There appears to be 1983 U.S. Tax Ct. LEXIS 122">*136 no serious disagreement between the parties that the water and sewer system qualifies as other tangible property. The real dispute is over the question whether the partnership was in the trade or business of providing these utility services as a separate business.

Respondent argues that the petitioners have not established that they were in the trade or business of furnishing water or 80 T.C. 314">*321 sewer services. Respondent claims that the providing of water and sewer services is only incidental to petitioners' business of running a mobile home park. Petitioners, on the other hand, contend that they are in two separate businesses; that is, they are in the business of providing mobile home sites for rent, and in the business of providing water and sewer services to Majestic Oaks' tenants, and to the park, itself.

On several occasions, this Court has been called upon to determine whether the providing of utility services is merely incidental to a taxpayer's primary business. ⁶ Other courts have also been called upon to make this determination. ⁷ The issue usually arises in situations where the taxpayer is engaged in a business that benefits directly from the furnishing of these utility1983 U.S. Tax Ct. LEXIS 122">*137 services. Whether a taxpayer is engaged in a separate trade or business of furnishing utility services is an essential factor in determining whether the taxpayer's property qualifies as section 38 property under section 48(a)(1)(B).

In Evans v. Commissioner, 48 T.C. 704">48 T.C. 704, 48 T.C. 704">709 (1967),1983 U.S. Tax Ct. LEXIS 122">*138 affd. 413 F.2d 1047">413 F.2d 1047 (9th Cir. 1969), this Court established the following standard for determining whether a taxpayer is in the separate trade or business of furnishing utilities:

in order to find that these activities constitute another trade or business of the petitioners, it would have to be shown that these activities earned a substantial amount of income, separate from the trailer park rental fees, and that there was a good faith intention of making a profit from them in and of themselves. * * *

We believe that the petitioners have satisfied this two-part test.

First, it is evident that a substantial amount of partnership income (net before depreciation) was derived from furnishing these utility services to Majestic Oaks' tenants. As shown by our findings herein, carefully segregated books and records for the utility service operation were maintained, and, in addition 80 T.C. 314">*322 to the direct costs incurred in buying the services from the Improvement District, the partnership allocated appropriate portions of its general and indirect cash costs to the utility business. ⁸ As operated by the partnership, the utility business showed positive cash1983 U.S. Tax Ct. LEXIS 122">*139 flow from the beginning, small at first, but increasing in later years, as the park filled up with tenants and upward adjustments in the monthly charges were made.

Respondent argues that the "substantial income" requirement of 48 T.C. 704">Evans v. Commissioner, supra, is not met, since, says respondent, a net loss for 5 of the 6 years was produced after deducting depreciation on the water and sewer system. We think, however, that looking only at net taxable income (after depreciation) is an unduly narrow and therefore unreliable standard to apply in this case in testing for "substantial income" for purposes of section 48. Depending upon the depreciation methods employed by the taxpayer and permitted by the Code (see secs. 167, 168; Brannen v. Commissioner, 78 T.C. 471">78 T.C. 471 (1982)),1983 U.S. Tax Ct. LEXIS 122">*140 widely different results can be produced in a given situation so far as net taxable income is concerned, which can be quite misleading, looked at alone, as to the inherent economic viability of an enterprise. Granted, that depreciation does occur and that it is proper to take it into account in the present situation, evenly distributed over the estimated life of the asset, i.e., on a straight-line basis (see Tejas Properties, Inc. v. United States, an unreported case ( E.D. Tex. 1970, 25 AFTR 2d 70-720, 70-1 USTC par. 9240)), it is also appropriate to test for "substantial income" by applying a pragmatic and businessman's standard; viz, whether the allegedly separate trade or business is structured so as to stand on its own feet financially and yield a reasonably predictable positive cash flow (see Westroads, Inc. v. Commissioner, 69 T.C. 682">69 T.C. 682 (1978); Scull v. Commissioner, T.C. Memo. 1983-33).

This is particularly true in the case of a newly organized business, as here. Most new businesses just commencing can reasonably expect that small net profits and even losses will1983 U.S. Tax Ct. LEXIS 122">*141 be realized in the early years of the venture, before the enterprise has become established and built up to its full potential, and 80 T.C. 314">*323 the net taxable results can be further distorted when methods of accelerated depreciation are used, producing large depreciation deductions in years when gross income is likely to be the least. Under the facts of this case, therefore, we think that "substantial income" within the meaning of 48 T.C. 704">Evans v. Commissioner, supra, has been shown (cf. 69 T.C. 682">Westroads, Inc. v. Commissioner, supra; Graybeal v. Commissioner, T.C. Memo. 1979-506), emphasizing that our approach is limited to the section 48 qualification requirement presented herein, and to which Evans was addressed, without any implications as to the requirements which taxpayers may have to meet under other sections of the Code, e.g., section 183, where the relationship of depreciation to income may be a relevant and material consideration.

Second, we believe it is clear that petitioners had a good-faith objective of making a profit from providing these services. Prior to the purchase of Majestic1983 U.S. Tax Ct. LEXIS 122">*142 Oaks, the partnership undertook a careful analysis to determine whether a substantial profit could be made from providing water and sewer services. The record indicates that Majestic Oaks' tenants were not provided these services at cost. Rather, the Improvement District charged Majestic Oaks wholesale rates, while the partnership charged Majestic Oaks' tenants retail rates. The partnership kept separate books to record the income and costs associated with providing utility services and the income and costs associated with renting mobile home sites.

Separate utility bills were sent monthly to Majestic Oaks' tenants. The professional management company that attended to the day-to-day operation of both the mobile home park and the water and sewer facilities, submitted a monthly report to the partnership showing the income and costs associated with the water and sewer system. These monthly statements were submitted and reviewed by the partnership. The fact that the partnership took careful steps to segregate the operation of the mobile home park from the operation of the water and sewer facilities indicates the intention of the partnership to make a profit from offering these services. 1983 U.S. Tax Ct. LEXIS 122">*143 Cf. Johnston v. United States, an unreported case ( D. Mont. 1979, 45 AFTR 2d 80-948, 80-1 USTC par. 9199); Hayden Island, Inc. v. United States, 380 F. Supp. 96">380 F. Supp. 96 (D. Ore. 1974).

80 T.C. 314">*324 Our determination in this matter is not dependent upon whether these water and sewer services actually resulted in a profit. In determining whether an activity is entered into with the objective of making a profit, it is not fatal that the chance of realizing a profit is poor, or even remote. For purposes of section 48, we think the "good faith intention of making a profit" is the same as it is for purposes of section 183, and that the test is satisfied when "the taxpayer entered into the activity * * * with the actual and honest objective of making a profit." Dreicer v. Commissioner, 78 T.C. 642">78 T.C. 642, 78 T.C. 642">645 (1982); Mercer v. Commissioner, 376 F.2d 708">376 F.2d 708 (9th Cir. 1967); sec. 1.183-2(a), Income Tax Regs.

Obviously, evidence of large and continuing losses is relevant and material in determining whether such good-faith intention exists ( Golanty v. Commissioner, 72 T.C. 411">72 T.C. 411 (1979),1983 U.S. Tax Ct. LEXIS 122">*144 affd. without opinion 647 F.2d 170">647 F.2d 170 (9th Cir. 1981); Scull v. Commissioner, supra). The facts in the instant case, however, do not compel us to find against petitioners on this point. Unlike 78 T.C. 471">Brannen v. Commissioner, supra, where the large losses (generated mostly by depreciation), compared to the gross income, suggested an intention to realize tax deductions rather than profit from the enterprise, the depreciation claimed by petitioners herein was on the most conservative basis, viz, straight line, and was not excessive in relation to the gross income from the water and sewer system.

In Golanty v. Commissioner and Scull v. Commissioner, supra, the record showed that the taxpayers in those cases not only had consistent net losses after depreciation, but also had consistent net losses even before depreciation, i.e., negative cash flow. In the instant case, petitioners had consistent positive cash flow, and had a net profit, after depreciation, in one of the 6 years following their acquisition of the new mobile home park. We do not think that such a record precludes our finding that1983 U.S. Tax Ct. LEXIS 122">*145 petitioners here had a good-faith objective of making a profit from the current operations of the water and sewer system. Additionally, and importantly, petitioners believed that the system was appreciating in value and that there was a separate profit potential in the event of a sale of the system. On this record, such a belief was not inherently incredible, and is a factor properly to be considered ( sec. 1.183-2(b)(4), 80 T.C. 314">*325 Income Tax Regs.), whether or not it turns out to be true in the future.

In this case, we see no reason why the furnishing of water and sewer services by the partnership should not be viewed as a separate trade or business. Subject to what follows hereinafter, therefore, we hold that this water and sewer system is "section 38 property" within the meaning of section 48(a)(1)(B).

II

Although the water and sewer facilities initially qualify as section 38 property, the amount of the investment tax credit available to the taxpayer is dependent, inter alia, upon whether they are new or used within the meaning of section 48(b) and (c). The facts in this case make such determination difficult. At the time of purchase, 82 1983 U.S. Tax Ct. LEXIS 122">*146 of a total 398 mobile home sites in Majestic Oaks were rented. The remaining 316 spaces had never been occupied, and in some cases were not completed. Thus, that portion of the system serving these unused mobile home sites had never been used.

The controversy between the parties is: should this system be treated as an indivisible whole, whereby the use of any part of the system would render the whole system "used"; or should this system be considered as "new" section 38 property, since the largest portion had never been used at the time the partnership purchased Majestic Oaks? Respondent argues for the former, while petitioners, although principally arguing that the whole system should be considered as "new" in their hands, ask us to consider the possibility of a division between "new" and "used."

"New" section 38 property means, inter alia, section 38 property, acquired after December 31, 1961, whose original use commences with the taxpayer, and "used" section 38 property is that which is not "new." Sections 48(b)(2) and 48(c)(1). "Original use" is defined in section 1.48-2(b)(7), Income Tax Regs., as "the first use to which the property is put, whether or not such use corresponds1983 U.S. Tax Ct. LEXIS 122">*147 to the use of such property by the taxpayer." The utility system here in question was built and installed by M & H Investment. Since 82 of the 398 mobile home sites were rented at the time the partnership purchased 80 T.C. 314">*326 Majestic Oaks, respondent reasons that the utility system was used at the time petitioners purchased the property. Respondent therefore argues that if the water and sewer system qualifies as section 38 property, the whole system must be used property as that term is defined in section 48(c).

Petitioners disagree, and claim that since the system separately services 398 mobile home sites, it should not be treated as an integrated whole. Petitioners contend that it would be contrary to reason to determine that the whole system was "used" property, since the great majority of the mobile home sites were new, and had never been rented, and the corresponding water and sewer facilities never used. Petitioner thus argues that a substantial part of the whole system should be treated as new, if not the entire system.

We think that the treatment of section 38 property as either new or used is not an all-or-nothing proposition. We are not required by the statute to ignore1983 U.S. Tax Ct. LEXIS 122">*148 established facts when it is shown that, as of a given time, use of a portion of certain section 38 property has commenced but use of another portion has not. The applicable sections of the Code (sections 46 and 48) and the regulations thereunder are flexible enough to permit, even require, that section 38 property be split, both for purposes of determining the correct year in which to claim the credit, as well as for purposes of fixing the amount of credit by determining the status of the property as new or used, where the facts require it.

In the instant case, the facts are that the construction of the water and sewer system was complete in 1975. It was thus "placed in service" in that year within the meaning of section 46 and section 1.46-3(d) of the regulations, and we do not understand the parties to be in disagreement about this. However, at the time the partnership acquired the property, the facts are also clear that only a small portion of the new system had been put to use by M & H Investment in providing services to tenants. The great majority of the system was still unused, apparently because the sites themselves were not yet ready to receive tenants. The remaining1983 U.S. Tax Ct. LEXIS 122">*149 work in preparing the parking places, roads and approaches having been completed after the acquisition of the mobile home park by the partnership and prior to the end of 1975, these previously unavailable sites, together with their water and sewer connections, were 80 T.C. 314">*327 then put in use by the partnership by the end of that year, regardless of the fact that some spaces may not then have actually been rented. S.M.C. Corp. v. United States, an unreported case ( E.D. Tenn. 1980, 46 AFTR 2d 80-5827, 80-2 USTC par. 9642), affd. per curiam 675 F.2d 113">675 F.2d 113 (6th Cir. 1982). Such use was the "original use" of this part of the system within the meaning of section 48(b)(2). On the other hand, the portion of the system serving the 82 mobile home sites already rented out by M & H Investment at the time of the partnership's purchase was already in use and clearly was "used" property in the partnership's hands. Sec. 48(c)(1).

Both this Court and respondent have recognized that, in appropriate cases, a single section 38 property can and should be divided between new and used elements. Sec. 1.48-2(c), example (5), Income1983 U.S. Tax Ct. LEXIS 122">*150 Tax Regs.; cf. Kansas City Southern Railway Co. v. Commissioner, 76 T.C. 1067">76 T.C. 1067 (1981), on appeal (8th Cir., Oct. 25, 1982).

Having concluded that the instant property must be divided between new and used elements for investment tax credit purposes, we must decide how to do it. The water and sewer systems (each separately) may be thought of as a tree, with a trunk and numerous branches. In the fresh water system, the water enters the trunk from the Improvement District and passes up the trunk and into the various larger branches and smaller branches until it is delivered to the tip of the twig and a mobile home owner. The parallel sewer system works exactly in reverse, transporting waste from the mobile home owner back through the branches and trunk to the Improvement District. With negligible variation, the various mobile home units were about the same size and the difference in their estimated use was so minor that the partnership concluded that it was appropriate to impose a uniform flat charge per unit per month.

In these circumstances, we think that a fair, practical, and reasonably accurate method of allocation can be made here by dividing the1983 U.S. Tax Ct. LEXIS 122">*151 property between "used" and "new" in the same proportion that the units rented out prior to the partnership's acquisition of the property bear to the total number of mobile home sites. Such a division proceeds on the assumption, which we find reasonable, that the use of water and sewer by each mobile home unit is approximately equal, and that, as to the 80 T.C. 314">*328 common elements, the use was also proportionate to the occupancy of home sites. We can think of no better method to make the necessary allocation here, and neither party has suggested one. ⁹ Accordingly, we conclude and hold that 82/398 of the water and sewer system was used section 38 property, and 316/398 was new section 38 property in the hands of the partnership in 1975, subject, however, to a further complication with respect to the used portion, which we next address.

1983 U.S. Tax Ct. LEXIS 122">*152 III

Finally, we must consider whether the portion of the water and sewer system which we have held to be "used" property within the meaning of section 48 is disqualified, as a basis for claiming investment tax credit, under the facts of this case.

At the time the partnership acquired the Majestic Oaks property on October 27, 1975 (including the water and sewer system), the seller, M & H Investment, had already rented out 82 out of the total of 398 mobile home spaces, together with the use of the corresponding water and sewer facilities. As we have held, this portion of the water and sewer system was therefore already in use when acquired by the partnership. As part of the purchase and sale agreement, however, M & H Investment leased back the entire property from the partnership until an agreed level of occupancy was reached, and this event did not occur until sometime in 1976.

The relevant portion of section 48(c) provides as follows:

SEC. 48(c). Used Section 38 Property. --

(1) In general. -- For purposes of this subpart, the term "used section 38 property" means section 38 property acquired by purchase1983 U.S. Tax Ct. LEXIS 122">*153 after December 31, 1961, which is not new section 38 property. Property shall not be treated as "used section 38 property" if, after its acquisition by the taxpayer, it is used by a person who used such property before such acquisition * * *

80 T.C. 314">*329 Section 1.48-3(a)(2)(i) of respondent's Income Tax Regulations further provides:

Property shall not qualify as used section 38 property if, after its acquisition by the taxpayer, it is used by (a) a person who used such property before such acquisition * * *. Thus, for example, if property is used by a person and is later sold by him under a sale and lease-back arrangement, such property in the hands of the purchaser-lessor is not used section 38 property because the property, after its acquisition, is being used by the same person who used it before its acquisition. * * *

The portion of the water and sewer system applicable to the 82 mobile home spaces previously rented out by M & H Investment, which we have held to be "used section 38 property," is thus clearly within the prohibition of the second sentence of the above-quoted portion of section 48(c)(1), and we must hold that the partnership is entitled to no investment 1983 U.S. Tax Ct. LEXIS 122">*154 credit with respect thereto. ¹⁰

With respect to the specific point involved here, petitioners complain that respondent first called attention to the second sentence of section 48(c)(1) in his reply brief; that this constituted the raising of a new issue by respondent in his reply brief which was not raised at trial nor on opening brief; that this new issue caught petitioners completely by surprise and should not, therefore, be considered by the Court. We find petitioners' objections without merit.

Ordinarily, a taxpayer should be apprised of the Code1983 U.S. Tax Ct. LEXIS 122">*155 sections and theories upon which the respondent relies prior to trial. However, even if a specific Code section, theory, or regulation has not been specifically raised in the notice of deficiency, if there is an absence of surprise on the taxpayer's part, he has no reason to complain. Mills v. Commissioner, 399 F.2d 744">399 F.2d 744 (4th Cir. 1968); Nat Harrison Associates, Inc. v. Commissioner, 42 T.C. 601">42 T.C. 601 (1964); cf. Commissioner v. Transport M & E Co., 478 F.2d 731">478 F.2d 731 (8th Cir. 1973). Furthermore, if the alleged "new theory" merely clarifies or develops respondent's original determination, there is no "new matter." 80 T.C. 314">*330 Achiro v. Commissioner, 77 T.C. 881">77 T.C. 881 (1981); Estate of Jayne v. Commissioner, 61 T.C. 744">61 T.C. 744 (1974). Estate of Scharf v. Commissioner, 38 T.C. 15">38 T.C. 15 (1962), affd. 316 F.2d 625">316 F.2d 625 (7th Cir. 1963).

In the instant cases, respondent's statutory notice of deficiency was based upon his determination that the water and sewer system involved herein did not qualify for the investment1983 U.S. Tax Ct. LEXIS 122">*156 tax credit under section 38 of the Code. Further, it is clear from this record, as well as from the briefs, that petitioners knew that there was a controversy between them and respondent, not only as to whether the property qualified as "section 38 property" in general, but also as to whether the property should be considered as "new" or "used." Petitioners were thus clearly on notice that they would have the burden of proving that the water and sewer system met all the requirements of the Code with respect to section 38 property, including the requirements of section 48(b) and (c). ¹¹61 T.C. 744">Estate of Jayne v. Commissioner, supra. We cannot see how petitioners were disadvantaged by respondent's making an argument that relies on a Code section that had already been placed in issue, nor can we understand how petitioners can claim surprise, when the prohibition raised by the respondent is expressed in clear language in the statute itself. ¹²

1983 U.S. Tax Ct. LEXIS 122">*157 In conclusion, we therefore hold that petitioners are entitled to an investment tax credit with respect to that portion of the water and sewer system which we have held to be "new section 38 property," and based upon the allocation formula which we have outlined above. We further hold, however, that petitioners are not entitled to any investment tax credit with respect to the portion of the water and sewer system which we have held to be "used section 38 property."

Decisions will be entered under Rule 155.