National Indus. Investors v. Commissioner

T.C. Memo. 1996-151

UNITED STATES TAX COURT

NATIONAL INDUSTRIAL INVESTORS, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 24863-93. Filed March 26, 1996.

Held: P's miscellaneous deductions redetermined;
held, further, for any underpayment due to denied
deductions P is liable for penalties under sec.
6662(a), I.R.C., for 1989 and 1990; held, further, for
any underpayment due to unreported income P is not
liable for penalties under sec. 6662(a), I.R.C., for
1990.

Donald Del Grande, for petitioner.

Elaine L. Sierra, for respondent.
 MEMORANDUM FINDINGS OF FACT AND OPINION

NIMS, Judge: Respondent determined the following

deficiencies and penalties in respect of petitioner's Federal

income taxes:

Taxable Year Deficiency Sec. 6662(a) Penalty

1989 $12,284 $2,457
1990 12,251 2,450

Unless otherwise indicated, all section references are to

sections of the Internal Revenue Code in effect for the years at

issue, and all Rule references are to the Tax Court Rules of

Practice and Procedure.

By amended pleadings, respondent asserted an increased 1990

income tax deficiency in the amount of $88,162, and an increased

1990 penalty under section 6662(a) in the amount of $17,632. The

parties settled the increased 1990 income tax deficiency, but the

additionally asserted penalty remains disputed. Petitioner has

also claimed increased deductions for automobile mileage for both

years and for dues and subscription expenses for 1990.

After concessions, the issues for decision are:

(1) How much is petitioner entitled to deduct for business

expenses for 1989 and 1990? After concessions and additional

claims by petitioner the following amounts are in contention:
 - 3 -

Category of deduction 1989 1990

Depreciation .................. $13,367.00 $13,180.00
Net operating loss carryover... 231,102.00 266,331.00
Interest....................... 19,010.46 20,236.32
Repairs........................ 123.00 300.00
Rents.......................... 940.00 850.00
Fees and expenses of C.M. Byrne III 276.72 500.00
Management fees of Charles Byrne 500.00 4,156.30
Insurance...................... 4,084.00 2,353.00
Office expenses................ 489.80 72.80
Telephone...................... 1,028.00 2,173.00
Auto........................... 2,318.63 3,285.36
Travel......................... 166.00 -0-
Professional services.......... 370.00 -0-
Dues and subscriptions......... 158.00 157.60

(2) Is petitioner liable for the accuracy-related penalty

for negligence under section 6662(a) in the amounts of $2,457.00

and $17,632.00 for 1989 and 1990, respectively?

Some of the facts have been stipulated and are found

accordingly. The stipulation of facts and attached exhibits are

incorporated herein by this reference.

FINDINGS OF FACT

Petitioner, National Industrial Investors, Inc. (NII), is a

California corporation. Since its inception, its principal place

of business, office address, and office address of all of its

subsidiaries has been 956 Jackling Drive, Hillsborough,

California, the residence of Charles M. Byrne (Byrne).

Byrne owned 51 percent of the stock of NII from 1972,

shortly after NII's incorporation, until 1980, when he divided

his interest among his wife and children. A non-Byrne minority

shareholder, McMahon, was bought out in early 1988, and when
 - 4 -

Byrne's wife died on July 28, 1988, Frances E. Byrne Jr.

(Frances) and Kimberly Byrne, Byrne's daughters, became NII's

sole shareholders.

Byrne has been a director of NII during most of its

existence, including the years in issue. He was also its

president from 1971 until he resigned on October 9, 1982, and its

vice president during the years in issue. After resigning as

president of NII, his daughter, Frances, succeeded him. His wife

was secretary of the corporation until her death. During 1989

and 1990, NII paid no employee compensation.

Respondent's notice of deficiency denies all of petitioner's

deductions for 1989 and 1990. Part of petitioner's net operating

loss carryover deductions come from depreciation, interest, and

other deductions incurred in prior years and in part from the

losses of petitioner's subsidiaries incurred in those years.

Establishing the net operating loss, therefore, requires

substantiating the deductions incurred by petitioner's

subsidiaries from as far back as 1975 and demonstrating their

business purpose. Establishing the amount of depreciation on a

building owned by petitioner requires substantiating its original

unadjusted basis in 1971. Interest deductions claimed by

petitioner relate to five different notes secured by petitioner's

building from time to time since 1971.
 - 5 -

Over the years NII has had four subsidiaries engaged in

various businesses, but its primary asset and source of income

has always been its building on Senter Road in San Jose,

California (the Burke Building). The original owner of the

building, Parr Properties (Parr), an industrial real estate

developer, leased the building to Burke Rubber Company (Burke) on

May 10, 1968, and later, in April of 1969, borrowed $310,000 from

Teachers Insurance & Annuity Association of America (TIAA)

against both the building and the lease. Shortly thereafter,

Parr liquidated all of its assets, including disposition of the

Burke Building.

Before that time, Byrne had worked for Parr for

approximately 20 years, and at the time of the liquidation, he

was an executive vice-president and industrial director of Parr.

When Parr sold off its assets, Byrne and a group of investors

bought the Burke Building.

Parr's board of directors approved the sale, but suggested

that Byrne not participate as a partner in the venture until

after Parr had liquidated so as to avoid the appearance of self-

dealing on his part. Consequently, Byrne devised an alternative

plan.

Byrne lent his brother-in-law, Hugh McMahon, Jr.,

(McMahon), money to invest in Senter Associates, the partnership

acquiring the Burke Building. With this loan and his own funds,
 - 6 -

McMahon purchased a 50-percent interest in Senter Associates.

When Byrne stopped working for Parr, McMahon repaid the debt by

transferring half of his interest in Senter Associates to Byrne.

Parr knew of this arrangement.

Parr sold the Burke Building, along with the lease, to

Senter Associates sometime before July 10, 1970. The sole

consideration was the assumption by Senter Associates of the TIAA

encumbering liability, which at the time of acquisition had a

remaining principal balance of $304,271.63.

In August of 1971, Senter Associates and Burke entered into

a second lease (the Burke Lease), which superseded the original

lease negotiated by Parr. The Burke Lease provided for the

construction of a 34,000 square foot addition to the Burke

Building (the Addition) and for a corresponding increase in rent.

The lease guaranteed an annual rent, starting at $65,250 and

increasing over time. Senter Associates purchased land for the

Addition from Burke for $21,600 on September 22, 1971.

Shortly before the Addition was completed and paid for,

Senter Associates incorporated and on December 18, 1971, became

NII. The partners contributed all the assets of Senter

Associates to NII, which also assumed all of the liabilities of

Senter Associates. In return the partners, including Byrne, each

received 500 shares of NII stock and a corporate note for
 - 7 -

approximately $2,900. After its incorporation, NII paid $167,186

to build the Addition.

Petitioner placed both the Burke Building and the Addition

(the Burke Property) in service on January 1, 1972, the date that

Burke took possession of the Addition. For the Burke Building,

NII has always used the straightline method of depreciation in

conjunction with a useful life of 28-1/2 years. For the

Addition, it has used the 125-percent declining balance method

with a useful life of 30 years.

Within a month after paying for the Addition, on January 31,

1972, petitioner borrowed an additional $202,918.92 against the

Burke Property from TIAA. Petitioner consolidated this loan and

the previous loan from TIAA into one $500,000 loan (the TIAA

Loan). Starting on March 1, 1972, the consolidated note required

monthly payments of interest and principal of $4,238.87. The

interest rate on the consolidated loan was 9-1/8 percent per

annum.

The Burke Property also secured other loans in later years.

For example, the property secured a $75,000 loan from a group of

investors (Investor Group Loan) from June 10, 1982, until October

29, 1985. On September 27, 1985, Owens Financial Group, Inc.,

lent petitioner $85,000 (Owens Loan). The Owens Loan was

collateralized by the Burke Property. Petitioner repaid the
 - 8 -

Owens Loan when it refinanced the property on March 4, 1988. At

that time, the principal balance of the loan was $86,181.50.

Petitioner issued another obligation against the property in

1988 to settle a shareholder derivative suit (the McMahon

Litigation). On August 17, 1984, McMahon, a minority

shareholder, instituted a suit against petitioner, all other

shareholders, and Byrne. McMahon alleged, among other things,

that Byrne unilaterally appointed his own family as officers and

directors, that the Byrne family caused NII to purchase three

subsidiary corporations without informing McMahon, that the

family diverted money from petitioner to the subsidiaries for the

purpose of paying salaries and stipends to the family, and that

the family's behavior generally constituted self-dealing and

breach of fiduciary duty. The parties pursued the litigation

from August 1984 through March 1988.

The litigation essentially ended on October 29, 1987, when

Judge Thomas Smith imposed sanctions after several attempts by

McMahon's lawyer, Jones, to enjoin the corporation from carrying

on its business. Judge Smith explained the sanctions, stating:

It appears to the court that your conduct and your
client's conduct in this case, Mr. Jones, is reprehensible,
to say the least.

* * * * * * *

There is no factual basis; there is no legal basis for
your continuing to proceed in this case. What you're doing
is, quite simply, harassing the other side and I'm tired of
it, and if you won't stop doing it on your own account, then
 - 9 -

I'm going to make you start paying for it, and you're going
to be paying the side who has to pay attorney's fees,
because you're not practicing the law the way you should be.

The parties subsequently settled. The agreement required

McMahon to relinquish any interest in NII and the Burke Building.

In return, it required petitioner and the other named defendants

to pay McMahon the sum of $32,500 and also required petitioner to

issue a $252,500 note to McMahon and his wife (McMahon Note).

The McMahon Note provided for 7-percent interest per annum

compounded annually starting on January 1, 1988, with any unpaid

principal and interest due and payable on December 31, 1997. If

the Burke Property were to be sold, however, the note would

become immediately due and payable. The note was nonrecourse

and, because a first mortgage holder with a superior claim to the

property already existed, was secured by a second deed of trust.

Around the time petitioner settled the McMahon litigation,

it was trying to refinance the Burke Property and also exchange

it under section 1031 for another piece of property. Both of

these transactions might have replaced the current first mortgage

holder with another. Consequently, as part of the settlement

agreement, petitioner negotiated for and received a subordination

agreement. The agreement provided that, so long as the amount of

the first mortgage did not increase, petitioner could refinance

or enter into a section 1031 exchange without a "sale" occurring,
 - 10 -

and the McMahon Note, therefore, would not become immediately due

and payable.

On March 4, 1988, petitioner refinanced the Burke Property.

Petitioner borrowed $475,000 from San Francisco Federal Savings

(San Francisco Loan) and paid off the remaining $323,731.51

balance of the TIAA Loan and the Owen's Financial Loan, the

remaining balance of which was $86,181.50. Respondent has

conceded that petitioner was entitled to deduct the interest on

the San Francisco Loan in 1989 and 1990. But the 1988 interest,

which substantially contributed to petitioner's net operating

loss for that year, has not been conceded to be deductible.

The San Francisco Loan required petitioner to pay $3,994.06

interest and principal monthly, beginning on April 1, 1988, and

continuing every month thereafter for 12 months. Afterward, the

note established a new monthly payment for the next 12 months

depending upon market interest rates. The total of the payments

required in 1988 was $35,946.54.

The interest rate of the loan was fixed at 9.5 percent for

the first 6 months of the loan. After that, the interest rate

varied from month-to-month in accordance with current market

interest rates. As of the end of 1988, the interest rate on the

San Francisco Loan had increased to 11.307 percent.

As previously stated, petitioner controlled several

subsidiaries over the years. These were Controlled Casting
 - 11 -

Systems Corp. (Controlled Casting), National For Sale by Owner

Realty Corp. (Sale By Owner), National Industrial Management

Corporation (Industrial Management), and Far Western Real Estate

Corp. (Far Western). For the years for which petitioner's

returns show consolidated losses, the separate gains and losses

of petitioner and its subsidiaries are as follows:
Total Controlled Industrial Sale By Far
Year Loss NII Casting Management Owner Western

1989 ($35,229) ($35,229) * * * *
1988 (32,766) (32,716) * * * (50)
1985 (46,115) (41,602) * (3,995) (408) (110)
1984 (35,992) (4,814) * (11,594) 3,722 (23,306)
1983 (38,514) 7,188 * (13,821) (5,232) (26,949)
1982 (47,378) (25,720) * (1,709) (19,949) *
1978 (40,328) (2,565) * (37,763) * *
1976 (19,941) (36,113) (486) 16,658 * *

* represent years in which petitioner's consolidated return did not include
the subsidiary.

Controlled Casting emerged from an arrangement between

Sears, an inventor, and Shell Chemical Company (Shell). They

sought to develop a new type of foundry equipment, which, by

injecting sand with a resin-type material, could form the mixture

into molds. Sears and Shell agreed that if Shell would develop

the resin and give Sears a 10-year license, then he, in turn,

would design the machine. Shell subsequently formulated the

resin from benzene, a petroleum derivative.

Sears incorporated Controlled Casting and, in 1973, sold 80

percent of its stock to petitioner. Not only did Controlled

Casting design the machine, but it also manufactured several of

them and sold two to General Motors. However, shortly
 - 12 -

thereafter, OPEC cut off the United States' supply of benzene,

and in 1974 Shell stopped producing the resin. With "no relief

in sight", petitioner liquidated the subsidiary in 1976.

Industrial Management, another 80-percent subsidiary,

provided real estate expertise to clients. It acquired and

developed property, designed buildings, found financing, and, if

necessary, dealt with related government legislation.

Far Western, a wholly owned subsidiary, operated a real

estate brokerage business. When petitioner formed Far Western,

Hugh McMahon III (Hugh) provided the necessary brokerage license

required by the California Department of Real Estate. Far

Western operated actively from 1983 until 1985, but Far Western

never generated any taxable income. The only gross income

reported for Far Western was $2,031 in 1984.

Petitioner's other wholly owned subsidiary, Sale By Owner,

experimented with an alternative real estate brokerage business.

For a $290 fee, a homeowner selling his own home could list his

house on the multiple listing service without engaging an

exclusive real estate agent. But, if a broker found a buyer, the

homeowner could use the broker and pay his fee.

Byrne, his wife, and Hugh incorporated Sale By Owner on

April 15, 1982, and obtained a corporate broker's license from

the Department of Real Estate, using Hugh's brokerage license.
 - 13 -

Hugh had sold real estate in San Diego before and believed that

the city was a good test market. Sale By Owner opened there.

Almost immediately the business had problems. As an

advance-fee broker the Department of Real Estate had to

preapprove all of its advertising. The time lag destroyed Sale

By Owner's marketing agility. Furthermore, and perhaps more

importantly, few homeowners in San Diego wanted the service. The

office in San Diego closed in November of 1982, and Sale By Owner

moved to the Palm Springs-Rancho Mirage area (Desert Area), a

resort market with seasonal buying patterns. Hugh, who was

"broke" at this point, quit the project.

The experiment continued in the Desert Area, using Hugh's

corporate brokerage license, and began to turn a profit early in

1984. However, in the same year, both Far Western and Sale By

Owner abruptly collapsed. In August of that year, Hugh's

membership with the Board of Realtors and the Multiple Listing

Service for the Desert Area, which both subsidiaries used, was

canceled. Hugh's father, McMahon, in that same month, instigated

the McMahon Litigation. As a consequence of the impending

litigation, Far Western and Sale By Owner were not able to find

another corporate broker and failed to participate in the 1984-

1985 selling season in the Desert Area. Furthermore, the suit

consumed much of the time of petitioner's management. By 1985,

both subsidiaries had ceased operations.
 - 14 -

The parties settled the McMahon Litigation in 1988, and in

October of 1989, petitioner destroyed most of the underlying

documentation for its expenses from 1971 to 1984 or 1985.

Petitioner's management considered them old and irrelevant. But

it kept the checks for Sale By Owner and Far Western, reasoning

that those expenses were "more current". Petitioner also kept

its unaudited books of original entry, and other books based on

them. Since 1976, the first contested loss year, a member of the

Byrne family has kept the books of original entry. An accountant

compiled some of the other ledgers and journals using the

information the Byrnes gave him.

While prior years' events generate petitioner's claimed net

operating losses, including depreciation and interest, the events

of 1989 and 1990 generate petitioner's other claimed deductions.

Respondent conceded some of these current deductions, and of the

amounts remaining in controversy, respondent has admitted that

petitioner has substantiated the following amounts:

Category 1989 1990

Management fees of Byrne......... $500.00 $3,656.30
Fees/expenses of Charles Byrne III... 276.72 500.00
Repairs............................... 123.14 299.57
Insurance
for Automobile.................. 795.80 661.60
on Byrne's Life................. 1,114.10 -0-
Telephone.............................. 905.39 1,864.15
Travel................................ 48.77 -0-
Dues and subscriptions
Newspapers....................... 40.00 92.60
SF Commercial Club............... 75.17 65.00
Office expenses
 - 15 -

Debris box....................... 410.00 -0-
Spellmaster....................... 79.80 -0-
Secretary of State of Colorado.... -0- 5.00
Riverside County Clerk's Office... -0- 67.80
Rents.................................. 940.00 850.00

After the settlement of the McMahon Litigation, petitioner

turned its attention to other matters. Frances and her sister,

Kimberly, had become NII's sole shareholders, and they wanted to

manage property as well as own it. They sought to swap the Burke

Property under section 1031 for an office building, an apartment

building, or a strip mall. Finding the right swap property,

however, proved difficult.

On November 18, 1987, almost directly after Judge Smith

imposed sanctions in the McMahon Litigation, NII by written

contract hired Byrne as a consultant, paying him $500 per month

plus reimbursement for car mileage. NII wanted his experience.

Moreover, at the time, Byrne worked for First Interstate Bank of

CA as the manager of special real estate assets. Through this

position he had contacts with others in the real estate industry

who might know of a suitable property for exchange. Furthermore,

by this time Byrne had acquired a real estate brokerage license.

In addition to requiring Byrne to give advice, the

consulting contract required him to inspect the Burke Property

and to seek out a section 1031 exchange property. Inspecting the

Burke Property required about 2 days' effort twice a year. But

the quest for exchange property took longer: it required finding
 - 16 -

a property, inspecting it, and negotiating with the owner. Byrne

scoured California, searching for a suitable exchange property.

His mileage logs for 1989 and 1990 detail his trips to at least

19 different properties.

In his search, Byrne drove two cars: A 1978 Chevrolet Malibu

(Malibu) owned by Frances and a 1977 Mercury Cougar (Cougar)

owned by NII. Byrne kept detailed mileage logs when he drove the

Malibu. Petitioner claims that Byrne drove the Malibu 10,305

miles in 1989, and 12,636 miles in 1990. Petitioner reimbursed

Byrne for his mileage by issuing him notes, payable on or before

December 31, 1997. The note for 1989 was for $2,318.63 (10,305

miles at 22.5 cents per mile). The note for 1990 was for

$3,285.36 (12,636 miles at 26 cents per mile).

The Malibu's 1990 mileage logs, however, are inaccurate.

Imbedded in the Malibu's logs were the Cougar's mileage logs for

June, July, and August of 1990. Moreover, some of the 1990

Malibu mileage logs that petitioner refers to in its summary

mileage calculation are not in evidence. After deducting these

miles, the Malibu's mileage logs indicate that Byrne drove the

Malibu 7,523 miles in 1990.

Except for the "imbedded" mileage logs, Byrne kept no Cougar

mileage logs. Petitioner claimed deductions only for the

Cougar's repairs and insurance.
 - 17 -

In addition to Byrne's consulting agreement, petitioner also

asked Byrne's son, Charles M. Byrne, III, (Charles) to

occasionally inspect prospective exchange property. Petitioner

also subscribed to two Northern California newspapers that

Charles collected and sent to Byrne or Frances, who searched in

the papers' real estate and business sections for an exchange

property. Ultimately, petitioner failed to find a suitable

exchange property. The value of the Burke Property declined as

the 1997 termination of the Burke Lease approached. In 1991,

with only 5 years left on the lease, interest in the Burke

Property vanished. Petitioner stopped searching for a swap

property in late 1991.

Petitioner had other normal operating expenses during 1989

and 1990, including a separate phone line at Byrne's residence,

used exclusively for business, and a Spellmaster for Frances

because she was "an atrocious speller". Petitioner also paid

part of the premium on Byrne's life insurance, asserting that it

was "key man insurance". As of 1988 NII was a 40-percent

beneficiary under the policy.

Petitioner also rented a storage space in Rancho Mirage

during 1989 and 1990. Petitioner stored brochures about Far

Western's services, and homeowner kits produced for Sale By

Owner, which provide how-to-sell-your-own-home information to
 - 18 -

customers. Petitioner stored this material until 1993, when it

abandoned hope of reviving the two subsidiaries.

The additional penalty asserted by respondent revolves

around services performed by Far Western for International

Marketing Limited (IML) sometime in the mid-1980s. On December

28, 1989, after petitioner had liquidated Far Western, petitioner

sent IML a bill for $57,100. As payment IML gave petitioner a

parcel of land, known as Lot 51. To offset the value of Lot 51,

petitioner issued IML a note for $38,000.

Although petitioner and its subsidiaries were accrual method

taxpayers, they failed to include in income the amount due for

services performed for IML. Petitioner concedes that Lot 51 had

a fair market value of $150,000, and concedes $112,000 of

services income for 1990.

OPINION

Respondent's primary contention is that there was no

business purpose for petitioner's deductions. Respondent claims

that petitioner deducted personal expenses of the Byrnes.

Respondent also asserts lack of substantiation in many instances.

Because respondent contends that petitioner deducted personal

expenses, failed to report services income, and failed to

maintain adequate records, she also asserts negligence.

Petitioner replies that it deducted only business expenses

that are substantiated by petitioner's books and in some cases by
 - 19 -

underlying documentation. Petitioner concedes that it had

unreported service income, but denies that its failure to report

it was negligent.

When a taxpayer contests the Commissioner's determination,

the burden of proof is ordinarily on the taxpayer to show that

the Commissioner's determination is in error. Rule 142(a). The

taxpayer's burden of proof includes the burden of substantiation.

Nevertheless, where the taxpayer is unable to substantiate

expenses through adequate records or other proof, the Court may

estimate the deductible amount, if some deductible amount is

suggested by other evidence, under the so-called Cohan rule,

bearing heavily, if the Court chooses, upon the taxpayer whose

inexactitude is of its own making. Cohan v. Commissioner, 39

F.2d 540 (2d Cir. 1930). The Cohan rule does not apply to

travel, entertainment, gifts, and listed property. Sec. 274(d).

Petitioner's net operating loss deductions for 1989 and

1990, for present purposes, consist of four parts: (1) NII's

depreciation deductions, (2) NII's interest deductions, (3) NII's

other deductions, and (4) losses incurred by NII's subsidiaries.

Our determination of petitioner's unadjusted basis in the Burke

Property will determine not only the depreciation deductions for

the net operating losses in prior years, but will also establish

petitioner's entitlement to these deductions in the current

years. Furthermore, our resolution of the deductibility of the
 - 20 -

interest on the McMahon Loan applies to both petitioner's 1988

net operating loss and to the current years.

Respondent denied all of petitioner's depreciation

deductions for lack of substantiation of its basis in the Burke

Property and for failure to establish a method of depreciation.

Petitioner, however, has established a method of depreciation and

also proven a substantial portion of its unadjusted basis in the

Burke Property. When Senter Associates incorporated and formed

petitioner in a section 351 transaction, in which no gain was

recognized, the basis of the Burke Building was carried over to

petitioner from the prior partnership. Proof of Senter

Associates' basis in the building, therefore, establishes

petitioner's basis.

Senter Associates assumed a $304,271.63 mortgage encumbering

the Burke Building when it purchased the property from Parr. No

credible evidence proves that Senter Associates paid any more for

the Burke Building. During the time it held the building, the

partnership accumulated $15,666.91 in depreciation. Petitioner's

unadjusted basis in the Burke Building, therefore, was initially

$288,604.72 to be reduced by $55,000 allocated to the land

(determined in accordance with the method of allocating the

strike price of Burke's purchase option under the Burke Lease).

Under the Burke Lease, Burke may purchase the Burke Property

when the lease ends in 1997. The price includes $76,600 for the
 - 21 -

land, including the land on which the Addition was built, and

$502,500 for the buildings and improvements. Under the Burke

Lease agreement, the price of the buildings increases over time,

determined with reference to the Consumer Price Index, whereas

the price of the land does not. Burke, therefore, had an

incentive to bargain for allocating more of the option price to

the land, and Senter Associates had an incentive to bargain for a

low land allocation. The land allocation in the lease,

therefore, is a bargained for allocation and is a strong

indication of the value of the land at that time. Since Senter

Associates paid $21,600 for the land on which the Addition was

built, $55,000 of petitioner's basis in the Burke Building itself

is allocable to land. The depreciable part of petitioner's

unadjusted basis in the Burke Building is therefore $233,604.72.

Petitioner also spent $167,186 to build the Addition.

As for petitioner's method of depreciation, respondent

insists that petitioner failed to establish one. We are

satisfied, however, that petitioner has consistently used the

straightline method of depreciation for the Burke Building with a

useful life of 28-1/2 years, and the 125-percent declining

balance method with a useful life of 30 years for the Addition.

Because petitioner's initial unadjusted depreciable basis in both

the Burke Building and the Addition is lower than the amount

petitioner claims, the depreciation deductions will be
 - 22 -

recalculated under Rule 155. Section 1016(a)(2)(A), which

requires basis to be adjusted for the depreciation "allowed",

creates a problem in this case for the years in which petitioner

has a net operating loss. For those years, the other deductions

modified herein and affecting petitioner's losses are to be

deducted first, and then the amount of the depreciation allowed

is to be determined. Sec. 1.1016-3(e), Income Tax Regs.

Except as regards the McMahon Note, respondent argues that

petitioner failed to substantiate its interest expense.

Petitioner, however, has proven the beginning balances, the

ending balances, and with a reasonable degree of certainty the

interest rates of the TIAA Loan and the San Francisco Loan. For

purposes of the Rule 155 calculation, amortization tables,

showing payments made and the amount of allocable interest, can

be derived from these numbers.

Unlike the TIAA Loan, however, the San Francisco Loan had a

variable interest rate. The interest on this loan is only in

issue from March 4, 1988, through December 31, 1988. The

interest rate was fixed at 9.5 percent until September 1, 1988.

The monthly payments on the loan for the entire period were fixed

at $3,994.06. A San Francisco Federal Savings loan statement of

December 12, 1988, reflects a loan balance as of that date of

$473,573.08. If the parties are unable to compute the interest

on the San Francisco loan for the March 4 to December 31, 1988,
 - 23 -

period, petitioner may move to reopen the record for the sole

purpose of offering additional evidence regarding the San

Francisco Loan interest deduction for this period.

As for the Investor Group Loan, the ending balance as of

October 29, 1985, is not in evidence. But because the deed of

trust for the Investor Group Loan overlaps the deed of trust for

the Owens Loan by only a month, we believe that the Owens Loan

effectively refinanced the Investor Group Loan. We, therefore,

find that the principal balance of the Investor Group Loan

increased from $75,000 to $85,000 between June 10, 1982 and

October 29, 1985.

The interest rate for the Investor Group Loan and for the

Owens Loan is also unknown. Nevertheless, we believe petitioner

accrued some interest on these notes, and that a reasonable rate

of interest for the period in question would be 5-1/2 percent

simple interest per annum. Interest deductions from these notes

will be recalculated on this basis under Rule 155.

The McMahon Note accrued interest in 1989 and 1990. The

McMahon Note requires no payment until December 31, 1997, the day

before the Burke Lease terminates, or until petitioner sells the

Burke Property. Petitioner claims that since it is an accrual

method taxpayer, it is entitled to deduct the interest currently.

Respondent denied petitioner's deduction, asserting that

petitioner's liability was neither fixed nor certain. Respondent
 - 24 -

contends that because the note was nonrecourse and the Burke

Property could be exchanged by petitioner under section 1031

without repaying the note, petitioner's liability on the note was

uncertain. We find respondent's logic less than compelling.

Even assuming that petitioner could have exchanged the Burke

Property without repaying the McMahon Note, an exchange partner

would reduce his valuation of the Burke Property according to the

note's balance. And, consequently, petitioner would receive less

in the exchange. In economic terms, petitioner's burden was

certain.

As for petitioner's other deductions from the loss years,

petitioner has introduced only its unaudited books of original

entry and other accounting records based upon them. While we

believe that petitioner's witnesses testified truthfully and that

petitioner's management was not dishonest, its books are

unreliable. Petitioner cannot substantiate all of its deductions

for the current years in issue, years in which it supposedly kept

its underlying documentation. For example, petitioner's mileage

logs for the Malibu contained miles allocable to the Cougar.

Petitioner included part of the fees paid to Charles for

investigating prospective exchange properties under "professional

services" rather than "fees". Petitioner's books standing alone

fail to prove that petitioner incurred the other deductions from

the loss years.
 - 25 -

The fourth category of deductions that compose petitioner's

net operating losses are its subsidiaries' losses. Petitioner's

deductions for Controlled Casting and Industrial Management are

supported only by petitioner's unaudited books. We have found

them unreliable, and therefore disregard the losses from these

subsidiaries in calculating petitioner's net operating losses.

Petitioner has, however, made a prima facie case with regard

to Sale By Owner's and Far Western's losses. Respondent argues

that these subsidiaries were not businesses and that their

expenses had no business purpose. We disagree.

Petitioner's witnesses testified that Far Western and Sale

By Owner were engaged in business as real estate brokers. This

testimony was corroborated by corporate minutes. Respondent

points to sworn affidavits from the McMahon Litigation that tell

a sordid story of the Byrne family members violating their

fiduciary duty and plundering the corporate coffers, but the

Judge in that case imposed sanctions against the plaintiffs and

stated: "There is no factual basis; there is no legal basis for

your continuing to proceed in this case."

Rather than engaging in corporate plundering, petitioner was

simply unlucky. Sale By Owner was beginning to show a profit

until McMahon filed his shareholder's derivative suit. The suit

consumed much of the time of petitioner's management and diverted

attention from the subsidiaries. And McMahon's son, Hugh,
 - 26 -

stopped his membership with the Desert Area Multiple Listing

Service and Board of Realtors. Because Sale By Owner and Far

Western operated under Hugh's brokerage license, his membership

cancellation effectively prevented the two companies from further

operation.

Petitioner substantiated the expense of Sale By Owner and

Far Western by both books and canceled checks. Respondent

asserts that some of the checks paid unrelated personal expenses

of the principals. There are several hundred checks, and

respondent has failed to direct us to the offending ones.

Petitioner has made a prima facie case on this point, and

respondent has offered no countervailing evidence. Petitioner is

entitled to include the losses from Sale By Owner and Far Western

in the calculation of its net operating losses.

In addition to net operating losses, depreciation, and

interest, respondent denied every other deduction petitioner

claimed for 1989 and 1990 on the grounds of lack of business

purpose and lack of substantiation. Respondent has since

conceded some of these other deductions, but $10,454.15 and

$13,848.06 of them for 1989 and 1990, respectively, remain in

controversy. Of these deductions still in controversy,

respondent has admitted that petitioner substantiated a total of

$5,308.89 and $8,062.02 for 1989 and 1990, respectively.

Petitioner has also established that during those years its
 - 27 -

business included managing the Burke Property, collecting its

liability against IML, and selling Lot 51. Petitioner also spent

considerable time and money attempting to exchange the Burke

Property for other real estate in a section 1031 transaction.

Nevertheless, several of petitioner's claimed deductions deserve

special attention.

Several checks to the S.F. Commercial Club in both 1989 and

1990, a check to the Secretary of State of Colorado for $5 in

1990, and one to the Riverside County Clerk's Office for $67.80

in 1990 are unexplained, and are therefore disallowed.

Petitioner claims that it maintained "key man insurance" on

Byrne. Byrne testified that he had been an officer of the

corporation, off and on, over the years. The corporate minutes

indicate that he was also petitioner's vice president during 1989

and 1990. Petitioner was a 40-percent beneficiary under the

policy. Under these facts, section 264(a) controls

deductibility. It provides:
 - 28 -

(a) General Rule--No deduction shall be allowed for--

(1) Premiums paid on any life insurance policy covering
the life of any officer or employee, or of any person
financially interested in any trade or business carried on
by the taxpayer, when the taxpayer is directly or indirectly
a beneficiary under such policy.

Since Byrne was an officer of petitioner, and since petitioner

was a beneficiary of the policy, petitioner may not deduct the

premium it paid on that policy. Merrimac Hat Corp. v.

Commissioner, 29 B.T.A. 690 (1934); Klinck v. Commissioner, a

Memorandum Opinion of this Court dated Dec. 31, 1952.

Respondent argues that petitioner was not entitled to deduct

automobile expenses due to lack of business purpose and

substantiation. Section 274(d) imposes stringent substantiation

requirements for travel, entertainment, gifts, and "listed

property (as defined in section 280F(d)(4))". Passenger

automobiles are listed property under section 280F(d)(4)(i).

Section 274(d) denies these deductions unless:

the taxpayer substantiates by adequate records or by
sufficient evidence corroborating the taxpayer's own
statement (A) the amount of such expense or other item, (B)
the time and place of the travel, entertainment, amusement,
recreation, or use of the facility or property, or the date
and description of the gift, (C) the business purpose of the
expense or other item, and (D) the business relationship to
the taxpayer of persons entertained, using the facility or
property, or receiving the gift. * * *

Under section 274(d), deductions for automobile expenses or

travel expenses may not be estimated. Instead the taxpayer must
 - 29 -

provide adequate records or corroborate testimony with other

evidence.

Petitioner proved that the business purpose behind Byrne's

use of the Malibu and Cougar automobiles was to find a section

1031 exchange property, and to inspect the Burke Property. Byrne

also recorded in mileage logs the time, place, distance, and

business reason for his drives in the Malibu. The logs

substantiate 10,305 miles in 1989 and 7,523 miles in 1990.

Respondent did not argue that the mileage rates were incorrect.

Petitioner is therefore entitled to deduct 22.5 cents per mile

for 1989 and 26 cents per mile for 1990.

Petitioner sought to deduct the insurance and repair costs

attributable to the Cougar for 1990. Generally, when a taxpayer

deducts the actual cost of operating an automobile, he is

required to allocate that cost between business and personal use,

and to substantiate that allocation. Henry Schwartz Corp. v.

Commissioner, 60 T.C. 728 (1973); sec. 1.274-5T(b)(6)(i),

Temporary Income Tax Regs., 50 Fed. Reg. 46006, 46014 (Nov. 6,

1985). In the past, if the taxpayer provided the Court with a

basis upon which to estimate an allocation, the Court has

estimated it under the Cohan rule. Sapp v. Commissioner, 36 T.C.

852 (1961), affd. 309 F.2d 143 (5th Cir. 1962). Now, however,

section 274(d) prohibits such an estimation. Sec. 1.274-5(a)

Income Tax Regs. Because petitioner has not proven the total
 - 30 -

1990 mileage of the Cougar, we cannot allocate the expenses

between business and personal use. Petitioner's repair

deductions are, therefore, denied.

Section 274(d) also applies to travel expenses. Petitioner

has failed to prove its business purpose for the $48.77 travel

expenses incurred in 1989. Section 274(d) requires

substantiation of the business purpose for each item. Sec.

274(d)(2). Petitioner submitted a receipt from the Madonna Inn

in San Luis Obispo, California, for the night of December 27,

1989, and Byrne's mileage logs indicate that he drove to San Luis

Obispo on that date, but for that particular trip the logs do not

indicate a business purpose.

As for the remainder of petitioner's expenses--fees of

Charles, management fees of Byrne, rents, other insurance,

telephone, subscriptions, other office expenses, other

professional services, and other travel expenses--totaling

$5,978.96 and $9,463.30 for 1989 and 1990, respectively, we find

that petitioner has proven its business purpose. We therefore

allow them to the extent substantiated; i.e., $3,151.91 and

$6,963.05 for 1989 and 1990, respectively. The unsubstantiated

expenses are supported only by petitioner's books. We have

already found them unreliable, and we therefore deny those

deductions.
 - 31 -

Respondent determined accuracy-related penalties for

negligence under section 6662(a) in the amounts of $2,457 and

$2,450 for 1989 and 1990, respectively. These penalties arose

from disallowed deductions. Respondent asserted by amended

pleadings an additional $15,182 to the accuracy-related penalty

for 1990. Respondent based this additional penalty on unreported

income from 1990. While petitioner bears the burden of proof as

to the penalties as determined by respondent in the deficiency

notice, respondent bears the burden of proof under Rule 142(a)

for the additional penalty.

Negligence, for the purpose of section 6662(a), includes any

failure to make a reasonable attempt to comply with the

provisions of the Internal Revenue Code. Sec. 6662(c).

Petitioner destroyed books and records needed to prove its net

operating losses, failed to maintain records necessary to

substantiate its deductions, and mixed up the nondeductible

mileage of one car with the deductible mileage of another.

Petitioner is liable for negligence to the extent that the

deductions that we have denied result in an underpayment for each

of the years in issue.

With respect to the additional penalty for 1990, however,

respondent has failed to prove negligence. Petitioner's

subsidiary, Far Western, an accrual basis taxpayer, performed

services for its client, IML, sometime in the mid-1980s. The
 - 32 -

subsidiary, however, was not paid immediately. Then, in 1990

after petitioner had liquidated the subsidiary, petitioner

received Lot 51 as compensation. Neither the subsidiary nor

petitioner ever included in income the earnings from these

services, but prior to trial petitioner conceded that it received

$112,000 of services income for 1990 upon the receipt of Lot 51.

Nevertheless, petitioner did not concede negligence.

According to the regulations, income accrues "when all events

have occurred which fix the right to receive such income and the

amount thereof can be determined with reasonable accuracy." Sec.

1.451-1(a), Income Tax Regs. It is unclear why petitioner

conceded that the service income accrued during a year in issue

and not when petitioner's subsidiaries performed the work in the

mid-1980s. The record does not disclose the terms of the service

contract or the specific services performed, nor does it disclose

why IML delayed payment. We therefore hold that respondent

failed to prove that petitioner is liable for the negligence

penalty attributable to the receipt of Lot 51.

To reflect the above,

Decision will be entered

under Rule 155.