Tabbi v. Commissioner

T.C. Memo. 1995-463

UNITED STATES TAX COURT

BRUNO AND FRANCESCA TABBI, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 15863-93. Filed September 28, 1995.

Gerald J. Carnago, for petitioners.

Dennis G. Driscoll, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COLVIN, Judge: Respondent determined deficiencies in

petitioners' Federal income tax and additions to tax as follows:
 - 2 -

Additions to Tax
Sec. Sec. Sec. Sec.
Year Deficiency 6651(a)(1) 6653(a)(1)(A) 6653(a)(1)(B) 6661
1
1987 $108,314 $79 $232 $27,078
2
1988 66,102 -- 3,305 -- 16,526
1989 36,411 8,695 -- -- --

Sec. Sec. Sec. Sec. Sec.
Year 6653(b)(1)(A) 6653(b)(1)(B) 6653(b) 6662 6663
3
1987 $77,762 -- -- --
1988 -- -- $49,576 -- --
1989 -- -- -- $2,304 $19,012
1
Fifty percent of the interest due on $4,632.
2
Sec. 6653(a)(1) for 1988.
3
Fifty percent of the interest due on $103,682.

After concessions, the issues for decision are:

(1) Whether petitioners had unreported income of $47,068

for 1987, $87,711 for 1988, and $30,475 for 1989. We hold that

they did, except as discussed below.

(2) Whether petitioners' unreported income is subject to

self-employment tax for 1987, 1988, and 1989. We hold that it

is, except as conceded by respondent.

(3) Whether petitioners had unreported income of $25,518

from the sale of their residence in 1988. We hold that they did.

(4) Whether petitioners' gains and losses from the sale of

real property in 1987, 1988, and 1989 were capital or ordinary.

We hold that they were ordinary.

(5) Whether petitioners had unreported capital gains of

$2,500 from the sale of their interest in Bagnasco-Tabbi Funeral

Home. We hold that they did.
 - 3 -

(6) Whether petitioners had unreported interest income of

$709 for 1987, $306 for 1988, and $379 for 1989. We hold that

they did.

(7) Whether petitioners may deduct advertising, rent,

office expenses, utilities and telephone, commissions, supplies,

licenses and fees, dues, rental maintenance, and insurance

expenses in excess of the amounts allowed by respondent. We hold

that they may not, except as discussed below.

(8) Whether petitioners may carry forward a net operating

loss of $1,008 for 1988. We hold that they may not.

(9) Whether petitioner Bruno Tabbi is liable for the

addition to tax for fraud under section 6653(b) for 1988 and the

fraud penalty under section 6663 for 1989. We hold that he is

not.

(10) Whether petitioners are liable for additions to tax

for: (a) Negligence under section 6653(a) for 1987 and, in the

alternative to fraud, for 1988 and the negligence penalty under

section 6662 for 1989; (b) substantial understatement of income

tax under section 6661 for 1987 and 1988; and (c) late filing

under section 6651(a)(1) for 1987 and, in the alternative to

fraud, for 1989. We hold that they are liable for the additions

to tax for negligence and substantial understatement of tax for

1987 and 1988, the negligence penalty for 1989, and the addition

to tax for late filing for 1987, but that they are not liable for

the addition to tax for late filing for 1989.
 - 4 -

(11) Whether petitioner Francesca Tabbi qualifies as an

innocent spouse under section 6013(e). We hold that she does

not.

Respondent concedes that petitioners are not liable for the

addition to tax for fraud for 1987, and that petitioner Francesca

Tabbi is not liable for the addition to tax for fraud for 1988

and 1989.

References to petitioner husband are to Bruno Tabbi.

References to petitioner wife are to Francesca (or Frances P.)

Tabbi. Section references are to the Internal Revenue Code in

effect for the years in issue. Rule references are to the Tax

Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

1. Petitioners

Petitioners resided in Clinton Township, Michigan, when they

filed the petition.

Petitioner wife worked as a secretary for her father,

Salvatore LoChirco (LoChirco), at Oliver Homes, Inc. (Oliver

Homes), from 1978 to 1988. She did not work in petitioner

husband's office and was not involved in his real estate

business.

Petitioners had two children born before 1988. Petitioners'

son Antonino was born in September 1988 with severe heart

problems that led to his death in August 1990. Petitioner wife
 - 5 -

spent most of the time after Antonino was born caring for him and

petitioners' two older children. Antonino was in the hospital

frequently from September 1988 to April 1990. He had heart

surgery in April 1990, and was hospitalized until late July.

Petitioners were at the hospital with him continuously during

these 4 months. Antonino died 10 days after he was discharged

from the hospital.

2. Petitioner Husband's Real Estate Activities

Petitioner husband was a real estate broker from 1974 to

1989. Petitioners owned rental properties and investment real

estate in 1987, 1988, and 1989.

Petitioner husband was also in the business of buying and

selling homes through his company, Americana Investment Corp.

(Americana). Because of changes in the Detroit real estate

market in 1986 and 1987, petitioner husband could not sell as

many houses in the years in issue as he had previously.

Petitioner husband rented the houses until he could sell them,

and made repairs that were necessary to keep the houses in

saleable condition.

Petitioner husband conducted his real estate activities

through several business entities. His business operations were

disorganized. He did not keep good records. He intermingled

assets and funds between his many business and personal bank

accounts, and he was thinly capitalized and overextended in

credit. Because of his disorganization and lack of records, he
 - 6 -

did not know and could not accurately reconstruct his income for

the years in issue.

a. 1987

In 1987, petitioner husband owned and was president of

Americana, a Michigan corporation that used investments to buy

certificates of deposit (CD's) and then borrow against them. He

used the loan proceeds to buy, sell, and manage residential real

estate for investors. Many of Americana's investors were friends

and relatives of petitioner husband's family. Americana promised

its investors a high rate (i.e., 17 percent) of return. It

reported gross sales of homes of $140,718.05 and a $31,149.26

loss for 1987. Americana went out of business in 1987.

In 1987, petitioner husband was a real estate broker and

operated rental properties for B.R. Tabbi, Inc., d.b.a. Earl Kiem

Realty Bell/Shores Realty, Inc., a Michigan corporation; BRT

Mortgage Co. (BRT); and Canta Building Co. (Canta). Petitioner

husband was president of Earl Kiem Realty. He sold $116,595 of

real property in 1987.

b. 1988

Petitioner husband was a real estate broker and operated

rental properties for Canta in 1988. He sold $27,847 of real

property in 1988.

c. 1989

Petitioner husband was a real estate broker and operated

rental properties in 1989 for Canta, Premiere Financial Services
 - 7 -

(Premiere), Homeowners Direct Co. (Homeowners), and La Terra Real

Estate (La Terra), d.b.a. Soldi Real Estate Co. (Soldi).

La Terra was a Michigan corporation owned by petitioner husband,

Anthony Duronio, and Joseph Ancona. Petitioner husband owned

one-third of La Terra's stock. La Terra's shareholders and

nonshareholder employees earned commissions from real estate

sales. Each salesperson contributed his or her share of expenses

to La Terra. LaTerra's shareholders did not share equally in La

Terra's income and were not paid for being shareholders or

officers. La Terra leased an office at 38600 Van Dyke, Sterling

Heights, Michigan.

On February 7, 1989, petitioner husband incorporated

Premiere in Nevada. Petitioner husband was the president of

Premiere.

On April 7, 1989, petitioner husband incorporated Canta in

Delaware. Petitioner husband was the president, and petitioner

wife was the secretary of Canta.

Petitioner husband sold $42,400 of real property in 1989.

3. Petitioner Husband's Bankruptcy

On December 2, 1987, petitioner husband filed for bankruptcy

under chapter 7 of the U.S. Bankruptcy Code in the U.S.

Bankruptcy Court for the Eastern District of Michigan.

Petitioner husband was granted a discharge under chapter 7 on

March 9, 1988. Petitioner husband's creditors pressed him for

payment, both before and after his discharge in bankruptcy.
 - 8 -

4. Americana

Before and during the years in issue, petitioner husband

transferred real estate without consideration from petitioners to

Americana, and from Americana to petitioners. During the years

in issue, petitioner husband deposited rental and installment

sales income from real estate owned by Americana to the Earl Kiem

Bell/Shores escrow account, which petitioner husband controlled.

In 1987, petitioner husband transferred $9,800 to

Americana's account. Petitioner husband liquidated Americana in

1987. At that time, he distributed its assets, including

financial investments and real estate to himself and assumed its

liabilities. In 1987, petitioners paid various expenses relating

to real estate owned by petitioners and/or Americana.

From 1987 to 1989, petitioner husband obtained second

mortgages on, and rented, real properties owned by petitioners

and/or Americana. At the same time, he sold parcels of real

estate that were owned by petitioners and/or Americana in 1987,

1988, and 1989. He sold five houses in 1987, three in 1988, and

two in 1989. Also in those years, petitioner husband used funds

invested in Americana to buy real estate for Americana.

Petitioners earned interest of $259 in 1987, $306 in 1988,

and $379 in 1989.
 - 9 -

5. Petitioners' Bank Accounts and Investments

a. Overview

Petitioner husband used the following personal and corporate

bank accounts in the years at issue:

Account Bank 1987 1988 1989

Frances P. Tabbi Comerica X X

Frances P. Tabbi Comerica X X

Frances P. Tabbi Comerica X

Frances P. Tabbi or Comerica X
Bruno Tabbi ITF
Bruno Tabbi, Jr.

Frances Tabbi ITF Comerica X
Bruno Tabbi, Jr. &
Paulette M. Tabbi

Bruno Tabbi First State Bank X

Canta Manufacturers X X X

Canta Wilmington Trust X
(a Delaware bank)

Earl Kiem Realty First State Bank X
escrow

BRT First State Bank X

Americana First State Bank X

Premiere First Interstate X
(a Nevada bank)

Homeowners Manufacturers X

b. 1987

Petitioner husband signed the signature card for the BRT

account. He was listed as president and petitioner wife was
 - 10 -

listed as secretary of Americana on its account. Petitioner

husband signed petitioner wife's name on the signature card for

the Americana account. Petitioner husband used his Social

Security number on the BRT and Canta business accounts for the

years in issue.

Petitioner husband deposited the following amounts in 1987:

Account Type of Income Amount
Petitioner wife commissions $3,534.74
Petitioner wife other 4,500.00
BRT commissions 34,103.96
BRT refunds 724.31
BRT other 3,052.00
Canta commissions 680.00
Canta refunds 133.95
Canta other 462.50
Americana other1 11,502.38

Petitioner husband had $32,598.70 of commissions,2 $858.26

of refund income,3 and $19,517 of other income in 1987.

Petitioners reported income of $29,522 from petitioner husband's

real estate activities for 1987.

Petitioner husband deposited the following amounts in the

Earl Kiem Bell/Shores escrow account in 1987:

1
Americana deposited in its checking account $11,502.38,
reflecting the net proceeds from cashing CD's of $80,002.38, and
replacing them with CD's of $68,500.
2
Petitioner husband deposited $38,318.70 in commissions;
however, we subtracted $4,875 of land contract payments and $845
of transfers between bank accounts in figuring his commission
income for 1987.
3
Petitioner husband received refunds of certain business
expenses, such as insurance and utilities, that he deposited in
his various accounts.
 - 11 -

Amount Source of funds
$50,002.78 Americana
30,268.57 sale of real estate owned by
petitioners and/or Americana
7,229.75 petitioner husband's income
1,907.00 installment income from sale of
real estate
2,707.00 Schedule E rental income
3,110.00 petitioners' bank accounts
Total: $95,225.10
Petitioner husband used $53,265.84 from the escrow account

in 1987 to pay petitioners' personal expenses and expenses

relating to various real properties owned by petitioners and/or

Americana.

Petitioner husband made several deposits of currency of more

than $100 in 1987.

Petitioner husband deposited income he earned in 1987 and

1988 in bank accounts in petitioner wife's name. She used these

bank accounts to pay personal and household expenses.

c. 1988

Petitioner husband earned commissions of $14,621.84 in 1988

from the sale of two residences in Rochester, Michigan.

Petitioner husband cashed the two commission checks at the East

Side Market, and deposited the cash. Petitioner husband made

several other large (i.e., more than $1,000) deposits of currency

in 1988.

Petitioner husband deposited the following amounts in 1988:

Account Type of Income Amount
Petitioner wife commissions $7,888.00
Petitioner wife other 4,651.58
Canta commissions 69,242.26
Canta refunds 403.50
 - 12 -

Canta other 2,488.30
unknown commissions 14,621.84

Petitioner husband had real estate commissions of $91,752,

refunds of $404, and other income of $7,180 in 1988. Petitioners

reported income of $15,480 from petitioner husband's real estate

activities for 1988.

d. 1989

Petitioner husband deposited his real estate commissions in

the bank accounts of Canta, Premiere, and Homeowners. He

routinely transferred funds between the Canta and Premiere

corporate accounts and the Canta and Homeowners noncorporate

accounts in 1989. Petitioner husband routinely used funds from

the Canta and Premiere corporate accounts to pay petitioners'

personal living expenses.

Petitioner husband deposited $23,425 of Soldi's commission

checks from various title companies in accounts which he

controlled. Soldi had not recorded those payments on its books.

Petitioner husband deposited the following amounts in 1989:

Account Type of Income Amount
Canta commissions $30,285.624
Canta other 150.00
Premiere commissions 25,989.495

4
This includes $12,508 of Soldi's funds petitioner husband
deposited in Canta's Manufacturers account.
5
This includes $3,929.49 of Soldi's funds petitioner
husband deposited in the Premiere account.
 - 13 -

Canta II commissions 21,826.426
Canta II refunds 481.05
Homeowners commissions 1,395.00

Petitioner husband deposited no commission checks in

petitioner wife's accounts in 1989. However, he or one of the

other Soldi shareholders wrote checks to petitioner wife on

Soldi's bank account totaling $4,148.29 in 1989.

Petitioner husband had real estate commissions of $79,496

(including $23,425 of Soldi's funds which petitioner husband

deposited in accounts which he controlled), refunds of $481.05,

and other income of $150 in 1989. Petitioners reported that they

had income of $49,652 from petitioner husband's real estate

activities for 1989.

6. Petitioner Husband's Payments to Clients and Investors

On October 16, 1986, petitioner husband was the agent for

Christoforo and Jacqueline Mazzola at a real estate closing on

42407 Jo-Ed, Sterling Heights, Michigan. As their agent, he

received $79,129 at the closing. Petitioner husband deposited

the $79,129 in Americana's bank account. In 1987, petitioner

husband borrowed $42,186 from his parents, Richard and Elvera

Tabbi, to pay the Mazzolas. He paid the Mazzolas (or Olympia

Homes on the Mazzolas' behalf) $46,387 from the Earl Kiem Realty

Bell/Shores escrow account in 1987 and $35,395 from Canta in

1988.

6
This includes $6,988 of Soldi's funds petitioner husband
deposited in Canta's Wilmington Trust account.
 - 14 -

Petitioner husband reimbursed investors in Americana for

their investments in 1987, 1988, and 1989. He paid them $3,725

in 1987, $1,800 in 1988, and $6,370 in 1989.

Petitioners refunded a deposit of $1,287 to two former

clients, Robert and Charlene Graham, which they paid for the sale

of a home at 16711 Lincoln, East Detroit, Michigan.

On November 24, 1987, petitioner husband borrowed $8,700

from Comerica Bank to pay investors and business expenses. In

December 1987, petitioner husband borrowed $32,000 from his

parents to pay investors and business expenses.

7. The Bagnasco-Tabbi Funeral Home

Petitioner husband owned an interest in the Madison Funeral

Home Corp., which operated the Bagnasco-Tabbi Funeral Home in

1987. He sold his interest in 1987 for 11 funeral certificates

(worth about $5,000 each) and 30 months of health insurance

(worth $2,500).

8. Petitioners' Residence

Oliver Homes, a Michigan corporation wholly owned by

LoChirco, bought a lot at 200 Tanglewood, Rochester Hills,

Michigan, for $19,500 from Biltmore Properties on December 20,

1977. On January 28, 1985, Oliver Homes conveyed the lot to

petitioner wife. Petitioner wife did not pay for the lot. On

March 4, 1987, petitioner wife conveyed the lot for no charge to

Oliver Homes, and Oliver Homes built a house on the lot. Oliver

Homes then sold the house to petitioner wife for $175,921.
 - 15 -

Petitioners lived in the Tanglewood home in 1987 and 1988.

Petitioners spent $15,000 to improve that home while petitioner

wife owned it. On August 2, 1988, petitioner wife sold it for

$237,000. Petitioner wife had sales expenses of $561. Her cost

basis in the house was $210,691.

On February 22, 1989, petitioner wife bought a lot at 41741

Alden, Clinton Township, Michigan, for $35,000. Canta built a

residence on this lot in 1989. Petitioner wife bought the

residence on October 12, 1989, for $160,000.

9. Petitioners' Returns

H & R Block prepared petitioners' 1987 and 1988 returns.

Petitioner husband gave H & R Block various documents to prepare

those returns. For the 1988 Schedule C, he gave H & R Block only

his real estate commission receipts totaling $15,480 as shown on

a Form 1099. He did not give them records of commission checks

that he cashed before depositing, records of corporate payment of

petitioners' personal expenses, or records of commissions

petitioner husband received that were payable to another entity.

Petitioners did not review the returns before signing them.

They did not claim all of their exemptions for 1987.

Gerald Carnago, of Carnago, Neddermeyer & Bringard, prepared

petitioners' 1989 return. Petitioners filed their returns for

1987 on April 25, 1988, for 1988 on September 5, 1989, and for

1989 on October 23, 1990.
 - 16 -

Petitioner husband did not keep books and records (other

than checks) for his businesses from 1987 to 1989. He used

accountants to keep his books, balance his checking accounts, and

prepare returns from 1974 to 1986. He could not afford to use

accountants after 1986 because his business declined.

Petitioners reported on their 1988 and 1989 returns that

they owned several real properties that Americana formerly owned:

11420 Nashville, 14509 Mayfield, and 9550 Whittier.

10. Respondent's Examination

Respondent's revenue agents reconstructed petitioners'

income for 1987, 1988, and 1989 using the bank deposits plus

expenditures method. Revenue Agent Martin interviewed petitioner

husband on May 29 and October 23, 1990, and on September 17,

1991. Petitioner husband cooperated with Revenue Agent Martin

and Revenue Agent Andrews' investigation. He gave the agents his

checks, which were his only records of the transactions. He did

not make misleading statements to, or give misleading documents

to, respondent's agents.

The revenue agents identified all bank accounts for which

petitioners had signatory authority during the years in issue,

and obtained signature cards, monthly statements, canceled

checks, deposits slips, and deposit items for these accounts.

The agents analyzed the deposits made to these accounts, and

excluded all deposits that the agents believed were nontaxable,

including transfers between accounts. The agents also obtained
 - 17 -

other documents, such as real estate closing statements, to

identify income from real estate commissions, rents, refunds, and

other sources. The agents concluded that petitioners had income

in 1987 from petitioner husband's use of the Earl Kiem

Bell/Shores escrow account to pay petitioners' personal living

expenses.

11. Petitioners' Unreported Income

Petitioners had unreported income of $35,566 in 1987,

$87,711 in 1988, and $30,475 in 1989.

Petitioners had gains from real estate sales of $5,595 for

1987, and losses of $19,759 for 1988 and $832 for 1989. They had

net gains of $5,595 for 1987, and net losses of $19,759 for 1988

and $520 for 1989.

Petitioners underreported their capital loss by $12,080 in

1987 and overreported capital gain by $12,377 in 1988. They had

a net loss of $63,165 in 1987 and a net gain of $474 in 1988,

excluding capital gain from the sale of their interests in the

Bagnasco-Tabbi Funeral Home and Americana.

OPINION

1. Respondent's Use of the Bank Deposits Method

Respondent used the bank deposits plus expenditures method

to determine petitioner's income for the years in issue.7 If a

7
Respondent determined petitioners' income from the escrow
account by computing disbursements as income less any funds
petitioner husband deposited in the account.
 - 18 -

taxpayer does not maintain adequate books and records, respondent

may reconstruct a taxpayer's income by any reasonable method

which clearly reflects income. Sec. 446; Holland v. United

States, 348 U.S. 121, 130-132 (1954). The bank deposits method

has long been approved by the courts as a method for computing

income. Estate of Mason v. Commissioner, 64 T.C. 651, 656

(1975), affd. 566 F.2d 2 (6th Cir. 1977). Bank deposits are

prima facie evidence of income. Tokarski v. Commissioner, 87

T.C. 74, 77 (1986); Estate of Mason v. Commissioner, supra at

656-657.8

Respondent's determination is presumed to be correct, and

petitioners bear the burden of proving otherwise. Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933). Petitioners must

overcome the presumption as to each item of unreported income in

respondent's deficiency determination. Foster v. Commissioner,

391 F.2d 727, 735 (4th Cir. 1968), affg. in part, revg. in part

on other grounds T.C. Memo. 1965-246.

Petitioners argue that respondent erred in including in

their income for 1987: $11,502 from Americana's bank account,

$23,6159 from petitioner husband's use of the Earl Kiem escrow

8
Respondent concedes that petitioners are not liable for
tax on other income items of $100 for 1987 and $144 for 1988.

9
Respondent calculated that petitioners had taxable income
of $23,615 from their personal use of funds in the Earl Kiem
escrow account as follows:
(continued...)
 - 19 -

account, $858 of refunds received by petitioner husband, and

$8,015 of other income.

Petitioners contend that respondent improperly reallocated

income from Americana to petitioners in disregard of section 482

by claiming that Americana was the alter ego of petitioner

husband. Similarly, petitioners argue that respondent improperly

9
(...continued)
Checks written on escrow account:
Checks for personal expenses
and real estate $53,265.84
Checks to/for benefit of Mazzolas 46,387.00
Checks to Charlene Graham 1,287.00
Total checks: 100,939.84

Petitioners' basis in account:
Americana funds
Americana funds deposited to account $50,002.78
Payments to/for Mazzolas 46,387.00
3,615.78

Petitioners' funds
Installment income from real estate
sales $1,907.00
Rental income deposited to account 2,707.00
Transfers 3,110.00
Income from real estate sales 13,788.38
Funds from other sources 7,229.75
28,742.13

Total: 32,357.91

Funds for petitioners' benefit:
Rental income deposited to account $2,707.00
Checks written for petitioners'
benefit 53,265.80
Total: 55,972.80

Taxable income from account:
Funds for petitioners' benefit $55,972.80
Petitioners' basis in account 32,357.91
23,614.89
 - 20 -

reallocated income from the Earl Kiem escrow account to

petitioners under section 482. However, respondent did not

reallocate income to petitioners from Americana or the Earl Kiem

escrow account under section 482.

Respondent argues that petitioners are taxable on

Americana's income because petitioner husband improperly

converted Americana's assets to his control and intermingled his

financial affairs with those of Americana such that Americana

became his alter ego. We disagree. Respondent cited no

authority for us to apply the alter ego theory in these

circumstances. We do not apply an alter ego theory to reallocate

income from Americana to petitioners because Americana engaged in

bona fide business activities and was a separate taxable entity.

Jackson v. Commissioner, 233 F.2d 289, 291 (2d Cir. 1956), affg.

24 T.C. 1 (1955); Paymer v. Commissioner, 150 F.2d 334, 336-337

(2d Cir. 1945) (income from property taxed to stockholders,

rather than the corporation, only if the corporation is a dummy

or sham or is used for tax avoidance purposes). As discussed

below infra par. 9, petitioner husband did not fraudulently

divert corporate funds from Americana. Cf. Ruidoso Racing

Association, Inc. v. Commissioner, 476 F.2d 502, 506 (10th Cir.

1973), affg. in part and revg. and remanding in part T.C. Memo.

1971-194; Moore v. Commissioner, T.C. Memo. 1977-275, affd. 619

F.2d 619 (6th Cir. 1980) (corporation's dominant shareholder

fraudulently diverted corporate funds for personal use and so
 - 21 -

controlled the corporation that the corporate entity was

destroyed and the corporation became the individual's alter ego).

Thus, we do not include $11,502 from Americana's account in

petitioners' income for 1987.

Petitioners contend that respondent must establish that

Americana and the Earl Kiem escrow account had sufficient

earnings and profits before respondent attributes income (i.e.,

constructive dividends) to petitioners. We disagree. Petitioner

husband controlled the deposits in the Earl Kiem escrow account,

and used those funds to pay petitioners' personal expenses and

petitioners' real property expenses. When a corporation pays a

nondeductible personal expense of its sole shareholder, or

permits a shareholder to use corporate property for a personal

purpose, the shareholder receives a constructive dividend to the

extent the corporation's earnings and profits provide personal

benefit to the shareholder. Secs. 301, 316; Falsetti v.

Commissioner, 85 T.C. 332, 356-357 (1985); Henry Schwartz Corp.

v. Commissioner, 60 T.C. 728, 744 (1973). Petitioners bear the

burden of proving that Americana and the Earl Kiem escrow account

had insufficient earnings and profits to support the constructive

dividend treatment. Hagaman v. Commissioner, 958 F.2d 684, 695

n.16 (6th Cir. 1992), affg. and remanding T.C. Memo. 1987-594;

United States v. Leonard, 524 F.2d 1076, 1083 (2d Cir. 1975);

Truesdell v. Commissioner, 89 T.C. 1280, 1295-1296 (1987).

Petitioners have not carried their burden.
 - 22 -

Petitioners argue that for 1988 respondent erred in

reconstructing their income,10 and in including in income refunds

of $404 and other income of $7,036. For 1989, petitioners argue

that respondent erred in including in income refunds from Lucido

Insurance Agency of $481.05, and as other income a check from

Michael Larco for $150 because it was a loan repayment.

Petitioners have failed to prove that the disputed items for

1987, 1988, and 1989 were nontaxable. Refunds petitioner husband

received are includable in petitioners' income because they were

refunds for various items, such as insurance and utilities, that

petitioner husband deducted as business expenses. Petitioners

have not proved that cash deposits they made, several of which

exceeded $1,000, were from a nontaxable source. Petitioners did

not show that the payment from Larco was repayment of a loan.

Petitioners have failed to prove that respondent erred by

including in income for 1987 petitioners' use of the Earl Kiem

escrow account to pay personal expenses and their real property

expenses of $23,615. Sec. 301; Falsetti v. Commissioner, supra;

Henry Schwartz Corp. v. Commissioner, supra. However, as stated

above, we do not treat funds deposited to Americana's account as

income taxable to petitioners. We sustain respondent's

calculation of petitioners' unreported income for 1987, 1988, and

1989, except for the inclusion of the Americana funds in 1987.

10
Petitioners incorrectly omitted installment sales of
$9,017 from their calculation of their income for 1988.
 - 23 -

2. Self-Employment Taxes

Respondent determined that petitioners are liable for self-

employment taxes under section 1401 for 1987, 1988, and 1989.

Section 1401 imposes a tax on a taxpayer's self-employment

income. "Self-employment income" includes the net earnings from

self-employment derived by an individual during the taxable year.

Sec. 1402(b). Net earnings from self-employment income means

gross income, less certain deductions, derived by an individual

from any trade or business carried on by such individual. Sec.

1402(a).

Respondent concedes that petitioners are not liable for

self-employment tax for 1987 on $23,615 attributed to them from

their personal use of Earl Kiem Bell/Shores escrow account funds,

and $11,502 from Americana's bank account.

Petitioners bear the burden of proving that they are not

liable for the taxes imposed by section 1401. Rule 142(a).

Petitioners concede that they are liable for self-employment tax

on their real estate income less business deductions. They

argue, however, that they are not liable for self-employment tax

on other amounts on the theory that they did not receive those

amounts, or if received, that those amounts were nontaxable gifts

or loan repayments. Petitioners also argue that petitioner

husband is not liable for self-employment tax on the income he

earned as a real estate dealer selling and renting houses he held

for sale primarily to customers. Sec. 1402(a)(1).
 - 24 -

We held above that petitioners failed to prove that they did

not have unreported income in the amounts asserted by respondent.

They have not proven that they did not receive that income, nor

have they proven that it is not subject to self-employment tax.

Petitioner husband received refunds for items, such as insurance

and utilities, that he deducted as business expenses. The

refunds are includable in petitioners' income and are subject to

self-employment tax.

An individual who is engaged in the business of selling

real estate to customers may be classified as a real estate

dealer. Sec. 1.1402(a)-4(a), Income Tax Regs. Rentals from real

estate and the related deductions are excluded from net earnings

subject to self-employment tax unless the rentals are received in

the course of a taxpayer's trade or business as a real estate

dealer. Sec. 1402(a)(1); Hopper v. Commissioner, 94 T.C. 542,

545 (1990); sec. 1.1402(a)-4(a), Income Tax Regs.

Whether property is held by a taxpayer for investment or for

sale to customers in the ordinary course of his trade or business

is a question of fact. Cottle v. Commissioner, 89 T.C. 467, 486

(1987); Daugherty v. Commissioner, 78 T.C. 623, 628 (1982). As

discussed below, we hold that petitioner husband was a dealer in

real estate. Thus, the rentals are subject to self-employment

tax. Sec. 1402(a)(1); Rockwell v. Commissioner, T.C. Memo. 1972-

133, affd. 512 F.2d 882 (9th Cir. 1975). Petitioners have failed
 - 25 -

to prove that they are not liable for self-employment tax except

as conceded by respondent.

3. Unreported Income From the Sale of Petitioners' Residence

The parties dispute the basis of the lot Oliver Homes gave

to petitioner wife. Respondent contends that the lot has a zero

basis; petitioners contend that the basis of the lot is $19,500,

which was the cost of the lot to Oliver Homes. Taxpayers bear

the burden of proving their basis in the lot. Rule 142(a).

A taxpayer who acquires property by gift takes a basis in

the property equal to the lesser of the donor's basis or the fair

market value. Sec. 1015. Respondent argues that petitioner

wife had no basis in the lot because her father, LoChirco,

misappropriated it from Oliver Homes. Respondent argues that

because transactions within a family group are subject to special

scrutiny, Fitz Gibbon v. Commissioner, 19 T.C. 78, 84 (1952), and

because LoChirco was petitioner wife's father, his failure to pay

Oliver Homes for the lot before Oliver Homes conveyed it to his

daughter should be treated as a constructive dividend to him,

followed by a gift of the lot from him to her. Respondent

asserts that petitioners did not show that LoChirco recognized a

constructive dividend on the transfer of the lot, and that

therefore he had no basis in the lot when Oliver Homes conveyed

it to petitioner wife. Commissioner v. Farren, 82 F.2d 141, 143-

144 (10th Cir. 1936); Crane v. Commissioner, 68 F.2d 640 (1st

Cir. 1934), affg. 27 B.T.A. 360 (1932). Respondent contends
 - 26 -

that, under section 1015, petitioner wife had no basis in the

lot.

Petitioners argue that under section 301, a distribution to

LoChirco was taxable to him at the lot's fair market value.

Revenue Agent Rizzardi used $10,000 as LoChirco's basis for the

lot, and concluded that LoChirco realized a constructive dividend

because Oliver Homes built petitioners' home on the lot.

Petitioners contend that petitioner wife's basis in the lot was

the amount Oliver Homes paid for it, namely $19,500, or, in the

alternative, the amount accepted by Agent Rizzardi in his audit

of the LoChircos, $10,000. Petitioners argue that their gain on

the sale of their home should be reduced accordingly.

Petitioners have not proven that LoChirco realized a

constructive dividend when Oliver Homes distributed the lot to

him. See Loftin & Woodard, Inc. v. United States, 577 F.2d 1206,

1242 (5th Cir. 1978); Goldstein v. Commissioner, 298 F.2d 562,

566 (9th Cir. 1962), affg. T.C. Memo. 1960-276; Melvin v.

Commissioner, 88 T.C. 63, 79-80 (1987), affd. per curiam 894 F.2d

1072 (9th Cir. 1990). Also, petitioners have not established the

fair market value of the lot when Oliver Homes distributed it to

LoChirco. Sec. 301(b). We hold that petitioner wife's basis in

the lot was zero.

4. Capital or Ordinary Income and Loss

Petitioners argue that the character of the gains and losses

from petitioner husband's sale of real estate in the years at
 - 27 -

issue was ordinary and not capital because he held the real

estate primarily for sale to customers in the ordinary course of

business. Sec. 1221(1); Suburban Realty Co. v. United States,

615 F.2d 171, 174 (5th Cir. 1980); Biedenharn Realty Co. v.

United States, 526 F.2d 409, 415 (5th Cir. 1976).

Section 1221(1) excludes from capital asset classification--

stock in trade of the taxpayer or other property of a
kind which would properly be included in the inventory
of the taxpayer if on hand at the close of the taxable
year, or property held by the taxpayer primarily for
sale to customers in the ordinary course of his trade
or business * * *

The function of section 1221(1) is "to differentiate between

'profits and losses arising from the everyday operation of a

business' * * * and 'the realization of appreciation in value

accrued over a substantial period of time'". Malat v. Riddell,

383 U.S. 569, 572 (1966). "Primarily" means "principally" or "of

first importance". Malat v. Riddell, supra.

Whether property is held by a taxpayer "primarily for sale

to customers in the ordinary course of * * * business" is a

question of fact. S & H, Inc. v. Commissioner, 78 T.C. 234, 242

(1982). Courts consider numerous factors in deciding this issue,

and no one factor is controlling. Biedenharn Realty Co. v.

United States, supra at 415. Petitioner bears the burden of

proving that his property was not so held. Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).

The following factors indicate that petitioner husband held

the houses primarily for sale to customers in the ordinary course
 - 28 -

of business: (a) The frequency and regularity of sales; (b) the

substantiality of sales; (c) the nature and extent of the

taxpayer's business; (d) the purpose for which the taxpayer

acquired and held the property before sale; (e) the extent of the

taxpayer's sales efforts by advertising or otherwise; and (f) the

extent of improvements to the property made by the taxpayer.

Byram v. United States, 705 F.2d 1418, 1424 (5th Cir. 1983);

United States v. Winthrop, 417 F.2d 905, 910 (5th Cir. 1969);

Ross v. Commissioner, 227 F.2d 265 (5th Cir. 1955), revg. T.C.

Memo. 1954-177; Goldberg v. Commissioner; 223 F.2d 709 (5th Cir.

1955), revg. 22 T.C. 533 (1954); Guardian Indus. Corp. v.

Commissioner, 97 T.C. 308, 316-317 (1991), affd. without

published opinion 21 F.3d 427 (6th Cir. 1994).

Before the years at issue, petitioner husband sold

properties regularly and frequently. For example, he sold 16 of

the 17 properties he acquired personally or from Americana in

earlier years. Petitioner husband actively advertised the houses

for sale and made substantial efforts to sell them. See Norris

v. Commissioner, T.C. Memo. 1986-151 (taxpayer's extensive

solicitation and advertising efforts and use of time and energy

for real estate pursuits show that real estate was not held for

investment). Petitioner husband made necessary repairs to keep

the houses in saleable condition. See Norris v. Commissioner,

supra. These factors suggest that petitioner husband held these

houses for sale to customers.
 - 29 -

Because of the downturn in the Detroit residential real

estate market in 1987, petitioner husband did not sell as many

houses. He sold five houses for $116,595 in 1987, three for

$27,847 in 1988, and two for $42,400 in 1989. To cut costs, he

rented properties that he did not sell immediately. The rents

paid his carrying costs, such as mortgage payments, utilities,

and property taxes. Cf. Baris v. Commissioner, T.C. Memo. 1965-

182 (gain on sale of rental property held for sale to customers

taxed as ordinary income; rental income deemed incidental).

Under these circumstances, we do not believe the infrequency of

petitioner husband's sales shows that he held the property for

investment rather than for sale. Suburban Realty Co. v. United

States, supra at 174; Biedenharn Realty Co. v. United States,

supra at 411-412; United States v. Winthrop, supra at 907. We

hold that petitioner husband held the houses for sale to

customers.

5. Petitioners' Gains and Losses From Other Investments

Petitioners underreported their capital loss by $12,080 for

a net loss of $63,165 in 1987 and overreported capital gain by

$12,377 for a net gain of $474 in 1988, excluding capital gain

from the sale of their interests in the Bagnasco-Tabbi Funeral

Home and Americana.

Petitioners concede that they had capital gain of $2,500 in

1987 on their receipt of 24 months of medical insurance coverage

for their interest in Bagnasco-Tabbi Funeral Home. Petitioners
 - 30 -

argue that they had a $33,809 ordinary loss and a $13,278 capital

loss in 1987 from their investment in Americana. In the

alternative, they argue that they had a $47,087 capital loss in

1987.

Gain or loss upon the disposition of an asset is computed by

comparing the amount received with the taxpayer's basis in the

asset. Secs. 1001, 1011. Petitioners failed to prove their

basis in Americana. Petitioners contend that their total

investment in Americana was $50,702 ($9,800 that petitioner

husband deposited in Americana's account, plus $5,000 paid for

capital stock, $500 loaned to Americana, and $35,402 for amounts

petitioner husband paid the Mazzolas), minus $3,615 credited by

respondent for petitioners' basis in Americana, for a net

investment of $47,087. There is no evidence to support

petitioners' position, e.g., no canceled checks. Their only

evidence of their investment in the corporation was a listing of

$5,000 in capital stock, and loans from stockholders of $499.71

on Americana's 1986 return and $459.99 on its 1987 return. This

evidence is not sufficient to substantiate their basis in

Americana. Cf. Wilkinson v. Commissioner, 71 T.C. 633, 639

(1979); Halle v. Commissioner, 7 T.C. 245, 249-250 (1946), affd.

175 F.2d 500 (2d Cir. 1949).

Petitioners claim that they may deduct business interest of

$2,660 for payments to the Mazzolas, and Americana's net
 - 31 -

operating loss of $31,149.29 for 1987. They claim $13,277.71 as

a capital loss in 1987.

We disagree. Petitioners are not entitled to basis in

Americana for petitioner husband's deposit of $9,800 into its

account because petitioner husband did not prove that this was a

true investment of funds in Americana; instead, it was an

instance of petitioner husband's moving funds between accounts.

Petitioners did not offer any evidence showing that the $2,660

petitioner husband paid to the Mazzolas was interest. Also,

petitioners have not established the value of the assets they

received from Americana when it liquidated. Petitioners have not

proven the amount of their basis in Americana, or that they may

deduct the business interest or net operating loss in the amounts

claimed. Thus, petitioners may not deduct a capital or ordinary

loss upon Americana's liquidation.

6. Unreported Interest Income

Gross income means all income from whatever source derived,

including dividends and interest. Sec. 61(a).

Petitioners argue that respondent erred in attributing

interest income from Americana's bank account in 1987, 1988, and

1989, to petitioners. They contend that interest earned on

Americana's account went directly into the account and was not

used by petitioners. Petitioners argue that a withdrawal of

funds from a closely held corporation is a dividend to the

recipient-shareholder to the extent of the corporation's
 - 32 -

earnings. See Halpern v. Commissioner, T.C. Memo. 1982-31

(controlling shareholder who diverts income from corporation

receives taxable dividend to the extent of the corporate earnings

and profits). Petitioners argue that Americana had no earnings

or retained earnings in 1986 or 1987, and that therefore the

interest is not income to them.

Petitioners' contention that respondent must show that

Americana had sufficient earnings and profits to reallocate

interest income to petitioners is erroneous. Petitioner husband

acquired ownership of Americana's assets when it liquidated and

went out of business in 1987. The interest earned during 1987,

1988, and 1989 on assets in the bank account that formerly

belonged to Americana is therefore taxable to petitioner husband.

We sustain respondent's determination.

7. Deductions

A taxpayer may deduct ordinary and necessary expenses paid

or incurred during the taxable year in carrying on a trade or

business. Sec. 162(a). Personal living expenses generally are

not deductible. Sec. 262. Deductions are a matter of

legislative grace, and taxpayers bear the burden of proving that

they are entitled to any deductions claimed on their returns.

Rule 142(a); Deputy v. DuPont, 308 U.S. 488, 493 (1940); New

Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Welch v.

Helvering, 290 U.S. 111, 115 (1933).
 - 33 -

Petitioners claimed Schedules A, C, and E deductions for

each of the years in issue. Respondent disallowed some of these

deductions because the Earl Kiem Bell/Shores escrow account,

rather than petitioners, paid the expenses. Respondent

disallowed others because petitioners failed to substantiate that

the expenses had a business purpose.11

Petitioners argue that they substantiated their business

deductions with canceled checks and through petitioner husband's

testimony about the purpose of the checks.

Petitioners contend that the legal and professional fees

they paid in 1987 are deductible on Schedule C, not Schedule A,

as determined by respondent. Petitioner husband spent $6,500

in legal fees relating to his bankruptcy resulting from his and

Americana's business failure. Petitioners argue that the legal

fees are a Schedule C deduction under the origin of the claim

doctrine. United States v. Gilmore, 372 U.S. 39, 48 (1963);

Dowd v. Commissioner, 68 T.C. 294, 303-304 (1977).

In Dowd v. Commissioner, supra, we relied on the origin

of the claim doctrine in deciding that business expenses of a

bankrupt taxpayer were deductible under section 162(a). Since

11
Respondent concedes that petitioners may deduct for
1987, advertising expenses of $140.13, office expenses of
$488.31, licenses and fees of $279.96, dues of $41, rental
maintenance of $684.70, and insurance expenses of $759; for 1988,
office expenses of $643.19, rental maintenance of $346, rental
insurance of $198, and Schedule C rental expenses of $6,832.85;
and for 1989, advertising of $135, and rental insurance of $197.
Respondent also concedes that petitioners may deduct a charitable
contribution of $50 to the Salvation Army for 1989.
 - 34 -

petitioner husband's business failure with Americana caused his

bankruptcy, legal fees paid to file his bankruptcy petition

originated with his business. We hold that petitioners may

deduct on Schedule C legal fees of $6,500 caused by his business

failure. Dowd v. Commissioner, supra at 304.

Petitioners argue that their payments to Americana investors

of $3,725 in 1987, $1,800 in 1988, and $6,370 in 1989 are

deductible on Schedule C as ordinary and necessary business

expenses.

Respondent argues that the payments to the Americana

investors are deductible on Schedule A because Americana's

activities were not a trade or business of petitioner husband.

Many of the investors were friends of petitioner husband's

family. Respondent argues that petitioner husband's claim that

he paid investors to protect his own business reputation are

self-serving. Respondent argues that no evidence suggests that

petitioner husband's financial problems with these investors

would affect his reputation as a real estate broker.

We disagree. We find that he carried his burden of proof in

this respect. Petitioners may deduct on Schedule C the payments

to the Americana investors.

Petitioners paid income tax return preparers' fees of $872

to H & R Block in 1988. Petitioner husband argues that since he

was a sole proprietor, he may deduct the return preparation fees

on Schedule C, not on Schedule A. We disagree. Tax preparation
 - 35 -

fees generally are deductible as a Schedule A expense. Sec.

212(3); sec. 1.212-1(1), Income Tax Regs.; sec. 1.67-

1T(a)(1)(iii), (b), Temporary Income Tax Regs., 53 Fed. Reg. 9875

(Mar. 28, 1988). Petitioners have not provided evidence that

would enable us to find or estimate any portion of the fees that

is allocable to petitioner husband's business.

We conclude that petitioners failed to prove that they may

deduct advertising, rent, office expenses, utilities and

telephone, commissions, supplies, licenses and fees, dues, rental

maintenance, and insurance expenses in excess of the amounts

allowed by respondent. Petitioners' evidence that they could

deduct these expenses consisted of the canceled checks and

petitioner husband's testimony. Petitioner husband did not

explain the nature or necessity of some of the advertising and

rental property repairs expenses, or the business purpose for

these expenses. He did not show that some insurance expenses had

a business, rather than a personal, purpose. Many of the

disputed checks were payable to cash or to payees related to

petitioners. He did not show whether some of the license fees,

rental maintenance, and insurance expenses related to Schedule C

or Schedule E activities. Petitioners also failed to meet the

section 274 substantiation requirements for his club dues for

Club Terrasini and the Italian American Cultural Society, and for

promotional expenses for watches bearing the Soldi logo. Except

as stated in this opinion, petitioners have failed to convince us
 - 36 -

that they may deduct any of the expenses in excess of those

allowed by respondent.

8. Net Operating Loss Carryforward

Section 172 allows a taxpayer to deduct net operating

losses.

Respondent determined that petitioners did not have a net

operating loss carryforward from 1987 to 1988 because

respondent's adjustments to petitioner husband's 1987 Schedule C

activity eliminated the claimed net operating loss. Petitioners

attached to their brief appendix C, entitled "Loss Carry Forward

1987", which purports to be petitioners' calculation of their net

operating loss for 1987. They did not include references to the

record, as required by Rule 151(e)(3). Due to our conclusions

about petitioners' unreported income, business expenses, rent

expenses, and additional business deductions for 1987, we are not

convinced that petitioners had a net operating loss for 1987. We

sustain respondent's determination on this issue.

9. Additions to Tax for Fraud Under Section 6653(b) and
Penalty Under Section 6663(a)

a. Background

Respondent determined that petitioner husband (but not

petitioner wife) is liable for the addition to tax for fraud

under section 6653(b) for 1988 and the fraud penalty under

section 6663(a) for 1989. A taxpayer is liable for an addition

to tax or penalty for fraud equal to 75 percent of the part of
 - 37 -

the underpayment which is attributable to fraud. Secs. 6653(b),

6663(a).

Respondent has the burden of proving fraud by clear and

convincing evidence. Sec. 7454(a); Rule 142(b). First,

respondent must prove the existence of an underpayment. Parks v.

Commissioner, 94 T.C. 654, 660 (1990). Respondent may not rely

on petitioners' failure to carry the burden of proof as to the

underlying deficiency. Id. at 660-661; Petzoldt v. Commissioner,

92 T.C. 661, 700 (1989). Second, respondent must show that

petitioner husband intended to evade taxes he believed to be

owing by conduct intended to conceal, mislead, or otherwise

prevent tax collection. Stoltzfus v. United States, 398 F.2d

1002, 1004 (3d Cir. 1968); Parks v. Commissioner, supra at 661;

Rowlee v. Commissioner, 80 T.C. 1111, 1123 (1983).

b. Underpayment

We conclude that respondent has clearly and convincingly

proven that petitioner husband underreported tax for 1988 and

1989.

c. Fraudulent Intent

Respondent must prove by clear and convincing evidence

that petitioner husband had fraudulent intent. Parks v.

Commissioner, supra at 664. For purposes of section 6653(b),

fraud means actual, intentional wrongdoing, Mitchell v.

Commissioner, 118 F.2d 308, 310 (5th Cir. 1941), revg. 40 B.T.A.

424 (1939); i.e., the intentional commission of an act for the
 - 38 -

specific purpose of evading a tax believed to be owing, Webb v.

Commissioner, 394 F.2d 366, 377 (5th Cir. 1968), affg. T.C. Memo.

1966-81. Fraud may be proven by circumstantial evidence because

direct evidence of the taxpayer's intent is rarely available.

Stephenson v. Commissioner, 79 T.C. 995, 1005-1006 (1982), affd.

748 F.2d 331 (6th Cir. 1984).

Respondent argues that the following badges of fraud are

present in this case: A pattern of unreported income, failure

to keep books and records, concealment of income, and false

statements to revenue agents. We disagree that the evidence is

sufficient to clearly and convincingly show that petitioner

husband fraudulently underreported income in 1988 and 1989. We

recognize that he could not accurately reconstruct income for

those years from his books and records, but we are not persuaded

that he underreported his income due to fraud, rather than

carelessness or negligence.

Respondent alleges that petitioner husband did not have

a bank account in his name. Respondent's allegation is not

entirely correct; petitioner husband had an account in his name

at First State Bank in 1987. Also, Respondent points out that

petitioner husband deposited his income in Canta's and petitioner

wife's bank accounts, that in 1988 he cashed two commission

checks totaling $14,622, and that he gave his return preparer

only the 1988 commission income documented by Forms 1099.

However, we do not believe petitioner husband's use of those bank
 - 39 -

accounts was fraudulent. He deposited all of his receipts,

including the two commission checks he cashed in 1988, in bank

accounts, several of which bore his Social Security number. We

do not think that he was trying to hide his income or ownership

of the accounts.

Respondent points out that petitioner husband did not keep

books and records for his real estate business in 1988 and 1989.

However, as stated above, we do not believe that he intended to

defraud. Instead, we think he did not keep books and records

other than his checks because he was disorganized and because he

could not afford accountants. See Compton v. Commissioner, T.C.

Memo. 1983-647.

Respondent points out that petitioner husband deposited

checks from Soldi in Premiere's and Canta's out-of-state bank

accounts. Petitioner husband admitted that he routinely

transferred funds between accounts. He did this to create a

float on these funds.12 It was not an attempt to hide his

income.

Respondent points out that petitioner husband used business

bank accounts to pay personal expenses, and that he deposited

commission checks in the Homeowners account rather than in a

personal account in 1989.

12
A float exists when checks that have been credited to
the depositor's bank account have not yet been debited to the
drawer's bank account. This often permits the interest-free use
of funds during the brief period before the checks are debited to
the drawer's account. Black's Law Dictionary 640 (6th ed. 1991).
 - 40 -

Respondent points out that petitioner husband deposited more

than $23,000 in checks payable to Soldi in other accounts he

controlled. Respondent argues that he tried to conceal

commissions by making Soldi commission checks payable to

petitioner wife. We disagree. We do not think this was an

attempt to conceal income because the Soldi checks that

petitioner husband wrote to petitioner wife were deposited to the

local Canta bank account that petitioner husband regularly used

and on which he was the signator. We do not believe that

petitioner husband diverted checks from Soldi to hide them from

the Government. Rather than depositing the checks to Soldi's

account, he deposited commissions he had earned to accounts that

he regularly used and on which he was the signator. We think the

fact that he left a record by depositing the checks is a factor

that negates the inference that he was trying to conceal income

from the Government.

Respondent argues that petitioner husband concealed

information from his preparers. We disagree. Petitioner husband

did not intentionally conceal information from the return

preparers; he did not have records to give them to accurately

prepare the returns. We are not persuaded that his lack of

records was due to fraud rather than negligence.

Respondent argues that petitioner husband did not cooperate

with respondent's agents, and made false statements to a revenue

agent. Respondent claims that petitioner husband told the
 - 41 -

revenue agent that he maintained separate bank accounts for

personal and business activities. We do not find that petitioner

husband made false statements to a revenue agent. Petitioner

husband's business and banking activities were disorganized and

he did not properly keep separate accounts for business and

personal activities. We are persuaded that petitioner husband's

statement, while mistaken in part, was not intentionally false or

misleading.

Respondent points out that petitioner husband wrote checks

to Americana investors and noted on the checks that they were

commissions. Similarly, respondent claims that petitioner

husband falsified business expenses by misrepresenting the

purpose of the payments on the checks and on schedules he gave to

respondent. We disagree. We think this is another example of

petitioner husband's failure to keep records and the disorganized

state of his business affairs. We do not find that petitioner

husband intentionally made false or misleading statements to

respondent's agents, or that he was uncooperative with

respondent's agents.

Respondent's counsel and petitioners' counsel worked hard to

reconstruct petitioners' finances. Respondent contends that this

shows the extent of petitioner husband's efforts to conceal his

financial affairs. We disagree. We think it shows petitioners'

belated cooperation with respondent's agents in attempting to get

to the bottom of petitioner husband's finances.
 - 42 -

While petitioners underreported some income and capital

loss, we are not convinced that it was due to fraud. It appears

that the underreporting was due to careless bookkeeping and

petitioners' difficult personal and financial circumstances,

which was negligent, but not fraudulent.

We conclude that respondent has not proven by clear and

convincing evidence that petitioner husband is liable for the

addition to tax for fraud under section 6653(b) for 1988 or

the penalty for fraud under section 6663(a) for 1989.

10. Additions to Tax

a. Late Filing

Petitioners filed their 1987 and 1989 returns late. A

taxpayer is liable for an addition to tax of up to 25 percent for

failure to timely file a Federal income tax return unless the

taxpayer shows that the failure was due to reasonable cause and

not willful neglect. Sec. 6651(a)(1). Petitioner bears the

burden of proving that his failure to file a timely return is due

to reasonable cause and not willful neglect. United States v.

Boyle, 469 U.S. 241, 245 (1985); Baldwin v. Commissioner, 84 T.C.

859, 870 (1985); Davis v. Commissioner, 81 T.C. 806, 820 (1983),

affd. without published opinion 767 F.2d 931 (9th Cir. 1985). To

prove reasonable cause, a taxpayer must show that he exercised

ordinary business care and prudence but nevertheless could not

file the return when it was due. Crocker v. Commissioner, 92
 - 43 -

T.C. 899, 913 (1989); sec. 301.6651-1(c)(1), Proced. & Admin.

Regs.

Petitioners argue that they had reasonable cause for filing

their 1987 return late because petitioner husband believed that

he had no tax liability for 1987 in view of his financial

difficulties and bankruptcy. They contend that they had

reasonable cause for filing their 1989 return late because their

infant son Antonino was gravely ill in 1989, was hospitalized and

had heart surgery in April 1990, and died in August 1990.

Illness of a taxpayer or member of his or her immediate

family may be reasonable cause for late filing if the taxpayer

shows that he or she cannot file a timely return because of such

illness. Williams v. Commissioner, 16 T.C. 893, 906 (1951);

Hayes v. Commissioner, T.C. Memo. 1967-80. While incompetence,

mental illness, alcoholism, or other incapacity may excuse a

taxpayer from late filing, a taxpayer's selective inability to

meet his tax obligations when he can conduct normal business

activities does not excuse his late filing or failure to file.

Kemmerer v. Commissioner, T.C. Memo. 1993-394; Bloch v.

Commissioner, T.C. Memo. 1992-1; Bear v. Commissioner, T.C.

Memo. 1992-690, affd. without published opinion 19 F.3d 26 (9th

Cir. 1994); Fambrough v. Commissioner, T.C. Memo. 1990-104.

Petitioner husband had business and financial problems

during the time petitioners should have filed their tax return

for 1987. However, he continued to operate his real estate
 - 44 -

business. The fact that he actively engaged in real estate

activities throughout this period, we believe, shows that his

financial difficulties did not prevent him from filing their 1987

tax return on time. We find that petitioners' failure to timely

file the 1987 return was not due to reasonable cause. Therefore,

we find that they are liable for the addition to tax under

section 6651(a)(1) for 1987.

Respondent argues that, despite petitioners' personal

problems resulting from Antonino's tragic illness and death,

petitioner husband was not ill and was able to carry on his

business activities in 1989. We disagree. Petitioners' son had

heart surgery in April 1990, around the time that their 1989

return was due to be filed. He was hospitalized until late July.

Petitioners were at the hospital with him continuously during

these 4 months. Petitioners' son died in August 1990, and they

filed their 1989 return in October 1990. We are convinced by

these facts that petitioners' late filing of their 1989 return

was due to reasonable cause and not willful neglect. We hold

that they are not liable for the addition to tax under section

6651 for 1989.

b. Negligence

Respondent determined that petitioners are liable for the

addition to tax for negligence under section 6653(a)(1)(A) and

(B) for 1987, and under section 6653(a)(1) for 1988, and the

negligence penalty under section 6662(b)(1) for 1989.
 - 45 -

Petitioners have the burden of proving that they were not

negligent. Neely v. Commissioner, 85 T.C. 934, 947 (1985).

Section 6653(a)(1)(A) (and section 6653(a)(1)) imposes an

addition to tax equal to 5 percent of the underpayment of tax if

any part of the underpayment is due to negligence or intentional

disregard of rules or regulations. Section 6653(a)(1)(B) imposes

an additional liability of 50 percent of the interest due on the

underpayment of tax attributable to negligence or intentional

disregard of rules or regulations. Beginning in 1989, taxpayers

are liable for a penalty equal to 20 percent of the part of the

underpayment attributable to negligence. Secs. 6662(a), (b)(1).

Negligence includes a failure to make a reasonable attempt to

comply with the provisions of the Internal Revenue laws or to

exercise ordinary and reasonable care in the preparation of a tax

return. Sec. 6662(c). Negligence is a lack of due care or

failure to do what a reasonable and ordinarily prudent person

would do under the circumstances. Zmuda v. Commissioner, 731

F.2d 1417, 1422 (9th Cir. 1984), affg. 79 T.C. 714 (1982); Neely

v. Commissioner, supra.

Petitioners argue that petitioner husband reasonably

believed that he had no taxable income in 1987, and that in fact,

if his personal activities are combined with Americana's, he had

a net operating loss for the year.

Petitioners contend that petitioner husband's income in 1988

was nominal since they had no taxable gain on the sale of their
 - 46 -

home until they decided whether they would buy a replacement home

and roll over the gain. They further contend that they had no

taxable income in 1988 after deducting itemized deductions,

losses on the sale of real estate, and a loss carryforward from

1987.

Finally, petitioners maintain that any inaccuracies on the

1989 return occurred because their child was seriously ill and

had heart surgery in April 1990, when the 1989 return was due.

They argue that they are not liable for the accuracy related

penalty for 1989 because loss carryforwards eliminate any tax

liability for 1989.

We disagree. We believe that petitioners' tragic

difficulties with Antonino excuse the lateness of the 1989

return, but not its inaccuracies. Petitioner husband did not

have books and records showing his sales, commissions, etc., or

other information relating to the operation of his businesses.

Petitioners substantially underreported their income and

overreported their deductions for each of the years in issue. We

find that petitioners' underpayments of tax in 1987, 1988, and

1989 were due to negligence because they failed to keep adequate

records. Gilman v. Commissioner, 72 T.C. 730, 751 (1979).

c. Substantial Understatement

The next issue for decision is whether petitioners are

liable for the addition to tax for substantial understatement of

income tax under section 6661(a) for 1987 and 1988. Section
 - 47 -

6661(a) provides for an addition to tax in the amount of 25

percent of the amount of any underpayment attributable to a

substantial understatement of income tax.

An understatement is the amount by which the correct tax

exceeds the tax reported on the return. Sec. 6661(b)(2)(A). An

understatement is substantial if it exceeds the greater of 10

percent of the tax required to be shown on the return or $5,000.

Sec. 6661(b)(1)(A). Petitioners bear the burden of proving that

the addition to tax under section 6661 does not apply. Rule

142(a); Tweeddale v. Commissioner, 92 T.C. 501, 506 (1989).

If a taxpayer has substantial authority for the

tax treatment of any item on the return, the understatement

is reduced by the amount attributable to it. Sec.

6661(b)(2)(B)(i). Similarly, the amount of the understatement

is reduced for any item adequately disclosed either on the

taxpayer's return or in a statement attached to the return.

Sec. 6661(b)(2)(B)(ii). Neither of these exceptions applies

here.

Petitioners argue that they did not substantially understate

their income for 1987 if all deductions and economic losses are

allowed for that year. They also argue that there was no

substantial understatement for 1988 because the tax liability

for 1988 is not substantial.

Petitioners omitted large amounts of income from their

1987 and 1988 joint returns, which caused substantial
 - 48 -

understatements of income tax. Petitioners underreported their

income by about $47,068 in 1987 and $87,711 in 1988. Petitioners

have cited no authority for their failure to report those items

of income. We sustain respondent's determinations that

petitioners are liable for the addition to tax under section 6661

for 1987 and 1988.

11. Whether Petitioner Qualifies as an Innocent Spouse

a. Background

We next decide whether petitioner wife qualifies as an

innocent spouse under section 6013(e).

Spouses who file joint tax returns generally are jointly and

severally liable for tax. Sec. 6013(d)(3). Petitioner argues

that she is not liable for the deficiencies and addition to tax

for substantial understatement of income tax because she is an

innocent spouse under section 6013(e). To qualify as an innocent

spouse, petitioner must prove that: (i) She filed a joint return

for the years in issue; (ii) there is a substantial

understatement of income tax attributable to grossly erroneous

items of the other spouse on the return; (iii) she did not know

or have reason to know of the substantial understatement when

she signed the return; and (iv) it would be inequitable to hold

her liable for the deficiency attributable to the substantial

understatement. Sec. 6013(e)(1). Failure to meet any of these

requirements precludes a taxpayer from qualifying as an innocent

spouse. Sec. 6013(e)(1); Purcell v. Commissioner, 826 F.2d
 - 49 -

470, 473 (6th Cir. 1987), affg. 86 T.C. 228 (1986); Shea v.

Commissioner, 780 F.2d 561, 565 (6th Cir. 1986), affg. in

part and revg. in part T.C. Memo. 1984-310. The innocent

spouse exception is construed in view of the congressional

purpose of protecting innocent taxpayers from injustice. Sanders

v. United States, 509 F.2d 162, 166-167 (5th Cir. 1975).

Respondent concedes that petitioner meets all of the

requirements to qualify as an innocent spouse under section

6013(e) except whether she knew or had reason to know of the

understatements when she signed the returns, and whether it

is inequitable to hold her liable.13 We need not decide whether

petitioner wife knew or had reason to know of the understatements

because we conclude that it is not inequitable to hold her

liable.

b. Inequitable to Hold Petitioner Liable

To be entitled to relief as an innocent spouse, petitioner

wife must show that it would be inequitable to hold her liable

for the deficiencies in tax for the years in issue. Sec.

6013(e)(1)(D).

In deciding whether it is inequitable to hold a spouse

liable for a deficiency, we consider whether the purported

innocent spouse significantly benefited beyond normal support,

13
Respondent also points out that respondent disallowed
some of petitioners' deductions for lack of substantiation, and
deductions disallowed merely for lack of substantiation are not
grossly erroneous items.
 - 50 -

either directly or indirectly, from the unreported income.

Hayman v. Commissioner, 992 F.2d 1256, 1262 (2d Cir. 1993), affg.

T.C. Memo. 1992-228; Belk v. Commissioner, 93 T.C. 434, 440

(1989); Purcell v. Commissioner, 86 T.C. at 242; H. Rept. 98-432

(part 2), at 1501, 1502 (1984); sec. 1.6013-5(b), Income Tax

Regs. Normal support is determined by the circumstances of the

taxpayers. Sanders v. United States, 509 F.2d at 168; Estate of

Krock v. Commissioner, 93 T.C. 672, 678 (1989); Flynn v.

Commissioner, 93 T.C. 355, 367 (1989).

Petitioners argue that petitioner wife did not benefit from

the substantial understatement of income by petitioner husband

or receive substantial amounts from petitioner husband in the

years at issue. Petitioners point out that petitioner wife owned

the home in which petitioners lived and she owned a home on

LaGrange which she sold in 1987. Her net cash proceeds were

$23,562, $14,848 of which she deposited in her household account.

She also received $64,482 from the sale of her home in 1988,

which she deposited in her own account.

Petitioner wife benefited from the understatements on

petitioners' 1987, 1988, and 1989 returns. Petitioner wife had

wages of $15,500 in 1987, $10,200 in 1988, and none in 1989, and

therefore depended on petitioner husband for her support. In

1987 and 1988 petitioner husband deposited funds in her bank

accounts which she used to pay household expenses. In 1989,

petitioner husband used the Premiere and Canta corporate accounts
 - 51 -

to pay many of petitioners' personal, living expenses. Also,

given petitioner wife's modest income in these years, she must

have used petitioner husband's unreported income to buy the

Tanglewood home for $175,000 in 1987, and to build the Alden home

for $160,000 in 1989.

We believe that petitioner wife fully benefited from the

omitted income. We believe that she fully shared in the tax

savings from the omitted income and that the understatements let

her maintain a standard of living that she would not have enjoyed

otherwise. See Scarafile v. Commissioner, T.C. Memo. 1991-512.

To reflect the foregoing,

Decision will be entered

under Rule 155.