Kikalos v. Commissioner

T.C. Memo. 1998-92

UNITED STATES TAX COURT

NICK AND HELEN KIKALOS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 10244-96. Filed March 3, 1998.

George Brode, Jr. and John J. Morrison, for petitioners.

Ronald T. Jordan and Timothy A. Lohrstorfer, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

CLAPP, Judge: Respondent determined the following

deficiencies and accuracy-related penalties in petitioners'

Federal income taxes:

Accuracy-related Penalty
Year Deficiency Sec. 6662(a)

1990 $686,872 $137,374
1991 805,093 161,019
1992 818,901 163,780
 - 2 -

The issues for decision are:

(1) Whether petitioners maintained inadequate records of

income in the years 1990, 1991, and 1992, justifying the use of

an indirect method of reconstructing income. We hold that they

did not maintain adequate records.

(2) Whether respondent's use of the percentage markup

method of reconstructing petitioners' income for the years 1990,

1991, and 1992 was reasonable. We hold that it was.

(3) Whether petitioners have shown that respondent's

determinations as to their unreported income were incorrect. We

hold that they have, to the extent set forth herein.

(4) Whether petitioners incurred a deductible theft loss in

the amount of $19,769 in the taxable year 1991. We hold that

they did not.

(5) Whether petitioners may deduct as a trade or business

expense in the taxable year 1992 an interest payment of $393,024

made in connection with their liability for deficiencies in

income taxes for their taxable years 1986 and 1987. We hold that

they may.

(6) Whether petitioners are liable for an accuracy-related

penalty under section 6662(a) for each of the taxable years 1990,

1991, and 1992. We hold that they are.1

1
Petitioners have not disputed other issues set forth in
the notice of deficiency, and we consider those issues to be
conceded. Those issues relate to the disallowance of an expense
of $3,060 for two cash registers; the disallowance of
(continued...)
 - 3 -

All section references are to the Internal Revenue Code in

effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure, unless otherwise

indicated.

FINDINGS OF FACT

Some of the facts are stipulated and are so found. We

incorporate by reference the stipulation of facts, the three

supplemental stipulations of facts, and attached exhibits.

Petitioners are husband and wife, who resided in Hammond,

Indiana, when the petition in this case was filed. Petitioner

Nick Kikalos (Nick) was born in Greece in 1935 and came to the

United States in 1936. He completed school through the eighth

grade. Since 1971, Nick has operated Nick's Liquors, a

cigarette, beer, and liquor store business, as a sole

proprietorship. During the years in issue, Nick's Liquors

operated in three separate store locations in Hammond: 4702

Calumet Avenue (store No. 1), 5705 Hohman Avenue (store No. 2),

and 6914 Indianapolis Boulevard (store No. 3). All three stores

had storage areas, and two of them had warehouse facilities.

A. Petitioners' Gross Profit Margins

Nick maintained his office at store No. 1, and his wife,

Helen Kikalos (Helen), worked there for several hours each

1
(...continued)
depreciation expenses of $39,301, $38,581, and $33,514 for the
respective years in issue; and the disallowance of a loss of
$9,707 on the sale of a rental house.
 - 4 -

morning. Nick Kikalos, Jr. (Nick, Jr.) managed store No. 2, and

petitioners' daughter, Liz Lukowski (Liz), managed store No. 3.

Petitioners computed their income using the cash receipts

and disbursements method. Every business day, Nick made entries

of income and expenses on bound, sequentially paged ledgers for

each of his three stores. Nick maintained a separate checking

account for each of the three stores and an additional "lotto"

account, which he maintained as a fiduciary for the State of

Indiana. Nick did not account for the lotto receipts directly.

Instead, he funded the account twice a week from the daily

proceeds of store No. 3. Keeping strict lotto accounts, he

reported, would be a "big pain." The State of Indiana obtained

its funds from the lotto account by means of electronic fund

transfers.

There was one cash register in each of the stores. Despite

advice that he do so, Nick did not retain the receipts or daily

summaries produced by the cash registers during the years in

issue.

Nick dealt substantially in cash. All sales were in cash;

credit cards were not accepted, and personal checks were rarely

taken. Customers could, however, pay for part of their cigarette

purchases with manufacturers' coupons. These took two forms:

"Physical" coupons, which Nick would send to the manufacturers

for redemption, and "buy down" coupons, for which the

manufacturers paid Nick directly. Petitioners' employees rang up
 - 5 -

coupons for cigarette discounts on a separate cash register key.

Nick, Jr. was in charge of beer purchases for the three

stores. His practice was to buy beer in the highest possible

quantities to obtain the lowest prices from his suppliers. Liz

was in charge of buying the stores' wine and liquor inventories.

Her suppliers regarded her as a very astute buyer. The manager

of a store would pay beer and liquor wholesalers with checks.

The manager paid other suppliers in cash, placing the receipts in

a "bill bag." In each of the stores, the manager also took cash

register readings at the end of a shift. The stores' cash

registers summarized the day's results on a "Z tape." The "Z

tapes", the receipts and other materials, such as paid lottery

tickets and cigarette coupons, all went into the bill bag at each

store. Cash was placed in a "drop safe" by the cash register

periodically during the day and at the end of each day. Before

opening the next business day, a family member, Nick, Helen,

Nick, Jr., or Liz, would count the cash in the drop safe, retain

enough for the day's business at each store, and prepare a

deposit slip for the balance. Usually, Helen deposited the

excess cash in the bank. A copy of the deposit slip was put into

the bill bag. The bill bags containing records of receipts and

expenses went to Nick at his office at store No. 1.

Not all the excess cash went to the bank. In order to meet

the payroll and other expenses, Nick would ask Liz for cash, or

he would retain cash from store operations himself. Nick also
 - 6 -

retained some of the cash for his personal use. Nick did not

record the amounts he kept for himself in his ledger books.

Petitioners did not maintain a personal checking account.

During 1990, 1991, and 1992, petitioners' stores sold beer

by the case (both 24-can and bottle cases and 30-can and bottle

cases), multiple cases, 12-packs, 6-packs, 40-ounce bottles and

cases, 32-ounce bottles and cases, and half-barrel and quarter-

barrel sizes. Nick's Liquors also sold single 12- and 16-ounce

cans of beer. All three stores sold warm beer from the floor and

cold beer from large coolers in each store. Nick's Liquors sold

liquor in cases and individual bottles in a variety of sizes,

ranging from 1.75 liter (L), 1 L, 750 milliliters (mL), 375 mL,

200 mL, down to 50-milliliter miniatures. Nick's Liquors also

sold wine, both warm and cold, in a variety of sizes and sold

cigarettes by the 30-carton case, by the 10-pack carton, by

multiple cartons, and by the pack.

In general, petitioners' profit margins were larger on sales

of the smaller sizes, whether they were sales of beer, liquor, or

cigarettes. For example, cigarettes sold by the pack were marked

up by an additional nickel per pack from their carton price.

Petitioners also sold cold beer from their stores' large coolers

at a higher price than warm beer.

Nick's Liquors was a high-volume, low-priced retail

operation. It was Nick's Liquors' practice to sell a high volume

of a limited number of brands and sizes of beer and liquor at low
 - 7 -

prices. Nick's Liquors advertised itself as a discount liquor

dealer. Its consistent goal was to maintain the lowest prices in

the area. It maintained the warehouse facility at store No. 1

primarily to house large-volume purchases of beer and liquor.

The warehouse was capable of accepting full truckloads and

pallets of beer. Petitioners were frequently able to buy in such

quantities to take advantage of quantity discounts and of

discounts in periodically issued "deal sheets" from the

wholesalers.

Nick's Liquors operated in a highly competitive environment.

Petitioners' stores were near the Illinois border and the city of

Chicago. Because of differences in State taxes, cigarettes sold

for considerably less in Indiana than in Illinois during the

years in issue. Liquor, on the other hand, was generally cheaper

in Illinois. Nick and his family tried to keep prices low, not

only to compete for the Illinois cross-border cigarette business,

but also to keep Indiana beer and liquor customers from making

their purchases in Illinois.

Nick's Liquors ran weekly advertisements in the local

newspaper, the Hammond Times. The advertised prices reflected an

average gross profit margin of 6.31 percent in 1990, 6.52 percent

in 1991, and 6.06 percent in 1992. Many of the ads were small,

single-item "rate holder" ads. The heaviest advertising took

place in December, when Nick's Liquors advertised many more items

than usual. Except for the month of December, the advertised
 - 8 -

sales prices were limited to a duration of 1 week. In the

December advertisements, the sales ended December 31, or "while

supplies last". Nick's Liquors also held "in-store" sales for

items that did not appear in the newspaper ads. In some

instances, petitioners' personnel kept items on sale beyond the

period indicated. Additionally, there were "perma sales" of

items that went on sale and retained the sale price indefinitely.

Nick's Liquors also sold merchandise that was not on sale

and produced substantially higher profit margins. For example,

in September of 1991, it sold "Old Style" beer at a price of

$9.98 per case, which represented a margin of 15.8 percent, based

upon the wholesale cost of $8.40 per case. Nick's Liquors sold

750-milliliter bottles of Riunite wine for $3.99, a margin of

26.1 percent. One-liter bottles of Jack Daniels whiskey sold at

a margin of 17 percent, and 750-milliliter bottles of Andre Pink

Champagne sold at a margin of 22.8 percent.

Petitioners' competitors in northwest Indiana had a markup

on warm beer, sold by the case, of 5 to 6 percent. The

competitors maintained a gross profit margin of 7 to 13 percent

on liquor, although the margin would be higher for slower-moving

items. The price of beer remained fairly stable during the years

in issue, and profits ranged between $.10 and $1.00 on a case for

warm beer. Although Nick's Liquors' margins on some merchandise

was as high as 26 percent, those margins were an exception to the

general rule of substantially lower margins.
 - 9 -

Other liquor stores in northern Indiana had an average

margin in the range of 25 percent, but those stores did not

operate with the low-price, high-volume philosophy of

petitioners' stores.

Nick's Liquors' cigarette pricing stayed the same between

1990 and 1994. In 1994, a competitor sued Nick in an Indiana

court, alleging that Nick sold cigarettes at such low prices that

he had violated Indiana's Unfair Practices Act. Indiana law

required cigarette profits to equal or exceed an 8-percent

addition to the retailers' cost, as a "retail cost of doing

business". Indiana statutes provided an exception, however, that

permitted a retailer to sell cigarettes below this 8-percent

addition in order to meet competition, as long as the retailer

sold the cigarettes above the retailer's own cost. Ind. Code

Ann. sec. 24-3-2-7 (Michie 1996). The Indiana court found that

Nick's Liquors qualified for this exception.

In connection with that litigation, petitioners presented

the evidence of an accountant, who calculated Nick's Liquors'

gross profit margins on cigarette sales in August and December of

1994. The average margin for August of brand-name cigarettes was

6.67 percent, and its margin for generic cigarettes was 6.39

percent. For December the average margin of brand-name

cigarettes was 2.92 percent, and its margin for generic

cigarettes was 2.57 percent. These very low margins for December

reflected the existence of the price war that caused petitioners'
 - 10 -

competitor to bring a lawsuit. In general, the competition was

such that petitioners' competitors could expect profits of

between $.10 and $1 per carton. Competitors who were some miles

away from the Illinois border marked up their cigarettes by 10 to

15 percent.

Petitioners' Federal income tax returns for the years in

issue were prepared by professional accountants, based upon

information furnished them. The accountants did not conduct an

audit of petitioners' business activities, nor did they establish

other inventory or cash controls.

For the years in issue, petitioners' Federal income tax

returns reported gross sales from Nick's Liquors ranging between

$8,535,458 and $9,054,086 per year. These returns reported

taxable income from operations of $500,698 for 1990, $543,245 for

1991, and $531,549 for 1992. In each instance, the amounts

reported represented gross margins on sales of approximately 6

percent. Respondent determined that petitioners had understated

their taxable income. Respondent accordingly redetermined

petitioners' income for the years in issue by utilizing the

"percentage markup method". Respondent's method results in

application of gross profit margins of approximately 26.8 percent

for the years in issue. Respondent based that redetermination on

margins in a report entitled, "Estimated Gross Margin as Percent

of Sales, by Kinds of Business", printed in the Combined Annual

and Revised Monthly Retail Trade reports issued by the U.S.
 - 11 -

Department of Commerce.

During each of the years in issue, beer represented 42

percent of petitioners' purchases of inventory, in terms of

dollars spent. Wine and liquor represented 22 percent of

purchases, and cigarettes represented another 33 percent.

Miscellaneous items, such as soda and snacks, represented the

remaining 3 percent. During those years, petitioners' sales in

each of those categories took place in the same proportions.

Petitioners' weighted gross profit margin for all products for

the years in issue was 10.54 percent. This is equivalent to a

markup on cost of goods sold of 11.78 percent.

B. Petitioners' Theft Loss Deduction

On October 25, 1991, store No. 1 was robbed. Some $22,773

was stolen, consisting of daily receipts, lottery tickets, cash

on hand, beer deposits, sales taxes, lotto machine cash, and

lotto daily cash. Petitioners' logbook entry for that date does

not contain an entry for the amount of the day's sales receipts.

Instead, the logbook contains the following entry: "Robbed

10-25-91". Petitioners deducted $22,773 as a theft loss

deduction on their Federal income tax return for 1991.

Respondent disallowed petitioners' theft loss deduction in the

amount of $19,769. Respondent allowed a deduction of the

remaining $3,004 of the amount stolen. The amount allowed

consisted of $1,750 for the cost of lottery tickets, $166 as beer

deposits, $695 as lotto machine cash, and $393 as lotto daily
 - 12 -

cash.

C. Petitioners' Interest Deduction

On or about February 10, 1992, respondent assessed

petitioners additional income tax of $286,147.50 for their 1986

tax year and $272,146 for their 1987 tax year. The assessments

for 1986 and 1987 resulted from respondent's increase in

petitioners' reported gross business profit for those years,

based upon respondent's use of a bank deposits analysis. In

1992, petitioners paid $393,024 in interest on the additional

amounts assessed for 1986 and 1987. Petitioners deducted the

amount of the interest payment on their 1992 Federal income tax

return. Respondent disallowed that deduction of $393,024.

OPINION

I. Petitioners' Records of Income

Taxpayers must maintain accounting records which enable them

to file correct income tax returns. Sec. 6001; DiLeo v.

Commissioner, 96 T.C. 858, 867 (1991), affd. 959 F.2d 16 (2d Cir.

1992). Section 6001 provides:

SEC. 6001. NOTICE OR REGULATIONS REQUIRING RECORDS,
STATEMENTS, AND SPECIAL RETURNS.

Every person liable for any tax imposed by this
title, or for the collection thereof, shall keep such
records, render such statements, make such returns, and
comply with such rules and regulations as the Secretary
may from time to time prescribe. * * *

In this regard, section 1.446-1(a)(4), Income Tax Regs.,

provides in part:

Each taxpayer is required to make a return of his
 - 13 -

taxable income for each taxable year and must maintain
such accounting records as will enable him to file a
correct return. See section 6001 and the regulations
thereunder. Accounting records include the taxpayer's
regular books of account and such other records and
data as may be necessary to support the entries on his
books of account and on his return * * *"

Respondent's determination of taxable income is

presumptively correct. Rule 142(a); Welch v. Helvering, 290 U.S.

111, 115 (1933); Mendelson v. Commissioner, 305 F.2d 519, 522

(7th Cir. 1962), affg. T.C. Memo. 1961-319.

Where a taxpayer fails to maintain or produce adequate books

and records, the Commissioner is authorized to compute the

taxpayer's taxable income by any method which, in the

Commissioner's opinion, clearly reflects the taxpayer's income.

Sec. 446(b); Holland v. United States, 348 U.S. 121, 134 (1954);

Webb v. Commissioner, 394 F.2d 366, 371-372 (5th Cir. 1968),

affg. T.C. Memo. 1966-81; Harbin v. Commissioner, 40 T.C. 373,

377 (1963). The Commissioner's method need not be exact but must

only be reasonable in light of the surrounding facts and

circumstances. Holland v. United States, supra; Rowell v.

Commissioner, 884 F.2d 1085, 1087 (8th Cir. 1989), affg. T.C.

Memo. 1988-410; Giddio v. Commissioner, 54 T.C. 1530, 1533

(1970).

Here, the principal issue is the amount of petitioners'

gross income for the years in issue. Petitioners' bookkeeping

practices have failed to produce "such other records and data as

may be necessary to support the entries on his books of account
 - 14 -

and on his return". Sec. 1.446-(1)(a)(4), Income Tax Regs. In

this case, Nick alone controlled and prepared the books. He did

not retain copies of the cash register tapes or other sales

receipts, which were the only records that would substantiate the

amount of petitioners' gross income. Schwarzkopf v.

Commissioner, 246 F.2d 731, 734 (3d Cir. 1957), affg. in part and

remanding T.C. Memo. 1956-155.2

Petitioners argue that their bookkeeping practices

accurately reflected their income. They urge that respondent's

methods of reconstructing that income have misstated the actual

amounts. Petitioners have overlooked the fact that their failure

to retain the necessary records, particularly the cash register

"Z tapes", precluded respondent from determining exactly what

petitioners' income was for the years in issue. In these

circumstances, respondent is not required to make an exact

determination. All taxpayers, including petitioners here, who

fail to maintain the records necessary to substantiate their

assertions on their Federal income tax returns assume the risk

that they may have to pay a tax based upon income that is not

determined with certainty. That is the fault of the taxpayers,

2
See also Edgmon v. Commissioner, T.C. Memo. 1993-486
(failure to retain register tapes, "Z-tapes" and bills); Votsis
v. Commissioner, T.C. Memo. 1988-70 (failure to retain register
tapes and sales receipts); Catalanotto v. Commissioner, T.C.
Memo. 1984-215 (failure to retain register tapes and sales
receipts).
 - 15 -

however, and not of the Commissioner. Mendelson v. Commissioner,

supra at 523.

II. Respondent's Use of the Percentage Markup Method

We must find petitioners' gross profit for each of the years

at issue. Their gross profit is the difference between the price

at which petitioners sold their inventory and their cost of

purchasing that inventory. Gross profit may be expressed in

terms of dollars, but gross profit is also often expressed in

terms of percentages--either "margin" or markup". "Margin"

refers to gross profit as a percentage of the price at which

petitioners sold their inventory. "Markup" refers to gross

profit as a percentage of the cost incurred by petitioners to

purchase that inventory. Margin and markup are related terms,

and, if we know a specific example of one, we can determine the

other. For example, a gross profit margin of 20 percent means

that the markup is 25 percent and vice versa.

In this case, respondent employed the "percentage markup"

method to determine that petitioners had underreported their

income. In the proceeding before us, however, each side has

attempted to prove its case by demonstrating the profit margins

at which petitioners, or other retailers, sold their merchandise.

Because the parties have made their arguments in terms of profit

margins, we shall use that approach as well.

Here, because of petitioners' failure to retain records of
 - 16 -

their gross receipts, respondent reasonably and justifiably

determined the deficiencies at issue using Department of Commerce

gross margin statistics as the basis for the deficiency

determinations. In doing so, respondent employed a form of the

percentage markup method. Under the percentage markup method,

gross sales are determined by adding a predetermined percentage

of cost of goods sold. Bernstein v. Commissioner, 267 F.2d 879,

880 (5th Cir. 1959), affg. T.C. Memo. 1956-260. The courts have

consistently approved the use of the percentage markup method as

an acceptable means of computing a taxpayer's income. Webb v.

Commissioner, supra at 377; Bollella v. Commissioner, 374 F.2d 96

(6th Cir. 1967), affg. T.C. Memo. 1965-162.

Respondent's use of generalized statistics from Government

reports is also permissible. There are longstanding acceptable

methods of computing income that involve application of an

objectively determined average that relates to the income-

producing activity. See Avery v. Commissioner, 574 F.2d 467 (9th

Cir. 1978) (approving the Commissioner's projection of taxpayer's

income on the basis of isolated drug sales), affg. T.C. Memo.

1976-129; Cannon v. Commissioner, 533 F.2d 959 (5th Cir. 1976)

(approving the Commissioner's assertion of deficiencies based

upon an equal division of gambling proceeds between two gamblers

when the contradictory testimony of each was unworthy of belief),

affg. T.C. Memo. 1974-219; Bishoff v. Commissioner, 27 F.2d 91,
 - 17 -

93 (3d Cir. 1928) (approving assertion of a deficiency based upon

the Commissioner's "observation of earnings made and taxes paid

by a corporation in a like business"), affg. 6 B.T.A. 570 (1927);

Giddio v. Commissioner, supra at 1532 (approving determination of

taxable income based upon Bureau of Labor Statistics report of

average cost of raising a family in New York).3

III. Petitioners' Evidence of Income

In this case, respondent had no quarrel with the amount of

petitioners' costs or expenses of operating Nick's Liquors.

Respondent's differences with petitioners instead involve the

amount of their gross profit margins. As we have held,

petitioners have failed to show that respondent's determinations

are arbitrary or unreasonable. Accordingly, the presumption of

correctness that attaches to respondent's determinations remains

in force. Harbin v. Commissioner, 40 T.C. 373, 376 (1963).

Petitioners thus bear the burden of proving that respondent's

determinations were erroneous. To some extent, they have

succeeded. At trial, petitioners presented sufficient evidence

3
Our cases reflect a number of instances approving
respondent's use of markup percentages based upon third-party
sources to determine taxable income. See, e.g., Estate of Shuman
v. Commissioner, T.C. Memo. 1995-327 (use of gasoline station
markups based upon publications of Department of Energy and Oil
and Gas Journal plus competitors' prices); Biggs v. Commissioner,
T.C. Memo. 1985-303 (use of percentage markup based upon advice
of local plumbers' unions); Howse v. Commissioner, T.C. Memo.
1974-225 (use of percentage markup based upon reports of National
Sporting Goods Association).
 - 18 -

to show us that their profit margins were lower than the average

margin figures reported in the Department of Commerce

publications and used here by respondent.

Petitioners' contentions concerning their profit margins for

the years in issue are founded principally upon an expert report

prepared by Peter E. Rossi, Ph.D., Professor of Marketing,

Econometrics, and Statistics at the Graduate School of Business,

University of Chicago.

Expert opinion may or may not aid the Court in determining

factual issues. See Laureys v. Commissioner, 92 T.C. 101, 129

(1989). We evaluate such opinions in light of the demonstrated

qualifications of the expert and all other pertinent and credible

evidence. Estate of Newhouse v. Commissioner, 94 T.C. 193, 217

(1990); Parker v. Commissioner, 86 T.C. 547, 561 (1986); Johnson

v. Commissioner, 85 T.C. 469, 477 (1985). We are not bound,

however, by the opinion of any expert witness when that opinion

is inconsistent with our considered judgment. Estate of Newhouse

v. Commissioner, supra at 217; Parker v. Commissioner, supra at

561. We may accept the opinion of an expert in its entirety,

Buffalo Tool & Die Manufacturing Co. v. Commissioner, 74 T.C.

441, 452 (1980), and we also may be selective in the use of any

portion thereof, Parker v. Commissioner, supra at 562.

Consequently, we take into account expert opinion testimony here

only to the extent that it aids us in arriving at petitioners'
 - 19 -

likely profit margins for the years at issue.

Dr. Rossi examined Nick's Liquors' advertising and invoices,

and he reviewed records of interviews with petitioners'

competitors and suppliers. He analyzed data from Nick's Liquors'

invoices. He also toured two of petitioners' stores and two

stores of their competitors. He concluded that Nick's Liquors'

margins on its sales were considerably less than the 27-percent

average obtained from the Department of Commerce survey. Dr.

Rossi based his determination on three factors: First, that

Nick's Liquors' advertisements and invoices suggest profit

margins of between 5 and 7 percent; second, that Nick's Liquors

did not operate a representative retail liquor business because

of Nick's Liquors' high-volume, low-priced operations; and,

third, that Nick's Liquors' prices were kept low by the

competitive retail environment of northwestern Indiana.

Dr. Rossi analyzed Nick's Liquors' likely profits by looking

at its three major product lines: Beer, wine and liquor, and

cigarettes. In the beer category, Dr. Rossi examined six highest

selling brands, which accounted for 57 percent of beer sales.

Based upon the newspaper advertisements, he determined that the

average margin in beer was 5.99 percent. Dr. Rossi concluded

that this margin did not apply only to infrequent "specials" but

to Nick's Liquors' beer prices generally.

Dr. Rossi observed that Nick's Liquors' wine and liquor
 - 20 -

margins were the most complicated category. He examined the top-

volume items in this category, some eight brands or sizes of

liquor and one of wine. These accounted for 17 percent of

purchases. Dr. Rossi determined that the average margin on the

advertised items was about 5 percent. As for the other 83

percent, the lower volume wines and liquors, Dr. Rossi estimated

that Nick's Liquors' large-scale December ads were representative

of the prices of at least 85 percent of this merchandise. The

average margin on the December sale items was 7 percent. For the

months other than December, Dr. Rossi opined that a "reasonable

but still conservative" estimate of the margin upon these lower

volume items was 14 percent. He concluded that, for wine and

liquor sales overall, "we would get * * * approximately 11

percent".

With respect to cigarettes, Dr. Rossi noted that the

advertised prices reflect margins of between 1 and 6 percent. He

took into account the lawsuit in which the plaintiffs had charged

Nick with unlawfully selling cigarettes below the State's

mandated 8-percent addition to cost. Dr. Rossi determined

ultimately that the margin "could not exceed 5 percent" and

settled upon that figure.

Dr. Rossi concluded that a weighted average of the margins

on beer, wine and liquor, and cigarettes produced a "conservative

estimate" of an overall margin of 6.79 percent.
 - 21 -

We have found Dr. Rossi's report helpful in a number of

respects. The other evidence produced at trial regarding

petitioners' prices for the years in issue is generally vague,

anecdotal, and, because it often relates to years other than

those in issue, somewhat irrelevant. Dr. Rossi's report provides

a useful structure for obtaining a meaningful analysis of the

information before us. In particular, we accept Dr. Rossi's

division of petitioners' product lines into three categories;

these divisions each display similar pricing and marketing

characteristics. We also accept his estimation of each such

category's percentage of total sales. Respondent contends that

Dr. Rossi's percentages do not agree exactly with other figures

for the year 1992 prepared by petitioners' accountants. Dr.

Rossi's percentages, however, find sufficient support in the

testimony of petitioners' witnesses. For each of the years in

issue, beer accounted for approximately 42 percent of sales, wine

and liquor accounted for 22 percent, cigarettes accounted for 33

percent, and miscellaneous items accounted for the remaining 3

percent. We additionally accept Dr. Rossi's assertion that an

analysis of data for 1991, the middle of the years at issue,

generally is applicable to the other 2 years as well. Neither

party has shown a basis for concluding otherwise. Finally, we

believe that Dr. Rossi's understanding of Nick's Liquors' methods

of doing business, and the competitive environment for that
 - 22 -

business, finds convincing support in the record.

While we agree with much of Dr. Rossi's presentation, we do

not agree with some of his premises. Nick, Jr. and Liz spent

considerable time in relating Nick's Liquors' advertised sales

prices for the years in issue to contemporary invoices from its

wholesalers. Their results have been placed into evidence. They

also furnished those results to Dr. Rossi for purposes of

preparing his report. Although Dr. Rossi's report does not

incorporate all their conclusions, the report does indicate that

Dr. Rossi's premises are almost exclusively based upon the

assumption that Nick's Liquors' advertised prices represent the

regular, everyday prices in the three stores. As we have found,

however, this is not necessarily the case. Nick's Liquors sold

much of its merchandise at margins considerably in excess of

those reflected in the newspaper advertisements. Such sales

raised the overall margins to percentages higher than those

reported by petitioners or ascertained by Dr. Rossi. We explain

our reasoning below.

A. Margins on Sales of Beer

Dr. Rossi determined the overall beer margin to be an

average of 5.99 percent. When Dr. Rossi found one of his six

selected beer items on an invoice from petitioners' records, he

noted its profit margin as reflected in the advertisements. He

found these 6 selected items on 99 invoices, and divided the
 - 23 -

total margin percentages by 99.

This procedure does not take into account sufficiently the

volume of the specific brands sold. Dr. Rossi's report indicates

that petitioners purchased substantially more of some of the six

selected items than others. Petitioners' usual margins on these

highest-volume items were higher than 5.99 percent. For example,

tables attached to Dr. Rossi's report indicate the usual margin

for the 2 biggest sellers, Budweiser/Bud Lite and Miller Lite, as

advertised was 6.81 percent. Third in volume, and most often

advertised, was a beer named "Old Style"; its usual margin as

advertised was 6.56 percent. Petitioners advertised other sizes

of "Old Style" and other brands at higher margins. We conclude

that, when volume of sales is taken into account, the average

margin of advertised beer was more likely 7 percent than the 6-

percent figure used by Dr. Rossi.

Additionally, Dr. Rossi apparently has assumed that the

average 5.99-percent margin for sale-priced beer applied to beer

that was not on sale. It does not appear that Dr. Rossi was

furnished evidence of the margins on beer that was not

advertised. When we take into account the margins on

unadvertised beer, such as the 15.8 margin on unadvertised "Old

Style", the average margin becomes higher.

Finally, Dr. Rossi's report does not consider the margins on

other beer sales, such as the sale of cold beer, beer sold in 6
 - 24 -

packs, and imported beers.

In view of the foregoing, we conclude that the margin for

all sizes of all beer sold, including imported and cold beer,

lies somewhere between Dr. Rossi's figure of 5.99 percent for

advertised "sale" beer and the 15.8 percent for unadvertised

beer. On the basis of the entire record before us, we find that

the margin applicable to overall beer sales during the years in

issue is 11 percent.

B. Margins on Sales of Wine and Liquor

Dr. Rossi's report also provides the basis for our findings

as to the overall margin applicable to petitioners' sales of wine

and liquor. Again, however, we disagree with some of his

premises.

Dr. Rossi based his determination of wine and liquor sales

upon his analysis of petitioners' invoices and advertised prices

for the years in issue, but his analysis apparently did not

include specific nonsale prices charged by petitioners during the

years at issue. Dr. Rossi determined that the margin applicable

to sale items in the month of December, when petitioners

advertised most heavily, was approximately 7 percent. He further

determined that, based upon sales invoices, petitioners sold

approximately 32 percent of their wine and liquor products during

December. He further assumed that the average margin was 14

percent for the rest of the year, when petitioners sold the
 - 25 -

remaining 68 percent of the wine and liquor inventory.

Respondent does not contest the average December margin of 7

percent. Respondent does take issue with Dr. Rossi's conclusion,

based upon the checks written during December of 1991 and the

first week of January 1992, that 32 percent of annual wine and

liquor sales took place in December of 1991. Petitioners' ledger

books for their three stores indicate total December sales of

$934,920. Their 1991 tax return indicates total annual sales of

$9,054,086. Thus, their books and tax returns indicate that

approximately 10.32 percent of total sales of all products took

place in December. We conclude that, while December was a month

of heavier-than-average sales of wine and liquor, such sales did

not amount to 32 percent of the total.

Moreover, we question Dr. Rossi's assumption that the

overall margin on wine and liquor for the other 11 months of the

year averaged 14 percent. That percentage seems somewhat

arbitrary. Dr. Rossi apparently was not made aware that

petitioners' unadvertised sales of wine and liquor provided much

higher profit margins, such as 17 percent on a liter of Jack

Daniels whiskey, 26.1 percent on a 750-milliliter bottle of

Riunite Wine, and 22.8 percent for the same size bottle of Andre

Pink Champagne.

Our review of the record indicates, moreover, that the 7-

percent average margin applicable to advertised wine and liquor
 - 26 -

in December is generally applicable to advertised wine and liquor

during the other months of the year. This low margin takes into

account the year-round "loss leaders" that petitioners advertised

and sold below cost, as well as the higher margin, but still

discounted, sale of wine and liquor. Petitioners charged

similarly discounted prices in this range for their in-store and

"perma sales".

We further conclude that there were substantial sales of

petitioners' nonadvertised, and smaller sized, wine and liquor.

This category included items such as the 750-milliliter Riunite

wine, the 750-milliliter Andre Pink Champagne, and 1-liter Jack

Daniels whiskey. These items, while still generally priced at a

discount from retail averages, nevertheless sold at margins near

20 percent.

On the basis of the foregoing, we find that the overall

margin applicable to petitioners' annual sales of wine and liquor

was 13.5 percent.

C. Margins on Sales of Cigarettes

Dr. Rossi determined that the cigarette invoices and

advertisements supported a finding that the average margin on

both generic and brand-name cigarettes was 5 percent.

Once again, Dr. Rossi's figures are based upon advertised

sale prices. Petitioners' principal competitor indicated,

however, that cigarette margins varied; he himself had made
 - 27 -

between $.10 and $1 per carton.

Petitioners did not always maintain sale-price margins for

all their cigarettes. Sometimes, some of their cigarettes were

not on sale. Our understanding of the highly competitive

cigarette prices near the Illinois border indicates, however,

that there was little room for the higher margin of 10 to 15

percent routinely charged by stores just 10 miles away from

Nick's Liquors. We doubt that Nick's Liquors' prices ever

exceeded the 8-percent "fair trade" addition to cost imposed

under Indiana law. Nick's Liquors' imposed a higher margin on

cigarettes sold by the pack, however. All things considered, we

find that Nick's Liquors' cigarettes, for the years in issue,

sold for an average margin of 6.5 percent.

Respondent argues that the cigarette margin could, in fact,

be much higher because Dr. Rossi's figures fail to take into

account the large volume of cigarette coupon proceeds that Nick

received from cigarette manufacturers. The evidence shows that

Nick's Liquors redeemed several hundred thousand dollars' worth

of these coupons per year. Our review of the evidence indicates,

however, that, in computing their margins on cigarette sales,

petitioners have taken into account such coupons. There is no

indication that they varied from this practice when they provided

their cost information to Dr. Rossi.

D. Petitioners' Average Margin

To summarize, for the years in issue, Nick's Liquors sold
 - 28 -

beer, which accounted for 42 percent of its sales, at an average

margin of 11 percent. Nick's Liquors sold wine and liquor, which

accounted for 22 percent of its sales, at an average margin of

13.5 percent. Cigarettes accounted for approximately 33 percent

of sales, and they sold at an average margin of 6.5 percent. The

other 3 percent of sales was for miscellaneous items.

Petitioners have not provided a sufficient basis for us to find

that their profit margin on miscellaneous items was less than the

approximately 27 percent proposed by respondent.

The overall result is that petitioners' weighted gross

margin for the years in issue is 10.54 percent.

IV. Petitioners' Theft Loss Deduction

On October 25, 1991, $22,773 was stolen from store No. 1.

Petitioners' logbook entry for that date does not contain an

entry for the amount of the day's sales receipts. Instead, the

logbook contains the following entry: "Robbed 10-25-91". Of the

amount stolen, respondent has allowed the deduction of $3,004,

which represents lottery tickets, receipts for the sale of those

tickets, and beer deposits. These apparently are amounts that

petitioners, in the course of their business, were holding as

agents for third parties, including the State of Indiana.

Section 165(h) permits a deduction for a loss arising from

theft. It is settled, however, that the amount of a theft loss

may not exceed basis. In the case of cash which is part of gross

receipts, the amount of loss due to theft is not deductible if
 - 29 -

the victimized taxpayer has failed to take the amount stolen into

income. Permitting a theft loss deduction in these circumstances

would amount to allowing a double deduction. United States v.

Kleifgen, 557 F.2d 1293, 1299 (9th Cir. 1977); cf. Alsop v.

Commissioner, 290 F.2d 726, 727 (2d Cir. 1961), affg. 34 T.C. 606

(1960).

In this case petitioners figured their taxable income by

totaling up their sales and then deducting from that total their

costs of goods sold and other expenses. When they excluded the

stolen $22,773 from their total sales but did not change their

cost of goods sold, they effectively lowered their reported

income by $22,773. Their action produced the same effect as if

they had included the $22,773 amount in sales (and thus in

income) and then been allowed a deduction of that amount as a

theft loss deduction. Here, having excluded the $22,773 from

total sales, they may not deduct the $22,773 as a theft loss. To

do so would be to obtain a second tax benefit for only one loss.4

4
Sec. 1.165-8(c), Income Tax Regs., provides that the
taxpayers are to determine the amount of a theft loss deduction
under the rules for deductibility of casualty losses. The
pertinent part of the latter regulations, sec. 1.165-7(b), Income
Tax Regs., provides that the amount deductible for such a loss is
the lesser of the difference between the fair market value of the
property before and after the theft, or the adjusted basis of the
property.

Petitioners are cash basis taxpayers. They have shown
neither that they actually received and took into income the
stolen money, nor that they paid income tax on the amount stolen
for 1991, or any other year. Thus, they did not acquire a basis
in the property. Apparently, however, they were required to
(continued...)
 - 30 -

V. Petitioners' Interest Deduction

On or about February 10, 1992, respondent assessed

petitioners additional income tax of $286,147.50 for their 1986

tax year and $272,146 for their 1987 tax year. The assessments

for 1986 and 1987 resulted from respondent's increase in

petitioners' reported gross business profits for those years,

based upon respondent's use of a bank deposits analysis. In

1992, petitioners paid $393,024 in interest on the additional

amounts assessed for 1986 and 1987. Petitioners deducted the

amount of the interest payment on their 1992 Federal income tax

return.

Respondent disallowed this deduction, alleging that it was

personal interest under section 1.163-9T(b)(2)(i)(A), Temporary

Income Tax Regs., 52 Fed. Reg. 48409 (Dec. 22, 1987). We

disagree.5

4
(...continued)
repay $3,004 of the amount stolen in lotto money and beer
deposits that they were holding for others. This repayment gave
them a basis in that amount. See Reis v. Commissioner, T.C.
Memo. 1996-469.
5
Sec. 1.163-9T(b)(2)(i)(A), Temporary Income Tax. Regs.,
52 Fed. Reg. 48409 (Dec. 22, 1987), provides in part:

(2) Interest relating to taxes--(i) In general.
Except as provided in paragraph (b)(2)(iii) of this
section, personal interest includes interest--

(A) Paid on underpayments of individual
Federal, State or local income taxes * * *
regardless of the source of the income
generating the tax liability * * *.
 - 31 -

Section 163(h)(2)(A) exempts from the category of personal

interest (which is nondeductible for individuals) "interest paid

or accrued on indebtedness properly allocable to a trade or

business (other than the trade or business of performing as an

employee)".

In Redlark v. Commissioner, 106 T.C. 31 (1996), on appeal

(9th Cir., May 15, 1996), the taxpayers deducted the amount of

interest on the portion of a deficiency in Federal income tax

arising out of the Commissioner's adjustments that resulted from

accounting errors in the taxpayers' unincorporated business. The

Commissioner, relying on the provisions of section 1.163-

9T(b)(2)(i)(A), Temporary Income Tax Regs., supra, denied the

deduction, arguing that the payment at issue was the payment of

personal interest. We disagreed, holding that section 1.163-

9T(b)(2)(i)(A), Temporary Income Tax Regs., supra, was invalid

insofar as it applied to the taxpayers' circumstances. We

further held that the interest at issue was deductible as

interest on an "indebtedness properly allocable to a trade or

business" within the meaning of section 163(h)(2)(A).

The principle of Redlark applies here. There is no dispute

that petitioners, cash basis taxpayers, paid the interest at

issue on income tax deficiencies resulting from their operation

of Nick's Liquors, their unincorporated trade or business. Under

section 163(h)(2)(A), the interest they paid is deductible

because it was paid upon an indebtedness properly allocable to
 - 32 -

their trade or business.

VI. Accuracy-related Penalties

Respondent determined that petitioners are liable for

accuracy-related penalties under section 6662(a). Section

6662(a) imposes a penalty equal to 20 percent of the underpayment

of tax attributable to one or more of the items set forth in

section 6662(b). Respondent asserts that the entire

underpayments in issue were due to petitioners' negligence or

disregard of rules or regulations. Sec. 6662(b)(1).

Negligence has been defined as the failure to do what a

reasonable and ordinarily prudent person would do under the

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

(citing Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir.

1967)). Respondent's determinations are presumed correct, and

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

Luman v. Commissioner, 79 T.C. 846, 860-861 (1982).

Failure to keep adequate records is evidence of negligence.

Marcello v. Commissioner, supra at 507; Magnon v. Commissioner,

73 T.C. 980, 1008 (1980). Petitioners here did not maintain

adequate records regarding the amount of their sales.

Petitioners argue that their ledgers adequately reflected their

records. They point out that the accountants who prepared their

returns found the records adequate, as did one of their expert

witnesses, who is an accountant, a former Internal Revenue

Service supervisor, and a veteran of many IRS audits.
 - 33 -

Petitioners also have produced bank reconciliations prepared by a

certified public accountant that indicate that the amounts

reported on petitioners' books for the years in issue support

their receipts and costs and expenses, as reflected on their

Federal income tax returns.

Petitioners' argument fails to take into account the

possibility that their books and bank deposits may appear to be

accurate, but still may not reflect all the cash receipts.

Respondent is entitled to insist that petitioners maintain

records in addition to books that only may be "apparently

accurate". Schwarzkopf v. Commissioner, 246 F.2d at 734. Nick's

practices of taking cash from the stores' proceeds to meet his

payrolls, to pay business expenses, and to provide for his

personal needs all provided ample opportunity for a failure to

record all the receipts taken in. Early during the years in

issue, Nick was properly advised to retain his cash register

receipts and "Z-tapes" before the years in issue. Retention of

these materials would have provided an objective measure of

petitioners' receipts. Doing so also would likely have provided

for the reporting of the proper amounts of income tax. Nick,

however, failed to follow that advice.

We conclude that the underpayments for the taxable years

1990, 1991, and 1992, to the extent that they relate to

understated profit margins, are attributable to negligence. With

regard to other underpayments, however, the record does not
 - 34 -

support the imposition of accuracy-related penalties.

To reflect the foregoing,

Decision will be entered

under Rule 155.