MEMORANDUM FINDINGS OF FACT AND OPINION
This deficiency case calls on us to apply the passive activity loss rules of section 469.
Petitioner Michael Rogerson is a successful entrepreneur. A patent holder and certified commercial pilot, Mr. Rogerson has owned and led an eponymous group of companies in the aerospace industry since the late 1970s. Also a sailing and boating enthusiast, during the tax years 2014, 2015, and 2016, Mr. Rogerson owned two yachts that he intended to charter.
The issues for our decision relate to the federal income tax consequences of Mr. Rogerson's participation in these two endeavors. Specifically, we must decide three questions: (1) whether, for the tax years 2014, 2015, and 2016, Mr. Rogerson materially participated in certain of his aerospace activities, with the result that income from those activities must be treated as nonpassive (we conclude he did); (2) whether Mr. Rogerson's yacht activities during the same years were per se passive as rental activities (we conclude they were); and (3) whether Mr. Rogerson is liable for accuracy-related penalties on the underpayments of tax resulting from our first two holdings (we conclude he is not).
As we explain in greater detail below, in light of the answers to the first two questions, Mr. Rogerson may not offset losses resulting from his passive yacht activities against income from his nonpassive aerospace activities. He is not liable for the accuracy-related penalties the Commissioner determined, however, because Mr. Rogerson had reasonable cause and relied in good faith on his certified public accountant in connection with the preparation of the returns at issue.
FINDINGS OF FACT
The parties have filed First and Second Stipulations of Fact, both with attached exhibits, and a Stipulation of Settled Issues, all of which are incorporated by this reference. Trial of this case was held remotely on May 5 and 6, 2021. Mr. Rogerson resided in Nevada when he filed his petition.
I. Aerospace Activities
A. Establishment of the Rogerson Companies
In the late 1970s, Mr. Rogerson had a summer job in the aerospace industry. When an acquaintance called to ask for help finding a new part, Mr. Rogerson decided that he would build the part himself. He engaged an engineer to design the part and a manufacturer to build it, and soon established his first company: Rogerson Aircraft Controls, Inc. The company manufactured electromechanical products and eventually changed its name to Rogerson Aircraft Corporation (RAC), which still operates today.
Over the next 40 years, Mr. Rogerson grew his business by acquiring and developing new product lines, all of which were held directly or indirectly by RAC. Business operations were located in California, in Irvine and Pasadena. Mr. Rogerson served as the chief executive officer of RAC and its subsidiaries at all times, personally held patents used in certain product lines, and obtained his commercial pilot's license to better understand the industry. By the end of 2013, the Rogerson companies included the following units, which Mr. Rogerson referred to as "brands":
B. 2014 Reorganization
By 2014, Mr. Rogerson was making an effort to separate the Rogerson companies' product lines based on whether they included legacy analog products or contemporary digital products. With the exception of analog instruments made by Kratos Instruments, the analog product lines were located together at RAC's facilities in Irvine.
During 2014, Mr. Rogerson gave further consideration to the organization of the Rogerson companies. In his view, the digital products of Rogerson Kratos were different from the analog products made by Kratos Instruments. Additionally, Mr. Rogerson had spoken with attorneys about estate planning and thought that "there was really no way the businesses would keep operating . . . after [his] demise." Accordingly, Mr. Rogerson wanted to reorganize the Rogerson companies.
In 2014, Mr. Rogerson decided that Kratos Instruments' operations should be moved from Pasadena to Irvine. He further decided to reorganize the Rogerson companies' legal structure: While all product lines had previously been owned directly or indirectly by RAC, Mr. Rogerson determined that the digital and the analog product lines would be divided and held (directly or indirectly) by two separate legal entities, each of which Mr. Rogerson would own directly.
Mr. Rogerson's plans were implemented in 2014 and 2015. First, RAC transferred all its interests in the analog product lines (including interests in legal entities that manufactured analog products) to Rogerson ATS, a corporation wholly owned by RAC, effective January 1, 2014.
After the 2014 reorganization was completed, Mr. Rogerson held his aerospace business through three corporations: RAC, RAEG, and RC. RAC (directly or indirectly) owned Rogerson Kratos and ITAN and was primarily engaged in manufacturing and selling digital products. RAEG (directly or indirectly) owned Controls, Systems, Pressure, and Kratos Instruments and was engaged in manufacturing and selling analog products.
C. Management of RAEG
Before and after the 2014 reorganization, the operations of RAEG's business units remained generally the same. With the exception of the physical relocation of Kratos Instruments to Irvine, the units manufactured the same products in the same locations and sold those products to the same customers. Indeed, at least some major customers were unaware of the reorganization as late as 2016. A small number of employees who declined to move with Kratos Instruments to Irvine were terminated, but otherwise staffing generally remained the same. And Mr. Rogerson continued to oversee the business as a whole.
Mr. Rogerson remained the CEO of RAC, RAEG, and RC from the time of their incorporation through the years at issue. While other company employees, including a small number of executives, ran the day-to-day operations of each corporation, Mr. Rogerson was actively engaged with them all, including RAEG, in particular by monitoring operations and production, communicating with management on employment issues, and taking a hands-on approach to sales and customer relations.
With respect to RAEG specifically, Mr. Rogerson received regular reports on the company's results, attended meetings to discuss the results, and took action when they fell below expectations.
On employment matters, Mr. Rogerson hired and fired executives, set department budgets, and weighed in on staffing at all levels of the company. During the years at issue, he was asked to approve all bonuses and even an hourly rate increase of $0.50. Generally, not even the president of RAEG was authorized to increase salaries or provide bonuses to RAEG employees—those decisions were made by Mr. Rogerson.
Consistent with his authority over staffing matters, Mr. Rogerson knew employees by their first names, communicated with them directly, and weighed in on how and when they should be replaced. When one employee was out on medical leave, Mr. Rogerson directed that his replacement should be hired from outside the company rather than promoted from within, citing "mid management depth" that was "too thin." Mr. Rogerson alerted executives when he felt certain employees were not pulling their weight, noting in one instance that an engineer "did not carry his own load during the [Kratos Instruments] move" and that Mr. Rogerson "[did not] see rewarding him by having [another engineer] doing his job now."
During this period, Mr. Rogerson was perhaps most extensively involved in sales and customer relations. On multiple occasions, he personally met with RAEG customers and potential customers and participated in customer negotiations. He traveled to visit customers, including internationally, and also hosted customers at RAEG's offices.
As part of his activities, Mr. Rogerson discussed RAEG with company executives, both in person and on the phone. During the years at issue, he communicated with RC and RAEG executives regarding RAEG's finances, its operations, the Kratos Instruments move, and the potential sale of the company. The RAEG president and the Rogerson companies' chief financial officer, together or separately, spent at least 10 to 15 hours per month with Mr. Rogerson on RAEG financial and operational matters. Mr. Rogerson also communicated with those individuals and others via email, including on weekends and holidays.
In short, Mr. Rogerson was an actively engaged CEO throughout the years at issue. And his level of involvement in RAEG in particular and in the Rogerson companies more generally during those years was substantially the same as it was during the years preceding the 2014 reorganization.
II. Mr. Rogerson's Yachts
In addition to being interested in aviation, Mr. Rogerson was a sailing enthusiast from an early age. He eventually developed an interest in powerboats, and during the years at issue he owned two yachts—the TOTO and the Falcon Lair—that he intended to make available for charter.
A. The TOTO
Mr. Rogerson purchased the TOTO, a 1983 Palmer Johnson 110-foot cutter, in or around 1999.
The TOTO was managed by a four-person crew, including a captain, a deckhand, a stewardess, and an individual that would help with the engine room and serve as a deckhand when needed. Because the TOTO was not chartered, the crew did not provide services to any customers during 2014, 2015, and 2016. For at least a portion of those years, the TOTO was in a shipyard for repairs.
B. The Falcon Lair
In 2014, Mr. Rogerson purchased the Falcon Lair, a 225-foot vessel built in 1983.
Like the TOTO, the Falcon Lair was not commercially registered during 2014, 2015, and 2016, nor was it chartered. Nevertheless, Mr. Rogerson engaged a management company to manage the Falcon Lair. The management company was responsible for arranging the Falcon Lair's trips from harbor to harbor, including by provisioning the yacht with fuel and food.
The Falcon Lair initially was operated by a 12-person crew, but that number dropped to 8 or 9 while the yacht was in the shipyard for refurbishment. Because the Falcon Lair was not chartered, the crew did not provide services to any customers during 2014, 2015, and 2016. When the Falcon Lair was not in the shipyard for repairs or refurbishment, Mr. Rogerson and his family sometimes used the yacht for personal trips.
III. Tax Reporting
A. Tax Preparation
From 2002 through the years at issue, Mr. Rogerson's personal income tax returns and the tax returns of the Rogerson companies were prepared by Tony Chang, a certified public accountant and tax professional.
Mr. Chang worked for one major accounting firm from 1994 to 1996 and for a second major accounting firm from 1996 to 2002. He then opened his own boutique practice with a partner. Mr. Rogerson and his companies had been clients of the second major accounting firm and continued to use Mr. Chang and his partner after they opened their boutique practice.
By 2014, Mr. Chang had been preparing Mr. Rogerson's personal income tax returns and the tax returns of the Rogerson companies for at least 12 years. He was familiar with the various entities in the corporate structure and the mechanics of the 2014 reorganization. He also was familiar with Mr. Rogerson's yacht activities. For each year from 2014 to 2016, Mr. Chang considered the application of the passive loss rules to Mr. Rogerson's activities and provided advice to Mr. Rogerson about how the activities should be reported on his personal income tax returns. As part of Mr. Chang's analysis, he collected information from Mr. Rogerson and other executives at the Rogerson companies, generally by having informal discussions with those individuals rather than requesting documentation. For each of the years at issue, Mr. Rogerson reported his activities consistent with Mr. Chang's advice.
B. Aerospace Activities
From at least 2005 to 2013, RAC filed Form 1120S, U.S. Income Tax Return for an S Corporation, reflecting all the results of Mr. Rogerson's aerospace business. For these years, no effort was made on the RAC returns to separate out the various activities of the Rogerson companies for purposes of the passive activity loss rules of section 469. In his personal income tax returns, Mr. Rogerson reported his involvement in RAC's combined activity as nonpassive.
Starting in 2014, RAC and RAEG each filed separate Forms 1120S. In his personal income tax returns for 2014, 2015, and 2016, Mr. Rogerson reported his involvement in RAC as nonpassive and his involvement in RAEG as passive. Based on Schedules K-1, Shareholder's Share of Income, Deductions, Credits, etc., issued by RAC, Mr. Rogerson reported a loss of $3,926,922 for 2014, income of $163,814 for 2015, and a loss of $2,855,771 for 2016. For the same years, he reported income of $7,093,760, $3,238,454, and $4,762,543 based on Schedules K-1 issued to him by RAEG.
RC filed a separate Form 1120S starting in 2015, and Mr. Rogerson reported his involvement in RC as nonpassive. For the taxable years 2015 and 2016, Mr. Rogerson reported ordinary income of $391,615 and $380,027, respectively, based on Schedules K-1 issued by RC.
C. Yacht Activities
In his 2014 personal income tax return, Mr. Rogerson sought to apply a passive loss carryforward of $3,409,986 related to his pre-2014 TOTO activity to offset the passive income that he reported from RAEG.
IV. Examination and Notice of Deficiency
Revenue Agent Amanda Dougherty conducted an examination of Mr. Rogerson's tax returns for 2014, 2015 and 2016.
Near the conclusion of the examination, Ms. Dougherty mailed Mr. Rogerson a Letter 5153, dated March 20, 2018, with an attached examination report proposing, among other adjustments, an accuracyrelated penalty under section 6662(a) for each tax year at issue. The letter was the first written communication sent to Mr. Rogerson regarding the penalties under section 6662(a) and was mailed before Ms. Dougherty had secured supervisory approval of the penalty assertion from her supervisor, Acting Group Manager Mayank Patel. When Mr. Rogerson failed to respond to the letter, Mr. Patel sent to Mr. Rogerson a signed "30-day letter" (Letter 950) on April 11, 2018, which again asserted the penalties under section 6662(a) and offered Mr. Rogerson the option to appeal. Additionally, on April 5, 2018, Ms. Dougherty prepared Form 300, Civil Penalty Approval Form. Mr. Patel signed the Civil Penalty Approval Form on June 25, 2018.
Mr. Rogerson appealed his case to the Internal Revenue Service Office of Appeals (IRS Appeals),
I. Burden of Proof
In general, the Commissioner's determinations set forth in a notice of deficiency are presumed to be correct, and the taxpayer bears the burden of showing that those determinations are in error. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). But the Commissioner bears the burden of proof with respect to any "new matter" he raises. See Rule 142(a). Where relevant, we discuss burden of proof in the individual issue sections below.
II. Section 469 Issues
Individual taxpayers may generally deduct, under sections 162 and 212 respectively, ordinary and necessary expenses paid or incurred in carrying on a trade or business or for the production of income. But the Code disallows any current deduction for a "passive activity" loss. I.R.C. § 469(a)(1), (b). A passive activity loss is the amount (if any) by which the aggregate losses from the taxpayer's passive activities for a taxable year exceed the aggregate income from passive activities for that year. I.R.C. § 469(d)(1). Thus, under the Code, passive losses cannot be used to offset income from nonpassive activities. See Beecher v. Commissioner, 481 F.3d 717, 721 (9th Cir. 2007), aff'g Cal Interiors Inc. v. Commissioner, T.C. Memo. 2004-99. A disallowed passive activity loss is not lost; rather, it is deferred or suspended and remains available as a deduction against future passive income. I.R.C. § 469(b).
In light of these rules, a great deal turns on whether an activity is passive or nonpassive under section 469. We therefore provide a brief discussion of how one makes that determination and then apply the relevant principles to Mr. Rogerson's case.
A. Passive Activities
A passive activity generally is an activity involving the conduct of a trade or business in which the taxpayer does not materially participate. I.R.C. § 469(c)(1). Moreover, subject to certain exceptions not relevant here, rental activities are passive regardless of whether the taxpayer materially participates. See I.R.C. § 469(c)(2), (4), (7).
B. Material Participation
A taxpayer's participation in an activity is "material" only if his involvement in the operations of the activity is regular, continuous, and substantial. I.R.C. § 469(h)(1). Temporary regulations first issued in 1988 provide seven tests for determining when this standard is satisfied. See Temp. Treas. Reg. § 1.469-5T(a) (stating that an individual will be treated as materially participating in an activity "if and only if" one of the seven tests is satisfied). Because, as explained below, we can resolve Mr. Rogerson's case based on one of the regulatory tests (the "five of ten" test), we do not discuss the remaining ones.
1. The Five of Ten Test
For purposes of section 469(h)(1), a taxpayer is treated as materially participating in an activity if he materially participated in the activity for any five out of the ten years immediately preceding the taxable year. Temp. Treas. Reg. § 1.469-5T(a)(5). The preamble to the temporary regulations adopting the test explained its purpose as follows:
T.D. 8175, 1988-1 C.B. 191, 203.
By its terms, the five of ten test applies to an activity that is the same over time. But the regulations also explain how to apply the test when a taxpayer's activities change over time. In these circumstances, final regulations call for a comparison of the taxpayer's current-year activities with his preceding-year activities. Specifically, Treasury Regulation § 1.469-5(j)(1) provides as follows:
In other words, if there is substantial similarity between the current-year activity and activities that the taxpayer materially participated in during a preceding year, then that preceding year counts as one year in applying the five of ten test to the current-year activity. See id. If there is substantial similarity between the current-year activity and activities that the taxpayer materially participated in for five of the last ten years, then the five of ten test is satisfied and the taxpayer is treated as materially participating in the current-year activity for the current year. See id.; Temp. Treas. Reg. § 1.469-5T(a)(5).
The history of Treasury Regulation § 1.469-5(j)(1) confirms this interpretation. When temporary regulations first established the five of ten test in 1988, they did not initially address how the test should apply to a situation in which an individual's business activities evolve during the ten-year period. See T.D. 8175, 1988-1 C.B. at 203; see also T.D. 8253, 1989-1 C.B. 121, 122 (noting the omission). In 1989, however, the Department of the Treasury (Treasury) and the IRS
As relevant here, the 1989 amendments also made certain changes to Temporary Treasury Regulation § 1.469-5T, including adding paragraph (j)(1), T.D. 8253, 1989-1 C.B. at 158, the precursor to Treasury Regulation § 1.469-5(j)(1). The preamble to the 1989 amendments explained the new rule as follows:
T.D. 8253, 1989-1 C.B. at 126. The text of the temporary rule tracked the preamble's explanation:
Temp. Treas. Reg. § 1.469-5T(j)(1), T.D. 8253, 1989-1 C.B. at 158. Like the current rule, therefore, the rule issued as part of the 1989 amendments required a comparison of the taxpayer's current-year activity to his preceding-year activity. If the activities were sufficiently similar—i.e., if they included undertakings that involved similar business operations—and if the taxpayer materially participated in the preceding-year activity, then the taxpayer would also be treated as materially participating in the current-year activity during the preceding year. See id.
By 1992, Treasury determined that the 1989 definition of activity, including the concept of undertaking, was too complicated and mechanical and that a more flexible approach was required. See Limitation on Passive Activity Losses and Credits—Definition of Activity, 57 Fed. Reg. 20,802, 20,803 (proposed May 15, 1992). As a result, Treasury issued Proposed Treasury Regulation § 1.469-4, 57 Fed. Reg. at 20,804, to replace Temporary Treasury Regulation § 1.469-4T. Simultaneously, Treasury finalized other parts of the 1989 amendments, including the clarification of the five of ten test that previously appeared at Temporary Treasury Regulation § 1.469-5T(j)(1). T.D. 8417, 1992-1 C.B. 173, 186.
When it was finalized in 1992, the rule explaining how the five of ten test should be applied was modified slightly to its current form, essentially replacing the concept of an "undertaking" with that of a "significant section 469 activit[y]." See Treas. Reg. § 1.469-5(j)(1). In describing the change, Treasury stated:
T.D. 8417, 1992-1 C.B. at 174.
Thus, the differences between the explanatory rule as originally proposed at Temporary Treasury Regulation § 1.469-5T(j)(1) and the final rule at Treasury Regulation § 1.469-5(j)(1) were not intended to be significant. And while the final rule's phrasing is somewhat convoluted, the text and regulatory history leave us with no doubt regarding its meaning. Specifically, the rule provides that even if a taxpayer's mix of activity changes over time, the taxpayer is treated as materially participating in a current-year activity if that activity substantially overlaps with activities that the taxpayer materially participated in for five of the last ten years. See Treas. Reg. § 1.469-5(j)(1); Temp. Treas. Reg. §. 1.469-5T(a)(5). As one commentator put it, "any significant overlap between activities for different tax years causes them to be treated as the same activity for purposes of the 5-out-of-10-years test." Libin Zhang, Passive Loss Rules, 549-3rd Tax Mgmt. (BNA), at IV.A.5.
2. Application to Mr. Rogerson and RAEG
In this case, we apply the material participation rules, and the five of ten test in particular, to determine whether Mr. Rogerson's involvement in RAEG was passive or nonpassive during 2014, 2015, and 2016. The Commissioner contends that Mr. Rogerson's involvement was nonpassive because Mr. Rogerson has failed to carry his burden to establish that he did not materially participate in RAEG. Additionally, the Commissioner argues that Mr. Rogerson satisfies the five of ten test for material participation.
Applying the five of ten test to RAEG for the tax years 2014, 2015, and 2016 requires us to examine Mr. Rogerson's pre-2014 involvement in the activities that ultimately constituted RAEG. See Temp. Treas. Reg. § 1.469-5T(a)(5). Moreover, given that the organization of Mr. Rogerson's activities changed during the relevant years (e.g., because of the 2014 reorganization), Treasury Regulation § 1.469-5(j)(1) informs our analysis.
Turning first to Mr. Rogerson's tax reporting, we have found at his request that all the results of his aerospace business, including the RAEG-related activity, were reported on RAC's income tax returns from 2005 to 2013. We have further found, again at Mr. Rogerson's request, that no effort was made during these years to separate the various activities of the Rogerson companies for purposes of the passive activity loss rules. In other words, RAC treated the aerospace business, including the activities that became part of RAEG, as a single, undifferentiated activity on its tax returns and when it issued Schedules K-1 to Mr. Rogerson. Mr. Rogerson reported his involvement in this consolidated activity as nonpassive on his personal income tax returns and similarly did not attempt to separate the activities. Cf. Treas. Reg. § 1.469-4(d)(5)(i) (providing that a shareholder of an S corporation may not treat activities grouped together by his corporation as separate activities). According to his own tax returns, therefore, Mr. Rogerson maintained that he materially participated in his aerospace business as a whole from at least 2005 to 2013.
Mr. Rogerson does not seem to dispute that his involvement in the overall business was nonpassive during those years; indeed, he maintains that Rogerson Kratos, which also was part of the aerospace business from 2005 to 2013, required large amounts of his time, and that he was involved with product development, manufacturing, and sales for the Rogerson Kratos product lines. Mr. Rogerson continued to report his activity with respect to Rogerson Kratos (i.e., RAC), as well as RC, as nonpassive during the years 2014 to 2016. And Mr. Chang, Mr. Rogerson's tax return preparer, testified with respect to the consolidated RAC activity that "it was pretty clear [Mr. Rogerson] was involved in that business."
There also is no dispute that, for the years 2005 to 2013, the product lines that ultimately were combined into RAEG in 2014 were a significant part of the consolidated RAC activity that Mr. Rogerson characterized as nonpassive. As described above, for purposes of applying the five of ten test, a taxpayer is treated as materially participating in an activity (here, RAEG) during a preceding year if the activity was included in an activity, or substantially overlaps with an activity (here, the aerospace business as a whole), in which the taxpayer materially participated for the preceding year. Treas. Reg. § 1.469-5(j)(1).
There can be no question there is substantial overlap between RAEG's activities in 2014 and later years and the activities of the overall aerospace business before 2014. Documentary evidence and the testimony of multiple witnesses confirms that the products, employees, and customers of the Rogerson companies were generally the same before and after the 2014 reorganization. In other words, the business activities that became part of RAEG were the same before and after the reorganization, but organized differently. And each of the RAEG product lines had been part of the RAC consolidated activity since long before the relevant ten-year period. As Mr. Rogerson states in his opening brief: "[T]he RAEG Activity that commenced in 2014 is really the compilation and consolidation of multiple product lines from various entities that had been conducted on a historical basis." Pet'r's Simultaneous Opening Br. 73.
In light of these facts and the applicable regulations, we conclude that, in 2014, 2015, and 2016, Mr. Rogerson's RAEG activity substantially overlapped with an activity (i.e., the aerospace business as a whole) that he materially participated in from at least 2005 to 2013. Under Treasury Regulation § 1.469-5(j)(1), therefore, the five of ten test has been met for each of 2014, 2015, and 2016, and Mr. Rogerson is treated as materially participating in RAEG for those years. See also Temp. Treas. Reg. § 1.469-5T(a)(5) (setting forth the five of ten test).
3. Mr. Rogerson's Counterarguments
Mr. Rogerson makes three primary arguments regarding the five of ten test: (1) the test is a new matter not properly before the Court, (2) the regulation containing the test is substantively and procedurally invalid, and (3) even if it does apply, the test does not require that Mr. Rogerson be treated as materially participating in RAEG. As we explain below, none of these arguments changes our conclusion.
a. New Matter
To begin with, Mr. Rogerson argues that the five of ten test is a new matter not pleaded by the Commissioner. Therefore, Mr. Rogerson contends, the matter is not properly before the Court or, in the alternative, the Commissioner bears the burden of proof.
The Commissioner is considered to have raised a new matter when the theory or basis upon which he relies was not stated in the notice of deficiency and the new theory or basis requires the presentation of different evidence. Id. at 197. But a new theory that merely clarifies or develops the original determination is not a new matter in respect of which the Commissioner bears the burden of proof. Id. at 191 (citing Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507 (1989)).
The notice of deficiency in this case stated that Mr. Rogerson's income from RAEG should be treated as nonpassive because he "materially participated in RAEG." Consistent with the notice, the Pretrial Memoranda of each party reflects an understanding that the nature of Mr. Rogerson's participation in RAEG would be addressed at trial.
As already discussed, the five of ten test is one of the seven regulatory tests for determining whether a taxpayer materially participated in an activity. See discussion in Opinion Part II.B.1 above. Indeed, Mr. Rogerson's own Pretrial Memorandum explained that the applicable regulations include "seven tests to determine whether a taxpayer has materially participated."
In summary, we conclude the five of ten test is properly before this Court. And, although we do not decide this issue based on the burden of proof, the burden with respect to the five of ten test remains with Mr. Rogerson.
b. Regulation Validity
Mr. Rogerson also contends, for the first time in his Supplemental Briefing, that the five of ten test is an invalid rule, both substantively and procedurally. We address these arguments in turn.
i. Substantive Validity
Mr. Rogerson argues that the five of ten test is substantively invalid because it contradicts section 469. Specifically, Mr. Rogerson contends that material participation exists under the statute only to the extent that a taxpayer's involvement in an activity is regular, continuous, and substantial during the year under consideration, citing section 469(h). Because the five of ten test analyzes taxpayer participation in an activity during prior years for purposes of determining participation in the current year, Mr. Rogerson views the test as contrary to the statute. We disagree.
Contrary to Mr. Rogerson's assertion, section 469 does not mandate the consideration of only present-year activity in determining material participation. Rather, section 469(h)(1) provides that "[a] taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is—(A) regular, (B) continuous, and (C) substantial." Nothing in the section addresses the timing of the taxpayer's involvement. Further, the statute dictates that "[t]he Secretary shall prescribe such regulations as may be necessary or appropriate to carry out provisions of this section, including regulations [that] specify what constitutes . . . material participation . . . for purposes of this section." I.R.C. § 469(l)(1). In other words, the statute is silent on the relevant period for assessing a taxpayer's involvement and directs the Secretary to fill in any gaps via regulation.
In light of these provisions, we easily conclude that the five of ten is not contrary to section 469 and that the authorities Mr. Rogerson cites are inapplicable.
ii. Procedural Validity
Next, Mr. Rogerson argues that the five of ten test is procedurally invalid because the temporary regulation in which it appears was enacted in violation of the notice and comment requirements of the Administrative Procedure Act (APA). See 5 U.S.C. § 553(b) and (c). Specifically, Mr. Rogerson observes that the five of ten test appears in Temporary Treasury Regulation § 1.469-5T, which was issued in 1988 without notice and comment. As described in Opinion Part II.B.1 above, certain parts of the original package were amended in 1989 and finalized in 1992, including Treasury Regulation § 1.469-5(j)(1). But the seven tests for material participation remain in their original temporary form.
Mr. Rogerson's argument raises an interesting issue that has been analyzed by judges and legal scholars. See, e.g., Intermountain Ins. Serv. of Vail, LLC v. Commissioner, 134 T.C. 211, 238-48 (2010) (Halpern & Holmes, JJ., concurring), supplementing T.C. Memo. 2009-195, rev'd and remanded on other grounds, 650 F.3d 691 (D.C. Cir. 2011), vacated and remanded, 566 U.S. 972 (2012); Eleanor D. Wood, Note, Rejecting Tax Exceptionalism: Bringing Temporary Treasury Regulations Back in Line With the APA, 100 Minn. L. Rev. 839 (2015) (collecting authorities); cf. Mann Constr., Inc. v. United States, 27 F.4th 1138, 1148 (6th Cir. 2022) ("Because the IRS's process for issuing Notice 2007-83 did not satisfy the notice-and-comment procedures for promulgating legislative rules under the APA, we must set it aside."). We need not resolve this issue, however, because it does not change the result in Mr. Rogerson's case, as described below.
For purposes of this discussion, we will assume (only for the sake of analysis) that Mr. Rogerson is correct and that the five of ten test is a procedurally invalid regulation that cannot be applied here. Because Mr. Rogerson's challenge to the regulation is that it was issued without first being subject to notice and comment, accepting his theory would mean that other temporary regulations issued as part of the same package would also be invalid. This would include all seven regulatory tests for determining material participation and the related rules in Temporary Treasury Regulation § 1.469-5T.
Assuming solely for the sake of analysis that (as Mr. Rogerson argues) the seven regulatory tests for material participation would need to be disregarded, we would be left with the general statutory rule of section 469(h) to determine whether Mr. Rogerson materially participated in RAEG during 2014, 2015, and 2016. As noted above, that provision states as follows: "A taxpayer shall be treated as materially participating in an activity only if the taxpayer is involved in the operations of the activity on a basis which is—(A) regular, (B) continuous, and (C) substantial."
Mr. Rogerson was a hands-on CEO during the years at issue. No major decisions could be made without his input, and no detail was too small for his attention. For example, Mr. Rogerson weighed in on accounting and financial reporting minutiae, interacted directly with company employees, and line-edited company documents, such as offer letters and press releases. Top RAEG executives reached out to him for permission to undertake routine actions, such as responding to customer inquiries or providing small bonuses or raises to company employees. On one occasion, RAEG's president sought approval from Mr. Rogerson to offer an employee a raise of $0.50 per hour. On other occasions, executives confirmed that Mr. Rogerson's direct involvement, whether in the form of "ongoing and specific directives," "edict[s]," or other directions, would be required to get things done.
Mr. Rogerson's involvement in sales and customer relations further belies any assertion that he was not substantially involved in RAEG's operations. Mr. Rogerson traveled to meet with RAEG customers, including on one occasion to Indonesia. He also met with RAEG customers at RAEG's offices. Indeed, the record reflects more than one instance in which Mr. Rogerson told RAEG executives that he would resolve a problem by meeting personally with the customer involved. Customers sometimes reached out to Mr. Rogerson directly to discuss issues, and Mr. Rogerson was involved in multiround negotiations with customers on pricing and other matters. He also approved any bid provided to a customer with an aggregate value over $100,000; in one month in 2016, that approval was requested at least a dozen times.
In the face of a record demonstrating that he spoke and emailed with executives regularly on RAEG matters, Mr. Rogerson asserts that most of these interactions took only minutes of his time. Even assuming that to be the case, however, Mr. Rogerson's ability to respond to detailed inquiries so quickly shows his detailed knowledge of every aspect of the business. Indeed, many of Mr. Rogerson's communications reflect first-hand experience with RAEG's employees, customers, and products that extends far beyond what could have been acquired by a passive investor.
To summarize, Mr. Rogerson would not prevail even if he were correct about the procedural validity of the five of ten test, because we find that he was regularly, continuously, and substantially involved in the operations of RAEG during 2014, 2015, and 2016 within the meaning of section 469(h). Accordingly, we need not decide whether the five of ten test is procedurally valid and turn instead to Mr. Rogerson's final argument.
c. Application of the Five of Ten Test
Mr. Rogerson argues that even if the five of ten test is valid and potentially applicable here, he should still prevail. Specifically, Mr. Rogerson asserts that applying the rules defining an "activity" for purposes of section 469 to the RAEG product lines before and after the 2014 reorganization results in two possible alternatives. First, RAEG could be viewed as an entirely new activity following the 2014 reorganization, with the result that there are no prior years of involvement for purposes of applying the five of ten test. Second, if a comparison of Mr. Rogerson's involvement in the RAEG activities before and after 2014 is required despite the 2014 reorganization, Mr. Rogerson contends that the five of ten test still does not apply because his involvement in the RAEG product lines was passive even before 2014. We take these arguments in turn.
i. New Activity Argument
Treasury Regulation § 1.469-4(c)(1) discusses the concept of an "activity" for purposes of section 469 and provides as follows: "One or more trade or business activities or rental activities may be treated as a single activity if the activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469." If a taxpayer decides based on all the facts and circumstances that multiple activities constitute a single economic unit and therefore may be treated as a single activity, the regulations refer to that determination as "grouping." See Treas. Reg. § 1.469-4(c)(2).
In support of his first proposed alternative—i.e., that for purposes of the five of ten test, RAEG did not exist as activity before 2014— Mr. Rogerson states as follows:
Pet'r's Simultaneous Suppl. Br. 25. Accordingly, Mr. Rogerson appears to contend that before the 2014 reorganization, the aerospace business as a whole (as reflected on RAC's returns) was the relevant activity under the regulations and that RAEG should therefore be treated as a new activity for 2014, 2015, and 2016. If RAEG was a new activity starting in 2014, Mr. Rogerson further contends, then the five of ten test cannot apply, because Mr. Rogerson would have no history of involvement in the activity.
Mr. Rogerson's argument is foreclosed by Treasury Regulation § 1.469-5(j)(1). As discussed in detail in Opinion Part II.B.1 above, that rule does not require the taxpayer's precise activity to have existed in prior years for purposes of applying the five of ten test. Indeed, the entire point of the rule is to address situations in which circumstances change over time. The rule applies as long as the taxpayer's currentyear activity (here, RAEG) "includes significant section 469 activities" (here, the RAEG product lines or RAEG as a whole) "that are substantially the same as significant section 469 activities there were included in [a preceding-year activity] in which the taxpayer materially participated" (here, the aerospace business as a whole). In other words, all that is required is substantial overlap between the current and preceding-year activities. The record here leaves no doubt that the activity conducted by RAEG in 2014, 2015, and 2016 overlaps substantially with the "single activity" reflected on RAC's prior returns—i.e., the aerospace business as a whole.
ii. Passive Activity Argument
Mr. Rogerson's second alternative—that his involvement in the RAEG product lines was passive even before 2014—faces a factual problem. There is no question that before 2014 Mr. Rogerson's involvement in the aerospace business as a whole was nonpassive. Similarly, there is no dispute that Mr. Rogerson reported his involvement in the aerospace business as a whole, including the activities that became part of RAEG, as nonpassive. In light of Treasury Regulation § 1.469-5(j)(1), these facts are sufficient to satisfy the five of ten test with respect to RAEG in 2014, 2015, and 2016.
In an attempt to escape the implications of his prior reporting, Mr. Rogerson contends that neither he nor RAC ever made an affirmative decision to group the RAEG product lines with his other aerospace activities. According to Mr. Rogerson, RAC's returns made no effort to indicate whether they reported "one activity or many activities, grouped or not." Pet'r's Simultaneous Answering Br. 34. The implication seems to be that, if the product lines that became part of RAEG were not formally grouped with RAC in prior years, then Mr. Rogerson's reporting and activity with respect to RAC as a whole would be irrelevant in applying the five of ten test to the RAEG product lines in subsequent years. But Mr. Rogerson is incorrect.
The regulations Mr. Rogerson cites required RAC to perform a grouping analysis for the years before 2014. See Treas. Reg. § 1.469-4(d)(5)(i) ("[A]n S corporation . . . must group its activities under the rules of this section."). Mr. Rogerson concedes that, before 2014, RAC reported the consolidated results of the entire aerospace business without differentiation.
Having addressed Mr. Rogerson's involvement with RAEG, we next turn to the proper characterization under section 469 of Mr. Rogerson's yacht activities for 2014, 2015, and 2016.
C. Rental Rules and the Yacht Activities
1. Rental Activities
As noted above, rental activities are passive regardless of a taxpayer's participation, subject to certain exceptions. See I.R.C. § 469(c)(2), (4), (7).
Neither of Mr. Rogerson's yachts (the TOTO and the Falcon Lair) was chartered during 2014, 2015, or 2016, but the parties agree that Mr. Rogerson intended to charter the yachts. Accordingly, the yachts were tangible property held for use by customers, and any income from the yacht activities would have represented amounts paid principally for the use of the tangible property. The yacht activities therefore were rental activities unless an exception applies.
2. Exceptions to Rental Activity
The regulations provide six exceptions to the definition of "rental activity," two of which are relevant to our analysis. Specifically, an activity involving the use of tangible property is not a rental activity if for the taxable year—(1) the average period of customer use for the property is seven days or less; or (2) the average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers. Temp. Treas. Reg. § 1.469-1T(e)(3)(ii)(A) and (B).
For purposes of these rules, a period of customer use is the period "during which a customer has a continuous or recurring right to use" the property. Treas. Reg. § 1.469-1(e)(3)(iii)(D). The average period of customer use is calculated by dividing the aggregate number of days in all periods of customer use of the property by the number of periods of customer use. Id. subdiv. (iii)(C).
Mr. Rogerson claims that his yacht activities qualify for both exceptions. We disagree.
a. Seven Days or Less Exception
As to the first exception, Mr. Rogerson has not requested any findings of fact or provided any evidence to allow us to conclude that his yacht activities involved charters of seven days or less during the years at issue or any other year. Mr. Rogerson claims that "[n]either TOTO nor Falcon Lair was available to be `rented' for weeks at a time" and that "the Yacht Charter Activity was intended to provide short-term use for day trips and other short-term excursions." Pet'r's Simultaneous Opening Br. 78. But regardless of these plans, no customers chartered the yachts during 2014, 2015, or 2016. And unlike the affirmative rule for defining a rental activity, which considers a taxpayer's intended or expected use of property, the exceptions to that rule turn on what actually happened during the taxable year. Compare Temp. Treas. Reg. § 1.469-1T(e)(3)(i) (allowing consideration of potential customer use and expected income in identifying a rental activity), with id. subdiv. (ii)(A) and (B) (establishing exceptions based on the "average period of customer use"), and Treas. Reg. § 1.469-1(e)(3)(iii)(C) and (D) (calculating the average period of customer use based on actual customer activity). Without any customer use, it is impossible to establish (as required by the regulations) the average period of customer use for the yachts. Accordingly, Mr. Rogerson fails to qualify for the first exception.
b. 30-day Exception
Mr. Rogerson's argument for the second exception falls short for the same reason. A claim in Mr. Rogerson's brief that "[n]o charter would have been for more than 30 days," Pet'r's Simultaneous Opening Br. 79, is not evidence, and again, the absence of any actual customer use of the yachts precludes us from determining that the average period of customer use was 30 days or less. Similarly, the fact that the TOTO and the Falcon Lair each had crews that conceivably could have provided services does not establish that significant personal services were in fact provided to customers. See Temp. Treas. Reg. § 1.469-1T(e)(3)(ii). Mr. Rogerson has requested no findings of fact nor produced any evidence about the kinds of services that crew members could or would provide to customers. And, more to the point, we know that no services were provided during the years at issue because the yachts were not chartered.
Mr. Rogerson has failed to establish that his yacht activities qualify under the exceptions provided in the temporary regulations. The activities therefore constituted rental activities and were per se passive during the years at issue.
III. Accuracy-Related Penalties
Lastly we must determine whether the section 6662 penalties the Commissioner determined in the notice of deficiency properly apply.
The Commissioner bears the burden of production with respect to an individual taxpayer's liability for a penalty and is required to present sufficient evidence showing that the penalty is appropriate. I.R.C. § 7491(c); Higbee v. Commissioner, 116 T.C. 438, 446-47 (2001). To meet this burden for a penalty under section 6662(a), the Commissioner must show that he complied with the procedural requirements of section 6751(b)(1). See I.R.C. § 7491(c); Frost v. Commissioner, 154 T.C. 23, 34 (2020). Once the Commissioner satisfies his burden of production, the taxpayer bears the burden of proving that the Commissioner's penalty determination is incorrect or that the taxpayer has an affirmative defense such as reasonable cause. See Rule 142(a); Higbee, 116 T.C. at 446-47.
Because we conclude that Mr. Rogerson had reasonable cause and relied in good faith on his adviser Mr. Chang in connection with the preparation of the 2014 to 2016 returns, we conclude that the penalties do not apply.
A. Section 6662(a) Penalty
Section 6662(a) and (b)(1) and (2) imposes a penalty equal to 20% of the portion of an underpayment of tax required to be shown on a taxpayer's return that is attributable to "[n]egligence or disregard of rules or regulations" and/or a "substantial understatement of income tax." Negligence includes "any failure to make a reasonable attempt to comply with the provisions of this title." I.R.C. § 6662(c). An understatement of income tax is a "substantial understatement" if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. I.R.C. § 6662(d)(1)(A). The Commissioner here has asserted section 6662(a) penalties on the basis of both negligence and substantial understatement.
B. Reasonable Cause and Good Faith
A taxpayer may avoid a section 6662(a) penalty by showing that there was reasonable cause for the underpayment and that the taxpayer acted in good faith. I.R.C. § 6664(c)(1). The determination of whether a taxpayer acted with reasonable cause and in good faith is made on a case-by-case basis, taking into account all of the pertinent facts and circumstances, including the taxpayer's efforts to assess the proper tax liability and the taxpayer's knowledge, experience, and education. Treas. Reg. § 1.6664-4(b)(1).
Mr. Rogerson contends, among other things, that he had reasonable cause for the position he took on his tax returns because he reasonably relied on Mr. Chang's advice.
1. Competent Tax Adviser
There is no precise threshold of competence that a tax adviser must have to justify a taxpayer's reliance. Rather, our practical test looks for expertise in the context of the facts of each case. CNT Inv'rs, LLC v. Commissioner, 144 T.C. 161, 224 (2015); see also 106 Ltd. v. Commissioner, 136 T.C. 67, 77 (2011) (finding the taxpayer's longtime attorney and accounting firm, who "would have appeared competent to a layman," and especially so to the taxpayer, had adequate expertise), aff'd, 684 F.3d 84 (D.C. Cir. 2012); Neonatology Assocs., P.A., 115 T.C. at 99 (holding that an insurance agent who did not claim to be a tax professional and had a direct financial interest in the transaction at issue lacked sufficient expertise to advise on the tax consequences of complex life insurance transactions).
Applying this practical test, we find that Mr. Chang was a competent tax adviser with sufficient expertise to justify reliance. Mr. Chang was a professionally licensed and experienced tax return preparer with his own practice. He knew Mr. Rogerson's personal and business affairs from his long relationship with Mr. Rogerson and his companies. There is no indication in the record that Mr. Rogerson had any reason to doubt Mr. Chang's competence to provide the advice he sought.
2. Provision of Information
To meet the second requirement of reasonable reliance, the taxpayer must provide necessary and accurate information to the adviser. See Alt. Health Care Advocates, 151 T.C. at 246. Additionally, the taxpayer cannot "fail to disclose a fact that [he] knows, or reasonably should know, to be relevant to the proper tax treatment of an item." Treas. Reg. § 1.6664-4(c)(1)(i). But a taxpayer is not obligated to share details that a reasonably prudent taxpayer would not know, or that he neither would know nor reasonably should know are relevant. CNT Inv'rs, LLC, 144 T.C. at 228.
We conclude that Mr. Rogerson provided Mr. Chang with necessary and accurate information during their discussions about Mr. Rogerson's activities and the positions taken on Mr. Rogerson's returns. Mr. Chang was Mr. Rogerson's long-time adviser and demonstrated his familiarity with Mr. Rogerson's affairs at trial. Additionally, Mr. Chang and Mr. Rogerson both credibly testified that Mr. Rogerson provided Mr. Chang with information regarding his level of involvement (generally in the form of hours estimates) in each of his activities each year for purposes of applying the passive loss rules.
United States v. Boyle, 469 U.S. 241, 251 (1985).
3. Good Faith Reliance on Advice
The last requirement is that a taxpayer must have actually received advice and relied upon it in good faith. Neonatology Assocs., P.A., 115 T.C. at 99. Advice is "any communication, including the opinion of a professional tax advisor, setting forth the analysis or conclusion of a person, other than the taxpayer, provided to (or for the benefit of) the taxpayer and on which the taxpayer relies, directly or indirectly." Treas. Reg. § 1.6664-4(c)(2).
Mr. Chang credibly testified at trial that he provided Mr. Rogerson with advice regarding the proper reporting of his activities under the passive loss rules for 2014, 2015, and 2016 and that Mr. Rogerson's reporting on his personal income tax returns was consistent with that advice. Mr. Rogerson likewise credibly testified that he received advice from Mr. Chang regarding the application of the passive loss rules to his activities and that he followed that advice. We believe their testimony and conclude that Mr. Rogerson reasonably relied on Mr. Chang's advice.
We note that we find credible Mr. Rogerson's reliance upon Mr. Chang's advice in part because Mr. Chang had been preparing Mr. Rogerson's individual returns and the Rogerson companies' returns for over a decade. See Schwalbach v. Commissioner, 111 T.C. 215, 230-31 (1998) (finding reasonable reliance where taxpayers consulted their long-time business and tax adviser, he advised them on what he believed was the correct reporting position, and they followed his advice). And Mr. Chang demonstrated his knowledge of the returns and the facts underlying them at trial. That Mr. Rogerson is a well-educated, sophisticated businessman does not preclude him from relying on Mr. Chang, his long-term tax adviser, to advise him regarding technical tax matters and prepare his returns. See Boyle, 469 U.S. at 251.
In light of these considerations, taking into account all of the facts and circumstances, we hold that Mr. Rogerson is not liable for the section 6662 accuracy-related penalties.
For the reasons described above, we conclude that Mr. Rogerson materially participated in RAEG for the tax years 2014, 2015, and 2016, with the result that income from that activity must be treated as nonpassive in each of those years. We further conclude that Mr. Rogerson's yacht activities during the same years were per se passive as rental activities and therefore that the income associated with those activities must likewise be passive. Finally, we conclude that the penalties the Commissioner determined in the notice of deficiency do not apply.
To reflect the foregoing,
An appropriate order will be issued, and decision will be entered under Rule 155.