Rhett Rance Smith and Alice Avila Smith, et al. v. Commissioner., U.S. Tax

Rhett Rance Smith and Alice Avila Smith, et al. v. Commissioner., U.S. Tax Court, CCH Dec. 57,202(M), T.C. Memo. 2007-368, 94 . 574, (Dec. 17, 2007) Rhett Rance Smith and Alice Avila Smith, et al. v. Commissioner. U.S. Tax Court, Dkt. No. 11902-05, 13225-05, 13226-05, 13227-05, 13228-05, TC Memo. 2007-368, December 17, 2007. Code Sec. 170 I Charitable contributions: Non•cash contributions: Substantiation: Appraisals. — Three related couples were denied deductions for non-cash charitable contributions pursuant to Code Sec. 170 and for business expenses under Code Sec. 183. The three couples contributed interests in their family limited partnerships (FU's) to a charity. The FLPs held shares of stock in the families' closely held corporation. It was undisputed that the interests were transferred to the charity. However, the taxpayers failed to (I) obtain a contemporaneous written acknowledgement from the charitable donee and (2) provide a "qualified appraisal" regarding the value of the donated property. Since the taxpayers' failed to substantially comply with Reg. §1.170A-13 their non-cash charitable contribution deductions were properly disallowed.—CCH. Code Sec. 183 I Hobby losses: Nonprofit activities: Hone breeding. — Two married couples were denied claimed business expenses for various activities. including raising horses and dog breeding. because they failed to prove they pursued the activities with a profit motive. Most of the factors found in Rcg. §1.183-2(b) weighed against them: (I) they failed to keep proper records regarding their business activities or the purchase, sale, or breeding of the respective animals; (2) they failed to keep separate bank accounts: and (3) they each reported continuous and increasing losses from the activities.—CCH. Code Sec. 6662 Penalties, civil: Reasonable reliance: Tax professional. — An accuracy-related penalty under Code Sec. 6662 was not imposed because the taxpayers reasonably relied on the advice of a qualified tax professional.—CCH. Robert J. Stientjes, Thomas C. Pliske, Shine Lin, and Anthony S. Gasaway, for petitioners; Anne W. Durning, Nicholas J. Richards, Laura Beth Salant, and Chris J. Sheldon, for respondent. RHETT RANCE SMITH AND ALICE AVILA SMITH, ET AL., ? Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent. MEMORANDUM FINDINGS OF FACT AND OPINION GERBER, Judge: Respondent determined the following income tax deficiencies and penalties with respect to petitioners in these consolidated cases: Petitioners ©2011 Wolters Kluwer. All rights reserved. Accuracy - Related Penalty Year Deficiency Sec. 6662 I of 31 7/28/2011 7:40 AM EFTA00598102 Rhett Rance & Alice Avila Smith Joel Rance & LaRhea Smith J. Zane & Shannon R. Creese Smith 1998 $311,514 S62,302.80 1999 368,777 73,755.40 2000 373,183 74,638.40 2001 110,429 22,085.80 2002 87,535 None 1998 988,392 197,678.40 1999 1,254,421 250,884.20 2000 439,132 87,826.40 2001 256,486 51,297.20 1998 375,999 75,199.80 1999 765,397 153,079.40 2000 386,956 77,391.20 2001 290,027 58,005.40 Unless otherwise indicated, all section references are to the Internal Revenue Code, as amended and in effect for the years under consideration, and all Rule references are to the Tax Court Rules of Practice and Procedure. After concessions ? of the parties, the issues remaining for our consideration are: 1. Whether petitioners, Rhett Rance and Alice Avila Smith; Joel Rance and LaRhea Smith; and J. Zane and Shannon R. Creese Smith, are entitled to charitable contribution deductions with respect to interests in family limited partnerships contributed to a charitable organization and, if so, what the values of the charitable contributions are; 2. whether petitioner J. Zane Smith's dog breeding activity constitutes an activity engaged in for profit within the meaning of section 183(a); 3. whether petitioner J. Zane Smith's cow and dairy farm activity constitutes an activity engaged in for profit within the meaning of section 183(a); 4. whether petitioner Rhett Rance Smith's cutting horse activity constituted an activity engaged in for profit within the meaning of section 183(a); and 5. whether petitioners are liable for section 6662(a) accuracy-related penalties for negligence or disregard of rules or regulations with respect to the above-referenced charitable contribution deductions and/or their section 183 activities. FINDINGS OF FACT ©2011 Wolters Kluwer. All rights reserved. 2 of 31 7/28/2011 7:40 AM EFTA00598103 Background Petitioners Rhett Rance Smith (Rhett) and Alice Avila Smith (Alice) are married and resided in Scottsdale, Arizona, at the time their petitions were filed. They timely filed Forms 1040, U.S. Individual Income Tax Return, for 1998, 1999, 2000, 2001, and 2002. On April 15, 2005, respondent sent notices of deficiency to Rhett and Alice for their 1998, 1999, 2000, and 2001 tax years. On March 25, 2005, respondent sent a notice of deficiency to Rhett and Alice for their 2002 tax year. Petitioners Joel Rance Smith (Rance) and LaRhea Smith (LaRhea) are married and resided in Eagle Point, Oregon, at the time their petitions were filed. They timely filed Forms 1040 for 1998, 1999, 2000, and 2001. On April 15, 2005, respondent sent notices of deficiency to Rance and LaRhea for their 1998, 1999, 2000, and 2001 tax years. Petitioners J. Zane Smith (Zane) and Shannon R. Creese Smith (Shannon) are married and resided in Earlville, New York, at the time their petition was filed. They timely filed Forms 1040 for 1998, 1999, 2000, and 2001. On April 15, 2005, respondent sent notices of deficiency to Zane and Shannon for their 1998, 1999, 2000, and 2001 tax years. Rance and LaRhea Smith are the parents of Rhett and Zane Smith. Noncash Charitable Contributions Each couple claimed deductions for noncash charitable contributions of interests in their family limited partnership (FLPs) which, essentially, was to hold interests in their closely held, family-owned Arizona C corporation Beneco, Inc. (Beneco). Beneco had been incorporated in 1989 with 1,000 initially issued shares of stock, held as follows: Petitioners Shares Rance 250.5 LaRhea 250.5 Rhett and Alice 249.5 Zane and Shannon 249.5 Total 1,000.0 Beneco's business was to provide a qualified retirement plan and trust and qualified health and welfare trust services to contractors who work under prevailing State and Federal wage laws, including the Federal Davis-Bacon Act. For its taxable years ended March 31, 1997 through 2004, Beneco did not pay a dividend. During December 1995, petitioners' attorney, Robert A. Kelley, Jr. (Attorney Kelley), who specialized in tax and estate planning, established three separate Arizona FLPs in each of which one couple owned a limited partnership interest of approximately 98 percent and the couple's wholly owned corporation, as general partner, owned the remaining 2 percent as follows: FLP mat partners General Partner. Eacn partnership agreement provided mat partners could not transter a partnersnip interest without prior written ©2011 Wolters Kluwer. All rights reserved. Jireh LP J. Rance & LaRhea Smith J.A. Rohi Corp. 3 of 31 7128120117:40 AM EFTA00598104 consent of all the other partners and that control over the partnership was vested in the general partner (the couple's wholly owned corporation). During 1995, Rance and LaRhea transferred their 51-percent ownership interest in Beneco to Jireh Limited Partnership (Jireh). Jireh is treated as a partnership for Federal tax purposes, and its only asset is 501 shares of Beneco stock. Sometime after December 20, 1995, Zane and Shannon transferred into Mustard Seed Limited Partnership (Mustard Seed) their 249.5 shares of Beneco stock which, during the years at issue, were its sole asset. Sometime after December 20, 1995, Rhett and Alice transferred into Zerubbabel Limited Partnership (Zerubbabel) their 249.5 shares of Beneco stock which, during the years at issue, were its sole asset. Christian Community Foundation (CCF), a section 501(c)(3) charity for tax purposes, was incorporated in 1980 under the laws of Colorado. On or about December 19, 1995, Attorney Kelley sent a letter to CCF, enclosing a check for $1,000 and an Application to Begin a Charitable Project. CCF set up the Zacchaeus Foundation (Zacchaeus), a donor-advised fund, for petitioners and assigned to it account No. 06022. Attorney Kelley advised CCF that for 1995, Rance and LaRhea would be contributing an FLP interest having a value of S350,000 and that Rhett and Alice and Zane and Shannon would each be contributing an FLP interest having a value of $185,000. Attorney Kelley further advised that petitioners would be making annual gifts in amounts to be determined by their income for the particular year. He further advised that all of the gifts of FLP interests that were made to the project would be reacquired via irrevocable life insurance trusts that were to be funded by life insurance and that application had been made for the insurance. In 1996, the irrevocable trust of each couple and CCF executed a separate Agreement for the Purchase and Sale of Limited Partnership Interest. Each agreement provided that upon the death of the later to die of the couple, CCF had the right to require the trustee to buy CCF's entire limited partnership interest. Similarly, the trust could require CCF to sell its interest to the trustee. CCF or the trust could exercise the right to buy or sell within "sixty * " • days from the date the * • • [trust] collects the death benefits" from a specified life insurance policy. It was intended that the sale or purchase transaction be funded by a life insurance policy. Sometime later, Attorney Kelley left the United States, and petitioners hired Attorney Frederick Meyer (Attorney Meyer). Attorney Meyer conducted a review of petitioners' documents, including wills, family limited partnerships, and insurance trusts, and he discovered what he considered to be inadequacies. Attorney Meyer believed that the partnership agreements should reflect a fiduciary duty to the charity and an obligation to share cashflow with the charity. Edward Kramer (Mr. Kramer), petitioners' certified public accountant ( ), and Rance did not believe this was necessary but reluctantly agreed to make the changes. In 1997 the limited partnership agreements were revised to accommodate the recommended changes. Petitioners did not rely on Attorney Meyer with respect to valuation questions. They relied on Mr. Kramer to take care of valuing the partnership interests. Petitioners paid annual administrative fees to CCF. From 1995 through 2001, Rance and LaRhea assigned interests in Jireh to CCF and claimed the following noncash charitable contributions deductions: Date Percent Assigned Per Tax Return Claimed Contribution 12/20/95 10.9157% $350,000 12/29/97 9.9133 Unknown 12/29/00 1.5988 145,000 12/31/01 11.272 480,000 ©2011 Wolters Kluwer. All rights reserved. 4 of 31 7/28/2011 7:40 AM EFTA00598105 Although Form 8283, Noncash Charitable Contributions, for 2000 indicated that an interest of 1.5988 percent had been contributed to CCF, the actual percentage contributed was 3.22 percent. Pursuant to Rance and LaRhea's request, during the period 1995 to 2002, CCF directed their contributed interests in Jireh to Zacchaeus. During the years 1998 through 2001, Rance and LaRhea did not transfer any Beneco stock to CCF. Rance and LaRhea attached section B of Form 8283 to their 2000 return and described the donated property as "1.5988% Units Jireh Ltd" with an appraised fair market value of $145,000. The Declaration of Appraiser, part III on Form 8283 for 2000, was signed by Mr. Kramer and stated that the appraisal date was September 1, 1999. No such appraisal was attached to Rance and LaRhea's 2000 return or made a part of the record. The Donee Acknowledgment, part IV on Form 8283 for 2000, was signed by Valerie Cornelius, Director of Operations for CCF, next to the typed date December 29, 2000. Attached to Rance and LaRhea's 2000 return was a letter, dated January 31, 2001, thanking them for their charitable donation on December 29, 2000, and stating that "No goods or services were provided for this donation." Likewise, Rance and LaRhea attached section B of Form 8283 to their 2001 return and reported the donated property as "11.272% Units (BENECO Stock) JIREH Ltd" with an appraised fair market value of $480,000. Mr. Kramer made the handwritten notation on part III, Declaration of Appraiser, of Rance and LaRhea's 2001 Form 8283 "see attached 11/19/01 report 11/19/2001 Frank E. Koehl Jr." The Form 8283 was not signed by Frank E. Koehl, Jr. (Mr. Koehl). Also attached to Rance and LaRhea's 2001 return was a one-page letter, dated November 19, 2001, from Mr. Koehl, to Rance referring to an $8,500-per-share valuation of Beneco as of March 31, 2000. No such appraisal was attached to Rance and LaRhea's 2001 return. The Donee Acknowledgment, part IV on Form 8283 for 2001, was signed by Valerie Cornelius, and the title "President" and the date "12/26/2001" were typed next to her name. The typewritten title President" and the date "12/26/2001" were both crossed out, and the title "Treasurer" and the date "4/13/2002" were handwritten. No letter of acknowledgment, gratitude, or statement that no goods or services were received was attached to the 2001 return. Also attached to Rance and LaRhea's 2001 return were two documents, each captioned "Assignment of Limited Interest In Jireh Limited Partnership with Consent Attached", one signed by Rance and the other by LaRhea. Each assignment described the assignment to CCF of an FLP interest valued at $240,000 and included CCF's acknowledgment by its president, John C. Mulder, who signed in that capacity. From 1995 through 2001, Zane and Shannon assigned interests in Mustard Seed to CCF and claimed corresponding noncash charitable contribution deductions on their personal income tax returns, as follows: Date Percent Assigned Per Tax Return Claimed Contribution 12/20/95 11.5857% $185,000 12/29/97 1.95 Unknown 12/31/98 4.11036 90,000 12/31/01 8.864 188,000 Zane and Shannon requested that CCF direct any contributed interests in Mustard Seed to Zacchaeus for the period 1995 to 2002. During the years 1998 through 2001, Zane and Shannon did not transfer any Beneco stock to CCF. Form 8283 attached to Zane and Shannon's 1998 return did not include section B, the portion of the form ©2011 Wolters Kluwer. All rights reserved. 5 of 31 7/28/2011 7:40 AM EFTA00598106 designated for gifts over S5,000. No appraisal or reference to a specific appraisal was mentioned in or attached to Zane and Shannon's 1998 tax return. An "Assignment and Agreement" was attached to their 1998 return signed by Zane and Shannon and a representative of CCF assigning and acknowledging a transfer of an FLP interest with a stated value of $90,000 as of December 31, 1998. The 1998 return did not have any reference to whether Zane and Shannon received goods or services in connection with their contribution. During 1998, Zane and Shannon assigned "an economic interest in that percentage of their limited partnership interest in the " " "[Mustard Seed] which has a value of $90,000 as of December 31, 1998, including all interest in the capital * * " of the partnership, but specifically excluding any right " " " to exercise any vote". Form 8283 attached to Zane and Shannon's 2001 return contains the statement that the donated property was "8.864% units of (Beneco stock) the Mustard Seed LP" with an appraised fair market value of $188,000. Section B, part III, Declaration of Appraiser, on Zane and Shannon's Form 8283, attached to their 2001 return contained the handwritten notation "see Ltr Attached Frank E. Koehl Jr on the line to be used for the signature of the appraiser. The Declaration of Appraiser and Donee Acknowledgment appeared to be signed by Mr. Koehl, and Valerie Cornelius for CCF. The typewritten date of appraisal in part III was "11/19/200V. Mr. Kramer made the handwritten notation "see Ltr Attached Frank E. Koehl Jr". Also attached to Zane and Shannon's 2001 return was a one-page November 19, 2001, letter from Mr. Koehl to Rance referring to an S8,500-per-share valuation for Beneco as of March 31, 2000. Also attached to Zane and Shannon's 2001 return was an acknowledgment from CCF of its receipt of the limited partnership interest, advising that "No goods or services were provided for this donation." Finally, there was attached an assignment of an FLP interest in Mustard Seed, along with a signed consent from CCF by its president. From 1995 through 2001, Rhett and Alice assigned interests in Zerubbabel to CCF and claimed corresponding noncash charitable contribution deductions on their personal income tax returns, as follows: Date Percent Assigned Per Tax Return Claimed Contribution 12/20/95 11.587% $185,000 12/29/97 3.92 Unknown 12/29/00 2.2851 100,000 12/31/01 13.674 290,000 Although Rhett and Alice's Form 8283 for 2000 contained the statement that an interest of 2.2851 percent had been contributed to CCF, the actual percentage contributed was 4.57 percent. Pursuant to Rhett and Alice's request, CCF directed their 1995-2001 assigned interests in their FLP (Zerubbabel) to Zacchaeus. Rhett and Alice did not donate Beneco stock to CCF during the years 1998 through 2001. Rhett and Alice attached Form 8283 to their 2000 return and in section B, part I, Information on Donated Property, described the donated property as "2.2851% Units Interest Zerubbabel Ltd", stating that it had an appraised fair market value of $100,000. The Declaration of Appraiser was signed by Mr. Kramer and contains the statement that the appraisal date was September 1, 1999. No appraisal was attached to Rhett and Alice's 2000 return, and no appraisal dated September 1, 1999, was provided to respondent or the Court. No signature appeared in the Donee Acknowledgment portion, part IV, of the first section B attached to the return. A second section B was also attached to the 2000 return bearing the Donee Acknowledgment signature of Valerie Cornelius on behalf of CCF. Also attached to the 2000 return was an acknowledgment of the contribution from CCF, dated January 31, 2001, which ©2011 Wolters Kluwer. All rights reserved. 6 of 31 7/28/2011 7:40 AM EFTA00598107 included the statement "No goods and services were provided for this donation." Rhett and Alice attached two Forms 8283, section B to their 2001 return and, in each, described the donated property as "13.674% Units (Beneco Stock) Zerrubbable Ltd" with a stated value of S290,000. The signature line of the Declaration of Appraiser was blank on one of the forms. The other had the handwritten notation "see attached 11/19/01 report Frank E. Koehl Jr with a typewritten address in Princeton, New Jersey, and a typewritten appraisal date of November 19, 2001. Mr. Kramer made the handwritten notation "see attached 11/19/01 report Frank E. Koehl Jr. No appraisal report was attached to the 2001 return. Attached to the 2001 return was a letter dated November 19, 2001, from Mr. Koehl, stating that the value of Beneco stock, as of March 31, 2000, was $8,500 per share. No detail or explanation as to how the valuation was done was attached to the 2001 return. Also attached to the 2001 return was an assignment of a portion of their FLP by Rhett and by Alice, along with consents and acknowledgment by the president of CCF, signed and dated in late December 2001. Rhett and Alice assigned an interest in Zerubbabel to Crossmen Ministries in 2002 and claimed a $247,500 charitable deduction for that contribution. Crossmen Ministries was a Texas nonprofit corporation that petitioners organized during 2002. LaRhea, Rance, and Rhett were the officers of Crossmen Ministries. During 2002, Crossmen Ministries was affiliated with World Bible Way Fellowship, Inc. (World Bible Way). During 2002, World Bible Way was a section 501(c)(3) tax-exempt entity which held a group exemption letter, permitting subordinate entities not listed as tax exempt to qualify for tax-exempt status because of their affiliation with World Bible Way. Rhett and Alice did not donate Beneco stock to World Bible Way or Crossmen Ministries during the years at issue. Rhett and Alice attached section B of Form 8283 to their 2002 return. It described the donated property as "11.67% Of FLP Beneco Stk" with an appraised fair market value of $247,500. That Form 8283 contained no Declaration of Appraiser, and no appraisal is attached. The name and address of the charitable donee was typewritten in section B, part IV, Donee Acknowledgment, but no signature appeared thereon. Also attached to Rhett and Alice's 2002 return was a document titled "Assignment of Limited Interest in Zerubbabel Limited Partnership with Consent Attached" wherein Alice, as a limited partner of Zerubbabel, assigned an interest in the FLP to Crossmen Ministries. That typewritten document reflected, in two separate locations, the value of the interest to be $91,050 as of December 27, 2002. However, both the $91,050 values were crossed out by hand and 1123,750" was handwritten in its place, along with three sets of initials. The document reflected that Alice signed the document on December 27, 2002, and Crossmen Ministries accepted the assignment to be effective as of December 27, 2002. Mr. Kramer served as petitioners' for the period 1995 through 2002. He prepared individual income tax returns, corporate returns, partnership returns, payroll tax returns, annual reports, personal property tax returns, and other documents for petitioners and their related entities. Mr. Kramer, at the times he was responsible for the preparation of petitioners' tax returns, was aware of section 170 and the reporting requirements for noncash charitable contributions during the years at issue. He was also aware that the noncash charitable contribution regulations required that taxpayers use an appraiser who represented that he was in the business of conducting appraisals for the general public. Mr. Kramer was not a certified appraiser. In addition to preparing petitioners' returns, Mr. Kramer, for purposes of a 1995 tax year noncash charitable contribution, performed a September 30, 1995, valuation of Beneco. Mr. Kramer's valuation did not state that it was prepared for income tax purposes or provide the date of any contributions to the charitable donee. Mr. Kramer's 1995 estimated fair market value of a 100-percent interest of Beneco stock was $6,400,000, as of September 30, 1995. In valuing petitioners' FLPs, Mr. Kramer simply chose to value the Beneco stock because it was the FLPs' only asset and the valuations of the FLPs depended in great part on the valuation of the Beneco stock. The 1995 valuation of the Beneco stock was used for the charitable contribution deductions of FLP interests claimed for the 1998 through 2000 tax years. The methodology Mr. Kramer used to value the FLP interests petitioners contributed was to obtain an appraised value of the Beneco stock and then to discount that value for minority interest and lack of marketability factors. No separate discount was used with respect to the FLP interests contributed to the charitable organization. Mr. Kramer ©2011 Wolters Kluwer. All rights reserved. 7 of 31 7/28/2011 7:40 AM EFTA00598108 valued the Beneco stock and did not separately assess the value of the partnership units. After his 1995 valuation, sometime around 1999-2000, Mr. Kramer advised petitioners to hire a certified appraiser. On April 5, 2000, Rance, as president of Beneco, retained Management Planning, Inc. (MPI), to prepare economic and financial analyses and evaluations of Beneco, and three limited partnerships (Jireh, Mustard Seed, and Zerubbabel) for a fee of $12,500. Mr. Koehl of MPI transmitted by a letter dated November 19, 2001, an evaluation of the "common stock of Beneco, Inc.," as of March 31, 2000, concluding that the aggregate freely traded equity capital of Beneco had a value of $9,195,000. Mr. Koehl opined that the average lack of marketability discount for private placements of nonpublicly traded stocks was 27.5 percent, and he decided to use a lack of marketability discount of 7.5 percent because he was valuing a controlling interest. Mr. Koehl concluded that the outstanding common stock of Beneco had a fair market value of $8.5 million (or S8,500 per share, based on 1,000 shares issued and outstanding) as of March 31, 2000, on a going-concern controlling -interest basis. Mr. Koehl and MPI did not prepare a separate valuation of petitioners' limited partnerships, Jireh, Mustard Seed, or Zerubbabel. Mr. Koehl's valuation of Beneco contained the statement that it was prepared for management information, income tax reporting, and other corporate purposes. Mr. Koehl's valuation did not contain a date for any contributions of an FLP interest to any particular donee, and it did not contain a separate valuation of each FLP. The valuations by Mr. Kramer and Mr. Koehl were the only valuations referenced in petitioners' returns. Rance's Schedule F Activity Rance began his cutting horse activity with a few horses in 1999. During the years at issue, Rance maintained several horses in his cutting horse activity. For the taxable years 1998 through 2005 Rance reported the following total income, expenses, and net losses: Year Income Expenses Net Losses 1998 -0- $124,291 $124,291 1999 -0- 76,352 76,352 2000 -0- 65,486 65,486 2001 $1,736 83,630 81,894 2002 3,817 83,691 79,874 2003 4,583 48,903 44,320 2004 4,084 66,677 62,593 2005 1,959 44,474 42,515 Total 16,179 593,504 577,325 The expenses were generally attributable to depreciation, animal and land maintenance, mortgage interest, and training. Other than the Schedules F, Profit or Loss From Farming, which were part of the tax returns and banking O2011 Wolters Kluwer. All rights reserved. 8 of 31 7/28/2011 7:40 AM EFTA00598109 records, Rance did not maintain books and records of his horse cutting activity. Rance rides his own horses at horse futurities (shows), and he first rode horses when he was a child and continued to ride when he attended college. He became involved in the cutting horse activity in the 1980s and discontinued the activity during 1987 because it was expensive, competitive, and risky, and he had a champion mare that had achieved success by winning the Pacific Coast Derby. During 1996, Rance and LaRhea purchased approximately 70 to 75 acres of land in Oregon. In October 1998, they began construction of a house, an office, a barn, fences, and stalls. The property was to be for their personal residence and activities as well as for conducting part of their Beneco business. Construction was completed in November 1999, after which Rance and LaRhea moved to the Oregon property. The barn had four horse stalls, a tack room, a feed room, and storage for hay and related farm equipment. During 1999, Rance purchased E., a driving horse which pulled carts and wagons and which Rance rode. Also during 1999, Rance purchased Leo, a western pleasure mule, which he rode around the Oregon property to check fences and tend the property. M. was sold sometime during 2000 or 2001. Rance also purchased Popcorn, a Royal Dartmoor pony mare that was in foal. Popcorn was a hunter/ jumper, and she was sold, along with her foal, sometime in 2001 or 2002. Rance again became involved in cutting horse activity because he could afford horses with better pedigrees. He purchased a 4-year-old, Dual Docs (Dual Docs), in 2001 for $30,000 and placed him in training in Medford with Bobby and Jolene Nelson. Semen was collected from Dual Docs, and he was used for live breeding, resulting in revenue of several thousand dollars. Dual Docs was entered in competitions and then sold in 2004 for $22,500. Rance, sometime in 2001 or 2002, acquired cutting horse reining mares named Mitzi and I Gotta Lotta. He then determined that they could not be entered into competitions, and he allowed high school girls to ride them in 4-H Club activities and other events. I Gotta Lotta was sold in 2003 for $6,000 and Mitzi was sold in 2004 for $6,300 for reported gains of $839 and $230, respectively. Zane's Dog Breeding, Showing and Judging Activity Zane first became interested in showing dogs after his parents bought him his first Staffordshire Bull Terrier and took him to a dog show at age 12. During grade school and high school, Zane owned and learned to show Staffordshire Bull Terriers. By 1995 or 1996, when Zane had substantial experience and had developed a reputation, he began contemplating conducting the dog breeding activity on a much more serious level. During the years at issue, he was considered a worldwide expert in and primarily focused on Staffordshire Bull Terriers and American Staffordshire Terriers. Zane became a championship show judge in 1985 at age 22, the youngest in recent history, and has judged in shows all over the world. Zane has not won more than nominal amounts showing dogs, and he did not earn any income from judging during the years at issue. Zane did not have a written business plan for his dog breeding activity. He did not keep a separate checking account for his dog breeding activity. When he wrote a check, he noted the purpose of the expense. At the end of the year, Zane summarized the expenses for his . for purposes of preparing his returns. Zane spent approximately 10 to 20 hours each week on the dog breeding activity and was showing one or two dogs regularly and three or four dogs less often. Zane had two Staffordshire Bull Terriers living with him in New York from 1996 through 2003, and his other dogs lived with professional handlers. In addition, Zane coowned some dogs that lived with his coowners. Zane had no income from the dog breeding activity in any of the years 1996, 1997, 1998, 1999, and 2000. Zane's 1997 Schedule C, Profit or Loss From Business, reflected no income and $52,683 in expenses. Zane's Schedules F attached to his other returns were entitled tattle Crops—Dog Breeding" and for 2004 included the term "Organic Dairy Milk". Some of them reflected income, but the source was not specified. O2011 Wolters Kluwer. All rights reserved. 9 of 31 7/28/2011 7:40 AM EFTA00598110 The following table shows the losses Zane claimed for the dog breeding activity for the years 1997 through 2004: Tax Year Total Income Total Expenses Total Losses 1997 — $52,683 (S52,683) 1998 - 61,490 (61,490) 1999 - 28,826 (28,826) 2000 - 51,409 (51,409) 2001 - 80,152 (80,152) 2002 - 56,818 (56,818) 2003 $5,673 7,651 (1,978) 2004 — 6,064 (6,064) Total 5,673 345,093 (339,420) Most of the expenditures were for travel, advertising, and show expenses. For example, in 1997, of the $52,683 of total expenses claimed, $28,676 was for show expenses, S10,850 for travel, and $9,800 for advertising. Accordingly, $49,326 of the $52,683 (almost 94 percent) was for shows, travel, and advertising. Most of the expenses were associated with showing dogs and judging dog shows. According to a March 2004 report from Synbiotics, Zane had 44 semen straws stored from the dog Malcolm. Synbiotics calculated that 7.9 inseminations could be accomplished from the 44 straws. Zane's Cow and Dairy Farm Activity Zane had an interest in cattle as a boy, and in July 1998, he purchased a 400-acre property in Earlville, New York, known as Goose Hill Farm. Zane had an interest in genetics and animal husbandry beginning with the Staffordshire Bull Terriers when he was a boy. Zane developed an interest in Normande cows, and he believed that they are good milking cows and grazing animals. He built his personal residence at Goose Hill Farm with the intent to raise cows. In 2000, Zane also purchased the Columbus Dairy, consisting of 225 acres and located 15 miles from Goose Hill Farm. A milking parlor and dairy operation were built at the Columbus Dairy, and calves were raised on the Goose Hill Farm property. After purchasing the Columbus Dairy, Zane worked to reclaim the pasture land for grazing. He studied and researched the various types of cattle that could be bred. Zane recognized that family dairy farms were not doing well, and he decided that, to be profitable, his cattle activity had to find a niche in the market that would let it compete as to product and price. After much research he decided to raise Normande cattle. The Columbus Dairy became an organic dairy farm. At the Columbus Dairy, Zane built a milking parlor and other buildings for the milking operation. Milking started sometime in 2002. ©2011 Wolters Kluwer. All rights reserved. 10 of 31 7/28/2011 7:40 AM EFTA00598111 Normande cows are good producers of milk in France but are largely used for beef consumption in the United States. After visiting many farmers and ranchers throughout the United States, Zane acquired a herd of Normande cows that he believed would be the best milk producers. He intended to further breed the acquired herd so his activity could become competitive in the dairy farming industry. Zane had a 7-year business plan involving the importation of bull semen from France, as he could not import Normande cows to breed with his cows to produce offspring that he believed could produce a higher quantity and better quality of milk. At the same time, Zane was working to convert his land from a conventional to a certified organic farm. Zane believed that if his farm could be certified as organic, he would be able to sell the milk at a price three times that of conventional milk. By the time of trial, Zane's animal breeding was progressing, and he hoped he could focus more on the cow activity and less on the dog breeding. The farm was certified organic in 2006. His gross revenues exceeded $100,000 for 2004, 2005, and 2006. Zane expects the revenue to triple in 2007 because of the organic certification. In operating this activity, Zane has consulted with experts, done marketing, maintained separate checking account records, and has focused on ways to maximize revenue. During August 2001, Zane purchased 77 Normande cows from Keith Miller of Stuart, Iowa. Beginning in May 2001, David Hughes (Mr. Hughes) had become Zane's part-time farm manager in exchange for a place to live at the Columbus Dairy. Beginning in January 2002, Mr. Hughes became Zane's full-time employee. Zane paid Mr. Hughes approximately $29,000 to $30,000 in cash wages and also provided him a double-wide trailer to live in and allowed him personal use of a pickup truck. Mr. Hughes performed the farm labor and Zane was the decision maker for the activity. Zane decided to graze his cattle rather than confine them because he believed that grazing positively affected the longevity of the cattle. He also leased an additional 60 acres of a farm adjacent to Columbus Dairy for the purpose of grazing cows. All milk cows were grazed at the Columbus Dairy property and on the adjacent leased land. Automatic milking equipment was placed in service in October 2001, and milking operations commenced during 2002. Zane began reporting the cattle activity and deducting expenses in his 1998 tax year. Zane kept a separate bank account for the Columbus Dairy. Penalties —Reliance Through the 2001 tax year, Mr. Kramer prepared Rance and LaRhea's tax returns. Mr. Kramer understood that one of the purposes of the Oregon property was to raise and breed horses. He believed that Rance and LaRhea purchased the Oregon property on account of their concerns about "Y2K" and their desire to have a self-sustaining facility. Mr. Kramer told Rance and LaRhea from the beginning of their Schedule F activity that they needed to show revenues in order to avoid "hobby loss classification". The only revenue Mr. Kramer was aware of was the sale of one horse in the second or third year. Mr. Kramer advised Rance to combine his Oregon Schedule F activity with Zane's New York Schedule F activity to keep them from being classified as hobbies. Rance and Zane did not follow Mr. Kramer's advice on forming a joint venture. Mr. Kramer did not know how Zane used his property. Mr. Kramer did not ask for or see any of Zane's underlying financial records in connection with his Schedule F activity. Mr. Kramer included on the returns all the expenses petitioners listed for him. Mr. Kramer knew the dog breeding business was expensive and that it was speculative, with a very small percentage of success. Mr. Kramer knew that it was very difficult to earn money in the dog breeding business. Mr. Kramer did not question the travel expense claimed on Zane's 1998 Schedule F because he knew that Zane traveled overseas as well as around the country. Mr. Kramer knew that expenses incurred at the Westminster dog show were extensive. Mr. Kramer understood that Zane had a cattle breeding activity separate from the dairy operation. ©2011 Wolters Kluwer. All rights reserved. 11 of 31 7/28/2011 7:40 AM EFTA00598112 OPINION Burden of Proof Petitioners, for the first time on brief, raise the issue of whether the burden of proof shifted to respondent under section 7491(a). Under that section the burden of proof may shift to the Commissioner with respect to a factual issue affecting the taxpayer's liability for tax where the taxpayer introduces credible evidence with respect to such a factual issue and meets certain substantiation requirements set forth in section 7491(a)(2)(A) and (B). Respondent contends that petitioners' argument as to the burden of proof was untimely raised and that, even if it had been timely, it is petitioners' burden to show that they have met the requirements of section 7491(a)(2), which they have not done. We agree with respondent that petitioners' attempt to raise section 7491 for the first time in their posttrial brief is untimely. Under section 7491 petitioners must, for example, show that they cooperated during the audit and that they met substantiation requirements. Petitioners' attempt on brief to show that they met the requirements by the simple expediency of stating that respondent did not question the substantiation or that they cooperated will not suffice. Petitioners, by raising those allegations on brief, do not afford respondent the opportunity to test the allegations by cross-examination or by producing evidence to show otherwise. Therefore, we hold that petitioners' attempt to shift the burden under section 7491 causes prejudice and is untimely. .q See, e.g., Deih/ v. Commissroner [Dec. 56,220(M)) T.C. Memo. 2005-287. Accordingly, petitioners continue to bear the burden of proof with respect to the noncash charitable contribution issue and the question of whether they carried on various activities for profit within the meaning of section 183. Respondent does bear the burden of production with respect to the section 6662 penalty. See sec. 7491(c). That burden is to come forward with sufficient evidence regarding the appropriateness of applying a particular addition to tax or penalty against the taxpayer. Sec. 7491(c); Wheeler v. Comm:swayer [Dec. 56,692) 127 T.C. 200 (2006); Higbee v. Commissioner [Dec. 54,356) 116 T.C. 438 (2001). Noncash Charitable Contributions Petitioners are members of the same family comprising a father (Rance) and two sons (Rhett and Zane) and their respective spouses. Together, they owned and operated Beneco, a corporation that provides business services in connection with qualified retirement and health and welfare plans. Rance and his wife owned slightly over 50 percent of Beneco, and Rhett and Zane, along with their wives, each owned one-half of the remaining minority interest. Petitioners claimed noncash charitable contributions of FLP interests. The FLPs were created and designed to hold interests in Beneco, which were to be contributed to the FLPs by petitioners. The issues concerning these contributions are whether petitioners complied with the reporting requisites of section 170 and underlying regulations so as to be entitled to the charitable contribution deductions. If we find that petitioners complied with those requisites, we will go on to consider the values of the interests contributed in order to decide the amounts of any allowable charitable contribution deductions. Section 170(a)(1) provides: There shall be allowed as a deduction any charitable contribution " ` payment of which is made within the taxable year. A charitable contribution shall be allowable as a deduction only if verified under regulations prescribed by the Secretary. If the contribution consists of property other than cash, the value of the contribution is generally the fair market value of the donated property at the time of contribution. Sec. 1.170A-1(c)(1), Income Tax Regs. Respondent argues that petitioners are not entitled to the noncash charitable contribution deductions claimed ©2011 Wolters Kluwer. All rights reserved. 12 of 31 7/28/2011 7:40 AM EFTA00598113 because they failed to comply with the reporting requirements of section 170 and the underlying regulations. Petitioners acknowledge that they failed to fully comply with some of the requirements for noncash charitable contribution deductions. Petitioners argue, however, that they are nevertheless entitled to the deductions for the noncash charitable contributions because they substantially complied (that the information provided is sufficient to meet the requirements) and because they had "reasonable cause " " for [any) failure to fully comply." A charitable contribution is allowable as a deduction only if verified under regulations prescribed by the Secretary. Sec. 170(a)(1); Hewitt v. Commissioner[Dec. 52,326) 109 T.C. 258, 261 (1997), affd. without published opinion 166 F.3d 332 (4th Cir. 1998). The obligation to substantiate charitable contribution deductions is clear and unambiguous. Blair v. Commissioner[Dec. 45,235(M)) T.C. Memo. 1988-581. No deduction is allowed for a contribution in excess of S5,000 unless the taxpayer meets the substantiation requirements of section 1.170A-13(c)(2), Income Tax Regs. Todd v. Commissioner[Dec. 54,721) 118 T.C. 334, 340 (2002); sec. 1.170A-13(c)(1)(i) Income Tax Regs. Section 1.170A-13(c)(2)(i), Income Tax Regs., generally provides that a taxpayer must comply with the following three requirements: (A) Obtain a qualified appraisal (as defined in paragraph (c)(3) of this section) for such property contributed. If the contributed property is a partial interest, the appraisal shall be of the partial interest. (B) Attach a fully completed appraisal summary (as defined in paragraph (c)(4) of this section) to the tax return (or, in the case of a donor that is a partnership or S corporation, the information return) on which the deduction for the contribution is first claimed (or reported) by the donor. (C) Maintain records containing the information required by paragraph (b)(2)(ii) of this section. Additionally, for contributions of S250 or more, a taxpayer must obtain a contemporaneous written acknowledgment from the donee organization. Sec. 170(f)(8)(A). The acknowledgment must be obtained by the earlier of the date the return is filed or its due date. Sec. 170(f)(8)(C). The acknowledgment must include the amount of cash and a description of any property other than cash along with certain information about any goods or services provided by the donee. Sec. 170(f)(8)(B). The purpose of these provisions has been described as providing the Commissioner with sufficient return information to effectively monitor the possibility of overvaluations of charitable contributions. Hewitt v. Commissioner, supra at 265. Section 1.170A-13(c)(3)(i) and (ii), Income Tax Regs., contains the specific requirements that a "qualified appraisal" must: (1) Be made not earlier than 60 days before the date of the contribution nor later than the due date of the return, including extensions, on which a deduction is first claimed or reported; (2) be prepared, signed and dated by a qualified appraiser; (3) contain the name address, identifying number, and qualifications of the qualified appraiser; (4) contain a statement that it was prepared for income tax purposes; (5) contain a description of the property in sufficient detail for a person who is not generally familiar with the type of property to ascertain that the property that was appraised is the property that was contributed; (6) include the terms of any agreement of understanding entered into or expected to be entered into by or on behalf of the donor or donee that relates to the use, sale, or other disposition of the property, including an agreement that restricts temporarily or permanently a donee's right to dispose of the property; (7) show the date on which the property was contributed; (8) show the fair market value of the property on the date of contribution; ©2011 Wolters Kluwer. All rights reserved. 13431 7/28/2011 7:40 AM EFTA00598114 (9) show the method of valuation and the specific bases for the valuation; and (10) show the date on which the appraisal was made. The Secretary promulgated the above-referenced regulations in response to the Deficit Reduction Act of 1984 (DEFRA), Pub. L. 98-369, sec. 155(a), 98 Stat. 691. DEFRA section 155 instructs the Secretary to provide heightened substantiation reporting requirements for certain noncash charitable contributions. DEFRA section 155 provides: (3) Appraisal summary. —For purposes of this subsection, the appraisal summary shall be in such form and include such information as the Secretary prescribes by regulations. Such summary shall be signed by the qualified appraiser preparing the qualified appraisal and shall contain the TIN of such appraiser. Such summary shall be acknowledged by the donee of the property appraised in such manner as the Secretary prescribes in such regulations. (4) Qualified appraisal.—The term "qualified appraisal" means an appraisal prepared by a qualified appraiser which includes— (A) a description of the property appraised, (B) the fair market value of such property on the date of contribution and the specific basis for the valuation, (C) a statement that such appraisal was prepared for income tax purposes, (D) the qualifications of the qualified appraiser, (E) the signature and TIN of such appraiser, and (F) such additional information as the Secretary prescribes in such regulations. See Bond v. Commissioner [Dec. 48,822) 100 T.C. 32, 37 (1993). In Bondthis Court considered whether certain aspects of the above-referenced regulations were mandatory or directory and whether the taxpayer in that case had substantially complied so as to be entitled to a charitable contribution deduction. In reaching the conclusion that the requirements were directory, the Court expressed the following rationale: Under the above test we must examine section 170 to determine whether the requirements of the regulations are mandatory or directory with respect to its statutory purpose. At the outset, it is apparent that the essence of section 170 is to allow certain taxpayers a charitable deduction for contributions made to certain organizations. It is equally apparent that the reporting requirements of section 1.170A-13, Income Tax Regs., are helpful to respondent in the processing and auditing of returns on which charitable deductions are claimed. However, the reporting requirements do not relate to the substance or essence of whether or not a charitable contribution was actually made. We conclude, therefore, that the reporting requirements are directory and not mandatory. (Id. at 41; citation omitted.) Bond involved the contribution of two blimps to a qualified charity. The parties agreed upon the value, the fact that the appraiser was qualified, and all other regulatory requirements except whether the taxpayers' failure to obtain and attach to their return a separate written appraisal containing the information specified in the regulations would result in the disallowance of a charitable contribution deduction. The Court noted that substantially all of the information specified in the regulations had been provided, except the qualifications of the appraiser on the Form 8283 attached to the return. The Court concluded that the taxpayers in Bond had substantially complied and that disallowance of the deduction under those circumstances would be too harsh a sanction (essentially that the purposes of the statute had been substantially achieved). Subsequently, in Hewitt v. Commissioner (Dec. 52,326) 109 T.C. 258 (1997), the Court again considered these ©2011 Wolters Kluwer. All rights reserved. 14 of 31 7/28/2011 7:40 AM EFTA00598115 regulations in a situation where taxpayers donated to a charitable organization their shares of stock of a corporation that was not publicly traded. They claimed deductions in amounts that the parties agreed represented the fair market value of the stock. However, the taxpayers did not obtain qualified appraisals before filing their returns for the years at issue. The values or deductions claimed were not based upon appraisals; instead they were based upon average per-share prices of the stock traded in arm's-length transactions at approximately the same time as the gifts. Even though the values were undisputed, the Court found that the taxpayers had not complied with section 170 and section 1.170A-13, Income Tax Regs., and that they were not entitled to deduct any amount in excess of the