¶2MEMORANDUM FINDINGS OF FACT AND OPINION
¶3JACOBS, Judge: Respondent determined deficiencies in petitioners' Federal income taxes and accuracy-related penalties under section 6662(a) for 1996 and 1997 as follows: 1
| Penalty | ||
| Docket No./Year | Deficiency | Sec. 6662(a) |
| Docket No. 7321-00 | ||
| 1996 | $ 186,324 | $ 37,264.80 |
| 1997 | 53,547 | 10,709.40 |
| Docket No. 7334-00 | ||
| 1996 | 235,290 | 47,058.00 |
| 1997 | 59,632 | 11,926.40 |
¶5The issues to be decided 2 are:
¶61. Whether payments by Ray Bitker & Sons partnership (the Bitker partnership) on petitioners' debts should be characterized (for tax purposes) as rental expenses of the Bitker partnership or constructive*207 partnership distributions to petitioners;
¶72. whether petitioners received distributions from the Bitker partnership in 1996 and 1997 that exceeded their bases in the Bitker partnership; and
¶83. whether petitioners are liable for accuracy-related penalties under section 6662(a) for the years at issue.
¶9 FINDINGS OF FACT
¶10Some of the facts have been stipulated and are so found. The stipulation of facts and the exhibits attached thereto are incorporated herein by this reference.
A. Petitioners and the Bitker Partnership¶11Curtis Bitker and Lynn Bitker are husband and wife. Jerry Bitker and Coleen Bitker are husband and wife. Curtis Bitker and Jerry Bitker (petitioner husbands) are brothers. All petitioners resided in Minnesota when the petitions in these cases were filed.
¶12*208 Petitioner husbands were raised on a farm in Norman County, Minnesota, owned by their father, Ray Bitker. Petitioner husbands and their father formed the Bitker partnership on January 1, 1979. Each owned a one-third interest in the Bitker partnership. The Bitker partnership's principal business is farming; however, it does not own any of the land that is farmed.
¶13In 1989, petitioner husbands acquired their father's interest in the Bitker partnership at no cost; each then held a one- half interest in the partnership. Although their father was no longer a partner in the Bitker partnership, the partnership continued to farm his land and pay him rent for the use thereof.
¶14In 1991, Lynn Bitker and Coleen Bitker (petitioner wives) each obtained a 20-percent interest in the Bitker partnership at no cost. Since 1991, each petitioner husband has held a 30-percent interest in the Bitker partnership, and each petitioner wife has held a 20-percent interest.
¶15During the years at issue, petitioner husbands conducted all of their farming activity through the Bitker partnership. Jerry Bitker is responsible for the day-to-day bookkeeping of the Bitker partnership's income and expenses.
¶16Some of the*209 farm crops were processed and sold through several cooperatives. Only active farm operators could purchase shares (and thus become members) of these cooperatives. In most instances, shares of stock in the cooperatives were issued to petitioner husbands (as opposed to the Bitker partnership). Nonetheless, petitioners accounted for their shares of the cooperatives' income through the Bitker partnership.
B. The Bitker Partnership's Forms 1065¶17Earl Mostoller, a certified public accountant, is a member of Drees, Riskey & Vallager, Ltd., an accounting firm that has prepared the Bitker partnership tax returns since its formation. Mr. Mostoller has prepared petitioners' Forms 1040, U.S. Individual Income Tax Return, and the Bitker partnership's Forms 1065, U.S. Partnership Return of Income, since 1985. Jerry Bitker provided Mr. Mostoller with information as to the Bitker partnership's income and expenses, as well as loan records from the Farm Credit Service. Loans made for partnership purposes were made in petitioners' names rather than in the name of the Bitker partnership. All four petitioners are personally liable for the Bitker partnership's debts.
¶18Mr. Mostoller prepared and maintained*210 a depreciation schedule showing the historical cost of equipment, less depreciation taken each year. He verified loan balances by calling the Farm Credit Service. Mr. Mostoller calculated the Bitker partnership's capital by subtracting the loan balances from the total adjusted cost bases of partnership assets (cost basis less depreciation). Mr. Mostoller determined the partners' capital contributions and distributions by taking each partner's beginning capital account, adding thereto (or subtracting therefrom) the partner's distributive share of the Bitker partnership's net income (or net loss) for the year, and subtracting the partner's ending capital account--the difference being the amount of the distribution to, or the amount of the contribution by, the partner to the Bitker partnership for the particular year.
¶19On Schedules K-1 attached to Forms 1065 filed by the Bitker partnership for years prior to 1991, the amounts for "Partner's share of liabilities" and "Analysis of partner's capital account" were left blank. Schedules K-1 attached to the Forms 1065 filed by the Bitker partnership for years 1991-97 (the 1991-97 Schedules K-1) reflect that each petitioner husband owned 30*211 percent of its capital and that each was entitled to 30 percent of its profits and losses. The 1991-97 Schedules K-1 reflect that each petitioner wife owned 20 percent of the capital of the Bitker partnership and that each was entitled to 20 percent of its profits and losses. The 1991-97 Schedules K-1 also reflect each "Partner's share of liabilities" and "Analysis of partner's capital account" as follows (discrepancies attributable to rounding):
Curtis Jerry Lynn
______ _____ ____
1991
Partner's share of liabilities $ 557,991 $ 557,991 $ 371,994
Analysis of partner's capital account:
*212 Capital account at beginning of year (519,852) (519,852) -0-
Capital contributed during year 117,284 117,284 -0-
Partner's share of net book income (loss) 19,149 19,149 12,766
Withdrawals and distributions -0- -0- (268,377)
Capital account at end of year (383,418) (383,418) (255,611)
1992
Partner's share of liabilities 629,863 *213 629,863 419,909
Analysis of partner's capital account:
Capital account at beginning of year (383,417) (383,417) (255,612)
Capital contributed during year -0- -0- -0-
Partner's share of net book income (loss) 11,246 11,246 7,497
Withdrawals and distributions (67,126) (67,126) (44,751)
Capital account at end of year (439,297) (439,297) (292,866)
*214 1993
Partner's share of liabilities 457,122 457,122 304,749
Analysis of partner's capital account:
Capital account at beginning of year (439,296) (439,296) (292,866)
Capital contributed during year 88,159 88,159 58,773
Partner's share of net book income (loss) 24,201 24,201 16,134
Withdrawals and distributions -0- -0- -0-
Capital account at end of year (326,936) (326,936) (217,959)
1994
Partner's share of liabilities 691,441 691,442 460,961
Analysis of partner's capital account:
Capital account at beginning of year*215 (326,296) (326,936) (217,959)
Capital contributed during year -0- -0- -0-
Partner's share of net book income (loss) 69,265 69,265 46,177
Withdrawals and distributions (255,431) (255,431) (170,287)
Capital account at end of year (512,462) (513,106) (342,070)
1995
Partner's share of liabilities 1 593,699 593,698395,799
Analysis of partner's capital account:
Capital account at beginning of year (513,102) (513,102) (342,070)
Capital contributed during year 20,240 20,240 13,494
Partner's share of net book income (loss) (75,354) (75,355) (50,236)
Withdrawals and distributions -0- -0- -0-
Capital account at end of year (568,216) (568,217) (378,812)
*216 1996
Partner's share of liabilities 1 554,358 554,357369,571
Analysis of partner's capital account:
Capital account at beginning of year (568,216) (568,217) (378,812)
Capital contributed during year -0- *217 -0- -0-
Partner's share of net book income (loss) 58,559 58,559 39,039
Withdrawals and distributions (209,266) (209,266) (139,511)
Capital account at end of year (718,923) (718,924) (479,284)
1997
Partner's share of liabilities 1 551,278 551,278367,518
Analysis of partner's capital account:
Capital account at beginning of year (718,923) (718,924) (479,284)
Capital contributed during year -0- -0- -0-
Partner's share of net book income (loss) 45,089 45,087 30,059
Withdrawals and distributions (4,673) (4,673) (3,116)
Capital account at end of year (678,507) (678,510) (452,341)
[Table continued]
Coleen Total
______ _____
1991
Partner's share of liabilities $ 371,994 $ 1,859,970
Analysis of partner's capital account:
*218 Capital account at beginning of year -0- (1,039,704)
Capital contributed during year -0- 234,568
Partner's share of net book income (loss) 12,766 63,830
Withdrawals and distributions (268,377) (536,754)
Capital account at end of year (255,611) (1,278,058)
1992
Partner's share of liabilities 419,909 2,099,544
Analysis of partner's capital account:
Capital account at beginning of year (255,612) (1,278,058)
Capital contributed during year -0- -0-
Partner's share of net book income (loss) 7,497 37,486
Withdrawals and distributions (44,751) (223,754)
Capital account at end of year (292,866) (1,464,326)
1993
Partner's share of liabilities 304,749 1,523,742
Analysis of partner's capital account:
Capital account at beginning of year (292,866) (1,464,324)
Capital contributed during year 58,773 293,864
Partner's*219 share of net book income (loss) 16,134 80,670
Withdrawals and distributions -0- -0-
Capital account at end of year (217,959) (1,089,790)
1994
Partner's share of liabilities 460,961 2,304,805
Analysis of partner's capital account:
Capital account at beginning of year (217,960) (1,089,151)
Capital contributed during year -0- -0-
Partner's share of net book income (loss) 46,177 230,884
Withdrawals and distributions (170,287) (851,436)
Capital account at end of year (342,071) (1,709,709)
1995
Partner's share of liabilities 1 395,799 1,978,995
Analysis of partner's capital account:
Capital account at beginning of year (342,071) (1,710,345)
Capital contributed during year 13,494 67,468
Partner's share of net book income (loss) (50,236) (251,181)
Withdrawals and distributions -0- -0-
Capital account at end of year*220 (378,813) (1,894,058)
1996
Partner's share of liabilities 1 369,571 1,847,857
Analysis of partner's capital account:
Capital account at beginning of year (378,813) (1,894,058)
Capital contributed during year -0- -0-
Partner's share of net book income (loss) 39,039 195,196
Withdrawals and distributions (139,510) (697,553)
Capital account at end of year (479,284) (2,396,415)
1997
Partner's share of liabilities 1 367,518 1,837,592
Analysis of partner's capital account:
Capital account at beginning of year (479,284) (2,396,415)
Capital contributed during year -0- -0-
Partner's share of net book income (loss) 30,059 150,294
Withdrawals and distributions (3,116) (15,578)
Capital account at end of year (452,341) (2,261,699)
¶20*221 None of the Bitker partnership's Forms 1065 for years before 1992 showed balance sheets. The balance sheets reported on the 1992-97 Forms 1065 show assets, liabilities, and partners' capital at yearend for 1991-97 as follows (discrepancies attributable to rounding):
¶21 1991 1992 1993 1994
¶22 ____ ____ ____ ____
¶23Assets:
¶24Cash $ 70,073 $ 23,230 $ 22,089 $ 4,000
¶25Other current assets 154,635 99,990 57,730 144,000
¶26Buildings & other depreciable
¶27 assets 1,389,587 1,625,901 1,466,600 1,678,611
¶28Less accumulated depreciation (1,032,382) (1,113,910) (1,112,469) (1,232,151)
¶29 ___________ ___________ ___________ __________
¶30 Total assets 581,913 635,220 433,950 594,460
¶31Liabilities & capital:
¶32Short-term mortgages, notes,
¶33 bonds 1,859,971 2,099,544*222 1,523,741 692,861
¶34Long-term mortgages, notes,
¶35 bonds -0- -0- -0- 1,611,944
¶36Partners' capital accounts (1,278,058) (1,464,324) (1,089,791) (1,710,345)
¶37 ___________ ___________ ___________ ___________
¶38 Total liabilities & capital 581,913 635,220 433,950 594,460
¶39 1995 1996 1997
¶40 ____ ____ ____
¶41Assets:
¶42Cash 128,593 85,057 29,964
¶43Other current assets 533,485 137,815 102,530
¶44Buildings & other depreciable
¶45 assets 1,661,845 1,635,270 1,930,251
¶46Less accumulated depreciation (1,299,147) (1,367,442) (1,453,207)
¶47 ___________ ___________ ___________
¶48 Total assets 1,024,776 490,700 609,538
¶49Liabilities & capital:
¶50Short-term mortgages, notes,
¶51*223 bonds 939,839 1,039,258 1,033,645
¶52Long-term mortgages, notes,
¶53 bonds 1,978,995 1,847,857 1,837,592
¶54Partners' capital accounts (1,894,058) (2,396,415) (2,261,699)
¶55 ___________ ___________ ___________
¶56 Total liabilities & capital 1,024,776 490,700 609,538
¶57Of the $ 939,839 of short-term debt and $ 1,978,995 of long- term debt reported on the 1995 Form 1065, $ 205,263 of short-term debt and $ 756,759 of long-term debt were owed by petitioners in their individual capacities.
¶58On the 1996 Form 1065, the Bitker partnership reported ordinary income of $ 132,754 that was attributable to its farming activity. On the 1996 Schedule F, Profit or Loss From Farming, the Bitker partnership reported $ 2,116,506 of gross income and $ 1,983,752 of expenses. The expenses included, inter alia, $ 236,390 for rent or lease of land, animals, etc., $ 92,811 for depreciation, and $ 223,411 for interest.
¶59On the 1997 Form 1065, the Bitker partnership reported ordinary income of $ 150,255 that was attributable to its farming activity. *224 On the 1997 Schedule F, the Bitker partnership reported $ 2,223,960 of gross income and $ 2,073,705 total expenses, which expenses included, inter alia, $ 141,072 for rent or lease of land, animals, etc., $ 85,267 for depreciation, and $ 211,622 for interest.
¶60Each year on their Forms 1040, petitioners reported the income reflected on their Schedules K-1 from the Bitker partnership. On their 1996 Forms 1040, in addition to the income from the Bitker partnership, petitioners reported other income from rental real estate on Schedules E. On their 1996 Form 1040, Curtis and Lynn Bitker reported $ 80,000 of rental income from farmland in Polk County, Minnesota. On their 1996 Form 1040, Jerry and Coleen Bitker reported $ 80,000 of rental income from two parcels of farmland in Norman County, Minnesota. Petitioners did not report any income from rental real estate on their 1997 Forms 1040.
C. The Notices of Deficiency¶61In September 1998, an agent of respondent began an examination of the Bitker partnership's 1996 and 1997 Forms 1065 and petitioners' 1996 and 1997 Forms 1040. Mr. Mostoller represented both the Bitker partnership and petitioners during the examination.
¶62The agent requested*225 that petitioners extend the period for assessment of tax for 1996 and 1997. They declined to do so. As a consequence, petitioners did not have an opportunity to have the proposed changes for 1996 and 1997 reviewed by the Appeals Office of the Internal Revenue Service.
¶63The agent calculated that, as of December 31, 1995, the partners had negative capital accounts totaling $ 1,144,343 and the Bitker partnership had short-term debt of $ 734,576 and long-term debt of $ 1,222,236. The agent determined that (1) for 1996 the Bitker partnership had a profit of $ 334,263, interest income of $ 12, and a short-term capital gain of $ 50,234 and (2) for 1997 it had a profit of $ 260,411 and interest income of $ 39. The agent also determined that the following amounts constituted personal expenses of petitioners and that the Bitker partnership's payment of the expenses constituted distributions by the partnership to the partners (discrepancies attributable to rounding):
Curtis Jerry Lynn Coleen Total
______ _____ ____ ______ _____
1996
Payments on land $ 121,347 $ 121,347 -0- -0- $ *226 242,694
Repairs 2,723 2,723 $ 1,816 $ 1,816 9,078
Supplies 102 102 68 68 340
Depreciation 296 296 197 197 986
Utilities 734 734 490 490 2,448
Medical insurance 1,780 1,780 1,187 1,187 5,934
_______ _______ ______ ______ _______
Total 126,982 126,982 3,758 3,758 261,480
1997
Payments on land 64,494 64,494 -0- -0- 128,988
Repairs 212 212 141 141 706
Supplies 407 407 271 271 1,356
Depreciation 277 277 184 184 922
Utilities 708 708 472 472 2,360
Medical insurance 1,304 1,304 870 870 4,348
*227 ______ ______ _____ _____ _______
Total 67,402 67,402 1,938 1,938 138,680
¶64The agent reclassified the depreciation, as well as the interest paid by the Bitker partnership on petitioners' personal mortgages on their farmland (the mortgages are on land that the partnership farms), as rental expenses on petitioners' Schedules E.
¶65Respondent issued notices of deficiency to petitioners for 1996 and 1997. The statements of changes attached to the notices reflect the following adjustments:
¶66 12/31/96 12/31/97
¶67Curtis & Lynn Bitker
¶68 Capital gain or loss $ 473,015 $ 89,312
¶69 Exemptions 14,076 1,590
¶70 Itemized deductions -- 2,171
¶71 K-1 Ray Bitker & Sons (C) 60,453 33,046
¶72 K-1 Ray Bitker & Sons (L) 40,302 22,031
¶73 Schedule E rental expense (101,453) (25,000)
¶74 Schedule F Curtis (947) *228 45,387
¶75 Schedule F Lynn (2,645) --
¶76 SE AGI adjustment 221 (5,332)
¶77 Self-employ health (1,762) (1,619)
¶78 _________ ________
¶79 Total adjustments 481,260 161,586
¶80 12/31/96 12/31/97
¶81Jerry & Coleen Bitker
¶82 Capital gain or loss $ 473,015 $ 89,312
¶83 Exemptions 5,100 1,060
¶84 Itemized deductions 6,770 2,535
¶85 K-1 Ray Bitker & Sons (C) 40,302 22,031
¶86 K-1 Ray Bitker & Sons (J) 60,453 33,047
¶87 Schedule E rental (101,597) (25,000)
¶88 Schedule F Coleen (1,032) -
¶89 Schedule F Jerry 36,545 33,770
¶90 SE AGI adjustment *229 (2,542) (4,511)
¶91 Self-employ health (2,241) (1,953)
¶92 Standard deduction (6,700) -
¶93 ________ _______
¶94 Total adjustments 508,073 150,291
¶95The explanations attached to the notices of deficiency state that the income from the Bitker partnership should be increased and "We have adjusted your return in accordance with the partnership return, which has also been examined." 3 The adjustments to Schedules F were explained as "Expenses were deducted on Schedule F that were attributable to the rental activity. These expenses are allowed on Schedule E." The adjustments to the Schedule E rental expenses were determined to be "Rental expenses, which you deducted elsewhere, are allowed as rental expenses. Losses are limited due to passive loss rules."
¶96*230 The explanations attached to the notices of deficiency state that adjustments were made with respect to capital gain or loss because "Amounts distributed by partnership, which are in excess of the partners' bases, have resulted in a capital gain. See Exhibit 3 to show you how we figured the gain." Exhibit 3 computes the gain as follows:
¶97 12/31/96 12/31/97
¶98 ________ ________
¶99Curtis & Lynn Bitker
¶100 Short-term capital gain or loss $ 506,139 $ 87,801
¶101 Short-term capital loss carryover -0- -0-
¶102 ________ _______
¶103 Net short-term capital gain or 506,139 87,801
¶104 Long-term capital gain or loss 7,378 6,238
¶105 Long-term capital loss carryover -0- -0-
¶106 ________ _______
¶107 Net long-term gain or loss 7,378*231 6,238
¶108 Net capital gain or loss 513,517 94,039
¶109 Capital loss limitation -0- -0-
¶110 Capital gain or loss as corrected 513,517 94,039
¶111 Capital gain or loss per return 40,501 4,727
¶112 Adjustment to income 473,015 89,312
¶113Jerry & Coleen Bitker
¶114 Short-term capital gain or loss 504,634 89,312
¶115 Short-term capital loss carryover -0- -0-
¶116 _______ _______
¶117 Net short-term capital gain or 504,634 89,312
¶118 Long-term capital gain or loss 9,634 10,521
¶119 Long-term capital loss carryover -0- -0-
¶120 _______ ______
¶121 Net long-term gain or loss 9,634 10,521
¶122 Net capital gain or loss *232 514,268 99,833
¶123 Capital loss limitation -0- -0-
¶124 Capital gain or loss as corrected 514,268 99,833
¶125 Capital gain or loss per return 41,253 10,521
¶126 Adjustment to income 473,015 89,312
¶127 OPINION
¶128I. Burden of Proof: Rule 142(a); Sections 7522 and 7491
¶129As a general rule, the Commissioner's determinations in a notice of deficiency are presumed correct, and the burden is on the taxpayer to prove otherwise. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115, 78 L. Ed. 212, 54 S. Ct. 8 (1933). However, this rule does not apply for new matters raised by the Commissioner after the issuance of the notice of deficiency. Rule 142(a). In addition, under certain circumstances, the burden of proof or production is on the Commissioner. See secs. 7522, 7491. 4
¶131Section 7522 requires a notice of deficiency to "describe the basis" for the tax deficiency. In some situations, this Court has held that failure to describe the basis for the tax deficiency in the notice of deficiency is analogous to the raising of a new matter under Rule 142(a). Shea v. Commissioner, 112 T.C. 183, 197 (1999); Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507 (1989); Estate of Ballantyne v. Commissioner, T.C. Memo. 2002-160. In this regard, we stated that a new matter is raised when the basis or theory upon which the Commissioner relies is not stated or described in the notice of deficiency and the new theory or basis requires the presentation of different evidence. Wayne Bolt & Nut Co. v. Commissioner, supra at 507. In such a situation, the burden of proof is placed on the Commissioner with respect to that issue. Id.
¶132The adjustments to petitioners' income were made primarily on the basis of adjustments to the income reported on Bitker partnership tax returns for 1996 and 1997. Knowledge of the specific adjustments to the income of Bitker partnership for the years at issue is necessary*234 to resolve the correctness of respondent's determinations.
¶133Petitioners assert that, because the notices of deficiency did not include a copy of the examination report for the Bitker partnership or otherwise specify the adjustments to its income, respondent did not adequately describe the basis for, or explain, the adjustments in the notices of deficiency. Petitioners conclude, therefore, that the burden is on respondent pursuant to section 7522 and Rule 142(a).
¶134We agree that it would have been helpful if respondent either had attached a copy of the examination report showing the adjustments to partnership income to the notices of deficiency or had included the computations and adjustments from the Bitker partnership in the explanations of the adjustments. See, e. g., Brodsky v. Commissioner, T.C. Memo 2001-240 (each notice of deficiency included schedules that listed for each of the years at issue the Commissioner's position regarding the sources of the deposits into the taxpayer's accounts during each year and the total amount of the deposits during each year from each source). But we do not find respondent's failure to do so in this case constitutes the raising of*235 new matter.
¶135The purpose of section 7522 is to give the taxpayer notice of the Commissioner's basis for determining a deficiency. Shea v. Commissioner, supra at 196. In the situation before us, Mr. Mostoller represented petitioners during the examination of their returns, as well as the examination of the Bitker partnership returns, and he had a copy of the examination report related to the partnership returns. The notices of deficiency, in conjunction with the partnership examination report to which petitioners had access through Mr. Mostoller, gave petitioners sufficient notice of respondent's basis for determining the deficiencies. Under these circumstances, we are satisfied that the notices of deficiency sufficiently described the basis of the deficiencies within the meaning of section 7522.
¶136B. Section 7491
¶1371. Penalties
¶138Under section 7491(c), the Commissioner has the burden of production with respect to an individual's liability for any penalty. Respondent acknowledges having the burden of production with respect to the accuracy-related penalties under section 6662(a).
¶1392. Factual Issues
¶140Pursuant to the general rule of section 7491(a)(1), if the taxpayer introduces*236 credible evidence with respect to any factual issue relevant to ascertaining the taxpayer's liability for income tax, the Commissioner bears the burden of proof with respect to that issue. The preceding rule applies, however, only if the taxpayer has: (1) Complied with requirements under the Internal Revenue Code to substantiate any item; (2) maintained all records required by the Internal Revenue Code; and (3) cooperated with reasonable requests by the Secretary for information, documents, and meetings. Sec. 7491(a)(2). Taxpayers bear the burden of proving that these requirements have been met. Snyder v. Commissioner, T.C. Memo 2001-255 (citing H. Conf. Rept. 105-599, at 240-241 (1998), 1998-3 C. B. 747, 994-995).
¶141Respondent contends that the burden of proof remains on petitioners with respect to all factual issues in this case because petitioners failed to comply with the substantiation requirements, failed to maintain all records required by the Internal Revenue Code, and failed to cooperate with reasonable requests for information and documents.
¶142In this case, there are multiple factual issues relevant to determining petitioners' tax liabilities. We*237 will define those factual issues and apply section 7491(a) to each on the basis of the circumstances involved.
II. Factual Issues in This Case¶143Respondent determined deficiencies in petitioners' Federal income taxes and self-employment taxes. The adjustments to petitioners' income resulted from adjustments made to the income of the Bitker partnership as reported on its tax returns for 1996 and 1997 and from a determination that it made distributions to the partners.
¶144For purposes of Federal income tax liability, a partnership is not taxed at the entity level. Sec. 701. Instead, the partnership's income is passed through to its partners, and each partner is individually taxed on his/her distributive share of partnership income. Secs. 701-704, 761(a).
¶145An individual's self-employment income is subject to a self-employment tax in addition to Federal income tax. Sec. 1401. Subject to exclusions not relevant to this case, self-employment income means net earnings from self-employment. Sec. 1402(b). Net earnings from self-employment include, inter alia, an individual's distributive share, whether or not distributed, of income or loss (as described in section 702(a)(8)) from any trade or*238 business carried on by a partnership in which the individual is a partner. Sec. 1402(a).
¶146 A. Whether Payments Made by the Bitker Partnership on
¶147 Indebtedness Owed by Petitioners Are Rental Expenses of the
¶148 Bitker Partnership or Constructive Distributions to Petitioners
¶149 From the Bitker Partnership
¶150The Bitker partnership claimed a deduction for interest it paid on mortgages against petitioners' farmland. Respondent disallowed the deduction. That disallowance resulted in increases in petitioners' distributive shares of partnership farming income, which is reported on Schedule F.
¶151Respondent determined that the interest on the mortgages represented petitioners' individual expenses (as opposed to partnership expenses) reportable as rental expenses on Schedule E of petitioners' returns and that the deductibility of that interest is subject to the passive loss rules of section 469. Those adjustments resulted in increases in petitioners' self-employment tax. The parties agree that the interest payments totaled $ 242,964 in 1996 and $ 128,988 in 1997 and that petitioner husbands each constructively received half of each year's payment. Moreover, petitioners*239 concede the reclassification of the claimed Schedule F interest expenses on the Bitker partnership's returns as Schedule E rental expenses on petitioners' returns; further, they acknowledge that the losses from their rental real estate activity are subject to the passive loss limitations of section 469. Petitioners contend, however, that the principal and interest paid by the Bitker partnership should be treated as payments by it for use of petitioners' land. In effect, petitioners are asserting that the payments are rental income to petitioners and an additional rental expense of the Bitker partnership.
¶152Payments a partner receives from a partnership generally fall into one of three categories. First, a partner may receive payments representing distributions of his/her distributive share of partnership income. See sec. 731. Second, a partner may receive payments in circumstances where he/she is not treated as a partner. Sec. 707(a). And third, a partner may receive guaranteed payments for services or use of capital that do not represent distributions of partnership income. Sec. 707(c).
¶153Payments made to a partner either in his capacity other than as a partner under section 707(a)*240 or as guaranteed payments under section 707(c) must satisfy the requirements of section 162(a) before such payments may be deducted by the partnership. Cagle v. Commissioner, 63 T.C. 86, 91, 95 (1974) (no deduction is allowed if the payment by the partnership to a partner constitutes a capital expenditure), affd. 539 F.2d 409 (5th Cir. 1976).
¶154Section 1.707-1(a), Income Tax Regs., provides in part:
¶155 Where a partner retains the ownership of property but allows the
¶156 partnership to use such separately owned property for
¶157 partnership purposes (for example, to obtain credit or to secure
¶158 firm creditors by guaranty, pledge, or other agreement), the
¶159 transaction is treated as one between partnership and a partner
¶160 not acting in his capacity as a partner.
¶161Here, petitioners retained ownership of their farmland but allowed the Bitker partnership to use the land in connection with its farming activity. Pursuant to section 707(a), this type of transaction is treated as one between the Bitker partnership and petitioners acting other than in their capacity as partners. Consequently, payments made to petitioners by the Bitker*241 partnership for use of the farmland could constitute ordinary and necessary rental expenses incurred in the conduct of its trade or business that are deductible under section 162.
¶162Petitioners maintain that the Bitker partnership's payments of principal and interest on petitioners' land mortgages should be treated as payments of land rent. Petitioners, however, have offered no evidence, testimonial or otherwise, that (a) the Bitker partnership made the payments as rent for such use or (b) the payments represented fair rental value. Moreover, the record is silent as to the number of acres used by the Bitker partnership. Simply stated, petitioners have failed to provide any information or substantiation that would permit us to estimate the allowable deductions as permitted under Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930). See Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985). Since petitioners have failed to provide evidence on the factual issue as to the amount of rent, if any, paid by the Bitker partnership for use of the land, section 7491(a) does not place the burden of proof on respondent with respect to this issue.
¶163Accordingly, in*242 computing petitioners' tax liabilities, (1) petitioners' shares of income from the Bitker partnership will not be reduced for rent of the farmland, (2) petitioners' income from their rental real estate activity will not be increased for such rent, and (3) petitioners' distributions from the Bitker partnership will include the partnership's payments of petitioners' personal debt.
¶164 B. Whether Distributions Petitioners Received From the Bitker
¶165 Partnership in 1996 and 1997 Exceeded Their Bases in Their
¶166 Partnership Interests
¶167Section 731(a) sets forth the circumstances under which a partner recognizes gain or loss from partnership distributions. In the case of a distribution by a partnership to a partner, gain is recognized only to the extent that the money (including marketable securities) distributed exceeds the adjusted basis of a partner's interest in the partnership immediately before the distribution. Sec. 731(a)(1); Jacobson v. Commissioner, 96 T.C. 577, 584 (1991), affd. 963 F.2d 218 (8th Cir. 1992). Any gain recognized under section 731(a) is considered gain from the sale or exchange of the partnership interest of the distributee*243 partner. Sec. 731(a); P.D.B. Sports, Ltd. v. Commissioner, 109 T.C. 423, 441 (1997). In the case of a sale or exchange of an interest in a partnership, gain recognized to the transferor partner is generally treated as gain from the sale or exchange of a capital asset. Sec. 741; Colonnade Condo., Inc. v. Commissioner, 91 T.C. 793, 814 (1988).
¶168Section 705(a) states a general rule for determining the adjusted basis of a partner's interest. In relevant part, section 705(a) provides that the adjusted basis of a partner's interest in a partnership is the basis as determined under section 7225 (relating to contributions to a partnership) or section 7426 (relating to transfers of partnership interests) (1) increased by the partner's distributive share of partnership income for the current and prior years and (2) decreased (but not below zero) by the amount of distributions from the partnership under section 7337 and by the partner's distributive share of partnership losses for the current and prior years.
¶170*245Section 705(b) grants the Secretary the authority to prescribe regulations under which the adjusted basis of a partner's interest in a partnership may be determined by reference to the partner's proportionate share of the adjusted basis of partnership property upon a termination of the partnership. The regulations promulgated to implement this section (found in section 1.705-1(b), Income Tax Regs.) provide that an alternative method (the alternative rule) may be used in circumstances where (a) a partner cannot practicably apply the general rule set forth in section 705(a) and section 1.705-1(a), Income Tax Regs., or (b) from a consideration of all the facts, the Commissioner reasonably concludes that the result will not vary substantially from the result obtainable under the general rule. Sec. 1.705-1(b), Income Tax Regs. Where the alternative rule is used, certain adjustments may be necessary to reflect discrepancies arising as a result of contributed property, transfers of partnership interests, or distributions of property to the partners. Id. Petitioners maintain that their bases should be determined under the alternative rule.
¶171Respondent asserts that petitioner wives' bases*246 in their partnership interests can be determined under the general rule of section 705(a) from their Schedules K-1 for 1991-97. On the other hand, petitioners maintain that petitioner wives' bases should be determined under the alternative rule. Respondent posits that, since petitioner wives neither paid their husbands for the interests nor contributed any property to the Bitker partnership, the bases of their partnership interests are equal to their respective shares of partnership debt. We disagree.
¶172The 20-percent interests that petitioner wives acquired in 1991 included 20-percent interests in the Bitker partnership's existing capital--property interests that had been owned by their husbands at the time the wives became partners. Under Minnesota law, a presumption exists that money or property transferred by a husband to his wife (or a parent to his/her child) is a gift. State v. One Oldsmobile Two-Door Sedan, 227 Minn. 280, 35 N. W. 2d 525 (Minn. 1948); Stahn v. Stahn, 192 Minn. 278, 256 N. W. 137 (Minn. 1934); *247 Jenning v. Rohde, 99 Minn. 335, 109 N. W. 597 (Minn. 1906); Kiecker v. Estate of Kiecker, 404 N. W. 2d 881 (Minn. Ct. App. 1987); see also Matarese v. Commissioner, T.C. Memo. 1975-184.
¶173Here, the facts show that petitioner wives paid nothing for their respective 20-percent interests in the Bitker partnership. We conclude, therefore, that petitioner wives acquired their interests in the Bitker partnership as gifts from their husbands. Consequently, pursuant to section 1015(a), for purposes of determining gain, the basis of each wife's 20-percent interest was two-fifths of her husband's basis in his partnership interest. This conclusion is supported by the fact that the Schedules K-1 for 1991 reflect that petitioner wives each held a 20-percent interest for the entire year and that petitioner wives were each treated as partners of the Bitker partnership for the entire year. Moreover, petitioner wives each reported (on their respective individual income tax returns) 20 percent of the partnership income and deductions for 1991. The 1991 Schedules K-1 do not accurately reflect the partners' capital accounts--the beginning year negative capital accounts*248 shown on petitioner husbands' Schedules K-1 reflect their 50-percent interests before gifts to their wives, not their 30-percent interests following the gifts. Moreover, the reported contributions from petitioner husbands to the Bitker partnership, as well as the distributions to petitioner wives were erroneous--the numbers used were "plugged in" in by Mr. Mostoller to account for the changes in ownership. Mr. Mostoller's approach to reporting the partners' capital accounts, contributions, and distributions for 1991 was not correct. The partners' capital accounts for 1991 are more accurately reflected as follows:
Curtis Jerry Lynn
______ _____ ____
1991
Analysis of partner's capital account
Capital account at beginning of year ($ 311,911) ($ 311,911) ($ 207,941)
Capital contributed during year
Partner's share of net book income
(loss) 19,149 19,149 12,766
Distributions (90,656) (90,656) (60,436)
Capital account at end of year*249 (383,418) (383,418) (255,611)
Partner's share of liabilities 557,991 557,991 371,994
[Table continued]
Coleen Total
______ _____
1991
Analysis of partner's capital account
Capital account at beginning of year ($ 207,941) ($ 1,039,704)
Capital contributed during year
Partner's share of net book income
(loss) 12,766 63,830
Distributions (60,436) (302,184)
Capital account at end of year (255,611) (1,278,058)
Partner's share of liabilities 371,994 1,859,970
¶174Respondent argues on brief that, pursuant to the principle known as duty of consistency, petitioners are bound as to the amounts of the capital accounts and distributions reported on the 1991 return. We disagree.
¶175*250A taxpayer is under a duty of consistency when:
(1) the taxpayer has made a representation or reported an item
for tax purposes in one year,
(2) the Commissioner has acquiesced in or relied on that fact
for that year, and
(3) the taxpayer desires to change the representation,
previously made, in a later year after the statute of
limitations on assessments bars adjustments for the initial tax
year. … [ Beltzer v. United States, 495 F.2d 211, 212
(8th Cir. 1974).]
¶176The duty of consistency is an affirmative defense that should be raised in pleadings before trial. Sec. 7453; Rule 39; LeFever v. Commissioner, 100 F.3d 778 (10th Cir. 1996), affg. 103 T.C. 525 (1994). In the instant case, respondent's answer contained no affirmative defenses or any allegation that respondent has relied upon the capital accounts and distributions reported on the 1991 Schedules K-1. Consequently, because the duty of consistency is an affirmative defense and was not pleaded by respondent, nor tried by consent of the parties, it is deemed waived. Rule 39; *251 Monahan v. Commissioner, 109 T.C. 235, 250 (1997); Green v. Commissioner, T.C. Memo. 1998-274 (collateral estoppel), affd. without published opinion 201 F.3d 447 (10th Cir. 1999); see also Gustafson v. Commissioner, 97 T.C. 85, 89-92 (1991) (if an affirmative defense is not pleaded, it is deemed waived). We conclude therefore that petitioners are not bound by the duty of consistency to the capital accounts and distributions reported on the 1991 tax return.
¶177The Bitker partnership was formed in 1979. The records of the partnership do not show the amounts of cash contributions or the bases in property contributed by petitioner husbands and their father, Ray Bitker, to the partnership when it was formed. Moreover, a calculation of the distributions made to each partner each year since its formation cannot be made. The partnership tax returns in the record cover only the years 1984-97. Only the tax returns for 1992-97 show balance sheets. Under these circumstances, it is appropriate to apply the alternative rule set forth in section 1.705- 1(b), Income Tax Regs., in order to establish petitioners' adjusted bases in their partnership*252 interests.
¶178Regardless of where the burden of proof may lie, the preponderance of the evidence establishes that the distributions petitioners received in 1996 and 1997 did not exceed their bases in their partnership interests.
¶179The parties agree that the Bitker partnership had the following assets and liabilities as of December 31, 1995-97:
¶180 12/31/95 12/31/96 12/31/97
¶181 ________ ________ ________
¶182Assets:
¶183 Cash $ 128,593 $ 85,057 $ 29,964
¶184 Adjusted basis of buildings and
¶185 other depreciable assets 362,698 267,828 477,044
¶186 Basis of other assets
¶187 Farm Services stock 134,345 137,815 102,530
¶188 Unit Retains 186,834 172,934 151,696
¶189 USWP stock -- -- 68,333
¶190 _________ _________ _________
¶191 Total assets *253 812,470 663,634 829,567
¶192Liabilities:
¶193 Short-term debt 734,576 988,477 1,189,635
¶194 Long-term debt 1,222,236 1,069,820 1,232,633
¶195 _________ _________ _________
¶196 Total liabilities 1,956,812 2,058,297 2,422,268
¶197On the basis of the Bitker partnership's assets and liabilities as of the beginning and end of each year at issue (as agreed to by respondent) and its income (as adjusted during the examination of the partnership return), the cash distribution to petitioners (including the deemed distribution for payment of petitioners' personal expenses) is $ 634,830 for 1996 and $ 458,488 for 1997. The amounts of the distributions to petitioners are computed as follows:
¶198 12/31/95 12/31/96 12/31/97
¶199 ________ ________ ________
¶200Assets:
¶201 Cash $ 128,593 $ 85,057 $ 29,964
¶202 Adjusted basis of*254 buildings and
¶203 other depreciable assets 362,698 267,828 477,044
¶204 Basis of other assets
¶205 Farm Services stock 134,345 137,815 102,530
¶206 Unit Retains 186,834 172,934 151,696
¶207 USWP stock -- -- 68,333
¶208 __________ __________ _________
¶209 Total assets 812,470 663,634 829,567
¶210Liabilities:
¶211 Short-term debt 734,576 988,477 1,189,635
¶212 Long-term debt 1,222,236 1,069,820 1,232,633
¶213 __________ __________ __________
¶214 Total liabilities 1,956,812 2,058,297 2,422,268
¶215Partners' capital (1,144,342) (1,394,663) (1,592,701)
¶216Analysis of partners' capital:
¶217 Net income per books 384,509 260,450
¶218 Distributions *255 (634,830) (458,488)
¶219 Balance at year end (1,394,663) (1,592,701)
¶220 Beginning year balance (1,144,342) (1,394,663)
¶221In order for the distributions to have exceeded $ 634,830 for 1996 and $ 458,488 for 1997, the Bitker partnership would have had to have depleted its assets, incurred additional debt, or earned more income.
¶222Under the alternative computation, a partner's basis is equal to the partner's proportionate share of the adjusted basis of partnership property upon a termination of the partnership. 8 That basis may equal his/her negative capital account plus his/her share of partnership liabilities. Long v. Commissioner, 77 T.C. 1045, 1084 (1981) (basis equaled negative capital account plus taxpayer's share of partnership liabilities); see also Tapper v. Commissioner, T.C. Memo. 1986-597; cf. Coleman v. Commissioner, T.C. Memo. 1974-78 (Court refused to apply alternative computation because taxpayer failed to provide proof of partnership's asset basis), affd. 540 F.2d 427 (9th Cir. 1976)*256 . The computation may require adjustments to reflect "any significant discrepancies arising as a result of contributed property, transfers of partnership interest, or distributions of property to partners." Sec. 1.705-1(b), Income Tax Regs.
¶223*257 The record contains no evidence that any contributions were entered on the Bitker partnership's books at other than their tax bases. Nor does the record reflect any differences between the financial and tax accounting treatment of partnership income or expense items or partnership losses (before the year in issue) that were not previously deductible by reason of section 704(d). Nor is an adjustment required for Ray Bitker's transfer of his interest in the Bitker partnership to petitioner husbands in 1989 or for petitioner husbands' transfers to petitioner wives in 1991 because all of those transfers were gifts. (The respective bases of petitioners are determined using transferred bases for the interests received by gifts Secs. 742, 1015(a); Cf. Tapper v. Commissioner, supra (adjustment required to reflect retirement of former partner's interest in prior year).)
¶224On the basis of the Bitker partnership's assets and liabilities as of the beginning and end of each year at issue as agreed to by respondent, its income as adjusted during the examination of the partnership return, and the cash distributions to petitioners of $ 634,830 for 1996 and $ 458,488 for 1997, which*258 necessarily included the deemed distribution for payment of petitioners' personal expenses, we conclude that the distributions did not exceed petitioners' bases in their partnership interests. The computations we have used in reaching this conclusion are as follows:
¶225 Total 1 Curtis (30%) Jerry (30%)
¶226 ______ ____________ ___________
¶2271996
¶228Assets at beginning of year:
¶229Cash $ 128,593 $ 38,578 $ 38,578
¶230Adjusted basis of buildings and
¶231 other depreciable assets 362,698 108,809 108,809
¶232Basis of other assets:
¶233 Farm Services stock 134,345 40,304 40,304
¶234 Unit Retains 186,834 56,050 56,050
¶235 USWP stock -- -- --
¶236 _________ _________ ________
¶237 Total assets 812,470 243,741 243,741
¶238Liabilities at beginning of year:
¶239Short-term debt *259 734,576 220,373 220,373
¶240Long-term debt 1,222,236 366,671 366,671
¶241 __________ _________ ________
¶242 Total liabilities 1,956,812 587,044 587,044
¶243Partners' capital at beginning
¶244 of year (1,144,342) (343,303) (343,303)
¶245Change in liabilities:
¶246 Liabilities at beginning of
¶247 year 1,956,812 587,044 587,044
¶248 Liabilities at year end 2,058,297 617,489 617,489
¶249 __________ _________ _________
¶250 Increase (decrease) 101,485 30,445 30,445
¶251Partners' bases at beginning of
¶252 year 812,470 243,741 243,741
¶2531996 Income (as adjusted) 384,509 115,353 115,353
¶254Contributions:
¶255Cash/property -0- -0- -0-
¶256Deemed by increase in
¶257 liabilities *260 101,485 30,445 30,445
¶258 __________ _________ _________
¶259Partners' bases before
¶260 distributions 1,298,464 389,539 389,539
¶261Distributions:
¶262Cash (634,830) (190,449) (190,449)
¶263Deemed by reduction in
¶264 liabilities -0- -0- -0-
¶265 __________ _________ ________
¶266Partners' bases after
¶267 distributions 663,634 199,090 199,090
¶2681997
¶269Assets at beginning year:
¶270Cash $ 85,057 $ 25,517 $ 25,517
¶271Adjusted basis of buildings
¶272 and other depreciable
¶273 assets 267,828 80,348 80,348
¶274Basis of other assets:
¶275 Farm Services stock 137,815 41,345 41,345
¶276 Unit Retains 172,934 51,880 51,880
¶277 USWP stock -- -- --
¶278*261 _________ ________ _______
¶279 Total assets 663,634 199,090 199,090
¶280Liabilities:
¶281Short-term debt 988,477 296,543 296,543
¶282Long-term debt 1,069,820 320,946 320,946
¶283 __________ ________ ________
¶284 Total liabilities 2,058,297 617,489 617,489
¶285Partners capital at beginning
¶286 of year (1,394,663) (418,399) (418,399)
¶287Change in liabilities:
¶288 Liabilities at beginning
¶289 of year 2,058,297 617,489 617,489
¶290 Liabilities at year end 2,422,268 726,680 726,680
¶291 __________ _________ ________
¶292 Increase (decrease) 363,971 109,191 109,191
¶293Partners' bases at beginning
¶294 of year 663,634 199,090 199,090
¶2951997 Income (as adjusted) 260,450 *262 78,135 78,135
¶296Contributions:
¶297Cash/property -0- -0- -0-
¶298Deemed by increase in
¶299 liabilities 363,971 109,191 109,191
¶300 _________ _________ _________
¶301Partners' bases before
¶302 distributions 1,288,058 386,416 386,416
¶303Distributions:
¶304Cash (458,488) (137,546) (137,546)
¶305Deemed by reduction in
¶306 liabilities -0- -0- -0-
¶307 __________ __________ ________
¶308Partners' bases after
¶309 distributions 829,570 248,870 248,870
¶310 [Table continued]
¶311 Lynn (20%) Coleen (20%)
¶312 _________ ____________
¶3131996
¶314Assets at beginning of year:
¶315Cash *263 $ 25,719 $ 25,719
¶316Adjusted basis of buildings and
¶317 other depreciable assets 72,540 72,540
¶318Basis of other assets:
¶319 Farm Services stock 26,869 26,869
¶320 Unit Retains 37,367 37,367
¶321 USWP stock -- --
¶322 ________ _______
¶323 Total assets 162,495 162,495
¶324Liabilities at beginning of year:
¶325Short-term debt 146,915 146,915
¶326Long-term debt 244,447 244,447
¶327 _________ _________
¶328 Total liabilities 391,362 391,362
¶329Partners' capital at beginning
¶330 of year (228,867) (228,867)
¶331Change in liabilities:
¶332 Liabilities at beginning of
¶334 Liabilities at year end 411,659 411,659
¶335 _________ _________
¶336 Increase (decrease) 20,297 20,297
¶337Partners' bases at beginning of
¶338 year 162,495 162,495
¶3391996 Income (as adjusted) 76,902 76,902
¶340Contributions:
¶341Cash/property -0- -0-
¶342Deemed by increase in
¶343 liabilities 20,297 20,297
¶344 __________ _________
¶345Partners' bases before
¶346 distributions 259,694 259,694
¶347Distributions:
¶348Cash (126,966) (126,966)
¶349Deemed by reduction in
¶351 _________ ________
¶352Partners' bases after
¶353 distributions 132,728 132,728
¶3541997
¶355Assets at beginning year:
¶356Cash $ 17,011 $ 17,011
¶357Adjusted basis of buildings
¶358 and other depreciable
¶359 assets 53,566 53,566
¶360Basis of other assets:
¶361 Farm Services stock 27,563 27,563
¶362 Unit Retains 34,587 34,587
¶363 USWP stock -- --
¶364 _________ _________
¶365 Total assets 132,727 132,727
¶366Liabilities:
¶367Short-term debt 197,695 197,695
¶368Long-term debt 213,964 213,964
¶369 __________ *266 _________
¶370 Total liabilities 411,659 411,659
¶371Partners capital at beginning
¶372 of year (278,933) (278,933)
¶373Change in liabilities:
¶374 Liabilities at beginning
¶375 of year 411,659 411,659
¶376 Liabilities at year end 484,454 484,454
¶377 _________ _________
¶378 Increase (decrease) 72,795 72,795
¶379Partners' bases at beginning
¶380 of year 132,728 132,728
¶3811997 Income (as adjusted) 52,090 52,090
¶382Contributions:
¶383Cash/property -0- -0-
¶384Deemed by increase in
¶385 liabilities 72,795 72,795
¶386 _________ ________
¶387Partners' bases before
¶388 distributions *267 257,613 257,613
¶389Distributions:
¶390Cash (91,698) (91,698)
¶391Deemed by reduction in
¶392 liabilities -0- -0-
¶393 _________ _________
¶394Partners' bases after
¶395 distributions 165,915 165,915
¶396Respondent argues that because petitioners erroneously treated $ 962,022 of personal debt as the Bitker partnership's liabilities, the adjustment that was made to remove the $ 962,022 of liabilities from the partnership's balance sheet should be treated as a distribution under section 752(b). We disagree.
¶397When a partnership assumes an individual partner's liabilities, the assumption of those liabilities results in a deemed distribution to the partner of the amount assumed by the partners. Sec. 752(b). Conversely, when a partner assumes the*268 partnership's liabilities, the assumption of such liability results in a deemed contribution by the partner to the partnership of the amount assumed. Sec. 752(a). Additionally, any increase or decrease in a partner's share of partnership liabilities is deemed either a cash contribution by the partner to the partnership or a distribution to the partner by the partnership. Sec. 752(a) and (b). The partner's basis in his/her partnership interest is increased by the amount of the deemed contribution or reduced by the deemed distribution. Secs. 705, 722, 733; Barron v. Commissioner, T.C. Memo. 1992-598; Moore v. Commissioner, T.C. Memo. 1987-499.
¶398Section 1.752-1(f), Income Tax Regs., provides:
¶399 (f) Netting of increases and decreases in liabilities
¶400 resulting from same transaction. If, as a result of a
¶401 single transaction, a partner incurs both an increase in the
¶402 partner's share of the partnership liabilities (or the partner's
¶403 individual liabilities) and a decrease in the partner's share of
¶404 the partnership liabilities (or the partner's individual
¶405 liabilities), only the net decrease is treated as a distribution
¶406*269 from the partnership and only the net increase is treated as a
¶407 contribution of money to the partnership.
¶408Section 1.752-1(g), Income Tax Regs., provides the following example of the effect of netting:
¶409 Example 1. Property contributed subject to a liability; netting
¶410 of increase and decrease in partner's share of liability. B
¶411 contributes property with an adjusted basis of $ 1,000 to a
¶412 general partnership in exchange for a one-third interest in the
¶413 partnership. At the time of the contribution, the partnership
¶414 does not have any liabilities outstanding and the property is
¶415 subject to a recourse debt of $ 150 and has a fair market value
¶416 in excess of $ 150. After the contribution, B remains personally
¶417 liable to the creditor and none of the other partners bears any
¶418 of the economic risk of loss for the liability under state law
¶419 or otherwise. Under paragraph (e) of this section, the
¶420 partnership is treated as having assumed the $ 150 liability. As
¶421 a result, B's individual liabilities decrease by $ 150. At the
¶422 same time, however, B's share of liabilities of the partnership
¶423*270 increases by $ 150. Only the net increase or decrease in B's
¶424 share of the liabilities of the partnership and B's individual
¶425 liabilities is taken into account in applying section 752.
¶426 Because there is no net change, B is not treated as having
¶427 contributed money to the partnership or as having received a
¶428 distribution of money from the partnership under paragraph (b)
¶429 or (c) of this section. Therefore B's basis for B's partnership
¶430 interest is $ 1,000 (B's basis for the contributed property).
¶431Petitioners were at all times personally liable for the debts erroneously included as partnership liabilities. Netting results in a complete offset (i. e., no change) for the deemed contributions and distributions when petitioners' personal liabilities are assumed by the Bitker partnership and when the liabilities are removed from the partnership. In essence, the total distributions to petitioners in 1996 are unaffected by the adjustment to the amount of partnership liabilities.
¶432Since we conclude that petitioners had sufficient bases taking into account only the assets and liabilities agreed to by the parties, we need not decide other*271 arguments made by petitioners regarding this issue.
¶433 C. Whether Petitioners Are Liable for The Accuracy-Related
¶434 Penalties Under Section 6662(a) for The Years at Issue.
¶435Respondent contends that petitioners are liable for an accuracy-related penalty under section 6662(a). Respondent has the burden of production under section 7491(c) and must come forward with evidence sufficient for us to sustain the section 6662(a) penalty. See Higbee v. Commissioner, 116 T.C. 438, 446-447 (2001); Emerson v. Commissioner, T.C. Memo. 2003-82.
¶436As pertinent here, section 6662(a) imposes a 20-percent penalty on the portion of an underpayment attributable to negligence or disregard of rules or regulations, sec. 6662(b)(1), or a substantial understatement of tax, sec. 6662(b)(2). Negligence includes any failure to make a reasonable attempt to comply with the provisions of the Internal Revenue Code, including any failure to keep adequate books and records or to substantiate items properly. Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs. An "understatement" is the excess of the amount of tax required to be shown in the tax return over the amount of tax shown*272 in the tax return, sec. 6662(d)(2)(A), and is "substantial" in the case of an individual if the understatement exceeds the greater of 10 percent of the tax required to be shown or $ 5,000, sec. 6662(d)(1)(A).
¶437The penalty under section 6662(a) does not apply to any portion of an understatement of tax if it is shown that there was reasonable cause for the taxpayer's position and that the taxpayer acted in good faith with respect to that portion. Sec. 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 the pertinent facts and circumstances. Sec. 1.6664- 4(b)(1), Income Tax Regs. The most important factor is the extent of the taxpayer's effort to assess his/her proper tax liability for the year. Id.
¶438Reasonable cause requires that the taxpayer exercise ordinary business care and prudence as to the disputed item. United States v. Boyle, 469 U.S. 241, 83 L. Ed. 2d 622, 105 S. Ct. 687 (1985); see also Neonatology Associates, P. A. v. Commissioner, 115 T.C. 43, 98 (2000), affd. 299 F.3d 221 (3d Cir. 2002). The good faith reliance on the advice of*273 an independent, competent professional as to the tax treatment of an item may meet this requirement. United States v. Boyle, supra; sec. 1.6664-4(b), Income Tax Regs. Whether a taxpayer reasonably relies on advice of a professional depends on the facts and circumstances of the case and the law applicable thereto. Sec. 1.6664-4(c)(1)(i), Income Tax Regs. The taxpayer must prove that: (1) The adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer actually relied in good faith on the adviser's judgment. Ellwest Stereo Theatres, Inc. v. Commissioner, T.C. Memo. 1995-610; see also Rule 142(a)(1). To show good faith reliance, the taxpayer must show that the return preparer was supplied with all the necessary information and the incorrect return was a result of the preparer's mistakes. Pessin v. Commissioner, 59 T.C. 473, 489 (1972); sec. 1.6664-4(c)(1)(i), Income Tax Regs.
¶439In this case, the understatement of tax is attributable to the disallowance of the Bitker partnership's deduction of interest on petitioners' individual*274 debt on the farmland they owned. We do not believe that petitioners reasonably relied on Mr. Mostoller with respect to this disallowance. The farmland was not shown as an asset of the Bitker partnership on the partnership return prepared by Mr. Mostoller. Consequently, we believe Mr. Mostoller knew that the Bitker partnership did not own any farmland.
¶440Mr. Mostoller verified loan balances by calling Farm Credit Services. Petitioners have failed to establish, however, that they furnished Mr. Mostoller with necessary and relevant information to identify any of the loans as mortgages on their individually owned farmland. Moreover, petitioners have failed to show that the incorrect treatment of the interest paid on those mortgages was due to Mr. Mostoller's mistakes. Accordingly, we hold that petitioners are liable for the section 6662(a) accuracy-related penalty with regard to the increases in income tax and self-employment tax resulting from the disallowance of the deduction claimed by the Bitker partnership for interest on petitioners' debt.
¶441To reflect the foregoing and concessions by the parties,
Footnotes
¶4431. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect at all relevant times, and Rule references are to the Tax Court Rules of Practice and Procedure.↩
¶4474. Sec. 7491 applies to court proceedings arising in connection with examinations beginning after July 22, 1998. Internal Revenue Service Restructuring and Reform Act of 1998, Pub. L. 105- 206, sec. 3001(a), 112 Stat. 726. In this case, the examination of petitioners' returns began after July 22, 1998. Accordingly, sec. 7491↩ is applicable to this case.
¶4485. Sec. 722 provides that the basis of a partnership interest acquired by contribution of property, including money, is "the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution". For purposes of sec. 722, a contribution of money includes: "Any increase in a partner's share of the liabilities of a partnership, or any increase in a partner's individual liabilities by reason of the assumption by such partner of partnership liabilities". Sec. 752(a)↩.
¶4496. Sec. 742 provides: "The basis of an interest in a partnership acquired other than by contribution shall be determined under part II of subchapter O (sec. 1011 and following)." In general, the basis of property acquired by gift is the same as it was in the hands of the donor. Sec. 1015↩. For purposes of determining loss, however, if that basis is greater than the fair market value of the property at the time of the gift, then the basis is the fair market value at the time of the gift. Id.
¶4507. In the case of a distribution by a partnership to a partner other than in liquidation of a partner's interest, the adjusted basis of the partner is reduced by the amount of money distributed to that partner. Sec. 733. Additionally, any decrease in a partner's share of the liabilities of a partnership is considered a distribution of money to the partner by the partnership. Sec. 752(b)↩.
¶4518. Section 705(a) sets forth the general rule for determining a partner's basis in his partnership interest. Any increase or decrease in a partner's share of partnership liabilities is deemed either a cash contribution by the partner to the partnership or a distribution to the partner by the partnership. Sec. 752(a) and (b). The partner's basis in his/her partnership interest is increased by the amount of the deemed contribution or reduced by the deemed distribution.
¶452This is not true as to the partner's capital account, however. The capital account generally reflects a partner's equity investment in the partnership and is not increased by his/her share of partnership liabilities. Tapper v. Commissioner, T.C. Memo. 1986-597. Thus, it is possible for partners, like petitioners in this case, to have negative capital accounts while maintaining positive tax bases in their partnership interest.
¶453Unlike a partner's basis, which can never be less than zero, a partner's capital account will be negative if the sum of the capital contributions credited to him on the partnership's books and his share of "book" profits is less than the sum of the amounts distributed to him and his share of "book" losses.↩