The Shahs' Claimed Loss From Coastal Imaging and Constructive Dividend Dr. Shah is a cardiologist who conducts his medical practice through Coastal Heart. On November 4, 2003, Coastal Heart leased3 a cardiac CT scanner from Siemens Medical Solutions USA, Inc. (Siemens), for a 60-month term. Dr. Shah signed the lease on behalf of Coastal Heart, and the lease was secured by a $500,000 life insurance policy on Dr. Shah naming Siemens as the beneficiary. The lease provided that Coastal Heart could not assign or dispose of its rights or obligations under the lease or enter into any sublease without Siemens' written consent. The lease also included an option to purchase the CT scanner at less than fair market value. At the end of the 60-month term, the lease was extended for another 18 months. Coastal Heart was the signatory on the lease renewal agreement.
On January 25, 2004, Coastal Heart paid $4,000 to Zabala Custom Constructions for construction work to accommodate the CT scanner. The construction work included erecting new lead walls to assist with the functionality of the scanner and housing the scanner on the bottom floor of Coastal Heart's new two-story office.
In 2004 Dr. Shah formed Coastal Imaging, a registered California limited liability company, with two other individuals to manage the CT scanner.4 One of these individuals was a doctor, and the other was Dr. Shah's former patient. Dr. Shah was the managing member of Coastal Imaging.
For the 2004 tax year the Shahs asserted that Dr. Shah had personally guaranteed the lease of the CT scanner and claimed a nonpassive loss deduction from Coastal Imaging of $291,985. Because the Shahs did not provide a copy of the guaranty, respondent determined that Dr. Shah did not have enough basis in Coastal Imaging to cover the entire loss. Therefore, respondent disallowed $272,244 of the loss deduction. Respondent also determined that the Shahs received a $4,000 constructive dividend from Coastal Heart for the 2004 tax year because of the construction work performed by Zabala Custom Constructions.
Dr. Shah's Claimed Real Estate Activities In 2004 Tenant Healthcare (Tenant), the company that owned the hospital where Dr. Shah was a leading physician, decided to sell that hospital and four others in the region. Dr. Shah thought it would be a good idea if the physiciansthemselves owned and operated the hospitals, so he placed a bid for the hospitals. To facilitate the transaction, Dr. Shah became the executive chairman of Integrated Healthcare Holdings, Inc. (IHHI), a hospital acquisition and management company. Dr. Shah raised capital for the purchase of the hospitals through an entity called the Orange County Physicians Investment Network (OCPIN). OCPIN was made up of various physician investors with Dr. Shah as manager. To ensure that the physicians would own the hospitals, OCPIN bought a controlling stake in IHHI. In 2005 after a year of deliberation, negotiation, and State Senate meetings in Sacramento, IHHI bought the hospitals from Tenant for $57 million. Dr. Shah testified that he spent around 16 hours a day negotiating the transaction with Tenant.
As executive chairman of IHHI, Dr. Shah was responsible for setting the overall strategies and direction of the company, monitoring and overseeing corporate performance, and guiding the board of directors in its oversight of the corporate activities and performance. IHHI compensated Dr. Shah for his role as executive chairman. After the sale, IHHI immediately split the real estate holdings portion of the transaction from the hospital operations aspect. In that respect, Pacific Coast Holdings Investment, LLC (PCHI), would own the propertiespurchased from Tenant and IHHI would manage the operations of the hospitals. After the division, $50 million of the investment belonged to PCHI and $7 million belonged to IHHI.
In order for the physicians and Dr. Shah to maintain an interest in the real estate portion of the deal, an entity called West Coast Holdings, LLC (West Coast), was formed to be a substantial investor in PCHI. West Coast had an ownership structure similar to OCPIN's, and Dr. Shah managed West Coast and comanaged PCHI.
Thereafter, PCHI leased the hospital properties purchased from Tenant to several different hospitals. Because the leases to these hospitals were "triple-net leases", the hospitals themselves were responsible for routine maintenance and repairs, not PCHI. Instead, Dr. Shah's duties as a comanager for PCHI during the years at issue were negotiating leases with the other hospitals, dealing with lawsuits pertaining to the transactions, and avoiding bankruptcy. Dr. Shah also spent time finding investors for the hospitals, refinancing loans used for the purchase of the hospitals, and obtaining guaranties on two properties that PCHI rented instead of owned.
The Shahs also managed RPS, LLC (RPS), during the years at issue. RPS owned the 30-suite office building where Coastal Heart's office and the CTscanner were located. As property managers of RPS, the Shahs collected rents for the building, prepared the leases, took care of maintenance and repairs throughout the building, and managed the utilities.
For each of the taxable years at issue the Schedule E, Supplemental Income and Loss, that petitioners filed contained the following warning: "Caution: Your rental real estate loss * * * may be limited. * * * Real estate professionals must complete line 43 on page 2." Despite this statement, petitioners left blank line 43 of Schedule E, dealing with "Reconciliation for Real Estate Professionals".
Petitioners did not make an election to group activities together for purposes of measuring material participation, nor did they elect to treat all of their interests in rental activities as one activity.
For tax years 2005 through 2007 the Shahs claimed nonpassive losses from RPS, West Coast, OCPIN, and an entity called Danon Danon Shah Younis Singh (DDSYS). For these years respondent determined that the Shahs' losses from these entities were from rental real estate activities and therefore were passive.
Coastal Heart's Reported Income and Claimed Deductions As sole owner and manager of Coastal Heart and Coastal Imaging, respectively, Dr. Shah maintained separate books for both entities. For the years at issue Coastal Heart reported income generated by the CT scanner for patients'use of its heart scanning services, while Coastal Imaging claimed depreciation deductions for the CT scanner. Coastal Heart also claimed deductions related to the CT scanner including: (1) salaries and wages of three employees involved in the operation of the CT scanner; (2) repairs and maintenance of the CT scanner and the office shared by Coastal Imaging and Coastal Heart; (3) monthly rental of the shared office; (4) depreciation of office furniture in the shared office; (5) rental payments on the CT scanner lease; and (6) expenses for operating the CT scanner.
Respondent determined that Coastal Heart had improperly included the gross income and business expenses of Coastal Imaging on its corporate tax returns for tax years 2004-06. At trial Dr. Shah testified that it was Coastal Heart, not Coastal Imaging, that paid the lease on the CT scanner, paid for training and employment of special technicians for the CT scanner, was the sole tenant of the office space in which the CT scanner operated, and made the downpayment and paid the construction costs related to the CT scanner. Respondent contends that Coastal Heart and Coastal Imaging are separate and distinct...
