T.C. Memo. 2008-64



                      UNITED STATES TAX COURT



               RAYMOND L. MONK, JR., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 10964-03, 6132-04.     Filed March 17, 2008.


     Caroline D. Ciraolo, for petitioner.

     Bradley C. Plovan, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     HOLMES, Judge:   For many years, Raymond Monk reported his

interest in a Baltimore bar called Chuck’s Place as a sole

proprietorship on his tax returns.    This wasn’t surprising--it

was his name on the bar’s liquor license, his name on the bar’s

checking account, and it was he who was recognized by Maryland as

the bar’s lottery agent.   But when the Commissioner began an

audit, Monk’s accountant delved deeper and determined that Monk
                                - 2 -

should have been reporting his income from the bar as nothing

more than rent.    “Taxation * * * is eternally lively; it concerns

nine-tenths of us more directly than either smallpox or golf, and

has just as much drama in it; moreover, it has been mellowed and

made gay by as many gaudy, preposterous theories.”1

     We must decide, in this lively controversy, whether Monk was

merely a landlord or whether, as the Commissioner implies, this

is just another gaudy, preposterous theory.

                          FINDINGS OF FACT

     Raymond Monk has dabbled over the years in a variety of

businesses, including drywall installation, plumbing, running a

delicatessen, and even raising rabbits.      He’s also invested in

more than a half dozen pieces of commercial real estate in and

around Baltimore.    In all but one of these rental arrangements,

Monk declined to draft written leases, relying instead on “you

pay, you stay” oral agreements.2

     Charles (Chuck) Maney met Monk more than twenty years ago

when Monk was dating his sister.    Their friendship grew and Maney

went to work for Monk in both his plumbing and drywall

businesses.    When Monk decided to retire from construction, Maney


     1
         H.L. Mencken, “The Dismal Science,” Smart Set, June 1922,
at 42.
     2
       Monk has only one written lease in his entire portfolio--
with a tenant who demanded formal documentation to maintain a
liquor license.
                               - 3 -

decided to retire as well.   But unlike Monk, who was leaving the

city life to move to the bucolic mountains of western Maryland,

Maney--who had worked in a saloon before meeting his friend--

wanted to stay in Baltimore and run a bar.   He faced just two

obstacles:   He didn’t have the money or knowhow to buy a building

for the bar, and in his distant youth he’d committed a felony

which, as far as he knew, would keep him from getting a liquor

license.   Maney talked to Monk; Monk said that since Maney liked

the bar business and Monk liked rental property, Monk would help

Maney out.

     In 1994, Monk and Maney went in together to buy a bar and

building in the blue-collar Baltimore neighborhood of

Highlandtown.   Maney gave Monk $40,000 to cover the cost of the

business--which he named Chuck’s Place--and Monk put up the

remainder of the $210,000 purchase price.    Monk then applied for

and received the liquor license for Chuck’s Place and became the

bar’s registered sales agent for the Maryland Lottery.   He also

set up a bank account for Chuck’s Place and gave Maney full

signatory authority over it.   With that done, Monk moved almost

200 miles away and left the operation of the bar to Maney.

     In the mid-1990s, Highlandtown was a rough neighborhood.

Chuck’s Place was open every day from 6 a.m. to 2 a.m., so Maney

and his family (who helped him run the bar) moved into the second

floor of the building to keep an eye on things.   He installed
                               - 4 -

security cameras so that he could watch the bar from the

apartment and set up separate phone lines for the bar and

residence so that he could be reached at any time with questions

or problems.   As the years passed, though, about the only problem

Maney really had was the occasional bounced check.   That wasn’t

enough of a problem, however, to deter him from offering to cash

both payroll and personal checks for his regular customers.

Since many of them didn’t even have bank accounts, cashing their

checks inclined them to spend more money at the bar.    (On this

point we found Maney particularly credible.)   In any event, the

increased business offset the risks of check cashing.    Out of

convenience more than anything else, Maney would keep any extra

change from the check (i.e., if the check was for $510.53, he’d

give the customer $510 and keep 53 cents) and set it aside along

with other change collected to help pay for an annual children’s

Christmas party.

     Per his oral agreement with Monk, Maney paid for all

interior expenditures himself and deducted the cost of any

exterior repairs and maintenance from the $2,500 monthly rent

that he paid Monk.3   Maney’s sister originally kept the books for

Chuck’s Place, but Maney’s wife took over when his sister started

getting--as Maney put it--“sticky fingers with the revenue.”      At


     3
       Maney referred to this cost allocation as the “swinging
door” agreement: if the door swung in, Maney was responsible; if
the door swung out, Monk was on the hook.
                              - 5 -

the end of each year, Maney would send a “Dome Book”4 to Monk for

him to figure out since the whole thing was, according to Maney,

far too complicated for him to untangle himself.

     Monk used Joseph Hahn, a certified public accountant, to

prepare his income tax returns for nearly twenty years.      Hahn

would send Monk an organizer with the previous year’s tax return

figures, and Monk would update the organizer and return it along

with all of his annual financial records.    After Hahn prepared

and reviewed the return, he sent it to Monk to sign and file.

Because Monk always included Chuck’s Place’s Dome Book in the

papers forwarded along with the organizer, Hahn assumed Monk

owned Chuck’s Place and thus reported it as Schedule C income.

     From 1994, then, Monk was reporting income and losses from

Chuck’s Place on a Schedule C attached to his income tax return.

But then the Commissioner audited Monk’s 1999 and 2000 returns,

which showed net operating losses.    Part of these losses was

attributable to Chuck’s Place, part to Monk’s rental properties,

and part to his other business activities.    As the audit

progressed, Hahn realized that Monk wasn’t directly involved in

the management of Chuck’s Place.   He and Monk then prepared




     4
       “Dome Book” was the witnesses’ shorthand way of referring
to a recordkeeping notebook published by the Dome Publishing
Company and widely used by small businesses to organize their
receipts and expenses.
                                 - 6 -

amended income tax returns for 2000,5 2001, and 2002, deleting

the income and expenses of Chuck’s Place from his schedule C and

including them (to the extent that they were landlord expenses)

on his schedule E.   Monk’s 2003 tax return listed the rent from

Chuck’s Place on Schedule E when originally filed.6

     The Commissioner rejected the change in characterization and

determined that Chuck’s Place was underreporting income from what

she was convinced was a check-cashing business.   She used two

different indirect analytic methods to quantify the resulting

deficiencies.   One was the well-known modified-bank-deposits

method.   See Fry v. Commissioner, T.C. Memo. 1991-51, affd.,

without published opinion, 

(9th Cir. 1993).   The other

--the check-cashing-fee method--was custom designed by the

revenue agent for this case and tried to determine unreported

check-cashing income by figuring out the cash on hand at the bar.

For the years in this case--1999 and 2000--the agent calculated

the deficiency using both methods and went with the one that

generated the highest tax due.    This led her to use the modified-

bank-deposits method for 1999, but to use the check-cashing-fee

method for 2000.



     5
       The amended 2000 tax return was filed with the IRS as part
of the audit.
     6
        Monk hadn’t reported the rent he received from Maney on
the older returns, though he also wasn’t deducting it as an
expense on the Schedules C.
                                 - 7 -

     The IRS mailed Monk notices of deficiency for both years.

Monk timely filed petitions, the cases were consolidated, and

trial was held in Baltimore.    Monk was a resident of Maryland

when he filed.

                                OPINION

     The Commissioner claims that Monk’s original position on his

tax returns for 1994 through 2002--i.e., that Chuck’s Place was

his own Schedule C sole proprietorship--was an admission by Monk

and so is the proper way to classify his interest in the bar.     In

support, she points out that it is Monk’s name that was stated as

the bar’s owner on the liquor license and lottery paperwork.

Monk was also the only person originally named on the bar’s only

bank account; even now, Maney’s name is on that bank account not

as an owner, but only as someone with signatory authority.

Finally, it was Monk who submitted the bar’s gross income and

losses to the IRS, not Maney.    Monk changed his position only

after the audit began.

     Each of these points supports the Commissioner’s view that

Monk actually owned Chuck’s Place, although maybe as a joint

venture or partnership with Maney rather than a sole

proprietorship.7   But we look at all the facts together to decide



     7
       Characterizing any potential ownership interest as a sole
proprietorship would mean classifying Monk and Maney’s
relationship as that of employer/employee. Nothing in the record
supports this.
                                 - 8 -

how to classify the friendly and informal arrangement that Monk

and Maney had reached.    First, we keep the parties’ own intent

foremost in our consideration.     Commissioner v. Culbertson, 

, 742 (1949); Nelson v. Seaboard Sur. Co., 

,

887 (8th Cir. 1959).     Second, we follow the principle that “State

law determines the nature of property rights, and Federal law

determines the appropriate tax treatment of those rights.”

Knight v. Commissioner, 

, 513 (2000) (citing United

States v. Natl. Bank of Commerce, 

, 722 (1985),

United States v. Rodgers, 

, 683 (1983), and Aquilino

v. United States, 

, 513 (1960)).

     First off, we need to decide whether Monk and Maney’s

initial agreement can be construed as a valid attempt to create a

lease under Maryland law.    Maryland law defines a lease as “any

oral or written agreement, express or implied, creating a

landlord and tenant relationship, including any ‘sublease’ and

any further sublease.”    Md. Code Ann., Real Prop. sec. 1-101(h)

(LexisNexis 2003).    The terms “landlord” and “tenant” are very

broadly defined to include “any landlord” and “any tenant.”

   And it is clear to us that there was a set

monthly rent that Maney paid to Monk and the allocation of

maintenance and repair expenses was understood and followed by

each of them.   We therefore specifically find that Monk and Maney

had a valid oral lease.     And we have previously held that valid
                               - 9 -

oral leases can be used to claim rental deductions.    See Lim v.

Commissioner, T.C. Memo. 1998-432; Wy’East Color, Inc. v.

Commissioner, T.C. Memo. 1996-136.     The issue then becomes

whether this particular oral lease was merely a formality or had

real substance.

     On this issue, we find that the lease did reflect reality.

One of its terms, remember, was that Monk would be responsible

for any repairs on the outside of the building while Maney would

be responsible for any repairs on the inside--the “swing-in,

swing-out” cost allocation.   Rather than have Maney submit bills

to him for any external work done, Maney would pay for it up

front and subtract the amount paid from that month’s rent.      We

find both Monk’s and Maney’s testimony credible on this point and

also find that this is in fact what happened.    There is ample

evidence in the Dome Book that the insurance was split along the

same lines, with Maney paying Monk (in addition to the monthly

rent) that portion of the insurance attributable to the inside of

the premises.   Both these practices show that the relationship

between Monk and Maney was that of landlord and tenant.

     Even more telling, however, is that Monk’s financial

interest--which consisted primarily of his monthly rent payment--

wasn’t tied to the profits or losses of Chuck’s Place.    In

University Hill Foundation v. Commissioner, 

, 568-69

(1969), revd. on other grounds 

(9th Cir. 1971), we
                                - 10 -

stated that one of the critical elements in determining whether a

lease is actually a joint venture is whether there is “a risk of

loss in the taxpayer.”    In that case, the taxpayer’s rent

payments were directly tied to the profits of the business, but

because he was not required to contribute to any losses, he had

no risk of loss and therefore was not involved in a joint

venture.

Monk looks even less like a

partner:    not only is he not required to contribute to any losses

sustained by Chuck’s Place, but he receives gross rent in the

same amount each month regardless of what those profits might

be.8

       In fact, the only evidence that weighs in favor of calling

Chuck’s Place a joint venture, instead of calling it a business

owned by Maney that pays rent to Monk, is Monk’s history of

listing himself as the bar’s owner on his original tax returns

and putting his own name on the state licensing applications and

other paperwork.    But we look at these facts in the context of

their old friendship.    Seen that way, this evidence looks more

like one friend trying to help another who made a mistake a long,



       8
       Maney also testified that he (and not Monk) has the bar’s
logo tattooed on his chest. Though the Court did not undertake a
visual inspection, we found him credible on this point. His
numerous expressions of pride in the bar and its role in the
neighborhood--and the fact that it is named “Chuck’s Place” and
not, say, “Famous Ray’s”--are additional, albeit minor, factors
supporting our conclusion that the bar is his.
                                  - 11 -

long time ago.   Maney believed that his 40-year-old felony

conviction would make fulfillment of his dream of owning a bar

impossible if he filed for the licenses himself.     So Monk filed

the paperwork for him, not realizing how much it might matter

whose name was on the liquor and lottery licenses or on the bank

account.   (Though we assert no expertise in Maryland

administrative law, it seems unlikely that either Monk or Maney

will benefit from the position on the true ownership of Chuck’s

Place that they have taken in this case when Maryland authorities

learn of it, further bolstering their credibility on this point.)

     In situations like this, where there is written

documentation which contradicts the reality of a situation, we

disregard the documents to properly tax the person actually

earning the income.   We did just this in the very similar case of

Malone v. Commissioner, T.C. Memo. 2005-69, where we held that a

family music business should be taxed to the children who

actually ran the business and not to the parents whose names were

on the legal paperwork.    “[A]lthough not determinative in a

general sense, in a labor-intensive business with no employees,

there is a strong suggestion that the individuals performing the

labor own the business.”

in this case

that the profits and losses from Chuck’s Place are not assignable

to Monk, who had no real involvement in the business, despite the

fact that he put his name on the paperwork.
                              - 12 -

     In addition, neither Monk nor Maney understood the

significance of Monk’s submission of the Dome Book to his

accountant and his reporting the business on his tax return.     We

believe them to be sincere, if completely mistaken, when they say

they didn’t think it mattered where the money was reported as

long as it was reported somewhere.     Although both have long

practical experience as businessmen, neither has the formal

education to understand the complexities of the Code--Monk has no

training past high school and Maney left school after the fifth

grade.   And that’s why Monk had a professional accountant, Hahn,

take care of his somewhat complicated tax return each year.

     Unfortunately, Hahn misunderstood Monk’s involvement with

Chuck’s Place.   When Monk said that he bought a bar, he meant he

had bought the building, but Hahn reasonably thought Monk meant

that he was running the bar himself.     When the audit began, Hahn

looked more closely into Monk’s involvement--or, rather, lack of

involvement--in Chuck’s Place and saw the mistake immediately.

It was this epiphany--not the expected tax consequences of the

audit--that moved Hahn to amend Monk’s tax returns for the

previous three years and change the way Chuck’s Place was

reported on his later tax returns.     In other words, we find the

inclusion of Chuck’s Place on Monk’s Schedule C was a mistake

rather than an admission--a mistake that was corrected as soon as

it was discovered.
                              - 13 -

     We also find that this mistake should not give rise to an

accuracy-related penalty under Internal Revenue Code section

6662(a) (2004).   Monk provided correct information to the

accountant (he gave him all the information he had), and the

mistake was a result of his accountant’s entirely understandable

error.   That’s all Monk needs to show under section 1.6664-

4(b)(1) of the Income Tax Regulations.    See, e.g., Westbrook v.

Commissioner, 

, 881 (5th Cir. 1995), affg. T.C. Memo.

1993-634.

     When all the evidence is considered, the picture becomes

clear that Monk’s relationship with Maney regarding Chuck’s Place

is truly that of a landlord/tenant.    Because this will trigger

various computational adjustments,



                                      Decisions will be entered

                               under Rule 155.