties should be imposed because the underpayments for

2005 and 2007 were attributable to petitioners’ negligence.    See

sec. 6662(a) and (b)(1).   For purposes of section 6662,

negligence is any failure to make a reasonable attempt to comply

with the provisions of the Internal Revenue Code, and disregard

includes any careless, reckless, or intentional disregard.     Sec.

6662(c); see also Neely v. Commissioner, 85 T.C. 934, 947 (1985)
                                - 21 -

(negligence is lack of due care or failure to do what a

reasonably prudent person would do under the circumstances); sec.

1.6662-3, Income Tax Regs.     Negligence also includes any failure

to exercise ordinary and reasonable care in the preparation of a

tax return, or any failure to keep adequate books and records and

to properly substantiate items.       Sec. 1.6662-3(b)(1), Income Tax

Regs.     A return position that has a reasonable basis is not

attributable to negligence.     Id.

        Respondent introduced evidence at trial establishing that

the rent paid by the medical corporation during 2005 and 2007 did

not comply with the terms of the 1980 lease.      Mr. Sarva’s

testimony confirmed that he made an allocation to rent at the end

of each taxable year without regard to the terms of the 1980

lease.     Nevertheless, petitioners took the position on their 2005

and 2007 returns that the 1980 lease was still binding and

treated the 2005 and 2007 rental income as passive income under

the transition rule of section 1.469-11(c)(1)(ii), Income Tax

Regs.     This evidence was sufficient to satisfy respondent’s

initial burden of production and shift the burden of production

to petitioners.     Petitioners did not prove that they were not

negligent in treating their 2005 and 2007 rental income from the

medical corporation as passive income under the transition rule

of section 1.469-11(c)(1)(ii), Income Tax Regs.      Because we hold

that the underpayments were attributable to negligence, we need
                              - 22 -

not address whether a substantial understatement of income tax

exists for either or both of the years at issue.11

     We turn then to petitioners’ contention that they are

entitled to relief under section 6664(c) from the section 6662

penalties.   A taxpayer may avoid liability for the section 6662

penalty if the taxpayer demonstrates that he or she had a

reasonable basis for the underpayment and that he or she acted in

good faith with respect to the underpayment.     Sec. 6664(c)(1);

sec. 1.6664-4(a), Income Tax Regs.     Reasonable cause and good

faith are determined on a case-by-case basis, taking into account

all pertinent facts and circumstances.     Sec. 1.6664-4(b)(1),

Income Tax Regs.   The most important factor in determining

reasonable cause and good faith is the extent of the taxpayer’s

effort to assess his or her proper income tax liability.      Id.;

see also Woodsum v. Commissioner, 136 T.C. 585, 591 (2011).

     A taxpayer may establish reasonable cause and good faith

within the meaning of section 6664(c) if the taxpayer

demonstrates that he or she reasonably relied in good faith on

the informed advice of an independent professional adviser as to

the proper tax treatment of an item.     Sec. 1.6664-4(c), Income



     11
      A substantial understatement of income tax exists with
respect to an individual taxpayer if the amount of the
understatement exceeds the greater of 10 percent of the tax
required to be shown on the return or $5,000. Sec.
6662(d)(1)(A). In any event, it would appear that a substantial
understatement exists for 2007.
                                 - 23 -

Tax Regs.; see also United States v. Boyle, 469 U.S. 241, 250

(1985); Neonatology Associates, P.A. v. Commissioner, 115 T.C.

43, 98 (2000), affd. 299 F.3d 221 (3d Cir. 2002).      The taxpayer

must show that:     (1) The adviser was a competent and qualified

professional who had sufficient expertise to justify the

taxpayer’s reliance, (2) the taxpayer provided all necessary and

accurate information to the adviser, and (3) the taxpayer

actually relied in good faith on the adviser’s judgment in

deciding on the proper tax treatment of the item.      See

Neonatology Associates, P.A. v. Commissioner, supra at 99.

     Mr. Sarva has been a practicing C.P.A. for over 30 years.

He has extensive experience in tax planning and return

preparation12 and has advised clients with respect to real estate

transactions.13     Petitioners relied on Mr. Sarva’s judgment in

purchasing the Woodside property in 1979, in setting up the

leasing transaction, and in preparing their and the medical

corporation’s tax returns each year.      Given Mr. Sarva’s

credentials and the longstanding professional relationship

between petitioners and Mr. Sarva, we find that petitioners were

justified in relying on Mr. Sarva.




     12
      Mr. Sarva testified that he serves approximately 180
clients residing in 17 States.
     13
          Mr. Sarva also has real estate investment experience.
                              - 24 -

     Petitioners depended upon Mr. Sarva to handle their books

and records and those of the medical corporation, to advise them

on their tax situation, and to prepare their tax returns.    Mr.

Sarva was either in possession of all necessary information and

records, including a copy of the 1980 lease, to perform his work

for petitioners and the medical corporation competently or could

get access to the information through petitioners.

     Finally, we are satisfied that, even though petitioners did

not testify, they nevertheless relied in good faith on Mr.

Sarva’s judgment regarding the proper tax treatment of the 2005

and 2007 rental income.   Mr. Sarva testified that he made all of

the rental expense allocations and that he determined that

petitioners’ rental income during 2005 and 2007 constituted

passive income.   Petitioners had no reason not to trust the

judgment of Mr. Sarva, who has served as their tax professional

for over two decades.

     Under the circumstances, we find that petitioners reasonably

relied in good faith on Mr. Sarva’s advice and judgment as

reflected on petitioners’ 2005 and 2007 returns.   We conclude

therefore that petitioners are not liable for the section 6662

accuracy-related penalties for 2005 and 2007.

     We have considered the parties’ remaining arguments and, to

the extent not discussed above, conclude those arguments are

irrelevant, moot, or without merit.
                        - 25 -

To reflect the foregoing,


                                 Decision will be entered for

                            respondent as to the deficiencies

                            and for petitioners as to the

                            accuracy-related penalties under

                            section 6662(a).
