Harp v. Commissioner

T.C. Memo. 1996-380

UNITED STATES TAX COURT

CHARLES R. HARP AND APRIL B. HARP, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 7456-94. Filed August 19, 1996.

Gary R. DeFrang, Joseph M. Wetzel, and Russell A. Sandor,

for petitioners.

Cheryl B. Harris, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

CHIECHI, Judge: Respondent determined the following defi-

ciencies in, and accuracy-related penalties on, petitioners'

Federal income tax:

Accuracy-Related Penalty
Year Deficiency Section 6662(a)1

1989 $235,120 $47,024
1990 95,898 19,180

1
All section references are to the Internal Revenue Code in
effect for the years at issue. All Rule references are to the
Tax Court Rules of Practice and Procedure.
 - 2 -

The issues remaining for decision are:

(1) Do petitioners have unreported income for each of the

years 1989 and 1990? We hold that they do to the extent stated

herein.

(2) Are petitioners liable for self-employment tax for each

of the years 1989 and 1990? We hold that they are to the extent

stated herein.

(3) Are petitioners liable for the accuracy-related penalty

under section 6662(a) for each of the years 1989 and 1990? We

hold that they are to the extent stated herein.

FINDINGS OF FACT

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

Petitioners resided in Hillsboro, Oregon, at the time the

petition was filed. They filed joint Federal income tax returns

(returns) for the years 1989 and 1990.

Charles Harp Construction

During the years at issue, petitioner Charles R. Harp,2 who

as of the time of the trial herein had a high school education

and had not received any formal training in accounting or book-

keeping matters, operated a sole proprietorship under the name

"Charles Harp Construction" (sole proprietorship) that he had

started in 1984 and that engaged in the residential construction

2
Hereinafter, references to petitioner in the singular are to
petitioner Charles R. Harp.
 - 3 -

business. During those years, Charles Harp Construction, which

petitioner operated from an office located in Hillsboro, Oregon

(Hillsboro), acted as a general contractor. As such, Charles

Harp Construction located and purchased lots as sites for the

construction of houses, worked with lenders to obtain financing

for its purchase and construction activities, hired and

supervised subcontractors with respect to those construction

activities, and arranged for the sales of the houses it con-

structed. During the years at issue, petitioner generally

financed his sole proprietorship activities by obtaining con-

struction loans from Washington Federal Savings Bank (Washington

Federal) at its branch in Portland, Oregon (Portland branch),

where its construction loan department was located.

During 1989, petitioner's license as a general contractor

expired, at which time Charles Harp Construction ceased undertak-

ing any new construction projects. At some unknown time during

1990, Charles Harp Construction completely terminated its opera-

tions except for limited activities that generally consisted of

selling houses constructed prior to that year.

During 1989 and 1990, petitioner maintained the books and

records, including the general ledger, of his sole proprietorship

and issued checks in payment of expenditures that he incurred in

connection with the operations of that business.
 - 4 -

Kabeiseman & Harp, Inc.

On February 6, 1989, petitioner and Robert Kabeiseman (Mr.

Kabeiseman) formed Kabeiseman & Harp, Inc. (K & H) as an Oregon

corporation to engage in the residential construction business.

During the years at issue, K & H operated from an office located

in Hillsboro that it shared with Charles Harp Construction. K &

H elected to be taxed as an S corporation.

During the years at issue, petitioner and Mr. Kabeiseman

each owned 50 percent of the issued and outstanding stock of K &

H and were its only officers and directors. During those years,

petitioner served as the president of K & H and in that capacity,

inter alia, arranged for the financing of its construction

projects and supervised the progress of such projects. Mr.

Kabeiseman served as the treasurer and secretary of K & H during

the years at issue and in those capacities, inter alia, main-

tained its books and records, including its general ledger and

job cards, and prepared its checks to pay for corporate expendi-

tures. Neither petitioner nor Mr. Kabeiseman received a salary

from K & H during 1989 or 1990.

During the years at issue, K & H financed its activities by

obtaining construction loans from the Portland branch of Washing-

ton Federal (K & H construction loans), a financial institution

at which K & H did not maintain a checking account. Those loans
 - 5 -

were personally guaranteed by petitioner3 and by Mr. Kabeiseman

and had maturity dates of six months, nine months, or one year.

During those years, as the construction work on each of K & H's

construction projects progressed and costs were incurred in

connection therewith, petitioner submitted a written draw request

to Washington Federal for a portion of K & H's construction loan

proceeds for each such project (draw request) in order to pay the

costs so incurred. He made such a request either by personally

presenting it to that bank's Portland branch or by presenting it

to that branch by facsimile transmission. Each draw request that

petitioner so presented asked Washington Federal either to

transfer a portion of K & H's construction loan proceeds for each

such project to petitioners' account at that institution or to

issue a check for those proceeds to K & H. Washington Federal

complied with the draw requests that petitioner submitted either

by transferring the loan proceeds sought to petitioners' account

at the branch of that institution located in Hillsboro (Hillsboro

branch) or by issuing a check to K & H for those proceeds.

In July 1989, K & H contracted to build a house for Milagros

Velilla (Ms. Velilla). Ms. Velilla, and not K & H, obtained a

construction loan with respect to that contract (Velilla con-

struction loan) from the Portland branch of Washington Federal

where she maintained a checking account. As he did with other K

3
The record is not clear as to whether petitioner April Harp
(Ms. Harp) also guaranteed those loans.
 - 6 -

& H construction projects, during 1989 and 1990, petitioner

submitted draw requests to Washington Federal for a portion of

those loan proceeds in order to pay the costs incurred by K & H

in constructing Ms. Velilla's house, and Washington Federal

complied with those requests either by transferring the loan

proceeds sought to petitioners' account at its Hillsboro branch

or by issuing a check to K & H for those proceeds.

During 1990, K & H encountered financial difficulties, did

not have sufficient funds to meet its outstanding obligations,

and was unable to obtain funds from its construction loan ac-

counts because various construction projects were stalled. As of

the spring of 1990, petitioner ceased being actively involved in

the operations of K & H and ceased carrying out the responsibili-

ties that he had undertaken in connection with those operations.

K & H completely terminated its business operations sometime

during 1991.

Deposits into and Disbursements
From Petitioners' Accounts
During the Years at Issue

During 1989, petitioners maintained accounts at the Hills-

boro branch of Washington Federal, Far West Federal Bank (Far

West Federal), and Benjamin Franklin Federal Savings and Loan

Association (Benjamin Franklin Federal). During 1990, in addi-

tion to those accounts, petitioners maintained accounts at Bank

of America and West One Bank and three additional accounts at

Benjamin Franklin Federal. During the years at issue, petition-
 - 7 -

ers used one or more of their various bank accounts (accounts),

inter alia, in order to pay their personal expenses, to pay

expenses incurred in connection with the operations of peti-

tioner's sole proprietorship, and to make payments to, or on

behalf of, K & H. During those years, petitioners deposited into

one or more of their accounts funds from various sources, includ-

ing funds obtained by petitioner in connection with the opera-

tions of his sole proprietorship, funds obtained by petitioner

through draw requests for proceeds of construction loans that had

been made to K & H and to Ms. Velilla, respectively, funds

obtained by petitioner from Mr. Kabeiseman, and funds obtained by

petitioners from certain other identified sources and certain

unidentified sources.

Deposits of K & H's Construction Loan
Proceeds, Checking Account Funds, and
Credit Line Funds and Ms. Velilla's
Construction Loan Proceeds and
Checking Account Funds

During 1989, petitioner deposited the following funds into

petitioners’ account at the Hillsboro branch of Washington

Federal: (1) $498,972.70 from the K & H construction loan

accounts at the Portland branch of Washington Federal,

(2) $35,000 from the K & H credit line at Washington Federal, and

(3) $10,351.27 from the K & H checking account. During that

year, petitioner also deposited $27,394 from Ms. Velilla's

construction loan account at the Portland branch of Washington

Federal into petitioners' account at its Hillsboro branch.
 - 8 -

During 1990, petitioner deposited the following funds into

either petitioners’ account at the Hillsboro branch of Washington

Federal or into their account at Benjamin Franklin Federal:

(1) $76,570.46 from the K & H construction loan accounts at the

Portland branch of Washington Federal and (2) $5,000 from the K &

H checking account. During that year, petitioner also deposited

into petitioners' account at the Hillsboro branch of Washington

Federal $27,225 from Ms. Velilla's construction loan account and

$7,528 from her checking account at that bank.4

With respect to petitioner's deposits during 1989 and 1990

of K & H's construction loan proceeds into petitioners' account

at Washington Federal, petitioner began making those deposits in

April 1989. It was only in May or June 1989, after petitioner

had made the first few such deposits, that Mr. Kabeiseman became

aware that petitioner had made those deposits. As soon as he

became aware that petitioner was depositing K & H construction

loan proceeds into petitioners' account at Washington Federal,

Mr. Kabeiseman disapproved of what petitioner had done. Specifi-

4
Hereinafter, (1) funds that petitioner obtained from K & H's
construction loan accounts, checking account, and/or credit line
and that he deposited into petitioners' accounts during one or
both of the years at issue will sometimes be referred to as K &
H's funds; (2) funds that petitioner obtained from Ms. Velilla's
construction loan account and/or checking account and that he
deposited into petitioners' accounts during one or both of the
years at issue will sometimes be referred to as Ms. Velilla's
funds; and (3) K & H's funds and Ms. Velilla's funds will some-
times be referred to collectively as K & H's and Ms. Velilla's
funds.
 - 9 -

cally, Mr. Kabeiseman advised petitioner at that time that

petitioner's deposits of K & H construction loan proceeds into

petitioners' account at Washington Federal was not a good ac-

counting practice, that Mr. Kabeiseman was unable to trace to any

particular construction loan account of K & H the direct payments

that petitioner had made to it during May or June 1989 of certain

of its construction loan proceeds, that petitioner should direct

Washington Federal to issue checks directly to K & H for the K &

H construction loan proceeds sought in the draw requests that pe-

titioner made, and that such checks should be deposited into K &

H's checking account. Petitioner nonetheless continued to de-

posit K & H construction loan proceeds into petitioners' account

at Washington Federal after May or June 1989 and through July

1990. Mr. Kabeiseman did not at any time during the years at

issue (1) authorize petitioner to deposit during those years the

K & H construction loan proceeds into petitioners' accounts or

(2) know the amounts of such proceeds that petitioner so depos-

ited.

During each of the years at issue, petitioner retained

certain of the K & H construction loan proceeds that he deposited

into petitioners' account at Washington Federal during each such

year and did not use all of those construction loan proceeds to

make payments to, or on behalf of, K & H. Mr. Kabeiseman did not

at any time during the years at issue (1) authorize petitioner to

retain any of the K & H construction loan proceeds that he had
 - 10 -

deposited into petitioners' account at Washington Federal or

(2) know the amounts of such deposits that petitioner retained.

With respect to petitioner's deposits during 1989 and 1990

of Ms. Velilla's construction loan proceeds into petitioners'

account at Washington Federal, the contract between Ms. Velilla

and K & H, which was called and is hereinafter referred to as a

contractor agreement, set forth the terms and conditions for K &

H's disbursements of her construction loan proceeds. The con-

tractor agreement did not authorize petitioner (1) to deposit Ms.

Velilla's construction loan proceeds into petitioners' accounts

or (2) to retain any portion of those deposits for petitioners'

own purposes. That agreement specifically provided that dis-

bursements from Ms. Velilla's construction loan account were to

be made "only to pay for costs of labor on and materials for the

Project pursuant to plans and specifications submitted to and

approved by Lender."

During 1989, petitioners made the following disbursements

from their accounts: (1) Payments to K & H in the amount of

$474,467.56 and (2) payments of K & H expenses in the amount of

$6,584.06. During 1989, the aggregate amount of K & H's funds

and Ms. Velilla's funds that petitioner deposited into petition-

ers’ account at Washington Federal exceeded the aggregate amount

that petitioners paid to, or for the benefit of, K & H and Ms.

Velilla by $90,666.35.

During 1990, petitioners made the following disbursements
 - 11 -

from their accounts: (1) Payments to K & H in the amount of

$52,462 and (2) payments of K & H expenses in the amount of

$3,693.40. During 1990, the aggregate amount of K & H's funds

and Ms. Velilla's funds that petitioner deposited into petition-

ers’ accounts at Washington Federal and Benjamin Franklin Federal

exceeded the aggregate amount that petitioners paid to, or for

the benefit of, K & H and Ms. Velilla by $60,168.06.

Miscellaneous Deposits

During 1989, in addition to the deposits of K & H's and Ms.

Velilla's funds that are at issue for that year, certain deposits

that respondent concedes do not constitute unreported income for

that year, and one deposit that petitioners concede constitutes

unreported income for that year,5 petitioners made various depos-

its totaling $83,364 (miscellaneous deposits) that are at issue

for 1989, including a deposit of $6,222.89 on May 30, 1989, into

petitioners' account at Washington Federal. The record does not

disclose and/or explain the nature or sources of those miscella-

neous deposits.

During 1990, in addition to the deposits of K & H's and Ms.

Velilla's funds that are at issue for that year and certain

deposits that respondent concedes do not constitute unreported

income for that year, petitioners made various miscellaneous

5
Petitioners concede on brief that a $2,500 deposit on Apr. 24,
1989, of the proceeds from the sale of plans constitutes unre-
ported income for 1989.
 - 12 -

deposits totaling $41,583.71 that are at issue for 1990, includ-

ing a deposit of $1,630.11 on May 2, 1990, into petitioners'

account at the Hillsboro branch of Washington Federal. The

$1,630.11 so deposited was obtained by petitioners from the sale

of a 1988 Chevrolet pickup truck. The record does not disclose

and/or explain the nature or sources of the remaining miscella-

neous deposits.

Deposits of Funds that Mr. Kabeiseman
Transferred to Petitioner

On January 18, 1989, and on February 7, 1989, Mr. Kabeiseman

transferred to petitioner $25,000 and $4,000, respectively, that

petitioner deposited into petitioners' account at the Hillsboro

branch of Washington Federal and that Mr. Kabeiseman expected

petitioner to repay within approximately one year after the date

on which each such transfer was made. (Hereinafter, we shall

refer to the $29,000 that Mr. Kabeiseman transferred to peti-

tioner in January and February 1989 as the Kabeiseman loans or

the Kabeiseman loan proceeds.)

During 1990, petitioner paid the following amounts totaling

$9,689.80 to Mr. Kabeiseman in repayment of the Kabeiseman loans:

Jan. 1990 $318.45
Feb. 1990 734.45
Mar. 1990 318.45
Apr. 1990 318.45
Apr. 1990 4,000.00
July 1990 4,000.00

As of the time of the trial herein, petitioner had not repaid the

entire balance of the Kabeiseman loans.
 - 13 -

Mr. Kabeiseman did not have any discussions with petitioner

regarding the respective outstanding principal balances of the

Kabeiseman loans on or after January 18, 1990, and on or after

February 7, 1990, the approximate respective dates on which Mr.

Kabeiseman expected repayment of those loans. That was because

Mr. Kabeiseman was preoccupied during 1990 with the financial

problems that K & H was encountering. During 1990, no identifi-

able event occurred that made it clear that petitioner never

would repay the respective outstanding balances of the Kabeiseman

loans.

The Lawsuit Filed Against
Petitioner by Mr. Kabeiseman

During 1990, after petitioner ceased to be actively involved

in the operations of K & H, a dispute arose between petitioner

and Mr. Kabeiseman regarding certain moneys that petitioner

allegedly owed Mr. Kabeiseman as petitioner's share of K & H

expenditures that Mr. Kabeiseman had paid. Sometime thereafter,

Mr. Kabeiseman retained the services of an attorney and insti-

tuted a lawsuit against petitioner regarding that dispute (law-

suit). In the complaint that Mr. Kabeiseman filed against

petitioner, Mr. Kabeiseman requested that a judgment of

$47,353.67 be entered against petitioner. In that complaint, Mr.

Kabeiseman alleged that that amount represented petitioner's

share of the following approximate amounts of K & H expenditures

that Mr. Kabeiseman had paid: (1) $49,905 that Mr. Kabeiseman
 - 14 -

had paid to U.S. National Bank as a repayment for loans that had

been made by that bank to K & H and that had been personally

guaranteed by both petitioner and Mr. Kabeiseman; (2) $41,731

that Mr. Kabeiseman had paid to a contractor for completion of

the construction of certain houses so that the proceeds from the

sale of those houses could be utilized to repay loans that had

been made to K & H by Washington Federal and that had been

personally guaranteed by both petitioner and Mr. Kabeiseman; and

(3) $3,270 which Mr. Kabeiseman had paid to a K & H creditor

named A-Boy Stores and for which petitioner had agreed to reim-

burse Mr. Kabeiseman.

On January 2, 1992, Mr. Kabeiseman and petitioner entered

into a settlement agreement (settlement agreement) with respect

to the lawsuit under which petitioner paid Mr. Kabeiseman

$37,500. In that settlement agreement, in consideration for the

payment of $37,500 by petitioner to Mr. Kabeiseman, Mr.

Kabeiseman agreed to "release, acquit, and forever discharge

CHARLES R. HARP of * * * any and all claims that were or could

have been brought" by Mr. Kabeiseman in that lawsuit. Mr.

Kabeiseman considered that settlement agreement to end all

disputes between him and petitioner.

Petitioners' 1989 and 1990 Returns

Petitioners filed returns for 1989 and 1990 that were signed

by them and by Francis J. Bernard (Mr. Bernard) as return pre-

parer.
 - 15 -

In their 1989 return, petitioners reported total income of

$24,034 consisting of the following:

Wages and salaries $4,8166
Interest 365
Business income 17,203
Capital gain 71
Ordinary gain 1,579

In Schedule C of their 1989 return, petitioners reported

$465,400 of gross receipts, $448,197 of expenses, and $17,203 of

profit from the operations of petitioner's sole proprietorship

Charles Harp Construction that they described therein as a

general contracting business. Petitioners did not report in

Schedule C, or elsewhere, in their return for that year income

from any business other than Charles Harp Construction.

In their 1990 return, petitioners reported total income of

$42,326 consisting of the following:

Wages and salaries $34,7547
Interest 711
Business income 6,861

In Schedule C of their 1990 return, petitioners reported

$195,300 of gross receipts, $188,439 of expenses, and $6,861 of

profit from the operations of petitioner's sole proprietorship

Charles Harp Construction that they described therein as a

6
The amount of wages and salaries reported in petitioners' 1989
return is equal to the total of the amounts of wages and salaries
reflected in Forms W-2 issued to Ms. Harp for 1989.
7
The amount of wages and salaries reported in petitioners' 1990
return is equal to the total of the amounts of wages and salaries
reflected in Forms W-2 issued to petitioner and Ms. Harp, respec-
tively, for 1990.
 - 16 -

general contracting business. Petitioners did not report in

Schedule C, or elsewhere, in their return for that year income

from any business other than Charles Harp Construction.

Petitioners did not include as income in their returns for

1989 and 1990 any portion of K & H's and Ms. Velilla's funds that

petitioner deposited into petitioners' accounts during those

years. Nor did they include in their returns for those years any

income in connection with the Kabeiseman loans.

The Examination of Petitioners' 1989 and
1990 Returns and the Notice of Deficiency

In June 1993, respondent assigned a revenue agent to examine

petitioners' returns for 1989 and 1990. During the course of

that examination, the revenue agent did not have sufficient books

or records relating to petitioner's sole proprietorship or

petitioners' other financial activities during the years at issue

in order to determine whether petitioners had reported in those

returns all of their income for those years, nor did petitioners

attempt during the course of that examination to re-create any of

the books or records relating to their financial activities dur-

ing the years at issue that they claim were accidentally dis-

carded during 1991. Consequently, in order to reconstruct peti-

tioners' income for the years at issue, the revenue agent used

the bank deposits method under which that agent examined the

deposits that were made during those years into petitioners'

accounts at various financial institutions. Based on certain
 - 17 -

limited information that the revenue agent was able to obtain

with respect to certain of those deposits, that agent excluded

from the calculation of petitioners' unreported income for those

years those deposits that that agent concluded were not taxable

(e.g., credit card advances) or that that agent concluded had

been reported by petitioners in Schedules C of their 1989 and

1990 returns.8

In the notice of deficiency (notice), respondent determined

that deposits into petitioners' accounts during the years 1989

and 1990 in the amounts of $817,214 and $319,904, respectively,

constitute unreported income. The notice further stated in

pertinent part:

It is determined that the taxpayer received gross
income from real estate sales of a general contracting
business for the tax years 1989 and 1990 which was not
reported on the returns. The gross income amounts have
been reconstructed according to the information avail-
able, including information from the Washington County

8
By way of illustration, in reconstructing petitioners' income
for the years at issue on the basis of the bank deposits method,
the revenue agent excluded from the calculation of petitioners'
unreported income for those years the following deposits into
petitioners' account at Washington Federal that that agent con-
cluded were deposits of amounts that were paid to petitioner in
connection with the sales of certain real properties that had
been reported in Schedules C of petitioners' 1989 and 1990 re-
turns:
Date of Amount of
Deposit Deposit

Jan. 17, 1989 $6,970.84
Feb. 22, 1989 15,608.58
May 3, 1989 14,747.67
June 1, 1989 10,794.10
Apr. 3, 1990 46,056.93
 - 18 -

records and information concerning deposits to the bank
accounts controlled by the taxpayer. The taxpayer
received gross income in the amounts of $ 1,282,614.00
and $ 515,204.00 rather than gross income from con-
tracting of $ 465,400.00 and $ 195,300.00 as reported
on the returns for the tax years 1989 and 1990 respec-
tively. It is further determined that the gross income
is self-employment income and thus subject to the self-
employment tax for the tax years 1989 and 1990.

OPINION

Before the trial herein had commenced but after the Court

had received and reviewed the document entitled "Stipulation of

Facts" and the exhibits attached thereto that the parties had

filed with the Court, the Court expressed its concern to the

parties about whether the record was clear as to (1) the conces-

sions, if any, made by the parties after the notice was issued

and (2) the amounts of the deposits that remained in dispute as

of the commencement of trial. The Court directed the parties to

supplement their stipulation of facts in order to clarify those

matters, and the parties filed a document entitled "Supplemental

Stipulation of Facts". (We shall refer to both the stipulation

of facts and the supplemental stipulation of facts as stipula-

tions.)

Upon review of the entire record in this case, we have found

certain errors in the stipulations and the briefs as to the

amounts of deposits into petitioners' accounts during 1989 and

1990 that remain in dispute. Consequently, we are not bound by

those errors in the stipulations, see Cal-Maine Foods, Inc. v.

Commissioner, 93 T.C. 181, 195 (1989), and in the briefs.
 - 19 -

Taking account of the parties' concessions and the errors

that we found in certain stipulations and in the briefs, on the

record before us, we find that the amounts of petitioners' un-

reported income for 1989 and 1990 that remain in dispute are

$174,030.35 and $121,061.97, respectively, calculated as follows:
1989 1990

Deposits treated as unreported
income in the notice . . . . . . . $817,214.29 $319,904.41

Less concessions by respondent . . 640,684.049 218,152.6410

Less concession by petitioners . . 2,500.0011 --

Deposits in the notice that remain
in dispute after taking account of
concessions by the parties . . . . 174,030.35 101,751.77

Amount of the Kabeiseman loan
proceeds deposited during 1989
and not repaid as of Dec. 31, 1990,
that respondent contends is income
from the discharge of indebtedness -- 19,310.20

Amounts of unreported income
remaining in dispute . . . . . . . 174,030.35 121,061.97

9
Respondent's concessions for 1989 consist of the following
deposits into petitioners' accounts during that year: (1) De-
posits of $481,051.62 disbursed from petitioners' accounts as
payments to, or on behalf of, K & H, (2) deposits of $29,000 of
the Kabeiseman loan proceeds, (3) a deposit of $17,000 of the
proceeds of the sale of a promissory note to Mr. Kabeiseman, and
(4) other deposits of various items totaling $113,632.42.
10
Respondent's concessions for 1990 consist of the following
deposits into petitioners' accounts during that year: (1) De-
posits of $56,155.40 disbursed from petitioners' accounts as
payments to, or on behalf of, K & H, (2) a deposit of $22,500 of
the proceeds of the sale of property known as "Dairy Creek", in
which petitioners had a basis of $22,649.60, and (3) other
deposits of various items totaling $139,497.24.
11
See supra note 5.
 - 20 -

On the record before us, we further find that the foregoing

amounts of unreported income remaining in dispute for 1989 and

1990 consist of the following items and amounts:12

1989 1990

Amounts of deposits in the notice
that remain in dispute

(1) Deposits of (a) K & H's
construction loan proceeds,
checking account funds, and
credit line funds and (b) Ms.
Velilla's construction loan
proceeds and checking account
funds . . . . . . . . . . . . $90,666.35 $60,168.06
(2) Miscellaneous deposits . . . . 83,364.00 41,583.71

Amount of the Kabeiseman loan
proceeds deposited during 1989 and
not repaid as of Dec. 31, 1990, that
respondent contends is income from
the discharge of indebtedness . . . . -- 19,310.20

Amounts of unreported income
remaining in dispute . . . . . . . . 174,030.35 121,061.97

Preliminary Matters

Respondent used the bank deposits method to reconstruct

petitioners' income for the years at issue. "A bank deposit is

prima facie evidence of income and respondent need not prove a

likely source of that income." Tokarski v. Commissioner, 87 T.C.

12
A review of the parties' briefs leads us to conclude that,
despite certain errors that we found in the stipulations and
briefs, the parties nonetheless agree that the two broad catego-
ries of deposits that remain in dispute are the two identified
below by the Court and that there also is a dispute regarding
whether the $19,310.20 of Kabeiseman loan proceeds that was not
repaid as of the end of 1990 constitutes income to petitioners
for that year.
 - 21 -

74, 77 (1986). Petitioners bear the burden of proving that

respondent’s determinations of income based on the bank deposits

method are erroneous. Clayton v. Commissioner, 102 T.C. 632, 645

(1994); DiLeo v. Commissioner, 96 T.C. 858, 869 (1991), affd. 959

F.2d 16 (2d Cir. 1992). Petitioners may satisfy that burden by

establishing that the deposits at issue are not taxable or

constitute income that they previously reported. See Calhoun v.

United States, 591 F.2d 1243, 1245 (9th Cir. 1978); Marcello v.

Commissioner, 380 F.2d 509, 511 (5th Cir. 1967), affg. T.C. Memo.

1964-303; Nicholas v. Commissioner, 70 T.C. 1057, 1064 (1978).

Respondent does not have to show that the deposits at issue

are taxable.13 Respondent nonetheless, through argument at trial

and on brief, offers a reason as to why the deposits of K & H's

and Ms. Velilla's funds that remain in dispute constitute income,

viz., they were deposits of funds misappropriated by petitioner.

Respondent also offers a reason, through argument at the conclu-

sion of trial14 and on brief, as to why the balance of the

Kabeiseman loan proceeds that was not repaid as of the end of

1990 (i.e., $19,310.20) constitutes income to petitioners for

that year; viz., that balance was forgiven or discharged by Mr.

13
Respondent must, however, take into account any nontaxable
source of a deposit of which respondent has knowledge. Clayton
v. Commissioner, 102 T.C. 632, 645-646 (1994).
14
Respondent conceded at the conclusion of the trial that the
funds totaling $29,000 that Mr. Kabeiseman transferred to peti-
tioner and that petitioner deposited into one of petitioners'
accounts during 1989 were loans.
 - 22 -

Kabeiseman during 1990.

Petitioners assert on brief (1) that respondent's arguments

at trial and on brief that petitioners have unreported income for

1989 and 1990 resulting from the deposits of funds misappropri-

ated from K & H and Ms. Velilla and for 1990 resulting from the

discharge of the outstanding balances of the Kabeiseman loans

raise matters that are not properly before the Court and

(2) that, assuming arguendo that such matters were properly

before the Court, respondent has the burden of proof as to such

matters. To support their assertions, petitioners point out that

respondent stated in the notice that certain deposits into

petitioners' accounts during the years at issue constitute

unreported income for those years from "real estate sales of a

general contracting business" or "from contracting", and not from

misappropriated funds or the discharge of indebtedness. Respon-

dent disagrees, pointing out, inter alia, that respondent's

arguments about which petitioners complain are properly before

the Court because petitioners were in no way prejudiced or

unfairly surprised by them.

With respect to the parties' disagreement over whether

respondent is raising certain matters not properly before this

Court, we note initially that, regardless how we resolve that

disagreement, petitioners nonetheless bear the burden of proving

that all the deposits at issue are not taxable or that they

represent income that they previously reported. See Calhoun v.
 - 23 -

United States, supra at 1245; Marcello v. Commissioner, supra at

511; Tokarski v. Commissioner, supra at 77.

Turning now to the parties' dispute as to whether respondent

is raising certain matters that are not properly before us, it is

significant that petitioners do not dispute, and we find on the

instant record, that they were not surprised or prejudiced by

respondent's arguments at trial and on brief that petitioners

have unreported income for 1989 and 1990 resulting from the

deposits of misappropriated funds and for 1990 resulting from the

discharge of the outstanding balances of the Kabeiseman loans.

See Leahy v. Commissioner, 87 T.C. 56, 65 (1986); Estate of

Horvath v. Commissioner, 59 T.C. 551, 555 (1973). We further

find on that record that those matters were before the Court

within the meaning of Rule 41(b)(1). The record before us

contains stipulations, joint exhibits, and testimony relevant to

those matters, and there is no indication that petitioners had

any additional evidence that they did not present at trial with

respect thereto. See Leahy v. Commissioner, supra at 64; Fox

Chevrolet, Inc. v. Commissioner, 76 T.C. 708, 735-736 (1981).

Moreover, with respect to respondent's argument that petitioners

have unreported income for 1989 and 1990 resulting from the

deposits of misappropriated funds, petitioners' counsel addressed

that argument in his opening statement at trial and elicited

relevant testimony with respect to it from both petitioner and

Mr. Kabeiseman. Furthermore, with respect to respondent's
 - 24 -

argument that petitioners have unreported income for 1990 result-

ing from the discharge of the outstanding balances of the

Kabeiseman loans, certain documents in the record indicate that

questions regarding that matter were raised prior to trial by

respondent, after petitioners had informed respondent that

certain deposits totaling $29,000 during 1989 consisted of two

loans that Mr. Kabeiseman had made to petitioner. On the record

before us, we find that respondent's arguments that petitioners

have unreported income for 1989 and 1990 resulting from the

deposits of misappropriated funds and for 1990 resulting from the

discharge of the outstanding balances of the Kabeiseman loans are

properly before us.

With respect to the parties' disagreement over whether

respondent bears the burden of proof on the two matters in

question, we shall deal with each of those matters separately

because we view them differently. Although a taxpayer generally

has the burden of proving that respondent's determinations in the

notice of deficiency are erroneous, respondent bears the burden

of proving any new matter that was not raised in that notice.

See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933);

Foster v. Commissioner, 80 T.C. 34, 197 (1983), affd. in part and

vacated in part by 756 F.2d 1430 (9th Cir. 1985). The assertion

of a new theory that merely clarifies or develops the original

determination without (1) being inconsistent with that determina-

tion, (2) increasing the amount of the deficiency, or (3) requir-
 - 25 -

ing the presentation of different evidence is not a new matter

requiring the shifting of the burden of proof to respondent. See

Seagate Tech., Inc. & Consol. Subs., v. Commissioner, 102 T.C.

149, 169 (1994); Foster v. Commissioner, supra at 197.

On the instant record, we reject petitioners' contention

that respondent raised a matter as to which respondent has the

burden of proof in arguing that petitioners have unreported

income for 1989 and 1990 resulting from the deposits of

misappropriated funds.15 During the course of respondent's

examination of petitioners' returns for 1989 and 1990, respondent

did not have adequate books or records to determine whether

15
Petitioners rely on dicta in Big "D" Development Corp. v.
Commissioner, T.C. Memo. 1971-148, affd. 453 F.2d 1365 (5th Cir.
1972), to support that contention. That case held that, under
the facts presented, respondent had not raised a matter as to
which respondent had the burden of proof because "respondent
merely narrowed an issue after taking a broad position in the
statutory notice." The Court further stated in dicta in that
case on which petitioners rely that "It would be otherwise where
respondent's determination in a statutory notice is narrowly
drawn and, after the matter has been petitioned to this Court,
respondent advances new grounds not directly or implicitly within
the ambit of the determination made in the notice." Id. That
language does not in any way indicate that in cases, such as the
instant case, where respondent (1) reconstructs a taxpayer's
income by using the bank deposits method, (2) determines in the
notice of deficiency, based on the application of that method,
that certain deposits constitute income, and (3) sets forth her
assumption therein as to the source of that income, respondent
necessarily is advancing "new grounds not directly or implicitly
within the ambit of the determination made in the notice", id.,
when she thereafter argues that a portion of those deposits is
income from a source different from that assumed in the notice of
deficiency.
 - 26 -

petitioners had reported all of their income for those years.16

Consequently, respondent had to reconstruct petitioners' income

for those years. Under such circumstances, petitioners generally

will be "held accountable for any imprecision in the language

employed in the notice of deficiency and for any procedural or

evidentiary consequences flowing therefrom." Beck v. Commis-

sioner, 74 T.C. 1534, 1549 (1980).

In the present case, respondent's determination in the

notice was that, under the bank deposits method, petitioners have

unreported income for the years at issue. In such a case, it is

well established that (1) the deposits into petitioners' accounts

during the years at issue are prima facie evidence of income;

(2) respondent is not required to prove a likely source for that

income; and (3) petitioners are required to establish that the

deposits at issue are not taxable or that they represent income

that they previously reported. See Calhoun v. Commissioner, 591

F.2d at 1245; Marcello v. Commissioner, 380 F.2d at 511; Clayton

v. Commissioner, 102 T.C. at 645; Tokarski v. Commissioner, 87

16
Around the time the petition was filed in May 1994, several
months after respondent mailed the notice to petitioners, peti-
tioners prepared certain schedules that purport to identify
(1) the sources of certain deposits made into petitioners’
accounts during each of the years at issue (petitioners' sched-
ules of deposits) and (2) certain expenses paid from those
accounts during each such year (petitioners' schedules of ex-
penses). Petitioners claim that petitioners' accountant, Mr.
Bernard, worked with them in preparing those schedules. The
nature and the extent of any such work by Mr. Bernard, whom
petitioners did not call as a witness, are not disclosed by the
record.
 - 27 -

T.C. at 77. Neither respondent's statement in the notice as to

the assumed source for the deposits that she determined to be

income on the basis of the bank deposits method nor respondent's

argument at trial and on brief that petitioners have unreported

income for 1989 and 1990 resulting from the deposits of misappro-

priated funds alters those principles.

Respondent's statement in the notice of her assumption as to

the source (i.e., "real estate sales of a general contracting

business" or "from contracting") for the deposits that she

determined constitute unreported income was not part of, and was

not essential to, respondent's theory in the notice that, under

the bank deposits method, all money deposited into petitioners'

accounts during 1989 and 1990 constitutes income (except money so

deposited that respondent knows (1) is not taxable or (2) is

income that petitioners previously reported in their returns for

those years). Clayton v. Commissioner, supra at 645-646; DiLeo

v. Commissioner, 96 T.C. at 868. Respondent's argument at trial

and on brief that petitioners have unreported income for 1989 and

1990 resulting from the deposits of misappropriated funds is not

inconsistent with, and merely serves to develop, that theory.

We view differently petitioners' contention that respondent

raised a matter as to which respondent bears the burden of proof

in arguing at trial and on brief that petitioners have unreported

income for 1990 from the discharge of the outstanding balances of

the Kabeiseman loans. For the reasons stated above, petitioners
 - 28 -

bear the burden of proving that the deposits into their accounts

during 1989 and 1990 do not constitute unreported income. Re-

spondent conceded at the conclusion of the trial herein that

petitioners had satisfied that burden with respect to the depos-

its of the Kabeiseman loans during 1989. Respondent, however,

advanced as an alternative argument in her opening statement and

as the sole argument at the conclusion of the trial herein and on

brief a new theory as to why petitioners have $19,310.20 of

unreported income for 1990, viz., unreported income resulting

from the discharge or forgiveness by Mr. Kabeiseman during that

year of the outstanding balances of the Kabeiseman loans (viz.,

$19,310.20). That new theory does not merely serve to develop

respondent's theory in the notice that, under the bank deposits

method, all money deposited into petitioners' accounts during

1990 constitutes unreported income for that year (except money so

deposited that respondent knows (1) is not taxable or (2) is

income that petitioners previously reported in their return for

that year). Accordingly, on the record before us, we sustain

petitioners' contention that respondent has raised a matter as to

which she bears the burden of proof in arguing that petitioners

have unreported income for 1990 resulting from the discharge of

the outstanding balances of the Kabeiseman loans.17

17
We note that on the record before us our findings and conclu-
sions with respect to respondent's argument that petitioners have
unreported income for 1990 resulting from the discharge of the
(continued...)
 - 29 -

Deposits of K & H's Construction Loan
Proceeds, Checking Account Funds, and
Credit Line Funds and Ms. Velilla's
Construction Loan Proceeds and
Checking Account Funds

The parties agree that (1) during 1989, petitioner deposited

into one of petitioners' accounts K & H's funds totaling

$544,323.97; (2) during 1989, petitioner deposited into one of

petitioners' accounts Ms. Velilla's construction loan proceeds

totaling $27,394; (3) during 1990, petitioner deposited into two

of petitioners' accounts K & H's funds totaling $81,570.46;

(4) during 1990, petitioner deposited into one of petitioners'

accounts Ms. Velilla's funds totaling $34,753; (5) petitioners'

1989 and 1990 returns did not include any portion of the forego-

ing deposits as income; (6) during 1989 and 1990, petitioners

made certain payments from their accounts to, or on behalf of, K

& H; and (7) to the extent that during 1989 and 1990 petitioners

made payments to, or on behalf of, K & H or Ms. Velilla, the

aggregate amount of such payments during each such year should

reduce the aggregate amount of the foregoing deposits during each

such year. The only disagreements between the parties with

respect to the deposits during 1989 and 1990 of K & H's funds and

Ms. Velilla's funds are (1) whether the aggregate amount of those

deposits during each such year exceeded the aggregate amount of

17
(...continued)
outstanding balances of the Kabeiseman loans would remain the
same regardless who bears the burden of proof with respect to
that argument.
 - 30 -

the payments made to, or on behalf of, K & H and Ms. Velilla

during each such year; and (2) whether any such deposits not

disbursed as payments to, or on behalf of, K & H and Ms. Velilla

(deposits that were not returned) are taxable and thus includible

in petitioners' income for each such year.18

With respect to the first dispute between the parties as to

whether the aggregate amount of the deposits into petitioners'

accounts during 1989 and 1990 of K & H's funds and Ms. Velilla's

funds exceeded the aggregate amount of the payments made to, or

on behalf of, K & H and Ms. Velilla during each of those years,

18
Respondent contends on brief (1) that the stipulated payments
to, or on behalf of, K & H do not include any payments to, or on
behalf of, Ms. Velilla and (2) that the deposits that were not
returned consist of (a) all of Ms. Velilla's funds and (b) an
unidentified portion of the aggregate amount of the deposits of K
& H's funds. Petitioners disagree and make no such distinctions
on brief with respect to K & H's funds and Ms. Velilla's funds.
As we understand petitioners' position, they maintain that any
payments made during the years at issue from Ms. Velilla's funds
that petitioner deposited into one of petitioners' accounts would
have been included as part of the payments that they made during
those years to, or on behalf of, K & H. We therefore construe
and treat petitioners' assertions on brief with respect to any
payments that they claim they made during the years at issue to,
or on behalf of, K & H as assertions that such payments were
payments to, or on behalf of, not only K & H, but also Ms.
Velilla. Since K & H contracted to build a house for Ms. Velilla
and was responsible for the costs incurred in connection with the
construction of that house, the payments that petitioners made
during the years at issue to, or on behalf of, K & H could have
included, as petitioners suggest, payments of some or all of Ms.
Velilla's funds that were deposited into one of petitioners'
accounts during those years. However, the record before us does
not enable us to identify (1) the nature of the payments made to,
or on behalf of, K & H, (2) the source of the deposits that were
used to make those payments, or (3) the source of the deposits
that were not returned.
 - 31 -

the parties stipulated as follows:

24. Petitioners made the following paryments [sic] in
1989:

$474,467.56 Payments to Corporation
6,584.06 Payments of Corporate Expenses

* * * * * * *

27. Petitioners made the following payments in 1990:

$52,462.00 Payments to Corporation
3,693.40 Payments of Corporate Expenses

Under the foregoing unqualified stipulations, the parties have

agreed that during 1989 and 1990 petitioners made payments to, or

on behalf of, K & H in the amounts of $481,051.62 and $56,155.40,

respectively.

On brief, petitioners appear to maintain that the foregoing

stipulations set forth the minimum payments that they made and

that they made additional payments during those years to, or on

behalf of, K & H and Ms. Velilla that increased the aggregate

amounts of such payments for 1989 and 1990 to $529,023.92 and

$89,643.25, respectively.19 To support their contention, they

rely on (1) petitioners’ schedules of expenses and (2) Ms. Harp's

testimony. Respondent disputes petitioners' contention.

19
Contrary to petitioners' position on brief, petitioner testi-
fied that the aggregate amount of the deposits into petitioners'
accounts during each of the years at issue of K & H's funds and
Ms. Velilla's funds were used to make payments to, or on behalf
of, K & H and Ms. Velilla. We question the reliability of that
testimony. Petitioner's testimony on that point also is incon-
sistent with petitioners' schedules of expenses that purport to
show that only a portion of those deposits were used to make
payments to, or on behalf of, K & H and Ms. Velilla.
 - 32 -

We are unwilling to accept either petitioners' schedules of

expenses or Ms. Harp's testimony as reliable evidence to support

petitioners' contention. Petitioners' schedules of expenses,

like Ms. Harp's testimony about those schedules, are nothing more

than self-serving statements that the additional disbursements

from petitioners' accounts during the years at issue that are

reflected in those schedules were made to, or on behalf of, K & H

and Ms. Velilla. Neither petitioners' schedules of expenses nor

Ms. Harp's testimony, which we found to be general, vague,

conclusory, and at times internally inconsistent, persuade us

that those additional disbursements were, in fact, made to, or on

behalf of, K & H and Ms. Velilla, rather than in payment of

petitioners' expenses.20 In this connection, Ms. Harp testified

that petitioners' schedules of expenses were prepared in reliance

on copies that petitioners were able to obtain of certain

supplier bills and canceled checks, which, she claims, indicated

thereon the purposes for which certain disbursements from

20
We note that, with respect to $9,689.80 of the additional
disbursements that petitioners claim they made during 1990 to, or
on behalf of, K & H and Ms. Velilla, they also claim that they
paid that same amount during that same year to Mr. Kabeiseman in
partial repayment of the $29,000 in Kabeiseman loans that peti-
tioner received in 1989. The record establishes that the pay-
ments totaling $9,689.80 that petitioners made during 1990 were
made to Mr. Kabeiseman in partial repayment of the Kabeiseman
loans. Thus, not only are petitioners wrong in contending that
those payments were made to, or on behalf of, K & H and Ms.
Velilla, they are counting those payments twice, once in advanc-
ing their argument with respect to the Kabeiseman loans and once
in advancing their argument with respect to the deposits of K &
H's and Ms. Velilla's funds.
 - 33 -

petitioners' accounts were made during the years at issue.21

However, petitioners did not attempt to introduce those documents

into evidence. Nor did they proffer as a witness their accoun-

tant, Mr. Bernard, who purportedly assisted petitioners with the

preparation of those schedules.

On the record before us, we find that during 1989 and 1990

petitioners made payments to, or on behalf of, K & H in the

amounts of $481,051.62 and $56,155.40, respectively. We further

find on that record that the aggregate amount of deposits into

petitioners' accounts during 1989 and 1990 of K & H's and Ms.

Velilla's funds exceeded the payments that petitioners made to,

or on behalf of, K & H and Ms. Velilla during each of those years

by $90,666.35 and $60,168.06, respectively.

With respect to the second dispute between the parties as to

whether the deposits that were not returned are includible in

21
Petitioners claim that certain other records and books, which
related to petitioner's sole proprietorship and petitioners'
other financial activities during the years at issue and which
would have assisted them in preparing petitioners' schedules of
expenses and petitioners' schedules of deposits, were acciden-
tally discarded during 1991 and that they had difficulty in
obtaining certain bank records from Washington Federal that would
have assisted them in preparing those schedules. Assuming
arguendo that petitioners' books and records were, in fact,
accidentally discarded and that they had difficulty in obtaining
certain records from Washington Federal, petitioners would still
have to satisfy their burden of proof. See Malinowski v. Commis-
sioner, 71 T.C. 1120, 1125 (1979). Under such circumstances,
petitioners would be able to meet that burden by presenting
reliable secondary evidence. Id. As stated above, we did not
find petitioners' schedules of expenses or Ms. Harp's testimony
regarding those schedules to be reliable.
 - 34 -

petitioners' income for each of the years at issue, as we stated

above, the deposits at issue are prima facie evidence of income,

and petitioners bear the burden of proving that those deposits

are not taxable.22 See Calhoun v. United States, 591 F.2d at

1245; Marcello v. Commissioner, 380 F.2d at 511; Tokarski v.

Commissioner, 87 T.C. at 77. As we understand petitioners'

position, they contend that no portion of the deposits into

petitioners' accounts of (1) K & H's construction loan proceeds,

checking account funds, and credit line funds and (2) Ms.

Velilla's construction loan proceeds and checking account funds

is includible in their income for each of the years 1989 and 1990

because petitioners held those deposits "for corporate purposes

and subject to an obligation which Mr. Harp recognized to return

the funds to the corporation." Respondent disagrees with those

contentions, arguing that those deposits represent funds misap-

propriated by petitioner and that, to the extent that during each

of the years at issue petitioners did not use those deposits

during each such year to make payments to, or on behalf of, K & H

and Ms. Velilla, they are taxable to petitioners under the

principles of James v. United States, 366 U.S. 213 (1961).

Regardless whether petitioner's actions during the years at

issue regarding K & H's and Ms. Velilla's funds are characterized

22
As noted above, the parties agree that petitioners' returns
for 1989 and 1990 did not include as income any of the deposits
during each of those years of K & H's and Ms. Velilla's funds.
 - 35 -

as a misappropriation, those deposits may nonetheless constitute

income to petitioners. Section 61(a) defines gross income to

include income from whatever source derived, including all

accessions to wealth over which a taxpayer has complete dominion.

Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). A

taxpayer must include in gross income funds obtained "lawfully or

unlawfully, without the consensual recognition, express or

implied, of an obligation to repay and without restriction as to

their disposition". James v. United States, supra at 219. Funds

so obtained are includible in the taxpayer's income even though

the taxpayer may still be required to return such funds.23 Id.

On the record before us, we reject petitioners' contention

that they held for corporate (i.e., K & H's) purposes the depos-

its of K & H's and Ms. Velilla's funds. To support their

contention with respect to the deposits at issue of K & H's

funds, petitioners rely on petitioner's testimony and the stipu-

lations that petitioners made certain payments to, or on behalf

of, K & H during each of the years at issue.24 We question the

23
A taxpayer's income is reduced for any year by the amount of
funds that were obtained by the taxpayer and included in the
taxpayer's income under the principles of James v. United States,
366 U.S. 213 (1961), and that the taxpayer repays in such year.
24
Although petitioners suggest on brief that certain financial
transactions may have taken place during 1991 between petitioner
and K & H that impact resolution of the issue whether petitioners
have unreported income for each of the years 1989 and 1990
resulting from the deposits that were not returned during each of
those years, neither petitioner nor Mr. Kabeiseman testified
(continued...)
 - 36 -

reliability of petitioner's testimony. It was not only self-

serving, but it also was at times inconsistent with other evi-

dence in the record. As for the stipulations about petitioners'

payments to, or on behalf of, K & H, we do not believe those

stipulations necessarily support, let alone conclusively prove,

petitioners' contention that during the years at issue they were

holding K & H's funds for K & H's purposes.25 Indeed, the record

(1) shows that petitioner was not even authorized to deposit K &

H's construction loan proceeds into petitioners’ accounts during

those years and (2) is silent as to (a) whether petitioner was

authorized to deposit K & H's checking account and credit line

funds into petitioners' accounts;26 (b) whether or how such funds

were disbursed during each of the years at issue; and (c) whether

petitioners were authorized to retain any portion of such funds

24
(...continued)
about the nature of any such transactions.
25
Under petitioners' contention, funds otherwise includible in
a taxpayer's income under the principles of James v. United
States, supra, would never be so included as long as such funds
are ultimately repaid. That is because, according to petition-
ers, repayment shows that the taxpayer was holding the funds for
the purposes of the person from whom they were obtained.
26
We find it hard to believe that petitioner would have been
authorized to deposit into petitioners' accounts funds from K &
H's checking account and credit line or to retain any portion of
those funds for petitioners' own use when he was not authorized
to deposit K & H's construction loan proceeds into their accounts
or to retain any portion of those deposits for their own use.
 - 37 -

during each of those years.27

With respect to the deposits at issue of K & H's construc-

tion loan proceeds, the record establishes that Mr. Kabeiseman

did not at any time during the years at issue (1) authorize peti-

tioner to deposit such proceeds into petitioners' accounts,

(2) know the amounts of such proceeds that petitioner so depos-

ited, (3) authorize petitioner's practice of retaining a portion

of such proceeds during each of those years and not using such

portion to make payments to, or on behalf of, K & H, or (4) know

the amounts of such proceeds that petitioner retained.

We find petitioners' apparent reliance on the following

testimony of Mr. Kabeiseman, in order to establish that the

deposits at issue of the K & H construction loan proceeds were

authorized, to be misplaced:

Q Mr. Kabeiseman, you were aware of the * * *
deposit of the loan draws to Mr. Harp's personal ac-
count?

A From Kabeiseman & Harp construction loans,
yes, uh-huh.

We are unable to find that the foregoing testimony establishes

that Mr. Kabeiseman authorized petitioner to deposit K & H's

construction loan proceeds into petitioners' accounts during the

27
Although Mr. Kabeiseman was generally responsible for prepar-
ing K & H's checks to pay for corporate expenditures, the record
does not show whether petitioner obtained the funds from the K &
H checking account that he deposited into petitioners' accounts
through actual checks drawn on that account or, if so, whether
Mr. Kabeiseman prepared, or was otherwise aware of, any such K &
H checks that were issued to petitioner.
 - 38 -

years at issue or to retain a portion of such proceeds during

each of those years. The record establishes, and we have found

as facts, that it was only in May or June 1989, after petitioner

had made the first few deposits of those loan proceeds, that Mr.

Kabeiseman became aware that petitioner had made those deposits.

As soon as he became aware that petitioner was depositing K & H's

construction loan proceeds into petitioners' account at Washing-

ton Federal, Mr. Kabeiseman disapproved of what petitioner had

done. Specifically, Mr. Kabeiseman advised petitioner at that

time that petitioner's deposits of K & H's construction loan

proceeds into petitioners' account at Washington Federal was not

a good accounting practice, that Mr. Kabeiseman was unable to

trace to any particular construction loan account of K & H the

direct payments that petitioner had made to it during May or June

1989 of certain of its construction loan proceeds, that peti-

tioner should direct Washington Federal to issue checks directly

to K & H for the K & H construction loan proceeds sought in the

draw requests that petitioner made, and that such checks should

be deposited into K & H's checking account. Petitioner

nonetheless continued to deposit K & H's construction loan

proceeds into petitioners' account at Washington Federal after

May or June 1989 and through July 1990, even after he ceased in

the spring of 1990 being actively involved in the operations of K

& H. Moreover, although petitioner testified that he obtained

those loan proceeds from Washington Federal in order to pay the
 - 39 -

costs incurred in connection with K & H's construction projects,

he was unable to explain why he did not immediately remit the

entire amount of such proceeds to, or immediately expend them for

the benefit of, K & H.

With respect to the deposits at issue of Ms. Velilla's

funds, except for petitioner's self-serving, general, and

conclusory testimony on which we are unwilling to rely, there is

no evidence in the record that supports petitioners' contention

that those funds were held for corporate (i.e., K & H's) pur-

poses. The record does not even show whether or how those funds

were disbursed during each such year. What the record does

establish is that, with respect to the deposits at issue of Ms.

Velilla's construction loan proceeds, the contractor agreement

between Ms. Velilla and K & H did not authorize petitioner (1) to

deposit such proceeds into petitioners' accounts or (2) to retain

any portion of such proceeds for petitioners' own purposes. That

agreement specifically provided that disbursements from Ms.

Velilla's construction loan account were to be made "only to pay

for costs of labor on and materials for the Project pursuant to

plans and specifications submitted to and approved by Lender."

With respect to the deposit at issue of Ms. Velilla's checking

account funds, the record is silent regarding whether that

deposit was authorized and whether petitioners were authorized to
 - 40 -

retain any portion of those funds during 1990.28

On the record before us, we also reject petitioners' conten-

tion that they held the deposits of K & H's and Ms. Velilla's

funds subject to an obligation that petitioner recognized to

return the funds so deposited to K & H. That record does not

establish that petitioner recognized an obligation to return

those funds to K & H. Nor does it show that petitioner recog-

nized an obligation to return Ms. Velilla's funds to Ms. Velilla.

It is significant that: (1) Petitioner did not disclose to Mr.

Kabeiseman the amounts of the K & H construction loan proceeds

that petitioner deposited into petitioners' account at Washington

Federal or the amounts of those proceeds that he did not return

to K & H; (2) the record does not show that petitioner disclosed

to Mr. Kabeiseman that he was depositing K & H checking account

or credit line funds into petitioners' accounts, the specific

amounts so deposited, or the specific amounts of such funds not

returned; (3) the record does not establish that petitioner

disclosed to Ms. Velilla that he was depositing Ms. Velilla's

construction loan proceeds and checking account funds into

petitioners' account at Washington Federal, the specific amounts

so deposited, or the specific amounts of such proceeds and funds

28
We find it hard to believe that petitioner would have been
authorized to deposit Ms. Velilla's checking account funds into
petitioners' accounts or to retain any portion of those funds for
petitioners' own use when he was not authorized to deposit Ms.
Velilla's construction loan proceeds into their accounts or to
retain any portion of those proceeds for their own use.
 - 41 -

not returned; (4) the record contains no evidence of any action

taken by petitioner at the time of the deposits of K & H's and

Ms. Velilla's funds that acknowledged his obligation to return

those funds; (5) the record contains no evidence indicating that

petitioner kept a contemporaneous accounting or record of (a) the

amounts and sources of the deposits that he made into petition-

ers' accounts during the years at issue or (b) the amounts of

those deposited funds, if any, that were used to make payments

to, or on behalf of, K & H and Ms. Velilla; and (6) petitioners

retained during each year at issue an unidentified portion of the

aggregate amount of K & H's and Ms. Velilla's funds that peti-

tioner deposited during each such year and did not use those

retained funds to make payments to, or on behalf of, K & H and/or

Ms. Velilla.

Even assuming arguendo that we were to find on the instant

record that petitioner had recognized an obligation to return K &

H's and Ms. Velilla's funds that petitioner deposited into

petitioners' accounts during the years at issue, petitioner's

unilateral recognition of such an obligation would be insuffi-

cient to cause those deposits to be excluded from petitioners'

income for the years at issue. See Moore v. United States, 412

F.2d 974, 979-980 (5th Cir. 1969). A taxpayer who obtains funds

without a consensual recognition, expressed or implied, of an

obligation to repay them and without any restriction as to their

disposition must include such funds in gross income. James v.
 - 42 -

United States, 366 U.S. at 219; Mais v. Commissioner, 51 T.C.

494, 498 (1968). In order for funds obtained from another person

to qualify for exclusion from income because the taxpayer was in

essence a borrower from that person who was in essence a lender,

there must be an "agreement between the [lender] and borrower

entailing 'consensual recognition' of an obligation to repay and

exact conditions of repayment." Moore v. United States, supra at

979-980. Such consensual recognition requires that there be

mutual consent. Solomon v. Commissioner, 732 F.2d 1459, 1461

(6th Cir. 1984), affg. per curiam T.C. Memo. 1982-603.

Petitioners do not even claim, and the record does not support a

finding that, petitioner entered into such an agreement with

either K & H or Ms. Velilla.

Based on our review of the entire record before us, we find

that petitioners have failed to establish that the deposits of K

& H's funds and Ms. Velilla's funds during each of the years 1989

and 1990 that were not returned during each of those years, viz.,

deposits of $90,666.35 and $60,168.06 during 1989 and 1990,

respectively, are not taxable to petitioners.29

29
Petitioners also argue that no portion of K & H's funds that
petitioner deposited into petitioners' accounts during the years
at issue is income to petitioners because (1) in the lawsuit that
Mr. Kabeiseman instituted around 1991 against petitioner, Mr.
Kabeiseman made no allegation of misappropriation; and (2) the
settlement payment of $37,500 by petitioner to Mr. Kabeiseman in
connection with that lawsuit encompassed a payment in settlement
of any such dispute between Mr. Kabeiseman and petitioner. We
disagree. On the record before us, we find that the omission of
(continued...)
 - 43 -

Miscellaneous Deposits

The parties agree that the total amounts of miscellaneous

deposits that remain at issue for 1989 and 1990 are $83,364 and

$41,583.71, respectively. Petitioners agree that those deposits

are prima facie evidence of income and that they bear the burden

of proving that respondent's determinations of unreported income

for the years 1989 and 1990 based on those deposits are errone-

ous. See Clayton v. Commissioner, 102 T.C. at 645; DiLeo v.

Commissioner, 96 T.C. at 869; Tokarski v. Commissioner, 87 T.C.

at 77.

Although petitioners' argument is not altogether clear, they

appear to argue that the miscellaneous deposits at issue for 1989

and 1990 do not constitute unreported income for those years

because they represent gross receipts derived from the operations

of petitioner's sole proprietorship Charles Harp Construction

that petitioners reported in Schedule C of their return for each

29
(...continued)
such an allegation from the complaint in the lawsuit does not
establish that those funds are not taxable to petitioners. In
fact, with respect to petitioner's deposits during 1989 and 1990
of K & H's construction loan proceeds, the record does not indi-
cate that Mr. Kabeiseman had any knowledge at any time throughout
the course of the years at issue of petitioner's practice of
retaining a portion of those proceeds. Even assuming arguendo
that we were to construe the settlement agreement as encompassing
a repayment of a portion of K & H's construction loan proceeds, a
repayment by petitioner in a year subsequent to the year in which
those proceeds were deposited into petitioners' accounts and for
which they constitute income to petitioners under the principles
of James v. United States, 366 U.S. 213 (1961), would not reduce
petitioners' income for the year during which those proceeds were
deposited. See Mais v. Commissioner, 51 T.C. 494, 499 (1968).
 - 44 -

of those years. Petitioners appear to argue further that, to the

extent that respondent did not treat those deposits as having

been so included, her computation of unreported income, based on

the application of the bank deposits method, is inaccurate.

If petitioners believe that respondent's method of computa-

tion of unreported income is unfair or inaccurate, the burden is

on them to show such unfairness or inaccuracy. Price v. United

States, 335 F.2d 671, 677 (5th Cir. 1964). In applying the bank

deposits method, respondent is not required to make an automatic

adjustment for amounts reported in the taxpayer's return if the

taxpayer fails to show that the reported amounts were in fact

used to make such deposits. See Marcello v. Commissioner, 380

F.2d at 511. Based on certain limited information that respon-

dent's revenue agent found reliable, that agent excluded from the

calculation of petitioners' unreported income those deposits that

that agent concluded had been reported income in petitioners'

1989 and 1990 returns.30 Based upon certain additional informa-

tion that petitioners provided to respondent subsequent to the

issuance of the notice and prior to the trial herein, respondent

reduced the amount of petitioners' unreported income for the

years at issue that she had determined in the notice on the basis

of the bank deposits method in order to reflect certain deposits

into petitioners' accounts during those years that respondent

30
See supra note 8.
 - 45 -

concluded had been included as income in petitioners' 1989 and

1990 returns. Petitioners presented no evidence at trial that

establishes that the miscellaneous deposits at issue for each of

the years 1989 and 1990 were in fact included in the gross

receipts that were reported in Schedule C of their return for

each of those years.

On the instant record, we find that petitioners have failed

to establish that the miscellaneous deposits at issue represent

income that they reported in their returns for those years.

Petitioners assert additional reasons for claiming that the

following two miscellaneous deposits do not constitute income:

(1) A deposit of $6,222.89 on May 30, 1989, into petitioners'

account at the Hillsboro branch of Washington Federal31 that

petitioners claim they obtained from an account at Far West

Federal and (2) a deposit of $1,630.11 on May 2, 1990, into

petitioners' account at that bank that petitioners obtained from

the sale of a 1988 Chevrolet pickup truck.32

31
Although the parties stipulated, and petitioners assert on
brief, that that deposit was a "Transfer to Far West Bank", we
shall disregard that stipulation, see Cal-Maine Foods, Inc. v.
Commissioner, 93 T.C. 181, 195 (1989), and that assertion because
they are clearly contrary to facts disclosed by the record. The
following facts are disclosed by the record: (1) A deposit of
$6,222.89 was made into petitioners' account at Washington
Federal on May 30, 1989; and (2) no deposit in that amount was
made into petitioners' account at Far West Federal on May 30,
1989, or on any other date during 1989.
32
Petitioners advance no additional arguments, and the record
does not support a finding, that the remaining miscellaneous
(continued...)
 - 46 -

With respect to the deposit of $6,222.89 on May 30, 1989,

petitioners' bank statement from Far West Federal does not show

that a transfer of $6,222.89 was made from their account at that

bank to their account at Washington Federal in or around May

1989. Assuming arguendo that the source of the $6,222.89 deposit

on May 30, 1989, into petitioners' account at Washington Federal

was a transfer from an account at Far West Federal, the record

does not contain any evidence as to the account at Far West

Federal from which that transfer may have been made or the

purpose of such transfer.

With respect to the deposit of $1,630.11 on May 2, 1990,

petitioners rely on the general and vague testimony of petitioner

that that deposit represented proceeds from the sale of a truck

that petitioners sold at a loss. The record contains no evidence

relating to the cost of that truck or its basis in petitioners'

hands at the time of its sale.

On the instant record, we find that petitioners have failed

32
(...continued)
deposits at issue are not taxable. In this regard, assuming
arguendo that we were to find petitioners' schedules of deposits
and Ms. Harp's testimony regarding those schedules to be reli-
able, we found neither those schedules nor that testimony helpful
in determining whether those deposits are not taxable. Petition-
ers' schedules of deposits either do not identify the sources of
certain of the miscellaneous deposits at issue or identify the
sources of certain of those deposits without providing petition-
ers' explanation as to why they are not taxable. Ms. Harp's
testimony regarding petitioners' schedules of deposits, which was
general, vague, and conclusory, did not provide any additional
explanation on behalf of petitioners as to why the miscellaneous
deposits at issue for each of the years at issue are not taxable.
 - 47 -

to establish that the foregoing two miscellaneous deposits at

issue are not taxable.

Based on our review of the entire record before us, we find

that petitioners have failed to establish that they do not have

unreported income resulting from the miscellaneous deposits at

issue for the years 1989 and 1990 in the amounts of $83,364 and

$41,583.71, respectively.33

Deposits of Funds that Mr. Kabeiseman
Transferred to Petitioner

The parties agree that (1) on January 18, 1989, and on

February 7, 1989, petitioner deposited into one of petitioners'

accounts loans obtained from Mr. Kabeiseman in the amounts of

$25,000 and $4,000, respectively; and (2) during 1990, petitioner

made payments totaling $9,689.80 to Mr. Kabeiseman with respect

to those loans. In addition, the parties do not dispute that

petitioner did not make any other payments with respect to those

loans to Mr. Kabeiseman. The only dispute is whether Mr.

Kabeiseman discharged the respective outstanding balances of

those loans during 1990.

Section 61(a)(12) provides that gross income generally

includes income from the discharge of indebtedness. A debt is

discharged at the point in time at which an identifiable event

occurs that makes it clear that the debt will never be paid.

33
We have considered all of petitioners' other arguments with
respect to the miscellaneous deposits at issue and find them to
be without merit.
 - 48 -

Cozzi v. Commissioner, 88 T.C. 435, 445 (1987). The test for

determining that point in time depends on a practical assessment

of all the facts and circumstances relating to the likelihood of

payment. Id.

Petitioners contend that no identifiable event occurred

during 1990 that made it clear that the Kabeiseman loans at issue

would never be repaid and that therefore petitioners were not

discharged from those debts during 1990 and have no income from

the discharge of indebtedness for that year. Respondent dis-

agrees.

On the instant record, we find that no identifiable event

occurred during 1990 that made it clear that petitioner never

would repay the respective outstanding balances of the Kabeiseman

loans. Indeed, the record establishes that during that year

petitioner repaid $9,689.80 of those loans.

Based on our review of the record before us, we find that

the respective outstanding balances of the Kabeiseman loans were

not discharged during 1990. Consequently, petitioners do not

have income for that year from the discharge of indebtedness.

Self-Employment Tax

Respondent determined that petitioners are liable for

self-employment tax for the years 1989 and 1990 because the

unreported income for those years is self-employment income.

Section 1401 imposes a self-employment tax on self-employment

income. Section 1402(b) generally defines self-employment income
 - 49 -

as net earnings from self-employment derived by an individual.

The term "net earnings from self-employment" means gross income

derived by an individual from any trade or business carried on by

such individual, less the deductions allowed by the Code that are

attributable to such trade or business, plus certain items not

relevant here. Sec. 1402(a). The term "trade or business", for

purposes of the self-employment tax, generally has the same

meaning as it has for purposes of section 162. Sec. 1402(c).

Petitioners contend that assuming arguendo that we were to

sustain respondent's positions that petitioners have unreported

income for 1989 and 1990 resulting from the deposits of K & H's

and Ms. Velilla's funds and for 1990 resulting from the discharge

of the outstanding balances of the Kabeiseman loans, such income

would not be subject to self-employment tax. According to peti-

tioners, any such income does not constitute self-employment in-

come because it is not gross income derived from a trade or busi-

ness carried on by petitioner. Since we have found that peti-

tioners do not have unreported income for 1990 resulting from the

discharge of the outstanding balances of the Kabeiseman loans, we

shall address petitioners' contention regarding respondent's de-

terminations of self-employment tax for the years at issue only

insofar as that contention relates to our findings that petition-

ers have unreported income for 1989 and 1990 resulting from the

deposits of K & H's and Ms. Velilla's funds. Respondent does not

address that issue in her opening brief, nor does she respond to
 - 50 -

petitioners' argument with respect to that issue in her answering

brief. Accordingly, we conclude that respondent has conceded the

self-employment tax issue relating to that unreported income.34

See Rybak v. Commissioner, 91 T.C. 524, 566 n.19 (1988).

Petitioners do not dispute, and we therefore assume that

they concede, that if we were to sustain respondent's determina-

tions of petitioners' unreported income for 1989 and 1990 result-

ing from the miscellaneous deposits at issue, respondent's deter-

minations imposing self-employment tax for those years on that

unreported income would be correct. In light of that concession

and our findings that petitioners have unreported income result-

ing from the miscellaneous deposits at issue for the years 1989

and 1990 in the amounts of $83,364 and $41,583.71, respectively,

we sustain respondent's determinations that such income consti-

tutes self-employment income that is subject to self-employment

tax.35

34
Even assuming arguendo that respondent had not conceded that
issue, we agree with petitioners that their unreported income for
1989 and 1990 resulting from the deposits of K & H's and Ms.
Velilla's funds is not gross income derived by petitioner from a
trade or business, see generally Mannette v. Commissioner, 69
T.C. 990, 992-993 (1978); Hankins v. United States, 403 F. Supp.
257, 259 (N.D. Miss. 1975), affd. without published opinion 531
F.2d 573 (5th Cir. 1976), and that, consequently, it does not
constitute self-employment income for either of the years at
issue that is subject to self-employment tax.
35
Petitioners do not dispute, and we assume that they also
concede, the imposition of the self-employment tax for 1989
relating to their unreported income for that year in the amount
of $2,500 from the sale of plans.
 - 51 -

Accuracy-Related Penalty

Respondent determined that petitioners are liable for each

of the years 1989 and 1990 for the accuracy-related penalty under

section 6662(a) because petitioners' underpayment of tax for each

of those years was due to negligence or disregard of rules or

regulations. In the alternative, respondent determined that

petitioners are liable for that penalty for each of the years at

issue because they have a substantial understatement of income

for each of those years.

Petitioners contend that assuming arguendo that we were to

sustain respondent's position that petitioners have unreported

income for 1990 resulting from the discharge of the outstanding

balances of the Kabeiseman loans, we should nonetheless reject

respondent's determination imposing the accuracy-related penalty

for 1990 to the extent that it relates to the underpayment

attributable to any such unreported income. In light of our

holding that petitioners do not have unreported income for 1990

resulting from the discharge of the outstanding balances of the

Kabeiseman loans, we shall not address that contention.

Petitioners do not dispute, and we therefore assume that

they concede, that if we were to sustain respondent's position

that petitioners have unreported income for 1989 and 1990 result-

ing from the deposits of K & H's and Ms. Velilla's funds and the

miscellaneous deposits at issue, respondent's determination of

the accuracy-related penalty for each of those years to the ex-
 - 52 -

tent that it relates to the underpayment attributable to that in-

come would be correct. In light of that concession and our find-

ings that petitioners have unreported income for 1989 and 1990

resulting from those deposits in the total amount of $174,030.35

and $101,751.77, respectively, we sustain respondent’s determina-

tion imposing the accuracy-related penalty for each of those

years to the extent that it relates to the underpayment for each

such year attributable to such unreported income.36

To reflect the foregoing and the concessions of the parties,

Decision will be entered

under Rule 155.

36
Petitioners do not dispute, and we assume that they also
concede, the imposition of the accuracy-related penalty for 1989
relating to their unreported income for that year in the amount
of $2,500 from the sale of plans.