12-85

Glen and Diane Flood owned and operated Flood's Auto Parts and Glenwtlod Wrecker Service in Chatsworth, Georgia. The cornpanies' offerings to the local rnarket included the sale of wholesale and retail auto parts, a wrecker service, and the sale of wrecked autos. Mr. Flood did not consistently prepare invoices for customers and had no other way to determine totalsales for his businesses. Although Mr. Flood deposited some of the cash revenue into the company's bank accounts, he stored some of it in a safe at his home. Over sevcral years, Mr. Flood purchascd multiple businssses and sold all or parts of others. The terms of payment were not always recorded in written filrm, and not all ol them were repot'ted on Schedule C of Mr. Flood's individual tax returns. Through a routine examination o1'the company's tax returns, an IRS examiner discovered that Mr. Flood had not reported all of the sales generated by his businesses. Specifically, the examiner detennined that Mr. Flood had understated taxable income lor 1991, 1992, and I993 by $28, 195, $22,695, and 74,0I3, respectively.

The Floods challenged the IRS auclit findings, specilically that: ( I ) Mr. Flood failed to rnaintain adequate books and records; (2) sales were routinely omitted from the recordkeeping process; (3) employees may have forgotten to record sales; (4) not all cash revenue was depositecl in the bank; and (5) Mr. Flood was aware of these failures and chose to withold this information from the tax preparer.

The tax court's memorandum is available at www.ustaxcourt.gov. At the homepage of this site, select the "Opinions Search" tab. Then, use the case keywords feature and enter: "Flood." A case wilh the name Glenn H. ttnd Diane J. Flood will be among the cases listed. Select this case this case for further use.

After reading the case, respond to the following questions.

1. What mcthod did the IRS examiner use to determine the amount of unreported income? Why did the IRS exarniner select this as an appropriate method for this case?

2. Explain how the source and application of funds method works.

3. Using the data presented in the case, recreate in an Excel spreadsheet the source arnd application of funds wclrksheets for 199I , 1992. and 1993. Then provide an explanation of how

each component of the spreadshcet contributes to the reconstruclic'rn of taxable incomc. In other words, explain the methodology employed by the IRS examiner.

4. In what specific area did the Floods disagree with the IRS examiner's findings'? If the Floods are correct, what impact would it have on the amounts calculated as unreported income? How

did the tax court rule on this matter?

5. How did the tax court view the indirect rnethodology used by the IRS examiner to develop unrcported incorne?

6. How did the tax court determine whether a loan from Mr. Flood to his father was in fact a loan that became worthless in 1992? How did the tax court rule?

7. The IRS examiner determined that a 20% accuracy penalty on the unreported amounts was appropriate. What was the basis ftrr this delcrminationation?

How did the court rule, and why?

8. Why was this case tried in the U.S. Tax court rather than U.S. District court? What is the difference? Who decides?

T.C. Memo. 2001-39

UNITED STATES TAX COURT

GLENN H. AND DIANE J. FLOOD, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 12279-98. Filed February 21, 2001.

Cheryl R. Frank and Gerald W. Kelly, Jr., for petitioners.

David Delduco, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Judge: Respondent determined deficiencies and

accuracy-related penalties in petitioners Federal income taxes

as follows:

Penalty

Year Deficiency Sec. 6662(a)

1991 $9,459 $1,892

1992 9,212 1,842

1993 23,323 4,665

- 2 -

1 Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the taxable periods under

consideration, and all Rule references are to the Tax Court Rules

of Practice and Procedure.

2 The parties stipulation of facts and exhibits is

incorporated herein by this reference.

The issues for our consideration are: (1) Whether

petitioners 1991, 1992, and 1993 income was underreported in the

amounts of $28,195, $22,695, and $74,013, respectively; (2)

whether petitioners are entitled to a 1992 bad-debt deduction

under section 166;1 (3) whether petitioners are entitled to a

1992 casualty loss deduction under section 165; (4) whether

petitioners 1992 gain from the sale of Glenwood Wrecker Service

was understated in the amount of $10,635; and (5) whether

petitioners are liable for the accuracy-related penalty under

section 6662(a) for the 1991, 1992, and 1993 tax years.

FINDINGS OF FACT2

When their petition was filed, petitioners Glenn H. and

Diane J. Flood resided in Chatsworth, Georgia. Glenn H. Flood

(petitioner) owned two businesses during the years in question,

Floods Auto Parts (FAP) and Glenwood Wrecker Service (Glenwood).

FAP

During the tax years in issue petitioner owned and operated

FAP, a sole proprietorship located in Chatsworth, Georgia. FAP

consisted of the wholesale and retail sale of auto parts, a

wrecker service, and the sale of junk cars to a scrap metal

- 3 -

dealer. Petitioner recorded most of the gross receipts for FAP

by creating invoices; however, he did not create an invoice for

every sale. Petitioner had no other means to determine the

amount of unrecorded receipts. Petitioner did not deposit all

proceeds from sales into his business or personal bank accounts

and also accumulated cash at his residence. Petitioner reported

income for FAP on Schedule C, Profit or Loss From Business. For

the years 1991, 1992, and 1993 FAP was petitioners primary

source of income.

Glenwood

On May 27, 1988, petitioner purchased Glenwood from Glenn

Cantrell for $18,643 and initially operated the business as a

sole proprietorship. An employee managed Glenwood until the

employees death that same year. Soon after the employees

death, petitioner agreed to form a partnership with Sam

Hammontree (Hammontree), who subsequently became petitioners

brother-in-law. Hammontree planned to draw cash from his

retirement fund to pay for a one-half partnership interest in

Glenwood, but he was unable to obtain the funds. Instead,

petitioner and Hammontree orally agreed that Hammontree would

manage and receive a salary from Glenwood and pay petitioner from

Hammontrees half of the business profits.

- 4 -

Petitioner and Hammontree filed a partnership tax return for

Glenwood for the calendar year 1988. For the 1988 tax year,

Glenwood reported ordinary losses of $517 and claimed $5,000 in

section 179 expenses. Glenwoods Schedule K for 1988 reflected

that petitioner and Hammontree each owned 50 percent of the

partnership. Petitioners reported flowthrough activity from

Glenwood for tax years 1988 through 1992 on their Forms 1040,

U.S. Individual Income Tax Return.

Effective February 28, 1989, Glenwood became incorporated as

Glenwood Wrecker Service, Inc., and the Glenwood partnership was

terminated. The partnership assets and liabilities were

exchanged for all of the issued stock in Glenwood.

Additionally, a short-year partnership tax return was filed for

the period ending February 28, 1989. The partnership reported

ordinary income of $788 for the short tax year ending February

28, 1989. Petitioners ending basis in Glenwood partnership and

his beginning basis in Glenwood corporation was $13,914.

On April 25, 1989, petitioner and Hammontree personally

guaranteed a bank loan to Glenwood in the amount of $43,080. The

loan was secured by Glenwoods assets, which consisted of six tow

trucks and one office trailer. Petitioner and Hammontree agreed

that $29,788.59 should be removed from the corporation by

Hammontree and paid to petitioner in payment for Hammontrees

one-half interest in the business. The following day, April 26,

1989, petitioner received a $29,788.59 corporate check, signed by

- 5 -

Hammontree. Petitioner used the $29,788.59 to pay off

outstanding debts of FAP.

For the short tax year beginning March 1, 1989, and ending

December 31, 1989, Glenwood elected S corporation status.

Glenwood filed Form 1120S, and reported ordinary income of $8,920

and claimed $8,900 in section 179 expenses. The Glenwood Form

1120S reflected that petitioner and Hammontree were 50-percent

shareholders for the short tax year ending December 31, 1989.

During the examination of petitioners, respondent determined

that the $29,788.59 received by petitioner was a distribution

from Glenwood reducing petitioners basis in Glenwood.

In July 1992, petitioner sold his one-half interest in

Glenwood to Hammontree for $42,930. Petitioner received a

cashiers check for $40,000 from Hammontree and a separate check

directly from Glenwood for $2,930. Petitioners reported a

capital gain from the sale of Glenwood stock in the amount of

$19,344 on their 1992 Form 1040, U.S. Individual Income Tax

Return. Respondent determined that petitioners understated their

capital gain on the sale of Glenwood by $10,635.

The Murray Avenue Auction

In 1986, petitioner began working for the Murray Avenue

Auction (the auction). The auction was wholly owned by

petitioners father, John Flood, until 1987. On January 1, 1987,

petitioners stepmother, Willene Flood, acquired an ownership

interest in the auction and applied for a certificate of

- 6 -

registration with the Georgia Department of Revenue.

The auctions primary activity was selling items such as

toys, tools, furniture, and collectibles that it acquired in

bulk. Petitioner, a licensed auctioneer, worked at the auction

and as a buyer, traveled to different locations to acquire the

items subsequently sold at the auction. Petitioners sister also

worked at the auction.

Petitioner cosigned and made payments on several bank loans

which were used for the benefit of his father and the auction.

The total amount advanced to petitioners father was $107,036.

Petitioner did not have an ownership interest in the auction. In

1992, a fire completely destroyed the auction, for which

petitioners father and stepmother claimed a casualty loss

deduction of $55,825 on their Form 1040 for the 1992 tax year.

Petitioners Income as Determined by Respondent for 1991

For the tax year 1991, respondent, using the source and

application of funds method, determined that petitioners had

unreported income. To compute unreported income using this

method, the funds petitioners used were identified through their

expenditures during the tax year 1991 and then compared with

petitioners total available funds from all sources during the

tax year 1991. Where the expenditures exceeded known available

sources of funds, the difference was determined to be income. As

part of the calculation, respondent excluded funds that were

accumulated during prior taxable years.

- 7 -

To make his determination as to petitioners income for

1991, respondent used the following information:

Source of funds:

Adjusted gross income $19,283

Loan balance 12/31/91 100,000

Bank account balances 1/1/91 7,081

Moneys advanced from daughter 4,500

Depreciation (noncash deduction) 4,620

Self-employment tax AGI deduction 1,133

Glenwood loan receivable 31,301

Cash on hand 1/1/91 3,000

Total sources available 1170,918

Application of funds:

Personal living expenses $23,780

Loan balance 1/1/91 99,013

Funds to construct house for daughter 30,301

Bank balance 12/31/91 284

Payment of fathers loan 34,001

Glenwood loan receivable 12/31/91 -0-

Increase in inventory 4,288

Increase to capital/Glenwood 4,379

Building improvements 6,067

Cash on hand 12/31/91 3,000

Total application of funds 205,113

Total sources available 170,918

Understatement of income 34,195

Less specific adjustments/rental income (6,000)

Understatement of income 28,195

1 Although the parties have stipulated $170,915, it

appears the correct amount is $170,918.

- 8 -

Petitioners Income as Determined by Respondent for 1992

For the tax year 1992, respondent, using the source and

application of funds method, determined that petitioners had

unreported income. To make his determination, respondent used

the following information:

Source of funds:

Adjusted gross income $26,805

Loan balance 12/31/92 56,894

Bank account balances 1/1/92 284

Moneys advanced from daughter 1,000

Depreciation (noncash deduction) 4,329

Basis in asset sold 20,656

Cash on hand 1/1/92 3,000

Total sources available 112,968

Application of funds:

Personal living expenses $24,093

Loan balance 1/1/92 100,000

Funds to construct house for daughter 4,697

Bank balance 12/31/92 1,667

Increase in inventory 5,000

Increase to capital/Glenwood 6,136

Cash on hand 12/31/92 3,000

Total application of funds 144,593

Total sources available 112,968

Understatement of income 31,625

Additional proceeds from sale of

Glenwood (2,930)

Sale of equipment (6,000)

Understatement of income 22,695

Petitioners Income as Determined by Respondent for 1993

For the tax year 1993, respondent, using the source and

application of funds method, determined that petitioners had

unreported income. To make his determination, respondent used

- 9 -

the following information:

Source of funds:

Adjusted gross income $15,154

Loan balance 12/31/93 52,210

Bank account balances 1/1/93 1,667

Depreciation (noncash deduction) 20,276

Amount payable on equipment 12/31/93 21,328

Self-employment tax deduction 848

Cash on hand 1/1/93 3,000

Total sources available 114,483

Application of funds:

Personal living expenses $21,980

Loan balance 1/1/93 56,894

Bank balance 12/31/93 3,250

Increase in inventory 67,868

Equipment purchases 35,504

Amount payable on equipment 1/1/93 -0-

Cash on hand 12/31/93 3,000

Total application of funds 188,496

Total sources available 114,483

Understatement of income 74,013

OPINION

We consider here whether petitioners underreported income

from the sale of a capital asset and from a business. We also

consider whether petitioners are entitled to a bad debt and/or a

casualty loss deduction. Finally, we must decide whether

petitioners are liable for accuracy-related penalties.

Was Petitioners 1991, 1992, and/or 1993 Business Income

Underreported?

Respondent, using the source and application of funds

method, determined that petitioners income was underreported for

the tax years 1991, 1992, and 1993 in the amounts of $28,195,

$22,695, and $74,013, respectively. Petitioners contend that

- 10 -

respondent used an understated amount of cash on hand in the

calculation of petitioners business income. A larger amount of

cash on hand would reduce respondents income determination under

the source and application of funds method.

Taxpayers are required to keep adequate records with which

the Commissioner may determine their correct tax liability. See

sec. 6001; sec. 1.6001-1(a), (d), Income Tax Regs. In the

absence of such adequate records, the Commissioner may

reconstruct income using a method that clearly reflects income.

See Cebollero v. Commissioner, 967 F.2d 986, 989 (4th Cir. 1992),

affg. T.C. Memo. 1990-618; Petzoldt v. Commissioner, 92 T.C. 661,

687 (1989). The Commissioner may use indirect methods to

reconstruct income, so long as they are reasonable in the

circumstances. See Holland v. United States, 348 U.S. 121, 126

(1954); Giddio v. Commissioner, 54 T.C. 1530, 1532-1533 (1970).

Respondent reconstructed petitioners income using the

source and application of funds method. Petitioners do not

question respondents use of the source and application of funds

method for reconstructing their income. Petitioners argue,

however, that respondents determination of their income was

overstated because respondent used too small an amount of cash on

hand in the computation. Petitioners do not question other

aspects of respondents calculations. Accordingly, we must

consider whether respondent erred in the reconstruction of

petitioners income only with respect to the amount of cash

- 11 -

petitioners maintained at their residence.

As part of the reconstruction of income using the source

and application of funds method, funds that were accumulated

before the first taxable year under examination must be excluded.

During the examination, petitioner told respondents agent that

petitioners kept approximately $3,000 in cash at their residence.

Relying on petitioners representation, respondent used $3,000 in

the reconstruction of petitioners income.

Petitioners now contend that $3,000 does not represent the

correct amount of cash on hand and that petitioners actually had

as much as $30,000 in cash at their residence. The only evidence

petitioners offered on this point was petitioners oral

testimony. On direct examination petitioner was asked: Now

today, with your knowledge of the facts, is that [$3,000] number

accurate, or is it higher or lower? Petitioner responded:

I just prefer to leave it the same. I dont

know. I couldnt tell you the truth about

that. Id just rather just leave it the

same, but I probably had--I had to have more

money than what I told him. Thats the only

thing I can say about it, but thats been a

long time ago. Lets just leave it $3,000,

and just let it ride like that. Thats what

I would say. [Emphasis added.]

- 12 -

3 Petitioners did not claim this loss on their returns.

Instead, the loss was claimed in an attempt to offset

respondents deficiency determination. Because of our holding,

this issue has no effect on the deficiency determined or the

accuracy-related penalties.

Accordingly, petitioners have failed to show that respondent

erred by using $3,000 as cash on hand. Therefore, respondents

reconstruction of petitioners income is upheld in full.

Have Petitioners Shown That Advances to Petitioners Father Were

Loans and That They Became Worthless During 1992?

We next consider whether petitioner is entitled to a section

166 bad-debt deduction for advances made to or on behalf of his

father. Petitioners argue that they are entitled to ordinary

loss treatment because the advances were loans made in

furtherance of petitioners trade or business and that said loans

became worthless when the auction was destroyed by fire in 1992.

Respondent argues that the advances petitioner made were gifts

which did not have the requisite characteristics of a bona fide

debt for the purposes of section 166.3

In order to maintain an ordinary loss deduction for a bad

debt, a taxpayer must demonstrate that the advances qualify for

section 166 treatment. See White v. United States, 305 U.S. 281

(1938); United States v. Virgin, 230 F.2d 880 (5th Cir. 1956). A

taxpayers entitlement to section 166 treatment depends upon a

showing that a bona fide debt existed and that the debt became

uncollectible during the year in which the deduction is claimed.

See sec. 166; Rule 142(a); Welch v. Helvering, 290 U.S. 111

- 13 -

(1933). A bona fide debt is one that arises from a debtorcreditor

relationship and is based upon a legally valid and

enforceable obligation to pay a fixed or determinable sum of

money. See sec. 1.166-1(c), Income Tax Regs.

We have held that our consideration of whether a taxpayer

created a debt with a true expectation of repayment and with the

intent to enforce the repayment of that debt requires an

examination of the facts and circumstances. The following

factors have been used to aid in deciding whether an advance is

debt within the meaning of section 166: (1) The existence of a

promissory note or written evidence of indebtedness; (2) whether

and in what amount interest is charged; (3) whether there is a

fixed repayment schedule; (4) whether there is security or

collateral for the debt; (5) whether the lender made a demand for

repayment; (6) whether the loan is reflected as a loan in the

parties books and records; (7) whether and in what amounts any

repayments have occurred; and (8) the solvency of the borrower at

the time the parties made the loan. See, e.g., Mayhew v.

Commissioner, T.C. Memo. 1994-310.

Considering these factors in light of the record, we

conclude that petitioners have not established the existence of a

bona fide debt to petitioner. Petitioners did not offer evidence

of a promissory note or similar type of instrument of

indebtedness that would identify the advances as loans. Although

petitioners reported $125 of interest income on their Form 1040

- 14 -

for the 1990 tax year, the source of that interest has not been

shown. In addition, $125 of interest income is wholly

disproportionate to the $107,036 that petitioner alleges he lent

to his father.

Although petitioners father owned assets other than the

auction, such as rental property and the land on which FAPs

business was situated, petitioner did not require security to

guard against default. Further, petitioner did not protect his

position to collect from his fathers assets in the event of

competing creditors. Petitioner did not seek collection or

repayment from his father. Petitioners testimony was that he

did not ask his father for repayment because he is my father.

Petitioner contends that his father made two lump-sum

partial repayments and that those repayments are indicia of bona

fide debt. However, there was no contemporary repayment

schedule, and the only evidence of repayment was a handwritten

schedule submitted for trial purposes. The schedule submitted

for trial reflected that the first repayment of $19,505 was made

to the lending bank and the second repayment of $13,000 was made

to petitioners.

We review transactions between family members with

heightened scrutiny. See Caligiuri v. Commissioner, 549 F.2d

1155, 1157 (8th Cir. 1977), affg. T.C. Memo. 1975-319; Perry v.

Commissioner, 92 T.C. 470, 481 (1989), affd. without published

opinion 912 F.2d 1466 (5th Cir. 1990). Loans between family

- 15 -

members have been considered gifts in the absence of sufficient

evidence of a true expectation of repayment and intent to enforce

collection of the debt. See Perry v. Commissioner, supra at 481;

Estate of Reynolds v. Commissioner, 55 T.C. 172, 201 (1970);

Estate of Van Anda v. Commissioner, 12 T.C. 1158 (1949), affd.

per curiam 192 F.2d 391 (2d Cir. 1951). Even if petitioners

father made the two payments reflected in the trial exhibit, that

evidence is insufficient, by itself, to show the existence of

bona fide debt.

Had petitioners shown that a bona fide debt existed, they

would not have been entitled to a deduction for the tax year 1992

because petitioners did not show worthlessness in that year. See

sec. 166(a)(1). In determining the worthlessness of a debt, all

available evidence including the value of any security and the

financial condition of the debtor must be considered. See sec.

1.166-2(a), Income Tax Regs. A taxpayer must provide evidence of

the worthlessness of the debt. See sec. 1.166-2(b), Income Tax

Regs. A debt becomes worthless in the tax year in which a

creditor, using sound business judgment, abandons all reasonable

hope of recovery on the basis of the available information

regarding the surrounding circumstances of the debt. See Crown

- 16 -

v. Commissioner, 77 T.C. 582, 598 (1981); Andrew v. Commissioner,

54 T.C. 239, 248 (1970); sec. 1.166-2(a), Income Tax Regs.

Petitioners argue that the loans became worthless in 1992

when the auction was destroyed by fire. Petitioner argues that

the auction was his fathers sole source of income, the

destruction of which resulted in an inability to repay the

advances. It is not entirely clear from the record who owned the

auction at the time of the fire. It appears from the record,

however, that the auction was owned entirely by petitioners

father and/or stepmother.

Although legal action by petitioner against his father is

not required to show his fathers inability to repay the

advances, in the absence of such action, petitioner must still

show that legal action would not have resulted in the

satisfaction of the debt. See sec. 1.166-2(b), Income Tax Regs.

Petitioners father owns the land upon which FAP is located.

Schedule D, Capital Gains and Losses, of John and Willene Floods

1992 income tax return shows the sale of a building for a gain of

$30,000, 2 weeks before the auction fire. Additionally, Schedule

E, Supplemental Income and Loss, of the 1992 income tax return

shows that the couple owned rental property at the time of the

fire.

Accordingly, petitioners have failed to show that the

advances were loans. Even if petitioners had shown that the

advances were debt within the meaning of section 166, petitioners

- 17 -

have not shown that they became worthless during 1992.

Are Petitioners Entitled to a Casualty Loss Deduction?

We next consider whether petitioners are entitled to a

casualty loss deduction under section 165 for losses stemming

from the destruction of the auction. Petitioners advanced their

casualty loss argument for the first time in their brief as an

entirely new and separate issue. After considering that this

issue was not tried by consent of the parties and that surprise

and prejudice to respondent would result, we hold that the issue

was not timely raised. See Estate of Horvath v. Commissioner, 59

T.C. 551, 555 (1973). Petitioners casualty loss argument

appears to be an afterthought. Petitioners have not shown that

they had an ownership interest in the auction. Additionally,

petitioners argument conflicts factually with petitioners

fathers and stepmothers claim of a $55,825 casualty loss for

the same property.

Petitioners Basis in Glenwood

We next consider whether petitioners have shown that they

correctly reported capital gain from the 1992 sale of Glenwood.

Section 1001(a) provides that gain from the sale or disposition

of property shall be the excess of the amount realized over the

adjusted basis. Section 1001(b) provides that the amount

realized is the sum of money received plus the fair market value

of any property received. Section 1001(c) requires that the

amount of gain on the sale or exchange of property be recognized

- 18 -

unless there are specific provisions for nonrecognition.

Respondent determined that petitioners understated their

capital gain from the sale of Glenwood by $10,635. The increased

capital gain results, in part, from respondents characterizing a

$29,788.59 check from Glenwood to petitioner as a distribution

which reduced petitioners basis in Glenwood to zero. The issue

before us is purely factual.

Petitioners argue that the $29,788.59 was a distribution to

Hammontree from Glenwood and, in turn, a payment to petitioner in

exchange for Hammontrees acquisition of a 50-percent interest in

Glenwood from petitioner. We agree with petitioner. In 1988

petitioner and Hammontree agreed that Hammontree would use funds

from a retirement account to become a 50-percent partner in

Glenwood. However, Hammontree was unable to draw from the

account. Thereafter, it was understood that Hammontree would run

the business and take a salary and that petitioners one-half

interest in Glenwood would be paid for from Hammontrees profit

and/or salary from the partnership. Glenwoods Federal income

tax returns for 1988 and short year 1989 reflect a 50-50

partnership. Early in 1989, however, Glenwood was incorporated,

the partnership was discontinued, petitioner and Hammontree

became equal shareholders, and petitioner had not been paid for

- 19 -

4 We are not required here to consider what effect

Hammontrees withdrawal of $29,788.59 from Glenwood had on

Hammontrees tax situation.

5 The extent to which our holding has any effect on

petitioners basis in Glenwoods stock should be determined by

the parties under Rule 155.

Hammontrees 50-percent ownership in Glenwood. Around that time,

petitioners basis in his Glenwood shares was $13,914.

On April 25, 1989, petitioner and Hammontree personally

guaranteed a loan in Glenwoods name for $43,080 which was

secured by Glenwoods operating assets. On April 26, 1989, in

accord with the original agreement of petitioner and Hammontree,

petitioner received a $29,788.59 payment from Glenwood. It was

their understanding that the $29,788.59 paid to petitioner was

Hammontrees payment for one-half of the shares in Glenwood.

In a July 1992 purchase of petitioners remaining 50-percent

interest in Glenwood, Hammontree used corporate funds to finance

a portion of the transaction, showing a pattern in the way

petitioner and Hammontree orchestrated their affairs.

Considering the record as a whole, the $29,788.59 payment was a

payment from Hammontree for petitioners interest in the

business.4 Accordingly, we hold that the $29,788.59 payment was

not a corporate distribution to petitioner and that it was from

Hammontree.5

- 20 -

Section 6662(a)--Accuracy-Related Penalty

Finally, we consider whether petitioners are liable for an

accuracy-related penalty under section 6662(a). Respondent

determined that a 20-percent accuracy-related penalty, based on

negligence, applied to the entire income tax deficiency for the

1991, 1992, and 1993 tax years.

An accuracy-related penalty is imposed by section 6662(a) in

an amount equal to 20 percent of the amount of the underpayment

that is attributable to negligence. See sec. 6662(b)(1).

Negligence is the failure to make a reasonable attempt to

comply with the provisions of the Internal Revenue Code. Sec.

6662(c).

A taxpayer is negligent where he fails to exercise due care

or fails to do what a reasonable and ordinarily prudent person

would do under similar circumstances. See Neely v. Commissioner,

85 T.C. 934, 947-948 (1985).

Petitioners contend that they were not negligent and should

not be subject to the accuracy-related penalty because they

provided sufficient records containing FAPs major tranactions to

their return preparer, leaving out only the minor sales.

Respondent contends that petitioners were negligent when they

failed to record and report all of FAPs sales transactions.

Petitioner did not maintain adequate books and records for

FAP. Petitioner testified that sales, from $1 to $10, were

regularly omitted from recordkeeping and that FAP employees may

- 21 -

also have forgotten to record other sales of unknown amounts.

Petitioners testimony reveals that he was aware that invoices

may not have been prepared for a number of larger items sold by

FAP. Petitioner used the understated amount reflected by the

invoices to prepare summary sheets which he then provided to the

return preparer. Petitioner failed to inform the return preparer

that certain sales were omitted. In addition, petitioner did not

always deposit the proceeds from FAPs sales into a bank

account; therefore, there was no record of some portion of the

sales.

Petitioners also contend that these unrecorded and

unreported sales were of minor consequence. However,

respondents reconstruction of petitioners income reflects

relatively sizable amounts of omitted income. As to the

remaining items making up the deficiency, apart from the capital

gain item, petitioners did not make any argument as to why

respondents determination was in error or that their return

position was reasonable. Therefore, we find petitioners liable

for the accuracy-related penalties on the resulting income tax

deficiencies.

To reflect the foregoing,

Decision will be entered

under Rule 155.