                        T.C. Memo. 2002-61



                      UNITED STATES TAX COURT



          OLIVER W. AND EDNA D. WILSON, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 3620-96, 3621-96.      Filed March 5, 2002.


     Oliver W. Wilson, pro se.

     Roger P. Law, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION



     MARVEL, Judge:   In separate notices of deficiency for 1992

and 1993, respondent determined the following deficiencies and

accuracy-related penalties for negligence with respect to

petitioners’ Federal income taxes:
                                - 2 -

                                            Penalty
            Year   Deficiency           Sec. 6662(b)(1)

            1992    $19,181                $3,836
            1993     24,707                 4,941


Petitioners filed a petition to redetermine the deficiency and

penalty for 1993 and a second petition to redetermine the

deficiency and penalty for 1992.   We consolidated these cases for

purposes of trial, briefing, and opinion pursuant to Rule 141(a)1

because they present common questions of fact and law.    For

convenience, these cases hereinafter are referred to as this

case.

     After concessions,2 the issues for decision are as follows:

     (1) Whether petitioners are entitled under section 162(a) to

deductions claimed on Schedules C, Profit or Loss From Business,

for 1992 and 1993 with respect to a purported

restaurant/nightclub business and, if so, in what amounts;

     (2) whether petitioners are entitled under section 167 to

deduct depreciation expenses claimed with respect to two




        1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years in issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
        2
      Respondent concedes that 25 percent of the building
petitioner Oliver W. Wilson owned at 5401-9 S. Broadway was
placed in service and used for rental purposes during 1991, 1992,
and 1993.
                              - 3 -

purported rental real properties for 1992 and 1993 and, if so, in

what amounts;

     (3) whether petitioners are entitled under section 162 or

212(2) to deduct on Schedule E, Supplemental Income and Loss,

expenses with respect to their two purported rental properties

for 1992 and 1993 and, if so, in what amounts;

     (4) whether petitioners are entitled to deduct under section

172 certain net operating losses they had computed with respect

to 1990 and 1991 and carried forward to 1992 and 1993 and, if so,

in what amounts;

     (5) whether petitioners are liable under section 6662(a) and

(b)(1) for accuracy-related penalties for negligence for 1992 and

1993.

                        FINDINGS OF FACT

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

The stipulation of facts, first supplemental stipulation of

facts, and second supplemental stipulation of facts are

incorporated herein by this reference.

     Petitioners, who filed joint Federal income tax returns for

1992 and 1993, resided in Los Angeles, California, when they

filed their petitions in this case.

Background

     On or about September 22, 1980, Oliver W. Wilson

(petitioner) and his brother, Fred L. Wilson (Fred), purchased
                               - 4 -

commercial real property located at 5401-9 S. Broadway, Los

Angeles, California (the 5401-9 S. Broadway property), for a

total purchase price of $130,000, consisting of a $30,000 cash

downpayment and a deed of trust to the sellers for the remaining

$100,000.   In 1985, Fred deeded his interest in the 5401-9 S.

Broadway property to petitioner for approximately $65,000.       Later

that year, petitioner paid off the deed of trust on the property.

     The 5401-9 S. Broadway property consists of a two-story

building and a large parking area.     The building, which was

constructed in 1922, has a total floor area of approximately

27,000 square feet, or 13,500 square feet per floor.     From the

1920s until 1968, the first floor of the building contained

various retail businesses.   The second floor contained a

nightclub/ballroom facility known as the “5-4 Ballroom”.

Following World War II, the 5-4 Ballroom became a popular

entertainment venue among Black entertainers and patrons in the

Los Angeles area and featured primarily Black entertainers and

musicians, including a number of prominent blues and jazz

artists.

     The 5-4 Ballroom closed in 1968, 3 years after the Watts

riots.   However, the rental activity on the first floor of the

building continued, with space being rented to various

businesses.   When petitioner and Fred purchased the 5401-9 S.

Broadway property in 1980, there were four tenants on the first
                                - 5 -

floor of the building:    A women’s dress shop, a refrigeration

business, a beauty shop, and Fred’s garment cutting business.

     Petitioner had learned from Fred that the property was for

sale.   Petitioner knew of the building’s history and the 5-4

Ballroom’s past popularity.    Petitioner purchased the 5401-9 S.

Broadway property intending to refurbish the building, equip it

with a restaurant, and reopen the 5-4 Ballroom as a full-service

restaurant and nightclub.

     In 1980, petitioner was a professor at California State

University-Domingues Hills in the Los Angeles area, where he

taught political science and related subjects.     He also had

experience working as a general contractor, having owned a

construction company that built some apartments and houses and

several gas stations.    He also once owned a small fast-food

restaurant.

Petitioner’s Renovation and Use of the 5401-9 S. Broadway
Property

     After purchasing the 5401-9 S. Broadway property, petitioner

initially attempted to secure financing to refurbish the building

and reopen its nightclub/ballroom.      He soon discovered, however,

that this area of South Central Los Angeles had been redlined by

institutional lenders and that financing would be difficult to

obtain.

     Around 1983, the city of Los Angeles passed an earthquake

retrofitting ordinance.    Pursuant to this ordinance, the city of
                                - 6 -

Los Angeles determined that many old buildings, including

petitioner’s building, required retrofitting to bring them up to

prescribed earthquake safety standards, and petitioner was issued

a notice requiring him to retrofit his building.   If petitioner

failed to retrofit his building, the city ultimately would close

the building and demolish it.

     In planning and carrying out the earthquake retrofitting and

refurbishing work on the building, petitioner acted as his own

general contractor.   He hired architects and civil and structural

engineers and prepared a plan for the work required.   He applied

to the city of Los Angeles for plan approval.   Beginning in 1987,

petitioner also entered into contracts with various engineers and

contractors in connection with the building’s renovation and

improvement.

     On or about July 2, 1987, petitioners received a $213,700

Small Business Administration program loan to retrofit and

refurbish the building (the SBA loan).

     From September 1980 through early July 1987, petitioner had

continued to rent space on the first floor of the building to

various tenants.   Shortly after petitioner received the SBA loan,

petitioner’s tenants vacated the premises to allow the earthquake

retrofitting work on the building to proceed.   From about July
                               - 7 -

1987, when the retrofitting work began, until 1991, no portion of

the building’s first floor was rented by petitioner to a tenant.3

     From mid-1987 through 1989, petitioner experienced a number

of unforeseen problems in his efforts to refurbish the building

and reopen the 5-4 Ballroom.   Sometime in 1989, petitioner

exhausted the SBA loan funds and was forced to seek additional

financing.   By the end of 1989, petitioners owed $231,992.67 on

the SBA loan and did not have the funds necessary to continue the

construction work.

     In early 1990, petitioners applied for and received a

construction loan from South Coast Thrift & Loan Association (the

South Coast Thrift loan).   To secure their repayment of the loan,

petitioners executed deeds of trust in favor of South Coast

Thrift on the 5401-9 S. Broadway property and on their home.

Based on representations made to petitioner by South Coast

Thrift, petitioner believed that South Coast Thrift would lend

him up to $850,000, an amount petitioner estimated would be

sufficient to (1) pay off the SBA loan, (2) complete the

refurbishing of the building, and (3) cover his initial operating

expenses in reopening the 5-4 Ballroom.




     3
      From September 1980 through at least the end of 1993, the
second floor of the building (which had contained the former 5-4
Ballroom) was not used by petitioner in any business or rental
activity.
                               - 8 -

     Shortly after petitioners settled on the South Coast Thrift

loan, construction on the building resumed.   However, work

proceeded very slowly as petitioner encountered further problems.

Among other things, multiple thefts of building materials and

electrical fixtures forced petitioner to install a security alarm

system for the building.   The city of Los Angeles also required

petitioner to perform unanticipated additional work and repairs

to the building, including replacing the sewer system from the

building to the street curb and installing an elevator from the

first to the second floor, a sprinkler system, and a unified

electrical system for the building.

     Sometime in 1990, after construction on the building

resumed, representatives of South Coast Thrift informed

petitioner that South Coast Thrift would not provide enough money

under the South Coast Thrift loan to complete all the work that

had been contemplated in his loan application.4

     By the end of 1990, petitioner was forced to scale back his

plans for renovating the building and reopening the 5-4 Ballroom.

At this point, petitioner decided it would be more feasible to


     4
      In 1991, litigation between South Coast Thrift and
petitioners ensued. On Mar. 18, 1992, petitioners commenced a
proceeding under ch. 11 of the Bankruptcy Code with the U.S.
Bankruptcy Court for the Central District of California.
Ultimately, in or about September 1994, petitioners and South
Coast Thrift entered into a settlement, pursuant to which they
agreed to reconfigure petitioners’ former South Coast Thrift loan
as a new $450,000 loan secured by the 5401-9 S. Broadway
property.
                                - 9 -

convert and use a 6,000-square-foot space on the building’s first

floor for a “Bluesroom” instead of proceeding with his original

plans for a restaurant and nightclub on the second floor.

     During 1991, 1992, and 1993, petitioner rented or tried to

rent approximately half of the building’s first floor to various

third parties.   In January 1991, he rented space on that floor to

an artist.   However, the artist occupied the space for less than

3 months and failed to pay petitioner the rent required under

their lease agreement.    During 1992 and 1993, petitioner

permitted an attorney to maintain her law office on part of the

first floor.   Pursuant to their rental arrangement, the attorney

agreed to perform legal services for petitioner in lieu of paying

petitioner cash rent.    From July through December 1992, this

attorney also rented additional space on the first floor from

petitioner for a nursery/flower shop business, but this planned

business venture never got off the ground.    In November 1992,

petitioner had a commercial property realtor attempt to rent

space on the first floor to prospective tenants, but the

realtor’s efforts proved unsuccessful.

     During 1991, 1992, and 1993, petitioner also sought to raise

funds to complete the building’s renovation.    For example,

beginning in 1991, petitioner attempted to interest others in

renovating the building and reopening the 5-4 Ballroom.      Among

other things, petitioner filed a fictitious business name for the
                              - 10 -

“5-4 Ballroom/Supper Club” in October 1991.   He then attempted to

raise capital to reopen the 5-4 Ballroom by providing an

“investment opportunity” for individuals in the “5-4

Ballroom/Supper Club”.   During 1992, petitioner worked with a

mortgage banking company in an effort to raise about $1.5 million

from the local Black business community.   However, the effort was

unsuccessful, due to the large claim South Coast Thrift was then

asserting against petitioners and the 5401-9 S. Broadway

property.

     During 1991 and 1992, petitioner also offered annual

memberships in the “5-4 Ballroom/Supper Club Inner Circle”.    A

membership would entitle a person to discounts when attending

performances in the planned ballroom/supper club and also to a

birthday celebration there.   Although a small amount of

membership fees was collected during 1992, no income from

membership fees was reported on petitioners’ 1992 income tax

return.5

     Beginning in 1992, petitioner arranged for various

charitable events to be held on the grounds of the 5401-9 S.

Broadway property.   He also arranged for an event to be held in



     5
      Because the planned 5-4 Ballroom/Supper Club did not open,
the membership fees petitioner collected were probably refunded
or refundable, but the record does not disclose what happened to
these fees. We note, however, that respondent did not determine
that the membership fees were income to petitioners in either
1992 or 1993.
                              - 11 -

the building’s Bluesroom in late 1992.     These and other similar

events held during 1992 and 1993 were primarily fundraisers for

local philanthropic organizations.     Petitioner believed that

these events would help to publicize and stimulate community

interest in his efforts to renovate the building and reopen the

5-4 Ballroom.   He also hoped the resulting publicity and

community interest might encourage others to invest in the

project.

     Petitioner and his agents contracted with entertainers and

musicians to perform at some of the events.     Petitioner also

obtained temporary liquor permits in the names of the

philanthropic organizations holding the events to sell alcoholic

beverages on the grounds and in the Bluesroom during the events.

During 1992 and 1993, there was no restaurant facility in the

building.   Any food provided at the events was obtained from

outside caterers, brought to the location, and heated.

     All gross receipts generated from the charitable events held

during 1992 and 1993 were used either to compensate the

entertainers and musicians or to pay for refreshments and other

overhead expenses.   Any balance remaining was paid to the

philanthropic organizations holding the events.     These gross

receipts consisted of donations from people attending the events

and payments for the refreshments sold during the events.

Although petitioner and his agents were involved in collecting
                               - 12 -

the gross receipts the events generated, none of the gross

receipts were reported on petitioner’s 1992 and 1993 income tax

returns.    Petitioner did not charge any rent for the use of the

grounds or the Bluesroom during these events or report any net

profit or income from the charitable events.

     On or about October 21, 1994, shortly after his settlement

with South Coast Thrift, petitioner hired a consultant to help

him obtain a liquor license for the Bluesroom/5-4 Ballroom.    On

October 28, 1994, petitioner held a public ceremony at the

building celebrating his “reopening of the 5-4 Ballroom/Supper

Club” and began operating the Bluesroom as a commercial

entertainment facility.   Following the ceremony, petitioner

offered performances in the Bluesroom to the public for which he

charged customers an admission fee or cover charge of $10 per

person.    Thereafter, on a number of days from 1994 through 1995,

petitioner charged customers admission fees to attend various

events and performances held in the Bluesroom.   None of the

performances were held in the original 5-4 Ballroom space on the

second floor because the second floor still required additional

substantial work before it could be used in a commercial

activity.

Petitioners’ 1992 and 1993 Income Tax Returns

     Since 1968, petitioners’ income tax returns, including their

returns for the years in issue, were prepared by William D.
                              - 13 -

Collins.   Mr. Collins has been a certified public accountant

since 1959.

     Schedule C Expenses

     On Schedules C of petitioners’ 1992 and 1993 returns,

petitioners reported no income and deducted the following

expenses and net loss from the restaurant business purportedly

conducted by petitioner at the 5401-9 S. Broadway property:

                                    1992         1993

      Expenses:
        Insurance                  $9,200      $11,200
        Legal and pro-
         fessional services         1,400        5,000
        Repairs and maintenance     2,700        4,964
        Taxes and licenses          4,837        4,191
        Utilities                     --           271
        Other--
          Alarm system                --           300
          Appraisals                  --         3,000
          Locksmith                   --            53
          Permits                     --           275
                                   18,137       29,254

      Net loss                    (18,137)     (29,254)

On Schedule C to their 1992 return, petitioners stated the

restaurant business had been in operation during all 12 months of

that year.

     Schedule E Expenses

     On Schedule E to their 1992 return, petitioners reported no

rental income and deducted the following expenses and net losses

from the 5401-9 S. Broadway property and another property located

at 5415 S. Broadway (the 5415 S. Broadway property):
                                       - 14 -

                               5401-9 S.              5415 S.
                             Broadway Prop.        Broadway Prop.

            Mortgage int.                –-          $7,015
            Gardening                    $475           --
            Depreciation               19,652         1,844
                                       20,127         8,859

         Net loss                     (20,127)       (8,859)

Applying the passive activity loss limitation of section 469,

petitioners for 1992 deducted $25,000 in total Schedule E losses

from the 5401-9 S. Broadway property and the 5415 S. Broadway

property.

     On Schedule E to their 1993 return, petitioners reported

the following rental income, expenses, and net losses from the

5401-9 S. Broadway property and the 5415 S. Broadway property:

                              5401-9 S.             5415 S.
                            Broadway Prop.       Broadway Prop.
                              1
   Rental Income               $18,000                --

   Expenses:
     Mortgage int.                     –-           $1,000
     Legal and pro-
                                  1
      fessional fees               18,000             -–
     Taxes                           –-              1,159
     Depreciation                  19,652            1,844
                                   37,652            4,003

    Net loss                  (19,652)              (4,003)
     1
      The rental income of $18,000 and corresponding $18,000 of
legal and professional fees expense that petitioners reported for
1993 from the 5401-9 S. Broadway property were attributable to
the previously described arrangement between petitioner and an
attorney whereby the attorney received office space on the
building’s first floor in exchange for her providing legal
services to petitioner.
                                      - 15 -

Applying the passive activity loss limitation of section 469,

petitioners for 1993 deducted total Schedule E losses of $25,000,

consisting of (1) their total net losses of $23,655 for that year

from the 5401-9 S. Broadway and the 5415 S. Broadway properties

and (2) $1,345 of unallowed prior year passive losses.

     The 1992 and 1993 depreciation expenses petitioners claimed

were computed as follows:

                                                                          Annual
                           Date      Cost/    Deprec.            Life       deprec.
  Rental Prop.           acquired    basis     basis    Method   (yrs.)     expense

  5401-9 S. Broadway--
    Building             10/1/80    $87,000   $87,000    S/L      20       $4,350
    Land                 10/1/80     75,000    75,000     --      --         –
    Improvement           6/1/87     70,250    70,250    S/L      31.5      2,230
                                                         (MM)
    Improvement           6/1/90    411,723   411,723    S/L      31.5     13,072
                                                         (MM)

  5415 S. Broadway       3/15/86     34,800    34,800    S/L      19        1,844


In computing petitioners’ depreciation expenses for 1992 and 1993

with respect to the 5401-9 S. Broadway property building and

improvements, Mr. Collins concluded that petitioners had used the

entire building in a trade or business or had held the entire

building for the production of income.

     Net Operating Loss Deductions

     On their 1992 and 1993 returns, petitioners deducted net

operating losses (NOL) in the respective amounts of $92,611 and

$57,518 that were carried forward from 1990 and 1991.

     The 1990 NOL carryover arose from a net loss of $132,121

petitioners had claimed on Schedule C to their 1990 return.                           On

their 1990 Schedule C, petitioners reported no income and
                                - 16 -

deducted the following expenses and net loss from their purported

“Louisiana Creole/Cajun” restaurant business at the 5401-9 S.

Broadway property:

              Expenses:
                Interest                 $116,121
                Insurance                  10,000
                Utilities                   3,000
                Lease expense               3,000
                                          132,121

              Net loss                   (132,121)

     On their 1990 return, petitioners failed to elect to

relinquish, under section 172(b)(3)(C), the 3-year carryback

period otherwise required by section 172(b)(1)(A) with respect to

their claimed 1990 NOL.   If petitioners had carried back the 1990

NOL to 1987, 1988, and 1989, as required, their claimed 1990 NOL

would have been reduced by $44,820.

     The 1991 NOL carryover arose from a net loss of $73,235

petitioners claimed on the Schedule C to their 1991 return.    On

their 1991 Schedule C, petitioners reported no income and

deducted the following expenses and net loss from their

restaurant business at the 5401-9 S. Broadway property:

             Expenses:
                Interest                      $43,276
                Insurance                       3,439
                Utilities                       2,077
                Repairs and maintenance         2,211
                Supplies                        1,263
                Taxes and licenses              6,492
                Other                          14,477
                                               73,235

              Net loss                        (73,235)
                                - 17 -

     The interest claimed on petitioners’ Schedules E for 1990

and 1991 was attributable to petitioners’ South Coast Thrift

loan.

Notices of Deficiency

        On November 27, 1995, respondent sent petitioners a notice

of deficiency for 1993.     On December 8, 1995, respondent sent

petitioners a notice of deficiency for 1992.

        In the notices of deficiency, respondent disallowed all the

Schedule C expenses petitioners deducted for 1992 and 1993.

Respondent determined that the expenses (1) had not been

substantiated, (2) had not been established to be ordinary and

necessary business expenses, or (3) were startup expenses,

because petitioner’s restaurant had not yet opened for business.

        Respondent also disallowed the entire Schedule E loss

petitioners deducted for 1992.     Respondent determined that the

Schedule E loss had not been either substantiated or established

to be deductible.     As to the 1993 Schedule E loss petitioners

deducted, respondent disallowed:     (1) All the expenses that

petitioners claimed from the 5401-9 S. Broadway property, except

for 6 percent of the $19,652 of depreciation and 6 percent of the

$18,000 of legal expense; (2) all the expenses that petitioners

claimed from the 5415 S. Broadway property; and (3) all $1,345 of

the unallowed prior year passive losses that petitioners claimed.

Among other things, respondent determined that only 6 percent of
                                - 18 -

the 5401-9 S. Broadway property building was used for rental

purposes during 1993.6   He also determined that only 6 percent of

the legal expense was allocable to the portion of the building

used for rental purposes and that the remaining 94 percent had to

be added to petitioners’ basis for the portion of the building

not used for rental purposes.

     Respondent also disallowed all the 1992 and 1993 NOL

deductions that petitioners claimed.       Among other things,

respondent determined that it had not been established either

that any 1990 and 1991 NOLs were incurred or that the 1990 and

1991 NOLs were available to be carried forward to 1992 and 1993.

     Finally, respondent determined that petitioners were liable

for accuracy-related penalties under section 6662 for negligence

with respect to the entire underpayment for 1992 and 1993.

Petitioners’ Various Bankruptcy Proceedings

     As previously indicated, on March 18, 1992, petitioners

commenced a proceeding under chapter 11 of the Bankruptcy Code

with the U.S. Bankruptcy Court for the Central District of

California (the Bankruptcy Court).       On October 5, 1994, the




     6
      Respondent now concedes that 25 percent of the building was
used for rental purposes by petitioner during 1992 and 1993 and
further agrees that petitioners are entitled to deduct, under
sec. 167, up to 25 percent of the $19,652 of annual depreciation
expense claimed for each year with respect to the building and
improvements.
                             - 19 -

Bankruptcy Court entered its Order Confirming the Debtors’ Joint

Non-Adverse Fifth Amended Plan of Reorganization.7

     Following the issuance of the notice of deficiency for 1993

on November 27, 1995, and the issuance of the notice of

deficiency for 1992 on December 8, 1995, petitioners timely filed

their respective petitions with this Court, commencing this case.

     On September 9, 1996, the Bankruptcy Court entered an order

granting petitioners’ motion to convert their chapter 11

proceeding to a chapter 7 proceeding.   As a result, on May 12,

1997, after being notified of petitioners’ pending chapter 7

proceeding before the Bankruptcy Court, we stayed the proceedings

in this case.

     On September 29, 1997, the Bankruptcy Court entered an Order

of Discharge releasing petitioners from all dischargeable debts.

As a result, after being notified by the parties of the discharge

order entered in petitioners’ bankruptcy proceeding, we ordered

this case restored to the general docket on March 26, 1998.

     On April 8, 1998, we entered an order setting this case for

trial during this Court’s trial session beginning on September 8,

1998, in Los Angeles, California.




     7
      This Oct. 5, 1994, order of the Bankruptcy Court had the
effect of lifting the automatic stay in petitioners’ ch. 11
bankruptcy proceeding. Moody v. Commissioner, 95 T.C. 655, 658-
664 (1990).
                              - 20 -

     On or about June 30, 1998, petitioners commenced a

proceeding under chapter 13 of the Bankruptcy Code with the

Bankruptcy Court.   As a result, on July 20, 1998, we stayed the

proceedings in this case.

     After being notified that the Bankruptcy Court had dismissed

petitioners’ chapter 13 proceeding, we lifted the stay in the

proceedings in this case on August 17, 1998.   We further directed

the parties to submit a joint status report concerning whether

this case would be ready for trial during this Court’s trial

session beginning on September 8, 1998, in Los Angeles,

California.

     On September 16, 1998, we held the trial in this case.

     On October 20, 1998, petitioners commenced a proceeding

under chapter 7 of the Bankruptcy Code with the Bankruptcy Court.

As a result, after being notified of petitioners’ commencement of

this bankruptcy proceeding, we stayed the proceedings in this

case on November 17, 1998.

     In its Order of Discharge dated February 8, 1999, the

Bankruptcy Court granted petitioners a discharge in the chapter 7

bankruptcy proceeding they had commenced on October 20, 1998.

The Explanation Of Bankruptcy Discharge in a Chapter 7 Case

included with this order, stated, in pertinent part:

     Debts That are Discharged

          The chapter 7 discharge order eliminates a
     debtor’s legal obligation to pay a debt that is
                             - 21 -

     discharged. Most, but not all, types of debts are
     discharged if the debt existed on the date the
     bankruptcy case was filed whether the debt was included
     in the schedules or omitted from them. * * *

     Debts That are Not Discharged

          Some of the common debts which are not discharged
     in a chapter 7 bankruptcy case are.

     a. Debts for most taxes;[8]

          *      *      *      *        *      *      *

           This information is only a general summary of the
     bankruptcy discharge. There are exceptions to these
     general rules. Any party may request reopening of a
     bankruptcy case to determine whether a particular debt
     was included within the scope of the discharge.
     *   *    *   Because the law is complicated, you may
     want to consult an attorney to determine the exact
     effect of the discharge in this case.

     On March 2, 1999, petitioner filed a motion to dismiss in

this case.

     By order dated March 27, 2000, we (1) lifted the stay of the

proceedings in this case, effective as of the February 8, 1999,

date of the Bankruptcy Court’s order of discharge and (2) denied

petitioner’s motion to dismiss.    The March 27, 2000, order

denying petitioners’ motion to dismiss cited our decision in

Freytag v. Commissioner, 110 T.C. 35, 40-41 (1998), and stated

that, when a Bankruptcy Court exercises its jurisdiction to

determine a taxpayer’s income tax liabilities, its decision does




     8
      See Sheinfeld et al., Collier On Bankruptcy Taxation, pars.
TX4.02[1][iii], TX5.03[4] (1997).
                              - 22 -

not deprive this Court of subject matter jurisdiction in a

proceeding filed by the taxpayer in this Court.

                              OPINION

I.   Preliminary Matters

     Petitioners filed an opening brief and a supplemental brief

in this case.   Petitioners’ arguments in both briefs focused

almost exclusively on the effect of petitioners’ various

bankruptcy proceedings on this Court’s jurisdiction and on this

Court’s ability to dispose of the substantive issues raised at

trial and in respondent’s trial briefs.   Petitioners also filed a

posttrial motion to dismiss, raising the same jurisdictional

issue discussed in their posttrial briefs.

     As best we understand them, the procedural issues raised in

petitioners’ posttrial briefs and/or in the motion to dismiss

were as follows:

     (1) Whether this Court has the requisite jurisdiction to

adjudicate the issues involved in this case;

     (2) whether the amounts at issue in this case were

discharged in petitioners’ bankruptcy proceedings; and

     (3) whether the doctrine of res judicata applies to prevent

the adjudication of the issues involved in this case.

     Upon consideration of petitioners’ motion to dismiss and

respondent’s objections to petitioners’ motion, we concluded

that petitioners’ bankruptcy proceedings did not deprive us of
                               - 23 -

jurisdiction over this case, Freytag v. Commissioner, supra at

41, and we denied petitioners’ motion.    Although petitioners in

their posttrial briefs again attempt to challenge this Court’s

jurisdiction in this case, we reject petitioners’ jurisdictional

argument.

     We also reject petitioners’ allegations that the tax

liabilities at issue in this case were fully litigated in their

bankruptcy proceeding and that the doctrine of res judicata

operates to preclude additional litigation in this Court.    The

record is devoid of any evidence demonstrating that the subject

tax liabilities were ever litigated in any of petitioners’

bankruptcy proceedings.   In fact, the order of discharge relied

upon by petitioners expressly states that the debts for most

taxes are not discharged in a chapter 7 bankruptcy case and that

any party to that case may request that it be reopened to

determine whether a particular debt has been discharged.    See

Neilson v. Commissioner, 94 T.C. 1, 9 (1990) (Tax Court lacks

jurisdiction to decide whether income tax deficiencies were

discharged in bankruptcy).    Moreover, petitioners have made no

effort to explain how the elements of res judicata are satisfied

by the record in this case.    Consequently, we reject petitioners’

bankruptcy-related arguments, and we proceed to the substantive

issues presented in this case.
                              - 24 -

II.   The Trade or Business Requirement of Section 162

      Section 162(a) authorizes a taxpayer to deduct ordinary and

necessary expenses incurred in carrying on a trade or business.

Petitioners summarily allege that they operated a Schedule C

trade or business, i.e., a restaurant/nightclub facility, and

that they properly deducted expenses incurred in operating the

trade or business on Schedules C to their 1992 and 1993 returns.

Petitioners also summarily allege that they properly deducted

NOLs carried forward from 1990 and 1991 arising from expenses

they incurred and paid with respect to the same business.     See

infra part VI.   Respondent contends that petitioners had not yet

started their restaurant/nightclub business in 1990, 1991, 1992,

or 1993 and that the expenses in question were not incurred in

carrying on an existing trade or business.

      Whether a taxpayer is engaged in a trade or business

requires an examination of the relevant facts and circumstances.

Commissioner v. Groetzinger, 480 U.S. 23, 36 (1987).     In

conducting the examination, we look to see whether the taxpayer

has undertaken the activity with the intent to make a profit,

whether the taxpayer is regularly and actively involved in the

activity, and whether the taxpayer’s business activity has

actually commenced.   McManus v. Commissioner, T.C. Memo. 1987-

457, affd. without published opinion 865 F.2d 255 (4th Cir.

1988).
                              - 25 -

     Respondent concedes that petitioners’ attempt to renovate

and retrofit the 5401-9 S. Broadway property was motivated by

their intention to make a profit through the operation of the 5-4

Ballroom and/or the Bluesroom.   Respondent contends, however,

that petitioners’ Schedule C business activity had not actually

commenced during the period from 1990 through 1993.   We examine

the relevant time periods below.

     A.   1990 and 1991

     The expenses petitioners allegedly incurred during 1990 and

1991 in connection with their restaurant/nightclub activity are

not deductible under section 162(a) “unless the taxpayer is

engaged in an ongoing business at the time the expense is

incurred.”   Kantor v. Commissioner, 998 F.2d 1514, 1518 (9th Cir.

1993), affg. and revg. on other issues T.C. Memo. 1990-380; see

also Jackson v. Commissioner, 86 T.C. 492, 514 (1986), affd. 864

F.2d 1521 (10th Cir. 1989), in which we stated:

     Section 162 does not allow deductions for otherwise
     deductible expenses until such time as the trade or
     business begins to function as a going concern even
     though the taxpayer may have made a firm decision to
     enter into business and has expended considerable sums
     of money in preparation of commencing business.

     The record clearly establishes that petitioners had not yet

opened the restaurant/nightclub facility during 1990 and 1991.

Petitioners were still refurbishing and retrofitting the building

in 1990 and 1991 and otherwise preparing to start their business.
                              - 26 -

No food or entertainment was offered to the public either on the

premises or inside the building during those years.

     B.   1992 and 1993

     Because of the many difficulties petitioners encountered in

financing and completing the renovation of the 5401-9 S. Broadway

property, petitioners were forced to alter their original plans.

They put their plans for the 5-4 Ballroom on hold and decided to

open a “Bluesroom” on part of the building’s first floor.

     Beginning in August 1992, petitioners permitted a few

performances and fundraising events to be held on the 5401-9 S.

Broadway property.   As of that date, however, and continuing

through 1993, petitioners did not yet have any functioning

restaurant or entertainment facility that petitioners operated

for profit.   Any events held on the 5401-9 S. Broadway property

during 1992 and 1993 were organized by volunteers who collected

admission fees and used the admission fees to offset the cost of

the event and to pay the performer.    Petitioners did not retain

any of the receipts from the events and charged no rent for the

use of the property.   Petitioners viewed these events as

opportunities to promote the Bluesroom and to solicit investors

who might be willing to invest funds to complete the renovation

of the property.

     During 1992 and 1993, petitioners did not maintain any

general ledger, cash receipts and disbursements journals, or
                              - 27 -

business checking account for their alleged restaurant/nightclub

activity.   Petitioners did not report any of the receipts from

admissions, the sale of food and beverages, or paid memberships

as income on their Schedules C for 1992 and 1993.   Indeed, in

1991, litigation with South Coast Thrift had ensued, and

petitioners commenced a proceeding under chapter 11 of the

Bankruptcy Code with the Bankruptcy Court on March 18, 1992.

Petitioner did not begin operating the Bluesroom as a commercial

entertainment facility until October 28, 1994, shortly after

reaching a settlement with South Coast Thrift.

     In Richmond Television Corp. v. United States, 345 F.2d 901,

907 (4th Cir. 1965), vacated per curiam on other grounds 382 U.S.

68 (1965), the Court of Appeals for the Fourth Circuit explained

that a trade or business within the meaning of section 162(a) is

one that “has begun to function as a going concern and performed

those activities for which it was organized.”    In Walsh v.

Commissioner, T.C. Memo. 1988-242, affd. without published

opinion 884 F.2d 1393 (6th Cir. 1989), we quoted the above-cited

language in support of our conclusion that the taxpayer’s

restaurant “could not function as a going concern until its

opening to the public.”   Since the restaurant did not open to the

public until a later year, we held that the taxpayer in Walsh was

not carrying on a trade or business in the year before its public

opening.
                              - 28 -

     Although petitioners permitted the 5401-9 S. Broadway

property to be used for certain events during 1992 and 1993, we

nevertheless conclude, based on our review of all the relevant

facts and circumstances, that petitioners did not actually

operate a restaurant/nightclub facility for profit during those

years.9   Consequently, we hold that the Schedule C deductions at

issue in this case, including those that gave rise to the

contested NOLs, were not incurred by petitioners in carrying on

an existing Schedule C trade or business and, therefore, are not

deductible under section 162(a).10

III. Capitalization of Production Costs Under Section 263A

     Respondent contends that, even if we concluded that

petitioners operated a restaurant and nightclub during 1992 and

1993, section 263A required petitioners to capitalize those

expenses they deducted on their Schedules C and E for 1990

through 1993 that qualify as production costs under section 263A.

Petitioners contend, however, that respondent did not determine



     9
      In addition, expenses relating to the startup of a
business that are incurred before that new business is
functioning are not deductible under either sec. 162 or 212.
Sec. 195; Hardy v. Commissioner, 93 T.C. 684, 687-693 (1989).
     10
      On brief, respondent concedes that, if and to the extent
petitioners’ claimed 1992 and 1993 Schedule C expenses are
substantiated, 25 percent of such “Schedule C expenses” are
allocable to the portion of the 5401-9 S. Broadway building used
by petitioner for rental purposes and may be deducted as Schedule
E expenses by petitioners under sec. 212, subject to the passive
loss limitation of sec. 469.
                               - 29 -

the expenses in question must be capitalized under section 263A

in the notices of deficiency and that we should reject

respondent’s belated attempt to raise section 263A under these

circumstances.   Petitioners do not explicitly contend that

respondent’s argument is a new matter on which respondent bears

the burden of proof.   See, e.g., Abatti v. Commissioner, 644 F.2d

1385 (9th Cir. 1981), revg. T.C. Memo. 1978-392; Shea v.

Commissioner, 112 T.C. 183 (1999).      Rather, petitioners seem to

focus on whether respondent’s delay in relying upon section 263A

is unfair and prejudicial to petitioners.     Nevertheless, because

petitioners represented themselves in these proceedings without

benefit of counsel and because we conclude petitioners implicitly

alleged that respondent’s section 263A argument was a new matter,

we shall address both petitioners’ explicit and implicit

arguments, just as respondent did in his posttrial briefs.

     A.   Respondent’s Delay in Relying Upon Section 263A

     The notices of deficiency for 1992 and 1993 employed broad

language in disallowing petitioners’ claimed Schedules C and E

expenses and NOL deductions and do not specifically mention

section 263A.    Petitioners, however, cannot complain that they

were unfairly surprised and prejudiced by respondent’s assertion

of, and reliance upon, section 263A.     Petitioners’ accountant

testified that respondent’s counsel had raised the application of

section 263A in this case at least 1 year before trial during a
                                - 30 -

meeting with petitioner and the accountant.      Respondent also

discussed section 263A in the trial memorandum he submitted

before trial.   Moreover, petitioners were not prejudiced by

respondent’s section 263A argument.      Accordingly, we shall not

bar respondent from relying upon section 263A.      Stewart v.

Commissioner, 714 F.2d 977, 985-987 (9th Cir. 1983), affg. T.C.

Memo. 1982-209; see also Achiro v. Commissioner, 77 T.C. 881, 891

(1981).

     B.   New Matter and Burden of Proof

     Section 752211 requires the Commissioner to issue a notice

of deficiency that contains a description of the basis for the

Commissioner’s determination.    In this case, respondent issued

two notices of deficiency.

     The first notice of deficiency, issued with respect to 1993,

described respondent’s basis for disallowing petitioners’

Schedule C expenses as follows:

     It is determined that schedule C expenses are $0.00
     rather than $29,254.00 for the taxable year 1993.
     Since your restaurant business was not in operation in
     the taxable year, all otherwise allowable expenses are
     start up expenses which must be amortized over not less
     than 60 months starting in the month that the
     restaurant is open for business. Further, it has not
     been established that any amount represents an ordinary
     and necessary business expense or was expended for the
     purpose designated.




     11
      Sec. 7522 applies to notices of deficiency issued after
Jan. 1, 1990.
                               - 31 -

The notice also described respondent’s basis for disallowing the

NOL carryforward as follows:

     It is determined that the net operating loss
     carryforward from the taxable year 1992 is $0 rather
     than $57,518 for the taxable year 1993. It has not
     been established that any deductible net loss was
     incurred or was available for carryforward to the
     taxable year 1993.

     The second notice of deficiency, issued with respect to

1992, described respondent’s basis for disallowing petitioners’

Schedule C expenses as follows:

     Since you did not establish that the business expense
     shown on your tax return was paid or incurred during
     the taxable year and that the expense was ordinary and
     necessary to your business, we have disallowed the
     amount shown.

The notice also described respondent’s basis for disallowing

petitioners’ NOL carryforward-–“Since you did not establish that

the amount shown [$92,611] was (a) a loss, and (b) sustained by

you, it is not deductible.”

     Neither notice of deficiency specifically mentions section

263A.    Petitioners implicitly argue that respondent’s belated

attempt to rely on section 263A amounts, in effect, to the

raising of a new matter on which respondent bears the burden of

proof.    See Rule 142(a) (“The burden of proof shall be upon the

petitioner, except as otherwise provided by statute or determined

by the Court; and except that, in respect of any new matter,

* * * it shall be upon the respondent.”).
                              - 32 -

     In Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507

(1989), we distinguished a new theory offered in support of a

proposed deficiency from a new matter requiring a shift in the

burden of proof as follows:

          A new theory that is presented to sustain a
     deficiency is treated as a new matter when it either
     alters the original deficiency or requires the
     presentation of different evidence. Colonnade
     Condominium, Inc. v. Commissioner, 91 T.C. 793, 795 n.
     3 (1988); Achiro v. Commissioner, 77 T.C. 881, 890-891
     (1981). A new theory which merely clarifies or
     develops the original determination is not a new matter
     in respect of which respondent bears the burden of
     proof. Achiro v. Commissioner, supra at 890; Estate of
     Jayne v. Commissioner, 61 T.C. 744, 748-749 (1974);
     McSpadden v. Commissioner, 50 T.C. 478, 492-493 (1968).

See also Shea v. Commissioner, supra at 191.   Citing this

language, respondent contends that his section 263A argument is

covered by the notices of deficiency and is merely a new theory,

not a new matter.12   Respondent also contends that (1) even if

his section 263A argument raises a new matter, the argument does

not require the presentation of evidence different from that

required for the issues raised in the notices, but that (2) even

if his section 263A argument requires the presentation of



     12
      In each of the notices of deficiency, respondent asserted
that petitioners had failed to establish that they had incurred
or sustained the NOL in question and disallowed the NOL
carryforward in its entirety. Respondent claims that “This
position is consistent with the argument that petitioners’ 1990
and 1991 expenses, being subject to capitalization under section
263A, do not produce a deductible loss that may be carried
forward. The section 263A argument merely clarifies the reason
the net operating loss had not been established.”
                              - 33 -

different evidence, the necessary evidence is a part of the

record in this case, and he has met his burden of proof regarding

the section 263A issue.

     Because we believe that the record is sufficient to decide

the section 263A issue regardless of which party bears the burden

of proof and that petitioners are not subjected to unfair

surprise or prejudice by the introduction of that issue, we

proceed to consider respondent’s section 263A argument on the

merits.

     C. Application of Section 263A

     Section 263A was enacted as part of the Tax Reform Act of

1986 (TRA 1986), Pub. L. 99-514, sec. 803(a), 100 Stat. 2350, and

is generally effective for costs incurred after December 31,

1986, in taxable years ending after December 31, 1986.   TRA 1986

sec. 803(d)(1), 100 Stat. 2356.   In enacting section 263A,

Congress intended that a single, comprehensive set of rules

generally should govern the capitalization of costs, including

interest expenses, of producing, acquiring, and holding property

in order to more accurately reflect income and make the tax

system more neutral.   Suzy’s Zoo v. Commissioner, 273 F.3d 875,

879 (9th Cir. 2001), affg. 114 T.C. 1 (2000); S. Rept. 99-313 at

140 (1986), 1986-3 C.B. (Vol. 3) 1, 140.   The term “produce” has

been construed broadly in order to give effect to legislative
                               - 34 -

intent.13   E.g., Suzy’s Zoo v. Commissioner, supra at 879-880

(taxpayer was “producer” of greeting cards manufactured by third

party contractors); Von-Lusk v. Commissioner, 104 T.C. 207, 214-

216 (1995) (taxpayer’s costs of meetings with governmental

officials, obtaining building permits, and drafting architectural

plans were development costs amounting to “production”).    Whether

an expenditure is deductible or must be capitalized is a question

of fact.    INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 86 (1992).

     Section 263A14 provides that a taxpayer’s direct and

indirect costs (including taxes) of producing real property for

use in a trade or business or activity conducted for profit must

be capitalized.   Sec. 263A(a)(1)(B) and (2), (b)(2) and (c)(1);

sec. 1.263A-1T(a)(6)(i) and (b)(1) and (2)(i), (ii), and (iii),

Temporary Income Tax Regs., 52 Fed. Reg. 10061, 10062 (Mar. 30,



     13
      In general, sec. 263A(g)(1) defines the term “produce” to
include “construct, build, install, manufacture, develop, or
improve.”
     14
      Temporary regulations under sec. 263A were issued in 1987.
Final regulations under sec. 263A were issued in 1993 and 1994.
These final regulations generally were made effective for costs
incurred in taxable years beginning after Dec. 31, 1993, and
interest incurred in taxable years beginning after Dec. 31, 1994.
Secs. 1.263A-1(a)(2)(i), 1.263A-15(a)(1), Income Tax Regs. For
costs or interest incurred in taxable years to which the final
regulations are not applicable, taxpayers must take reasonable
positions on their returns in applying section 263A. A
“reasonable position” is a position consistent with the temporary
regulations, revenue rulings, revenue procedures, notices, and
announcements concerning sec. 263A applicable in taxable years
beginning before the effective date of the final regulations.
Secs. 1.263A-1(a)(2)(ii), 1.263A-15(a)(2), Income Tax Regs.
                                - 35 -

1987); sec. 1.263A-1T(b)(2)(iii)(I), Temporary Income Tax Regs.,

52 Fed. Reg. 29378 (Aug. 7, 1987).       The production of real

property includes the rehabilitation or improvement of an

existing building.    Sec. 263A(g)(1); sec. 1.263A-1T(a)(5)(ii),

Temporary Income Tax Regs., 52 Fed. Reg. 10061 (Mar. 30, 1987);

S. Rept. 99-313, supra at 143, 1986-3 C.B. (Vol. 3) at 143;

Notice 88-99, 1988-2 C.B. 422.

            (1)   Interest Expense

     Interest paid or incurred during the production period of

real property must be capitalized under the special rules of

section 263A(f).     Sec. 263A(f)(1)(A) and (B)(i), (4)(A)(i).    The

interest to be capitalized includes (1) interest on any

indebtedness directly attributable to production expenditures

with respect to the real property, and (2) interest on any other

indebtedness to the extent that the taxpayer’s interest costs

could have been reduced if production expenditures had not been

incurred.    Sec. 263A(f)(2); sec. 1.263A-1T(b)(2)(iv)(A) and (B),

Temporary Income Tax Regs., 52 Fed. Reg. 10063 (Mar. 30, 1987).

The production period covers the period (1) beginning on the date

on which production of the real property begins and (2) ending on

the date on which the real property is ready to be placed in

service.    Sec. 263A(f)(4)(B); sec. 1.263A-1T(b)(2)(iv)(A),

Temporary Income Tax Regs.
                                - 36 -

     Petitioners deducted interest on the South Coast Thrift loan

on their Schedules C for 1990 and 1991 in the amounts of $116,121

and $43,276, respectively.   Petitioners appear to contend that

the South Coast Thrift loan was a general business loan obtained

to start a new business and was not a construction loan governed

by the interest capitalization rules of section 263A(f).     The

record in this case suggests otherwise.     Regardless of which

party bears the burden of proof with respect to section 263A, we

have found as a fact that the South Coast Thrift loan was a

construction loan taken out by petitioners to finance the

retrofitting and renovation of their 5401-9 S. Broadway property

and that the interest deducted by petitioners for 1990 and 1991

was attributable to that loan.15   Under section 263A(f), because

the interest attributable to the South Coast Thrift loan was paid

to prepare the 5401-9 S. Broadway property to be placed in

service in a trade or business or in an activity for profit,

except to the extent allowed by respondent’s concession,16 the

interest must be capitalized.    Sec. 263A(f)(1).

          (2)   Other Schedule C Expenses

     On Schedule C of their 1990 tax return, petitioners deducted


     15
      Petitioners did not deduct any interest attributable to
the South Coast Thrift loan on their Schedules C or E for 1992
and 1993.
     16
      See supra note 2. Respondent also conceded that 6 percent
of the building was available for rent and placed in service as
rental property during 1989 and 1990.
                               - 37 -

insurance, utilities, and lease expenses in connection with the

5-4 Ballroom/Supper Club.   Although respondent in his posttrial

brief points out that petitioners offered no explanation of these

expenses, respondent also states that “common sense dictates the

conclusion that petitioner had to maintain utilities, provide

liability and fire insurance and rent equipment as a consequence

of [petitioner’s] rehabilitation activities.”   Respondent also

acknowledged that “property taxes relate to the ownership of the

building”, but asserts that petitioners failed to prove what

portion of the tax and licenses expense represented property

taxes.    Respondent nevertheless does not argue that petitioners’

Schedule C expenses must be disallowed for lack of

substantiation; rather, respondent argues only that “the expenses

for insurance, utilities, lease expense and taxes and licenses,

to the extent not allocable to rental activity,[17]will have to be

capitalized” as indirect costs of production under section 263A.

     Respondent takes a similar position with respect to the

expenses petitioners claimed on their 1991 Schedule C, arguing

only that the expenses are indirect costs of production under


     17
      To the extent the expenses are allocable to petitioners’
rental activity, respondent acknowledges that the expenses may be
deductible under sec. 212(2). Thomason v. Commissioner, T.C.
Memo. 1997-480. However, respondent notes that, for 1990 and
1991, petitioners already deducted the maximum Schedule E losses
permitted by the passive loss limitation of sec. 469, and,
therefore, allowing any part of petitioners’ Schedule C expenses
to be deducted on Schedule E will not produce any additional
deductible losses in 1990 and 1991.
                               - 38 -

section 263A and must be capitalized.   The only years for which

respondent argues that petitioners failed to adequately

substantiate their Schedule C expenses are 1992 and 1993.    We

address respondent’s substantiation argument in part V.A.3. of

this opinion.   In this part of the opinion, we focus only on

whether petitioners must capitalize their noninterest Schedule C

expenses under section 263A.

     Regardless of which party bears the burden of proof on the

section 263A issue, the evidence shows that petitioners were

engaged during the years 1990 through and including 1993 in the

rehabilitation, renovation, and retrofitting of the 5401-9 S.

Broadway property.   The evidence also shows: (1) The production

period with respect to that part of the property intended for use

as a restaurant/nightclub facility began in approximately 1987

and continued through at least 1993; (2) as of August 1992,

petitioners lacked sufficient funds to complete the retrofitting

and renovation of the restaurant/nightclub facility; (3)

petitioners did not operate either a nightclub facility or a

restaurant for profit at any time during 1992 or 1993; and (4)

any expenses petitioners substantiated and deducted on their

Schedules C for 1990, 1991, 1992, and 1993, with the exception of

those properly allocable to petitioners’ Schedule E rental

activity, were attributable to petitioners’ efforts to retrofit

and renovate the 5401-9 S. Broadway property for use as an
                                - 39 -

entertainment facility.

      We hold, therefore, that section 263A requires petitioners

to capitalize the expenses they incurred in retrofitting and

renovating the 5401 S. Broadway property during the years 1990,

1991, 1992, and 1993, which they deducted on their respective

income tax returns, except to the extent we conclude that certain

expenses are allocable to petitioners’ Schedule E rental activity

or were not substantiated.

IV.   Petitioners’ 1992 and 1993 Depreciation Deductions

      Section 167 generally allows as a depreciation deduction a

reasonable allowance for the exhaustion, and wear and tear of

property used in the trade or business, or property held for the

production of income.     The period for depreciation of an asset

begins when the asset is placed in service and ends when the

asset is retired from service.     Sec. 1.167(a)-10(b), Income Tax

Regs.   An asset subject to depreciation is placed in service

“when first placed in a condition or state of readiness and

availability for a specially assigned function”.     Sec. 1.167(a)-

11(e)(1)(i), Income Tax Regs.     As a general rule, an asset “is

clearly considered as placed in service when it is acquired and

put into use” in a trade or business or income-producing

activity.   Piggly Wiggly S., Inc. v. Commissioner, 84 T.C. 739,

746-748 (1985), affd. on another issue 803 F.2d 1572 (11th Cir.

1986); see also Simonson v. United States, 752 F.2d 341, 342-343
                              - 40 -

(8th Cir. 1985).   Depreciation is not allowed on an asset

acquired for a business that has not yet begun operations.

Piggly Wiggly S., Inc. v. Commissioner, supra at 745.

     A. 5401-9 S. Broadway Property Depreciation Expenses

     The 5401-9 S. Broadway property building has a total floor

area of approximately 27,000 square feet, or 13,500 square feet

per floor.   For 1992 and 1993, petitioners’ accountant calculated

depreciation deductions with respect to the entire building.      The

parties, however, have stipulated for purposes of this case that,

from 1990 through 1993, the second floor of the building was

still under construction and that no business or rental activity

was conducted there during 1992 and 1993.

     Although petitioners contend that the entire first floor at

one time had been held out by petitioner for rent, by the end of

1990, petitioner had decided to convert and use a space of

approximately 6,000 square foot as a Bluesroom.    Neither the

Bluesroom nor the 5-4 Ballroom was used by petitioners in a

Schedule C trade or business or in a Schedule E rental activity

during 1992 or 1993.

     Respondent concedes that 25 percent of the building was used

for rental purposes during 1991, 1992, and 1993.    We consider

respondent’s estimate of the portion of the building petitioner

used for rental purposes to be reasonable.   Together, the 5-4

Ballroom and the Bluesroom (which petitioner had removed from
                                - 41 -

rental use) represent just over 72 percent of the building’s

total floor area (13,500 square feet plus 6,000 square feet, all

divided by 27,000 square feet).       Some use of the first floor

common areas and restroom facilities in connection with the

Bluesroom must also be taken into account.       Petitioners have

failed to show that more than 25 percent of the building was used

for rental purposes.    We hold, therefore, that petitioners,

subject to the passive loss restriction of section 469, are

entitled to deduct depreciation expenses for 1992 and 1993 under

section 167 with respect to only 25 percent of the building.

     B. 5415 S. Broadway Property Depreciation Expenses

     Petitioners failed to introduce evidence regarding their

alleged rental activity at the 5415 S. Broadway property.

Petitioners also failed to describe the nature and type of

property that they held and were depreciating.       Consequently, we

sustain respondent’s determinations, in the notices of

deficiency, disallowing the Schedule E depreciation expenses

petitioners claimed with respect to the 5415 S. Broadway property

for 1992 and 1993.     Rule 142(a).

V.   Substantiation of Petitioners’ Other Schedules C and E
     Expenses For 1992 and 1993

     A. 5401-9 S. Broadway Property

          1. Gardening/Repairs and Maintenance Expenses

     On their Schedule E for 1992, petitioners deducted $475 of

gardening expense and did not claim any expenses for repairs and
                               - 42 -

maintenance.    On their Schedule E for 1993, petitioners did not

claim any expenses for gardening, or repairs and maintenance.

However, on their Schedules C for 1992 and 1993, petitioners

deducted repairs and maintenance expenses of $2,700 and $4,964

respectively.

     At trial, the parties stipulated the admissibility of a

written statement from Billy Diamond, who confirmed that he was

paid $3,400 annually from 1992 through 1994 to perform general

maintenance and repair work and to water plants.    We find facts

accordingly.    As limited by respondent’s concession, we hold that

petitioners are entitled to deduct the amounts paid to Mr.

Diamond for 1992 and 1993, subject to the passive loss limitation

of section 469.

            2. Schedule E Legal Expense

     On their Schedule E for 1993, petitioners reported barter

income of $18,000 and a corresponding deduction of $18,000 for

the value of legal services furnished to them in lieu of rent.

On brief, respondent notes that, although the notice of

deficiency for 1993 allowed a deduction for only 6 percent of the

$18,000 legal expense that petitioners claimed on Schedule E, no

adjustment was made to the corresponding $18,000 of rental income

petitioner reported under his barter arrangement with that same

attorney.    Respondent now concedes that, if and to the extent we

find the legal services the attorney performed were worth
                               - 43 -

$18,000, petitioners are entitled to deduct this legal expense,

subject to the passive loss limitation of section 469.

       The attorney testified that she represented petitioner on

numerous legal matters, including in the South Coast Thrift loan

litigation.    We find that petitioners reasonably estimated the

value of the legal services attributable to petitioners’ rental

activity to be $18,000.    We hold that, as limited by respondent’s

concession, petitioners are entitled to deduct this legal expense

of $18,000, subject to the passive loss limitation of section

469.

            3. Other Schedule C Expenses

       Petitioners contend their accountant, at some point,

possessed receipts and other documents fully substantiating all

their 1992 and 1993 Schedule C expense deductions.    However,

neither petitioners nor their accountant introduced documentation

or testimony at trial to substantiate many of the deductions

claimed.    For example, no checks for property tax payments were

introduced, even though the accountant testified that he, at one

time, had the canceled checks.    The only other documents

introduced in evidence to document petitioners’ Schedule C

expenses were a letter from Heitz Insurance Agency documenting

some, but not all, of the insurance expenses deducted for 1993,

two invoices from Pickney Electric Co., which were partly

illegible but appeared to relate to electrical work done as part
                             - 44 -

of the renovation of the 5-4 Ballroom, a letter from Joan M.

Miller, confirming petitioners’ payment of $5,888 of chapter 11

bankruptcy costs in 1993,18 and a statement from Rafael Rosario

acknowledging that he was paid $3,000 for “carpentry, painting,

and electrical work” at the 5401-9 S. Broadway property.       Neither

petitioners nor their accountant offered any satisfactory

explanation as to why additional documentation was not provided.

     Although petitioners did not introduce substantiation to

fully document all the Schedule C expenses they claimed for 1992

and 1993, petitioners did substantiate some expenses.     In

addition, we are convinced from our review of all the evidence

that petitioners incurred and paid at least some of the claimed

expenses for which documentation has not been provided.

Unfortunately, with respect to most of the undocumented expenses,

petitioners did not provide any factual record from which we

might estimate the expenses they paid.   See Vanicek v.

Commissioner, 85 T.C. 731, 743 (1985).   Therefore, using our best

judgment and bearing heavily against petitioners because this

inexactitude is of their own making, Cohan v. Commissioner, 39

F.2d 540, 543-544 (2d Cir. 1930), we find that the following

expenses have either been documented or are allowable under Cohan

with respect to the 5401-9 S. Broadway property as follows:



     18
      Petitioners did not offer any explanation of why they
claimed the bankruptcy costs were deductible.
                                 - 45 -

            (1)   1992

                                             Allowed
 Expense          Claimed      Documented   per Cohan   Disallowed
Insurance         $9,200          -0-       $6,140       $3,060
Legal/prof.        1,400          -0-         -0-         1,400
Repairs            2,700          -0-          -0-         2,700
Taxes/
licenses           4,837          -0-         4,837         -0-

            (2)   1993

                                             Allowed
  Expense         Claimed      Documented   per Cohan   Disallowed
Insurance         $11,200        $6,140       -0-        $5,060
Legal/prof.         5,000          -0-        -0-         5,000
Repairs             4,964          -0-        -0-         4,964
Taxes/
licenses            4,191          -0-      $4,191         -0-
Utilities                271       -0-         271         -0-
Alarm sys.               300       -0-        -0-           300
Appraisals          3,000          -0-        -0-         3,000
Locksmith                 53       -0-        -0-            53
Permits                  275       -0-        -0-           275

Consistent with respondent’s concession, we hold that 25 percent

of the allowable Schedule C expenses is allocable to petitioner’s

rental activity with respect to the 5401-9 S. Broadway property

and is deductible as Schedule E expenses pursuant to section

212(2), subject to the passive loss limitation of section 469.
                               - 46 -

      B. 5415 S. Broadway Property

      As indicated previously, petitioners offered almost no

evidence concerning their purported rental activity involving the

5415 S. Broadway property.   In addition, petitioners failed to

substantiate certain rental expenses that respondent had

disallowed.   Consequently, we sustain respondent’s determinations

for 1992 and 1993 with respect to that property.    Rule 142(a)(1).

      C. Prior Year Disallowed Passive Losses

      Petitioners have failed to establish that they are entitled

to deduct prior year unallowed passive losses of $1,345.

Consequently, we sustain respondent’s determination disallowing

their deduction for 1993 of prior year passive losses.    Rule

142(a).

VI.   1992 and 1993 NOL Deductions

      Petitioners claimed NOL deductions for 1992 and 1993 on the

basis of certain NOL carryforwards that petitioners had computed

from 1990 and 1991.   The 1990 and 1991 NOL carryforwards they had

computed arose from Schedule C expenses they deducted with

respect to their purported nightclub/restaurant business at the

5401-9 S. Broadway property.   As discussed supra in part II,

petitioners had not opened and did not operate any restaurant or

nightclub on the property during 1990 and 1991.    In addition,

nearly all the 1990 and 1991 Schedule C expenses were direct and

indirect costs of producing petitioner’s nightclub/restaurant
                               - 47 -

property, which must be capitalized under section 263A.    Because

petitioners did not incur the NOLs they had reported for 1990 and

1991, we hold that petitioners are not entitled to claim NOL

carryforward deductions for 1992 and 1993.

VII. Accuracy-related Penalties

     Respondent determined that petitioners were liable for

accuracy-related penalties under section 6662(a) and (b)(1), for

1992 and 1993, for negligence with respect to their entire

underpayment for each year.

     Negligence is defined as any failure to make a reasonable

attempt to comply with the provisions of the Internal Revenue

Code.   Sec. 6662(c).   However, section 6664(c)(1) provides that a

penalty under section 6662 will not be imposed on any portion of

an underpayment if the taxpayer shows reasonable cause for such

portion of the underpayment and that the taxpayer acted in good

faith with respect to such portion.     Reliance on the advice of a

professional, such as a certified public accountant, may

constitute a showing of reasonable cause if, under all the facts

and circumstances, such reliance is reasonable and the taxpayer

acted in good faith.    Henry v. Commissioner, 170 F.3d 1217, 1219-

1223 (9th Cir. 1999), affg. in part and revg. in part T.C. Memo.

1997-29; Betson v. Commissioner, 802 F.2d 365, 372 (9th Cir.

1986), affg. in part and revg. in part T.C. Memo. 1984-264; sec.

1.6664-4(b)(1), (c), Income Tax Regs.    To prove reasonable cause,
                               - 48 -

a taxpayer must show that he reasonably relied in good faith upon

a qualified adviser after full disclosure of all necessary and

relevant facts.    Collins v. Commissioner, 857 F.2d 1383, 1386,

(9th Cir. 1988), affg. Dister v. Commissioner, T.C. Memo. 1987-

217; sec. 1.6664-4(b)(1), Income Tax Regs.

     Applying these principles to this case, we conclude that

petitioners have sustained their burden of establishing that they

had reasonable cause for: (1) Their claimed 1992 and 1993

Schedule C deductions from the 5401-9 S. Broadway property; (2)

their claimed 1992 and 1993 Schedule E deductions from that

property; and (3) their claimed NOL deductions for 1992 and 1993.

Petitioners engaged the services of William D. Collins, C.P.A.,

to prepare their 1992 and 1993 income tax returns.    Mr. Collins

had prepared petitioners’ returns since 1968 and was familiar

with petitioner’s activities involving the 5401-9 S. Broadway

property.    Petitioners provided Mr. Collins with all the

information relevant to the proper tax treatment of the foregoing

items.

     Mr. Collins testified that, around 1987, a fictitious

business name statement was filed for the “5-4 Louisiana

Creole/Cajun Restaurant” that petitioner planned to operate at

the 5401-9 S. Broadway property, and petitioners obtained an SBA

loan.    Mr. Collins also testified that, after petitioners

received the SBA loan in 1987, he concluded that the interest
                                 - 49 -

expense from the SBA loan and later for the South Coast Thrift

loan should be reported and deducted on Schedule C to

petitioners’ tax return because the SBA and South Coast Thrift

loans were “business loans”.     Mr. Collins concluded that

petitioner commenced conducting an active business at the 5401-9

S. Broadway property during 1992 because the property was used

for performances and events.     Mr. Collins also concluded that

section 263A was not applicable to petitioner’s “fixing up” of

the building prior to 1992.    In preparing petitioners’ 1990

through 1993 returns, Mr. Collins concluded section 195 permitted

petitioners to deduct currently the interest, real property

taxes, and other expenses petitioners paid with respect to the

5401-9 S. Broadway property.19

     The characterization of various costs relating to

petitioner’s rehabilitation and improvement of the 5401-9 S.

Broadway building as deductible Schedule C expenses involves

analyzing and applying a technical area of tax law.     Thus, it is

reasonable for a taxpayer to consult and rely on a certified

public accountant in determining how to treat such costs.

Petitioners relied upon Mr. Collins, their certified public

accountant, to determine the proper characterization and

deduction of these costs, and they furnished information to Mr.


     19
      Under sec. 195(c), interest, taxes and certain research
and experimental expenditures are excluded from the definition of
startup expenditures.
                              - 50 -

Collins to enable him to do so.   We find that petitioners’

reliance upon Mr. Collins, who characterized the costs incurred

for 1990 through 1993 in renovating 5401-9 S. Broadway as

Schedule C deductions, was reasonable.   We hold that petitioners

are not liable for section 6662(a) accuracy-related penalties for

1992 and 1993 with respect to that part of the underpayments

attributable to the deduction of these costs as Schedule C

expenses.   See Test v. Commissioner, T.C. Memo. 2000-362; Koenig

v. Commissioner, T.C. Memo. 1998-215, affd. without published

opinion 221 F.3d 1348 (9th Cir. 2000).

     Similarly, in computing petitioners’ NOL carryover from

1990, Mr. Collins misapplied and misinterpreted section 172(b).

Mr. Collins carried forward the entire 1990 NOL, without having

petitioners elect to relinquish the carryback period, because he

misunderstood the NOL carryback rules.   Cf. sec. 172(b)(3)(C);

Young v. Commissioner, 83 T.C. 831, 840-842 (1984) (holding

taxpayer failed to make a timely election to relinquish the 3-

year carryback period), affd. 783 F.2d 1201, 1204-1207 (5th Cir.

1986); Diesel Performance, Inc. v. Commissioner, T.C. Memo. 1999-

302 (same), affd. 16 Fed. Appx. 718 (9th Cir. 2001).   Petitioners

clearly relied upon Mr. Collins to compute properly their NOL

carryover from 1990.   We find that petitioners’ reliance on Mr.

Collins was reasonable, and we hold that petitioners are not

liable for a section 6662(a) accuracy-related penalty for 1992
                              - 51 -

with respect to that part of the underpayment resulting from

respondent’s NOL carryforward adjustment.

     As to petitioners’ disallowed 1992 and 1993 depreciation

expenses from the 5401-9 S. Broadway property, the record

reflects that Mr. Collins visited the property many times over

the years, was familiar with the configuration of the building,

and was aware that not all the building was being used for rental

purposes by petitioner during 1992 and 1993.   Nevertheless, Mr.

Collins computed depreciation with respect to 5401-9 S. Broadway

for 1993 and prior years by taking into account the entire

building.   When questioned about this inconsistency, Mr. Collins

explained that the entire property, at one time, had been

available for rental.

     In addition, although some of petitioners’ claimed Schedules

C and E expenses for 1992 and 1993 from the 5401-9 S. Broadway

property were not substantiated at trial, Mr. Collins testified

that petitioners had receipts and documents substantiating all

these claimed expenses.

     We are satisfied that petitioners relied upon their

accountant to compute their annual depreciation expenses and to

decide whether the expenses claimed on their Schedules C and E

from the 5401-9 S. Broadway property were deductible.   In light

of petitioners’ lack of tax training and their attempts to obtain

competent professional help, we are also satisfied that
                              - 52 -

petitioners’ reliance on their accountant was reasonable.    We

hold, therefore, that petitioners are not liable for section

6662(a) accuracy-related penalties for 1992 and 1993 with respect

to that part of the underpayments attributable to the disallowed

depreciation and Schedules C and E expenses claimed with respect

to the 5401-9 S. Broadway property.

     We reach a different conclusion, however, with respect to

the 5415 S. Broadway property.   Petitioners presented scant

information regarding their purported rental activity at the 5415

S. Broadway property, and they did not attempt to substantiate

their Schedule E expenses claimed with respect to that property

for 1992 and 1993.   Petitioners have failed to establish that

they acted reasonably and in good faith in deducting the Schedule

E expenses from that property.   Consequently, we sustain

respondent’s determinations that petitioners are liable for the

section 6662(a) accuracy-related penalties for 1992 and 1993 with

respect to that part of the underpayments attributable to the

disallowed expenses petitioners deducted with respect to the 5415

S. Broadway property.   Rule 142(a).

     Petitioners also failed to prove that they acted reasonably

and in good faith in deducting on their 1993 return a prior year

unallowed passive loss of $1,345.20    Consequently, we sustain


     20
      Petitioners did not offer any evidence to explain the
source of the prior year passive loss or why they claimed they
                                                   (continued...)
                             - 53 -

respondent’s determination that petitioners are liable for the

section 6662(a) accuracy-related penalty for 1993 with respect to

that part of underpayment attributable to their deduction of a

prior year’s unallowed passive loss.   Rule 142(a).

     In light of the foregoing and to reflect concessions made by

the parties,

                                         Decisions will be entered

                                   under Rule 155.




     20
      (...continued)
had reasonable cause for their deduction of the loss. Because
petitioners made no credible attempt to explain the loss, or to
justify their deduction of it, we reject petitioners’ argument
that the penalty should not apply to respondent’s adjustment
disallowing the loss.
