T.C. Memo. 2017-16 UNITED STATES TAX COURT STEPHEN P. HARDY AND ANGELA M. HARDY, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent Docket No. 22409-14. Filed January 17, 2017. Stephen L. Kadish, Matthew F. Kadish, and Dean M. Rooney, for petitioners. Anita A. Gill and Nancy P. Klingshirn, for respondent. MEMORANDUM FINDINGS OF FACT AND OPINION BUCH, Judge: Dr. Stephen P. Hardy is a plastic surgeon who performs surgeries in various facilities, including Missoula Bone & Joint Surgery Center, LLC (MBJ). Dr. Hardy owns a minority interest in MBJ, but he has no day-to-day management responsibilities. Beginning with 2008 the Hardys reported the - 2 - [*2] income from MBJ as passive after having reported the income as nonpassive for previous years. The passive income allowed the Hardys to absorb unrelated passive activity losses. The Commissioner issued a notice of deficiency for 2008 through 2010 recharacterizing the income as nonpassive and determining deficiencies. The Commissioner also determined a section 6662(a) accuracy- related penalty for each year. The Commissioner argues that Dr. Hardy’s activity as a plastic surgeon should be grouped with his activity at MBJ. After concessions by both parties, we must decide whether the Hardys may report Dr. Hardy’s income from MBJ as passive. If so, we must also decide whether they may deduct a passive activity loss carryover from prior years. If the Hardys are liable for deficiencies, then we must decide whether they are liable for accuracy-related penalties. At trial the Hardys moved to amend the pleadings to conform to the evidence, arguing that they overpaid self-employment tax for 2008 and 2009. We will grant this motion. The Hardys may treat Dr. Hardy’s income from MBJ as passive for all three years. Because they did not previously group Dr. Hardy’s medical practice with his ownership interest in MBJ, they are not regrouping his interest in MBJ. Moreover, the Commissioner may not regroup Dr. Hardy’s activities into a single unit because there is more than one reasonable method for grouping his activities - 3 - [*3] and the Hardys’ grouping does not have the principal purpose of circumventing the underlying policies of section 469.1 However, the Hardys may not deduct a passive activity loss carryover for 2008 because they should have deducted the loss for the year in which the loss was incurred. Moreover, the Hardys are not liable for self-employment tax for 2008 or 2009 because Dr. Hardy received the distributions from MBJ as a limited partner acting in his capacity as an investor. Although the Commissioner did not meet his burden of production for section 6662(a) accuracy-related penalties for underpayments due to negligence, he may have met his burden of production for underpayments due to substantial understatements of income tax, depending on the Rule 155 computations. However, the Hardys established that they had reasonable cause and acted in good faith when they relied on the advice of a tax professional for claiming a passive activity loss carryover deduction from years that are not before us. They did not establish that they had reasonable cause and acted in good faith with respect to the portions of the underpayments due to the disallowed charitable contribution deductions, which were among the items they conceded. 1Unless otherwise indicated, all section references are to the Internal Revenue Code (Code) in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. All monetary amounts are rounded to the nearest dollar. - 4 - [*4] FINDINGS OF FACT I. The Hardys The Hardys were married during 2008 through 2010, the years in issue. Dr. Hardy is a plastic surgeon. Since the early nineties he has practiced as a plastic surgeon specializing in pediatric reconstructive surgery. Dr. Hardy conducts his medical practice through Northwest Plastic Surgery Associates, a single-member PLLC, which Mrs. Hardy runs as the chief operating officer. Before joining a surgery center, Dr. Hardy operated on his patients at his office or at two local hospitals. Dr. Hardy can operate at his office only if the procedure requires local anesthesia. If a procedure requires general anesthesia, Dr. Hardy operates at a hospital. And if a procedure requires an overnight stay, then the procedure must be performed at a hospital. Dr. Hardy will explain to his patients the options for where a surgery can take place, and the practice manager will give them a cost estimate for different locations. His patients determine where a surgery will be performed. Because of the limited availability of operating rooms, however, Dr. Hardy struggles to obtain space at a hospital for the procedures. Dr. Hardy is paid for the surgeries that he performs. Surgical procedures generally have three fee components: (1) a fee for surgical services provided by - 5 - [*5] the surgeon; (2) a fee for anesthesia services provided by the anesthesiologist; and (3) a fee for the use of a surgical facility and its accompanying services. Patients pay the facility fee separately from Dr. Hardy’s fee as a surgeon. Facility fees typically include the use of medical equipment, supplies, and staff, who include the front office clerk and the nurses who provide pre- and post-operative care. In 2001 the Hardys first considered opening their own surgery center. The Hardys believed that a surgery center would benefit patients because it would provide a cost-efficient alternative to having surgeries performed at a hospital, and it would provide Dr. Hardy with greater latitude in scheduling those surgeries. The following year, the Hardys purchased land and drew up plans to build a surgery center. Before the Hardys began construction, representatives of MBJ and two other surgery centers approached Dr. Hardy about his becoming a member. The Hardys determined that it would be a wiser business decision to join an already operational surgery center because of the expenses of constructing, staffing, certifying, and operating the center. II. MBJ MBJ was a limited liability company formed by a group of practicing physicians in 2004 for the purpose of operating a surgery center. It is treated as a - 6 - [*6] partnership for Federal income tax purposes. In 2005 MBJ began operating a surgery center.2 MBJ provides patients with a cost-efficient alternative to having procedures performed at a hospital. MBJ is equipped for doctors to perform procedures that require local or general anesthesia; however, complex procedures and procedures that require an overnight stay must be performed at a hospital. MBJ is professionally managed. MBJ hires its own employees and does not share any employees with Northwest Plastic Surgery. Like hospitals, MBJ directly bills patients for facility fees. MBJ then distributes to each of its members his or her share of the earnings based on the facility fees less expenses. MBJ uses a third-party accounting firm to prepare the Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., for the members. MBJ does not pay physicians for their procedures. In 2006 Dr. Hardy purchased a 12.5% interest to join seven other practicing physicians in MBJ. He paid $163,974 for his interest. Dr. Hardy cannot sell his interest in MBJ to a third party. The following year, the Hardys built an office next to MBJ for Northwest Plastic Surgery. 2MBJ Orthopedic Center is a separate entity that was formed by some of the same doctors as MBJ. It is in the same building as MBJ. Dr. Hardy has no interest in the orthopedic center. - 7 - [*7] Dr. Hardy has never managed MBJ, and he has no day-to-day responsibilities there. Although he meets with the other members quarterly, he does not have any input into management decisions. He generally is not involved in hiring or firing decisions. His role and participation in MBJ have not changed since he became a member. Dr. Hardy performs surgeries on patients at MBJ on Mondays. Rarely, Dr. Hardy will operate at MBJ on other days of the week. Dr. Hardy does not pay rent to perform surgeries at MBJ; the patients pay the facility fees directly. In 2008 and 2009 Dr. Hardy performed 11% of the surgeries at MBJ. In 2010 Dr. Hardy performed 9% of the surgeries at MBJ. He also had designated alternating Tuesdays as his surgical days at two area hospitals. On the other days of the week, Dr. Hardy continued to perform surgeries at his medical practice. He performed approximately 50% of his surgeries at his office, 20% at MBJ, and the remainder at other facilities. Dr. Hardy receives a distribution from MBJ regardless of whether he performs any surgeries at the surgery center, and his distribution is not dependent on how many surgeries he performs at MBJ. MBJ does not have a minimum surgery requirement to receive a distribution. - 8 - [*8] After 2010 Dr. Hardy hired another surgeon at Northwest Plastic Surgery. If that surgeon’s patient chooses, the surgeon performs the surgery at MBJ. That surgeon does not hold an interest in MBJ. III. Reporting Since 2004 the Hardys have been hiring Walter Kero, a partner and tax director at Junkermier, Clark, Campanella, Stevens, PC, to prepare and file their Forms 1040, U.S. Individual Income Tax Return. Mr. Kero is a certified public accountant with over 40 years of experience. For 2006 and 2007 the Hardys reported their MBJ income as nonpassive. Using his training and experience, Mr. Kero tries to identify income as either payroll, passive, or portfolio. Mr. Kero determined that the income from MBJ was nonpassive by relying on the Schedule K-1. The Schedule K-1 stated that the income was from a trade or business and included self-employment tax. He did not group Dr. Hardy’s ownership interest in MBJ with Dr. Hardy’s medical practice activity, and he did not consider the grouping regulations. The Hardys filed their 2006 return and attached a Schedule E, Supplemental Income and Loss, reporting $279,988 of nonpassive income from MBJ. They attached a Form 8582, Passive Activity Loss Limitations, reporting a total unallowed loss of $58,786. They did not attach any statement reporting that - 9 - [*9] they had grouped Dr. Hardy’s ownership interest in MBJ with his medical practice activity. The Hardys filed their 2007 return and attached a Schedule E, reporting nonpassive income from MBJ of $199,121. They attached a Form 8582, reporting a total unallowed loss of $119,615, which included carryover losses from the previous year of $58,786. They did not attach any statement reporting that they had grouped Dr. Hardy’s ownership interest in MBJ with his medical practice activity. In 2008 Mr. Kero determined that the income from MBJ was passive, and he began reporting it as such. Mr. Kero learned that Dr. Hardy was not involved in the management of MBJ and was not liable for the debts of MBJ. In determining that the income was passive, he went through a checklist of passive activity criteria and obtained corroborating information from the Hardys. He determined that the relationship of Dr. Hardy to MBJ was passive. Mr. Kero did not amend the Hardys’ return for 2006 or 2007. Mr. Kero understood that the difference between passive and active characterization can have a profound effect on a taxpayer’s income. However, because he did not believe the change would be material, he did not amend the Hardys’ return for 2006 or 2007. - 10 - [*10] The Hardys filed their 2008 return and attached a Schedule E, reporting passive income from MBJ of $250,494. They attached a Form 8582, reporting a total passive activity loss of $256,411, which included carryover losses from previous years of $119,615. After netting their passive income against their passive losses, they also reported an allowable loss of $250,494, leaving $5,917 as a suspended loss. Additionally, the Hardys reported self-employment tax of $26,745 from the income Dr. Hardy received from Northwest Plastic Surgery and MBJ. The Hardys filed their 2009 return and attached a Schedule E, reporting passive income from MBJ of $245,012. They attached a Form 8582, reporting an allowed passive activity loss of $104,224, which included a $5,917 carryover loss from the previous year. Additionally, the Hardys reported self-employment tax of $26,530 from the income Dr. Hardy received from Northwest Plastic Surgery and MBJ. The Hardys filed their 2010 return and attached a Schedule E, reporting passive income from MBJ of $270,521. They attached a Form 8582, reporting an allowed passive activity loss of $157,187.