Donald R. Fitch, et ux. v. Commissioner, TC Memo 2012-358 ,
Code Sec(s) 162; 453; 1001; 6662; 7491.
DONALD R. FITCH AND BRENDA T. FITCH, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent .
Case Information:
Code Sec(s):
162; 453; 1001; 6662; 7491
Docket: Docket
Nos. 157-10, 27401-10,
Date Issued:
12/26/2012
OPINION
I. General Rules The Commissioner's determinations are
generally presumed correct, and the taxpayer bears the burden of proving the
determinations erroneous. 8 Rule 142(a);
New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 [13
AFTR 1180] (1934). The taxpayer bears the burden of proving that he or she is
entitled to the deductions claimed, and this includes the burden of
substantiation. Hradesky v. Commissioner, 65 T.C. 87, 90 (1975), aff'd per
curiam, 540 F.2d 821 [38 AFTR 2d 76-5935] (5th Cir. 1976). A taxpayer must
substantiate amounts claimed as deductions by maintaining the records necessary
to establish that he or she is entitled to the deductions. Sec. 6001; sec.
1.6001-1(a), Income Tax Regs.
Taxpayers are allowed a deduction for ordinary and necessary
expenses paid or incurred in carrying on a trade or business. Sec. 162(a).
Whether an expenditure is ordinary and necessary is generally a question of
fact. Commissioner v. Heininger , 320 U.S. 467, 475 [31 AFTR 783] (1943).
Generally, for an expenditure to be an ordinary and necessary business expense,
the taxpayer must show a bona fide business purpose for the expenditure; there
must be a proximate 8
Petitioners have neither claimed nor established that they
satisfy the requirements of sec. 7491(a) for any of the issues remaining for
decision. Accordingly, the burden of proof does not shift to respondent. [*10]
relationship between the expenditure and the business of the taxpayer.
Challenge Mfg. Co. v. Commissioner 37 T.C. 650 (1962); Henry v. Commissioner, ,
36 T.C. 879 (1961). To be “necessary” within the meaning of section 162, an
expense needs to be “appropriate and helpful” to the taxpayer's business. Welch
v. Helvering, 290 U.S. 111, 113 [12 AFTR 1456] (1933). The requirement that an
expense be “ordinary” connotes that “the transaction which gives rise to it
must be of common or frequent occurrence in the type of business involved.”
Deputy v. du Pont, 308 U.S. 488, 495 [23 AFTR 808] (1940) (citing Welch v.
Helvering, 290 U.S. at 114).
When taxpayers establish that they have incurred deductible
expenses but are unable to substantiate the exact amounts, we can estimate the
deductible amount in some circumstances, but only if the taxpayers present
sufficient evidence to establish a rational basis for making the estimate. See
Cohan v. Commissioner, 39 F.2d 540, 543-544 [8 AFTR 10552] (2d Cir. 1930);
Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). In estimating the amount
allowable, we bear heavily against taxpayers whose inexactitude is of their own
making. See Cohan v. Commissioner, 39 F.2d at 544. There must be sufficient
evidence in the record, however, to permit us to conclude that a deductible
expense was paid or incurred. Williams v. United States, 245 F.2d 559, 560 [51
AFTR 594] (5th Cir. 1957). Furthermore, we may not use the Cohan doctrine to
estimate expenses subject to the strict [*11] substantiation requirements of
section 274(d). See Sanford v. Commissioner, 50 T.C. 823, 827 (1968), aff'd,
412 F.2d 201 [24 AFTR 2d 69-5021] (2d Cir. 1969).
II. Amortization of the C.P.A. Practice A taxpayer is
entitled to an amortization deduction with respect to any amortizable section
197 intangible, the amount of which is determined by amortizing the adjusted
basis of the intangible ratably over a 15-year period beginning with the month
in which it was acquired. Sec. 197(a). An amortizable section 197 intangible is
any section 197 intangible 9 acquired by a taxpayer after
August 10, 1993, and held in connection with the conduct of
a trade or business. Sec. 197(c)(1). For purposes of depreciation and
amortization, a taxpayer's basis in purchased property is the cost, including
any valid liabilities incurred in acquiring the property. Crane v.
Commissioner, 331 U.S. 1 [35 AFTR 776] (1947). Petitioners claimed a $900,000
cost basis in the C.P.A. practice as a result of the repurchase transaction,
and they claimed an amortization deduction of $45,000 in each of the years in
issue on their tax return. 10 Respondent principally argues that “the alleged
[*12] sales agreements petitioners submitted are untrustworthy and the alleged
sales did not take place”. Alternatively, respondent argues the sale and
repurchase transactions were rescinded or that petitioners reacquired self-created
intangibles of the C.P.A. practice in a series of related transactions. 11 We
address each of respondent's arguments in turn.
Respondent contends that petitioners presented false
testimony and fabricated documents in an attempt to prove that the transactions
took place. We disagree. We find petitioners' testimony to be credible and
persuasive. See Diaz v. Commissioner, 58 T.C. 560, 564 (1972) (stating that the
process of distilling truth from the testimony of witnesses, whose demeanor we
observe and whose credibility we evaluate, is the daily grist of judicial
life). Furthermore, we find the sale and repurchase agreements to be genuine
and trustworthy. [*13] Respondent attacks the agreements for their brevity,
arguing that they lack “details that would certainly be present on an authentic
sales contract of nearly one million dollars.” 12 However, the circumstances
surrounding the sale and repurchase transactions present a different story. Mr.
Fitch was recovering from an aneurysm at the time he sold the C.P.A. practice
to Mr. Gronke. They had a working relationship dating back to 1996, and they
understood the need to effect a quick sale on account of Mr. Fitch's medical
condition. They put the basic elements of their agreement into writing and left
the details to be sorted out later. Likewise, when Mr. Gronke suffered a
seizure, they signed a similar agreement to effect a quick repurchase. In these
circumstances, we find it hard to believe that a lack of details somehow
suggests the agreements were fabricated. Respondent does not argue that the
sale and repurchase agreements are invalid or unenforceable under State law.
Accordingly, we find that petitioners have proven that the sale and repurchase
transactions actually took place.
Next, respondent argues that the sale and repurchase
transactions were rescinded. Rev. Rul. 80-58, 1980-1 C.B. 181, defines
rescission as “the abrogation, canceling, or voiding of a contract that has the
effect of releasing the [*14] contracting parties from further obligations to
each other and restoring the parties to the relative positions that they would
have occupied had no contract been made.” “For the rescission to be effective,
both buyer and seller must be put back in their original positions.” Hutcheson
v. Commissioner, T.C. Memo. 1996-127 [1996 RIA TC Memo ¶96,127] (citing Rev.
Rul. 80-58, 1980-1 C.B. at 181). “A rescission may be effected by mutual
agreement of the parties, by one of the parties declaring a rescission of the
contract without the consent of the other if sufficient grounds exist, or by
applying to the court for a decree of rescission.” Rev. Rul. 80-58, 1980-1 C.B.
at 181-182.
The repurchase agreement, by its own terms, effected a sale
of the C.P.A. practice from Mr. Gronke to Mr. Fitch and not an unwinding of the
earlier sale. There is no evidence that Mr. Fitch and Mr. Gronke intended to
abrogate, cancel, or void the sale agreement. Furthermore, we do not believe
that the repurchase agreement returned them to their original positions. The
C.P.A. practice continued as a dynamic, ongoing enterprise for approximately
4-1/2 months after the sale transaction, and we cannot say that Mr. Fitch
received the C.P.A. practice back in the exact same condition in which he had
sold it. Accordingly, we find that the sale and repurchase transactions were
not rescinded. [*15] Respondent cursorily cites section 1.197-2(d)(2)(iii)(C),
Income Tax Regs., in support of the position that “no amortization is available
under I.R.C. § 197 for self-created intangibles that are repurchased as part of
a series of related transactions”. Self-created intangibles generally are not
amortizable. Sec. 197(c)(2). However, an exception is provided if a taxpayer
disposes of a self-created intangible and subsequently reacquires the
intangible from a seller (in whose hands the intangible is amortizable) in an
unrelated transaction. Sec. 1.197- 2(d)(2)(iii)(C), Income Tax Regs.
Almost all of the intangibles that Mr. Fitch reacquired in
the repurchase transaction were originally created by him. The issue therefore
turns on whether the sale and repurchase transactions were related
transactions. We find that the transactions were impelled by separate business
exigencies, namely Mr. Fitch's anuerysm and Mr. Gronke's seizure. It is hard to
believe these medical conditions could have been predicted or the transactions
necessitated by them preplanned. We find that the sale and repurchase
transactions are not related transactions, and therefore the rules generally
disallowing the amortization of self-created intangibles do not apply. 13 [*16]
Accordingly, petitioners are entitled to an amortization deduction of $60,000
for each of the years in issue.
III. Deductibility of the Rental Real Estate Losses
A. The E Street Property
Section 212 allows as a deduction all the ordinary and
necessary expenses paid during the year for the production or collection of
income, sec. 212(1), or for the management, conservation, or maintenance of
property “held for the production of income”, sec. 212(2). Section 167(a)(2)
allows as a deduction a reasonable allowance for depreciation of property “held
for the production of income.” The phrase “held for the production of income”
has the same meaning in section 212 and section 167. Mitchell v. Commissioner,
47 T.C. 120, 129 (1966). Expenses and depreciation may be deducted only if the
property is held for production of income during the taxable year at issue.
Meredith v. Commissioner, 65 T.C. 34, 41 (1975). Section 1.212-1(b), Income Tax
Regs., provides: “ordinary and necessary expenses paid or incurred in the
management, conservation, or maintenance of a building devoted to rental
purposes are deductible notwithstanding that there is actually no income
therefrom in the taxable year, and regardless of the manner in which or the
purpose for which the property in question was acquired.” Furthermore, expenses
paid or incurred in [*17] connection with investment property may be deductible
under this regulation, “even though the property is not currently productive
and there is no likelihood that the property will be sold at a profit or will
otherwise be productive of income and even though the property is held merely
to minimize a loss with respect thereto.” Sec. 1.212-1(b), Income Tax Regs.
Whether property is held for the production of income is a question of fact to
be determined from all the facts and circumstances. Johnson v. Commissioner, 59
T.C. 791 (1973), aff'd, 495 F.2d 1079 [33 AFTR 2d 74-1102] (6th Cir. 1974).
Mr. Fitch and his two brothers each inherited a one-third
interest in the E Street property in early 2005 when their mother passed away.
They immediately tried to sell the property but did not receive a satisfactory
offer. Toward the end of 2005 Mr. Fitch purchased an additional one-third
interest from one of his brothers and as of the time of trial owned a
two-thirds tenancy in common with his other brother.
While Mr. Fitch did not succeed in renting the E Street
property in 2005 to 2007, we find that he held the property for the production
of income. 14 He credibly testified that he intended to make the property into
a rental when he [*18] purchased the one-third interest from his brother. To that
effect, he posted a “for rent” sign on the property, placed an advertisement on
Craigslist, and secured bids with insurance companies for a landlord protection
policy. He further credibly testified that he performed property management
services at least weekly in 2005 and continued performing those services in
2006 and 2007. Accordingly, he incurred expenses for the management,
conservation, or maintenance of property held for the production of income, and
he is entitled to deduct those expenses under section 212.
B. Passive Activity Loss Limitation Rules
Deductions for certain business and investment expenses
pursuant to sections 162 and 212 may be limited under section 469, which
generally disallows any passive activity loss for the tax year. A passive
activity is any trade or business in which the taxpayer does not materially
participate. Sec. 469(c)(1). A passive activity loss is defined as the excess
of the aggregate losses from all passive activities for the year over the
aggregate income from all passive activities for such year. Sec. 469(d)(1). A
rental activity is generally treated as a per se [*19] passive activity
regardless of whether the taxpayer materially participates. 15 Sec. 469(c)(2).
Pursuant to section 469(c)(7), the rental activities of a
taxpayer who is in the real property business (real estate professional) are
not per se passive activities but are treated as a trade or business subject to
the material participation requirements of section 469(c)(1). Sec.
1.469-9(e)(1), Income Tax Regs. A taxpayer qualifies as a real estate
professional and is not engaged in a passive activity under section 469(c)(2)
if:
(i) more than one-half of the personal services performed in
trades or businesses by the taxpayer during such taxable year are performed in
real property trades or businesses in which the taxpayer materially
participates, and
(ii) such taxpayer performs more than 750 hours of services
during the taxable year in real property trades or businesses in which the
taxpayer materially participates. Sec. 469(c)(7)(B). A real property trade or
business is defined in section 469(c)(7)(C) as “any real property development,
redevelopment, construction, reconstruction, acquisition, conversion, rental,
operation, management, leasing, or brokerage trade or business.” In the case of
a joint return, the foregoing [*20] requirements for qualification as a real
estate professional are satisfied if, and only if, either spouse separately
satisfies the requirements. Sec. 469(c)(7)(B). All of a taxpayer's real estate
activities are taken into account to determine whether the 750-hour requirement
is satisfied. See Fowler v. Commissioner, T.C. Memo. 2002-223 [TC Memo
2002-223]; Bailey v. Commissioner, T.C. Memo. 2001-296 [TC Memo 2001-296].
Section 1.469-5T(f)(4), Temporary Income Tax Regs., 53 Fed.
Reg. 5727 (Feb. 25, 1988), provides:
The extent of an individual's participation in an activity
may be established by any reasonable means. Contemporaneous daily time reports,
logs, or similar documents are not required if the extent of such participation
may be established by other reasonable means. Reasonable means for purposes of
this paragraph may include but are not limited to the identification of
services performed over a period of time and the approximate number of hours
spent performing such services during such period, based on appointment books,
calendars, or narrative summaries. We have held that the regulations do not
allow a postevent “ballpark guesstimate”. Bailey v. Commissioner, T.C. Memo.
2001-296 [TC Memo 2001-296]; Goshorn v. Commissioner, T.C. Memo. 1993-578 [1993
RIA TC Memo ¶93,578]. Mrs. Fitch works full time as a licensed real estate
agent. She credibly testified that she works weekdays and many weekends, and
typically wakes up at 6 a.m. to review business emails, new real estate
listings, and buyer criteria for her clients. She credibly testified that in
addition to the time she spent managing her [*21] rental real estate, she spent
more than 750 hours each year in 2005 to 2007 performing real estate related
activities as an independent contractor with Remax, which we find qualifies as
a real property trade or business under section 469(c)(7)(C). She further
credibly testified that she was not involved in any activities besides real
estate. We find Mrs. Fitch has established that she separately satisfies the
requirements to qualify as a real estate professional under section 469(c)(7),
and therefore petitioners' rental activities are subject to the material
participation requirements of section 469(c)(1).
Material participation is defined as involvement in the
operations of the activity that is regular, continuous, and substantial. Sec.
469(h)(1). As explained insection 1.469-5T(a), Temporary Income Tax Regs., 53
Fed. Reg. 5696 (Feb. 25, 1988), a taxpayer can satisfy the material
participation requirement if the individual meets any one of the seven
regulatory tests:
(1) The individual participates in the activity for more
than 500 hours during such year;
(2) The individual's participation in the activity for the
taxable year constitutes substantially all of the participation in such
activity of all individuals (including individuals who are not owners of
interests in the activity) for such year;
(3) The individual participates in the activity for more
than 100 hours during the taxable year, and such individual's participation in
the activity for the taxable year is not less than the participation in [*22]
the activity of any other individual (including individuals who are not owners
of interests in the activity) for such year;
(4) The activity is a significant participation activity ***
for the taxable year, and the individual's aggregate participation in all
significant participation activities during the year exceeds 500 hours;
(5) The individual materially participated in the activity
*** for any five taxable years (whether or not consecutive) during the ten
taxable years that immediately precede the taxable year;
(6) The activity is a personal service activity *** , and
the individual materially participated in the activity for any three tax years
(whether or not consecutive) preceding the taxable year; or
(7) Based on all of the facts and circumstances *** , the
individual participates in the activity on a regular, continuous, and
substantial basis during such year. “Participation” generally means all work
done in an activity by an individual who owns an interest in the activity. Sec.
1.469-5(f), Income Tax Regs. Work done by an individual in the individual's
capacity as an investor in an activity is not treated as participation in the
activity unless the individual is directly involved in the day-to-day
management or operations of the activity. Sec. 1.469-5T(f)(2)(ii)(A), Temporary
Income Tax Regs., 53 Fed. Reg. 5727 (Feb. 25, 1988).
In determining whether a taxpayer materially participates,
the participation of the spouse of the taxpayer shall be taken into account.
Sec. 469(h)(5). We therefore treat petitioners as one unit for the purpose of
determining their [*23] participation in an activity. However, petitioners did
not make the election to treat all of their interests in real property as one
activity pursuant to section 469(c)(7)(A) and section 1.469-9(g)(1), Income Tax
Regs., and must therefore satisfy the material participation requirements with
respect to each of their rental properties separately. See Shaw v.
Commissioner, T.C. Memo. 2002-35 [TC Memo 2002-35].
We find that petitioners satisfy the second enumerated test
for material participation: their participation in the rental real estate
constituted substantially all of the participation. Mr. Fitch testified
extensively as to the activities he performed with respect to his rental
properties, 16 including, inter alia, advertising, bookkeeping, accounting,
dealing with contractors, decorating, resolving fence disputes, making repairs,
paying taxes, and procuring insurance. He further testified that no one else
performed any services for his properties. Mrs. Fitch similarly testified as to
the activities she performed in managing her rental properties, including,
inter alia, advertising, decorating, dealing with contractors and the
homeowners' associations, screening tenants, filling out paperwork, making
repairs, and handling the lockbox and keys. She further testified that no one
other than she and Mr. Fitch performed any services for her properties. [*24] Respondent
argues that we should disregard petitioners' testimony as self-serving;
however, we find their testimony credible and persuasive. We do not believe
that petitioners' decision to occasionally hire a contractor to perform
technical tasks disqualifies their substantial day-to-day management of their
rental properties from constituting “substantially all of the participation”.
17 See sec. 1.469-5T(a)(2), Temporary Income Tax Regs, supra. Accordingly,
petitioners' losses attributable to their rental real estate in 2005 to 2007
are not limited by the passive activity loss limitation rules of section 469.
18
In reaching our holdings herein, we have considered all
arguments made, and, to the extent not mentioned above, we conclude they are
moot, irrelevant, or without merit. [*32] To reflect the foregoing and the
parties' concessions,
Decisions will be entered under Rule 155.
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