Payne v. Commissioner

                        T.C. Memo. 1998-227



                      UNITED STATES TAX COURT



                  JERRY S. PAYNE, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 980-95, 26812-95.       Filed June 29, 1998.



     Jerry S. Payne, pro se.

     Richard C. Cummings, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     SWIFT, Judge:   Respondent determined deficiencies in and

additions to tax with regard to petitioner as follows:
                                          - 2 -
Docket No. 980-95
                                                     Additions to Tax
Year            Deficiency         Sec. 6653(b)(1)(A) Sec. 6653(b)(1)(B)   Sec. 6661

1987             $172,310               $128,693                *          $43,078

         *   50 percent of interest payable under sec. 6601 with respect
             to portion of underpayment attributable to fraud.


Docket No. 26812-95
                                                   Additions to Tax
  Year       Deficiency      Sec. 6651(a)(1)   Sec. 6653(a)(1)   Sec.6653(b)(1)    Sec.
6661
1988     $653,048             $15,233             $3,047        $444,087          $163,262


         Unless otherwise indicated, 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.

         The primary issues for decision are:              (1) Whether petitioner

received legal fees and other income that he did not report on his

Federal income tax returns; (2) the value of stock petitioner

received in September of 1988 as income; (3) whether for 1988

petitioner is to be charged with discharge of indebtedness income;

(4) whether for 1988 a corporation petitioner controlled made a valid

S election; (5) whether for 1987 and 1988 petitioner is entitled to

certain claimed deductions; and (6) whether for 1987 and 1988

petitioner is liable for the fraud addition to tax.

         Because of the inadequacy of petitioner’s books and records,

respondent used a combination of the specific item and bank deposits

methods of proof in determining significant increases to petitioner’s

income over that reported on petitioner's income tax returns.

Respondent also disallowed claimed deductions, made other
                                 - 3 -

adjustments, and charged petitioner with the fraud addition to tax

for each year.

     Respondent’s adjustments and the capacity in which various

funds, bank deposits, and stock were received by petitioner, whether

they constitute taxable income to petitioner, the deductibility of

the disputed deductions, and respondent’s imposition of the fraud

addition to tax are the subject of much confusion and disagreement

between the parties.   Certain items of income and deductions have

been conceded.   Also, petitioner now claims additional deductions

that were not reflected on his Federal income tax returns and that

were not properly raised in his pleadings.


                           FINDINGS OF FACT

     When the petitions were filed, petitioner resided in Houston,

Texas.

     During the years in issue, petitioner practiced law primarily as

a litigation specialist, and petitioner owned and operated in

Houston, Texas, a law firm under the name of Payne & Associates.

Petitioner provided extensive legal representation to and eventually

managed, controlled, and owned the stock of 2618, Inc. (2618 Inc) a

corporation that owned and operated in Houston, Texas, a topless

dance club under the name of Caligula XXI (the Club).

     During part of the years in issue, Gerhard Helmle (Helmle) owned

50 percent of the stock of 2618 Inc, and he assisted in managing

operations of the Club.   Petitioner also provided legal
                                 - 4 -

representation to Helmle in criminal proceedings against Helmle for

possession of illegal drugs.

     During the years in issue, petitioner provided management

services to and was actively involved in the business operations of

2618 Inc and of the Club.   Petitioner's involvement in the business

operations of 2618 Inc and of the Club increased as petitioner became

concerned that 2618 Inc and Helmle might not be able to pay legal

fees owed to petitioner in excess of $500,000.

     During 1986 through 1988, petitioner received funds relating to

various transactions and litigation involving Helmle, 2618 Inc, the

Club, and other entities and activities.   Those funds were generally

deposited into petitioner’s bank accounts, and portions of the funds

were then disbursed out of petitioner’s bank accounts for and on

behalf of 2618 Inc and the Club, on whose behalf portions of the

funds had been received by petitioner; other portions of the funds

were used by petitioner for his personal purposes.

     For the years in issue, petitioner failed to maintain adequate

books and records for his law firm, and adequate books and records

were not maintained for 2618 Inc and for the Club.


Houston Ordinance No. 86-323

     During 1986 through 1988, petitioner provided legal

representation to 2618 Inc and to the Club in litigation against the

City of Houston involving Houston Ordinance No. 86-323.    The

ordinance was passed by the City of Houston on March 5, 1986, and
                                 - 5 -

provided that no two topless dance clubs could operate within 1,000

feet of each other and that topless dance clubs were required by

April 4, 1986, to apply to the City of Houston for a permit to

conduct a sexually oriented business (SB).

     The Club had applied timely for an SB permit, but on April 25,

1986, because the Club was located within 1,000 feet of Texas

Cowgirls (another topless dance club that purportedly had been in

existence longer than the Club), its application for an SB permit was

denied.   Under the denial order, the Club was to be permitted to

remain in operation until March 31, 1990, so that the owners could

recoup their capital investments in 2618 Inc and in the Club.

     In 1986, petitioner initiated litigation on behalf of 2618 Inc

against the City of Houston, Texas Cowgirls, and its successor, the

Body Shoppe, involving the denial of the SB permit.   The primary

underlying issue in the litigation concerned whether the Club or

Texas Cowgirls had been in operation longer.

     Litigation over the SB permit negatively affected the value of

2618 Inc and of the Club, and without an SB permit continued

operation of the Club was in doubt.

     On November 27, 1989, during a hearing before the District Court

of Harris County, Texas, with regard to the SB permit, Helmle

testified that the market value of the Club with an SB permit would

be at least $2 million.   Helmle also submitted a report at the

hearing in which he represented that since 1980 the Club had made an

average of over $2 million in gross alcoholic beverage sales per year
                                - 6 -

and that the Club, with an SB permit, would earn a net profit of over

$1 million per year.

     On March 14, 1990, in the above litigation, the City of Houston

decided in favor of the Club and issued the Club an SB permit for an

indefinite period of time.


Mixed Beverage Permit Issue

     During the years in issue, petitioner also provided extensive

legal representation to 2618 Inc and to the Club in litigation

against the Texas Alcoholic Beverage Commission (TABC).

     During 1987, largely because of the criminal charges pending

against Helmle, TABC refused to renew the Club's two mixed beverage

permits necessary to sell alcohol to patrons.   Sales of alcoholic

beverages constituted the majority of the Club's gross receipts.     As

discussed further below, in order to increase the likelihood of

receiving mixed beverage permits from TABC, petitioner nominally

arranged to buy out Helmle's stock interest in 2618 Inc.

     After TABC failed to act on the Club's application for the mixed

beverage permits, petitioner filed suit in a State court against TABC

on behalf of 2618 Inc and the Club seeking actual damages of $2

million and punitive damages of $10 million.

     In August of 1988, a settlement agreement was reached between

TABC and the Club wherein no damages were awarded, but TABC agreed to

issue the mixed beverage permits to the Club effective September 20,

1988.
                                 - 7 -

$55,753 and $275,000 Loans From TexAmBkSW and TexGuarantyBk

     In 1986, a $55,753 loan was obtained from Texas American Bank

South West (TexAmBkSW) on behalf of 2618 Inc but nominally in the

name of petitioner.

     In 1987, a $275,000 loan was obtained from Texas Guaranty

National Bank (TexGuarantyBk) on behalf of 2618 Inc but nominally in

the name of petitioner.

     The $55,753 in loan proceeds received from TexAmBkSW was used in

1986 to pay a portion of Helmle’s legal fees owed to petitioner.    On

his 1986 Federal income tax return, petitioner reported his receipt

of the $55,753 as taxable income.

     In 1987 and 1988, petitioner received additional funds from 2618

Inc that he used to make payments of principal and interest to

TexAmBkSW on the $55,753 loan.   The following schedule reflects for

1987 and 1988 the funds that petitioner received from 2618 Inc to

make payments on the $55,753 loan and the principal and interest that

petitioner paid to TexAmBkSW on the loan.


                                          Funds Paid to
               Funds Received       TexAmBkSW on $55,753 Loan
     Year      from 2618 Inc        As Principal As Interest
     1987         $27,500             $23,272       $4,228
     1988          10,000               9,598           402


     The $275,000 in loan proceeds received from TexGuarantyBk was

used on behalf of 2618 Inc to redeem a 50-percent stock interest in

2618 Inc that was held by Spiro Kalantzakis.
                                   - 8 -

     In 1987 and 1988, petitioner received additional funds from 2618

Inc, and he used those funds (with the exception of $17,281 that was

used by petitioner in 1988 for personal purposes) to make payments of

principal and interest to TexGuarantyBk on the $275,000 loan.    The

following schedule reflects for 1987 and 1988 the funds petitioner

received from 2618 Inc to make payments on the $275,000 loan and the

principal and interest that petitioner paid to TexGuarantyBk on the

loan.

                                               Funds Paid to
                  Funds Received      TexGuarantyBk on $275,000 Loan
        Year      from 2618 Inc         As Principal   As Interest
        1987        $ 90,900              $68,751        $22,149
        1988         121,200               91,668         12,251

        For 1988, on its corporate Federal income tax return, 2618 Inc

deducted as a business expense for legal fees the above $121,200 in

funds that it paid to petitioner relating to the $275,000 loan.


Funds Received From 2618 Inc as Legal and Management Fees

        During 1987, petitioner received funds from 2618 Inc and from

the Club as legal and management fees in the following amounts:


                         Funds Received from 2618 Inc
        Year       As Legal Fees        As Management Fees
        1987          $108,713               $67,500
        1988            52,881                90,000
                                 - 9 -

Withdrawals of Cash From Cash Registers of 2618 Inc

     During 1987 and 1988, respectively, petitioner withdrew a total

of $6,721 and $4,699 in cash from the cash registers at the Club and

used this cash for personal purposes.


Payne & Potter

     In 1987, petitioner received $12,826 relating to his ownership

of 50 percent of the stock of a real estate development corporation

doing business under the name of Payne & Potter.   This $12,826

relates to the disposition of certain real estate held by Payne &

Potter.

     During the years in issue, Payne & Potter did not maintain

adequate books and records.   By the end of 1987, Payne & Potter was

insolvent.


Legal Fees From Miscellaneous Clients

     In 1987 and 1988, petitioner received $65,498 and $33,376,

respectively, for legal services he provided to clients other than

2618 Inc and the Club.


Miscellaneous Bank Deposits and Checks Not Deposited

     For 1987 and 1988, petitioner received $205,262 and $198,522,

respectively, in miscellaneous additional funds that were deposited

into his bank accounts.   For 1987, petitioner also received an

additional $5,426 in checks that were not deposited into his bank

accounts.
                                         - 10 -

         The record does not indicate the nature of the above funds that

   petitioner received during 1987 and 1988.


   Summary of Total Funds Received by Petitioner

         As summarized below, the evidence indicates that in 1987 and

   1988, petitioner received at least $590,346 and $510,678,

   respectively, in total funds from all sources.              As indicated, with

   the exception of $56,958 in 1987 and $4,699 in 1988, the funds

   petitioner received in each year were deposited into petitioner's

   bank accounts:



                                          1987
                             Funds Received by Petitioner
                                                 Funds Deposited        Funds Not
                                                Into Petitioner's       Deposited
          Relates To                 Amount         Bank Accts       Into Bank Accts
$55,753 TexAmBkSW Loan              $ 27,500        $ 5,000              $22,500
Legal Fees from 2618 Inc             108,713          88,402              20,311
Mgmt Fees from 2618 Inc               67,500          67,500                -0-
$275,000 TexGuarantyBk Loan           90,900          90,900                -0-
Withdrawals of Cash from the Club      6,721            -0-                6,721
Payne & Potter                        12,826          12,826                -0-
Other Legal Fees                      65,498          63,498               2,000
Misc. Bank Deposits                  205,262         205,262                -0-
Misc. Checks Not Deposited             5,426            -0-                5,426

                 Total             $590,346        $533,388              $56,958


                                          1988
                            Funds Received by Petitioner
                                                Funds Deposited        Funds Not
                                               Into Petitioner's       Deposited
             Relates To               Amount      Bank Accts        Into Bank Accts
   $55,753 TexAmBkSW Loan            $ 10,000       $ 10,000             $ -0-
   Legal Fees from 2618 Inc/Club       52,881         52,881               -0-
   Mgmt Fees from 2618 Inc/Club        90,000         90,000               -0-
   $275,000 TexGuarantyBk Loan        121,200        121,200               -0-
   Cash Withdrawals from the Club       4,699           -0-               4,699
   Other Legal Fees                    33,376         33,376               -0-
   Misc. Bank Deposits                198,522        198,522               -0-

                 Total               $510,678       $505,979            $4,699
                               - 11 -

Petitioner's Receipt of Property and Stock of 2618 Inc

     By the end of 1987, as a result of the outstanding legal fees in

excess of $500,000 owed to him by 2618 Inc and by Helmle, petitioner

began exercising increasing control over the finances and operations

of 2618 Inc and of the Club.

     On February 15, 1988, ownership interests in certain intangible

and tangible personal property relating to the Club (namely, 2618

Inc's leasehold interest in the building in which the Club operated,

the equipment, leasehold improvements, furniture and fixtures located

in the building, and the right to use the Caligula XXI name) were

transferred to petitioner in satisfaction of a portion (namely,

$35,000) of the legal fees owed to petitioner.   Petitioner then

leased the above property back to 2618 Inc.

     In 1988, ownership of all of the outstanding stock of 2618 Inc

was transferred from Helmle to petitioner in further payment of legal

fees that 2618 Inc and Helmle owed to petitioner.

     As indicated above, largely on account of the criminal charges

pending against Helmle, TABC had denied the Club the mixed beverage

permits required to sell alcoholic beverages to patrons.   During

1988, petitioner had actively sought a buyer for Helmle's interest in

2618 Inc, but he was unsuccessful.   Transfer of the stock of 2618 Inc

to petitioner therefore served the additional purpose of eliminating

Helmle as one of the stockholders of 2618 Inc.
                                  - 12 -

     The transfer to petitioner of the stock of 2618 Inc took the

form of a purchase.   Nominally, petitioner agreed to purchase

Helmle’s stock in 2618 Inc for a stated consideration of $10 in cash

and a $500,000 promissory note.    Petitioner, however, was not

personally liable on the $500,000 promissory note, and petitioner

never made any payments on the promissory note.

     The purported stock purchase agreement between petitioner and

Helmle, dated March 15, 1988, was conditional and provided that the

transfer to petitioner of the stock of 2618 Inc would not be

effective unless and until TABC granted 2618 Inc's application for

mixed beverage permits.   On July 5, 1988, petitioner and Helmle

reduced the stated principal amount of the promissory note that had

been executed by petitioner in favor of Helmle from $500,000 to

$300,000.   Petitioner also was not personally liable on the revised

$300,000 promissory note, and petitioner never made any payments on

the $300,000 promissory note.

     In 1988, before conditions associated with the transfer of the

stock were satisfied, petitioner represented himself to third parties

as the sole stockholder of 2618 Inc.

     On September 20, 1988, the litigation with TABC essentially was

resolved, 2618 Inc was issued mixed beverage permits, and transfer to

petitioner of the outstanding stock of 2618 Inc became effective.

     In fact, the purported March 15, 1988, agreement under which

petitioner was to purchase from Helmle the stock of 2618 Inc was a
                                    - 13 -

sham, and petitioner received the stock of 2618 Inc not by purchase,

but in payment and in satisfaction of the over $500,000 in legal fees

owed to him by 2618 Inc and by Helmle.

     During 1986 through 1988, in correspondence to various

individuals, petitioner made statements regarding the value of the

stock of 2618 Inc and of the Club.        The following schedule summarizes

petitioner's statements:

 Date                                Description

09/19/86   Letter to hearing officer for City of Houston in which petitioner
           stated that the market value of the Club was between $1 million and
           $1.5 million.

02/11/87   Letter to loan officer for TexGuarantyBk in which petitioner stated
           that the Club could be sold for $1.5 million.

06/05/87   Letter to district judge for Harris County, Texas, in which petitioner
           stated that the market value of the Club was between $1 million and
           $1.5 million.

11/17/87   Letter to Kalantzakis in which petitioner stated that a 50-percent
           stock interest in 2618 Inc had a value of over $700,000 and that an
           individual had offered to purchase the Club for $1 million.

02/29/88   Letter to Helmle in which petitioner stated that an offer had been
           received to purchase a 50-percent stock interest in 2618 Inc for
           $600,000.


Relief as Guarantor of $705,000 Debt Obligation

     On March 14, 1985, Payne & Potter borrowed $705,000 from Texas

Commerce Bank in Houston (TexCommBk) to develop four luxury

condominium units on a golf course in Lakeway, Texas.           Petitioner was

shown on the loan documentation as guarantor of this $705,000 loan.

     By 1987, apparently because of the declining regional real

estate market, Payne & Potter defaulted on its $705,000 debt

obligation to TexCommBk.      During 1987 and 1988, petitioner made
                                - 14 -

payments totaling $76,361 and $19,139, respectively, to TexCommBk in

connection with his guaranty of this $705,000 loan.

     On October 3, 1988, petitioner and TexCommBk entered into a

restructuring agreement under which several loans between petitioner

and TexCommBk and petitioner's liability as guarantor of the above

$705,000 loan were restructured.   Under the restructuring agreement,

in full satisfaction of petitioner's liability as guarantor of the

$705,000 loan, petitioner agreed to pay $105,000 and other amounts to

TexCommBk and to assign to TexCommBk certain rent receivables.    In

addition, two parcels of real estate that were held by Payne & Potter

were transferred to TexCommBk in further payment on the $705,000

loan.

     For 1988, TexCommBk mailed a Form 1099 to respondent and to

Payne & Potter reflecting that Payne & Potter had realized discharge

of indebtedness income of $349,500 in connection with the above

restructuring agreement.   This $349,500 apparently was calculated on

the basis of the unpaid principal balance of the $705,000 loan less

the $105,000 that petitioner agreed to pay TexCommBk and less the

value of the two parcels of real property that were transferred to

TexCommBk.   The unpaid principal balance of the $705,000 loan and the

value of the two parcels of real property are not in evidence.


Payments Made to Banks

     As indicated above, in addition to the deposits petitioner made

into his bank accounts, during 1987 and 1988, petitioner made
                                     - 15 -

significant payments to various banks.          The payments apparently

related to various personal and business obligations that petitioner

owed to the banks, such as petitioner’s guaranty of the $705,000

TexCommBk loan.      Petitioner's books and records, however, and the

evidence herein, generally fail to establish either the specific

nature of the payments (whether principal or interest) and/or the

specific nature of the related debt obligations (whether personal or

business).      The schedule below summarizes the payments that

petitioner made to the various banks and, where established in the

record, indicates the general nature of the payments:


     Bank             Nature of Payments             1987           1988
TexGuarantyBk                                     $119,146       $ 58,702
TexCommBk           Guarantor $705,000 Debt         76,361         19,139
TexCommBk                                           16,763         11,669
TexAmBkSW                                            7,254         10,361
Merabank            Mortgage on Residence           19,402         30,666
Savings Banc                                         3,658          4,482
Other Banks                                         27,069            250

                             Total                $269,653       $135,269


     Forms 1099-INT that respondent received relating to petitioner

for 1987 and 1988 indicate that petitioner paid the following

interest expenses:


                                          Interest Paid
               Bank                     1987            1988
           Merabank                   $15,965        $27,397
           TexGuarantyBk                9,204         12,251
           TexCommBk                   13,526         20,336
           TexAmBkSW                    7,254             --
           Savings Banc                 2,079             --

                   Total              $48,028          $59,984
                                - 16 -

False Information Submitted to Banks

     During 1984 through 1988, petitioner submitted falsified

financial documents and falsified copies of his Federal income tax

returns that misstated his net worth and income to various banks and

other financial institutions.


Petitioner's Books and Records Relating to Expenses

     For 1987 and 1988, petitioner’s records generally fail to

adequately establish and substantiate the nature and amount of

expenses that petitioner incurred.


Petitioner’s Federal Income Tax Returns
and Respondent’s Audits

     On October 13, 1988, and on October 28, 1989, petitioner filed

his 1987 and 1988 Federal income tax returns on which petitioner

reported, among other things, the following:


                                             1987          1988
Gross Receipts from Law Practice           $232,438      $189,788
Business Interest Income                      9,254         2,189

Less:
     Cost of Goods Sold                      17,201           49,596
     Other Business Expenses                230,767          147,993

          Net Business Loss               ($   6,276)   ($    5,612)

Other Income                                     --          32,326
Less Itemized Deductions                         --          35,057

          Net Tax Loss                    ($   6,276)   ($    8,343)
                                - 17 -

     Apparently because of the reported business loss and the absence

of other reported income, petitioner did not claim any itemized or

standard deductions on his 1987 Federal income tax return as filed.

     The record herein does not indicate specifically the source and

nature of the income that petitioner included in the gross receipts

and business interest income figures that were reported on his 1987

and 1988 Federal income tax returns.     Thus, we do not know

specifically how, if at all, petitioner treated on his 1987 and 1988

Federal income tax returns the various funds that petitioner received

from 2618 Inc, from Payne & Potter, and from other sources.

     On his 1988 Federal income tax return, petitioner did not report

any income relating to the stock of 2618 Inc that he received in

payment of outstanding legal fees, and he did not report any income

relating to relief from his liability as guarantor of the $705,000

TexCommBk loan.

     As indicated, on audit, because of the inadequacy of

petitioner’s books and records, respondent reconstructed petitioner's

taxable income for 1987 and 1988 using the specific item and the bank

deposits methods of proof.   Respondent disallowed many claimed

business and itemized deductions, and respondent asserted the fraud

and substantial understatement additions to tax.

     With regard to the income adjustments, respondent determined

that petitioner for 1987 and 1988 had additional unreported business

income relating to his law practice of $154,667 and $2,114,700,
                                    - 18 -

respectively.      This alleged additional income is based primarily on

the unexplained deposits into petitioner's bank accounts, the alleged

value of the stock of 2618 Inc that petitioner received in 1988, and

the alleged discharge of indebtedness income relating to petitioner’s

relief from liability as guarantor of the $705,000 TexCommBk loan.

     In an amended answer for 1988, respondent asserted that $91,668

in additional flow-through income from 2618 Inc should be taxable to

petitioner on the grounds that 2618 Inc was an S corporation and the

$91,668 was improperly deducted on 2618 Inc's Federal income tax

return as legal fees.

     The following schedules reflect the deductions as claimed on

petitioner's 1987 and 1988 Federal income tax returns and the amount

thereof allowed and disallowed by respondent in respondent’s notices

of deficiency:


                           1987 Business Deductions
                           Amount Claimed   Amount Allowed   Amount Disallowed
         Item                On Return       By Respondent     By Respondent
Temporaries and Steno        $ 8,712              -0-            $ 8,712
Materials and Supply            3,710             -0-               3,710
Depositions, Court Costs        4,779             -0-               4,779
Bad Debts                      22,826             -0-              22,826
Dues and Publications             623          $ 623                 -0-
Insurance                       6,933            6,933               -0-
Interest                      149,137             -0-             149,137
Rent and Utilities             24,317             -0-              24,317
Taxes                           2,861             -0-               2,861
Travel, Meals, etc.             3,212             -0-               3,212
Telephone                       3,564            3,564               -0-
Parking                         3,248             -0-               3,248
Auto & Plane                   14,051             -0-              14,051
Error Correction                   (5)            -0-                  (5)

           Total             $247,968         $11,120           $236,848
                                       - 19 -
                              1988 Business Deductions
                              Amount Claimed   Amount Allowed   Amount Disallowed
        Deduction               On Return       By Respondent     By Respondent
Temporaries and Steno           $ 30,677             -0-            $ 30,677
Labor                             11,999             -0-              11,999
Depos., Court Costs, etc.          6,920             -0-               6,920
Dues and Publications                850          $ 850                 -0-
Insurance                         10,366           10,366               -0-
Interest                          69,622             -0-              69,622
Rent and Utilities                27,704             -0-              27,704
Taxes                              6,678             -0-               6,678
Travel, Meals, etc.                2,674             -0-               2,674
Telephone                          8,474             -0-               8,474
Parking                            4,728             -0-               4,728
Auto and Plane                    16,897             -0-              16,897

           Total                $197,589         $11,216           $186,373



                             1988 Itemized Deductions
                              Amount Claimed   Amount Allowed   Amount Disallowed
         Item                   On Return       By Respondent     By Respondent
Medical and Dental               $16,321             -0-            $16,321
Taxes                              5,076          $ 5,076              -0-
Interest                          11,320           11,320              -0-
Charitable Contributions           2,300             -0-              2,300
Error Correction                      40             -0-                 40

           Total                $35,057          $16,396           $18,661



     Respondent also audited 2618 Inc's Federal income tax returns

for 1987 and 1988 and eventually issued no-change letters with regard

thereto.


Items of Income Conceded by the Parties

     For 1987 and 1988, petitioner and respondent have made

concessions and have entered into stipulations as to the treatment as

taxable income to petitioner of portions of the total deposits made

into petitioner’s bank accounts and of checks made payable to

petitioner but not deposited into his bank accounts (Other Checks),

as set forth below.         The amounts shown as conceded by petitioner are
                                             - 20 -

         to be treated as taxable income.       The amounts shown as conceded by

         respondent are to be treated as nontaxable income.


           Total Deposits Into            Deposits Conceded           Other Checks Conceded
Year   Petitioner’s Bank Accounts   By Petitioner By Respondent   By Petitioner By Respondent
1987            $533,388              $234,453       $253,477        $20,311        $19,249
1988             505,979               182,338        278,757           --             --


               The above deposits and other checks conceded by petitioner as

         taxable income generally reflect funds petitioner received as legal

         and management fees from 2618 Inc and other funds that petitioner

         received in connection with his law practice.


         Bank Deposits and Other Checks Still in Dispute

               For 1987, the treatment as taxable income of $45,458 in bank

         deposits and $10,677 in checks made payable to petitioner but not

         deposited into petitioner's bank accounts remains disputed by the

         parties.

               For 1988, the treatment as taxable income of $44,884 in bank

         deposits remains disputed by the parties.

               With regard to the $45,458 in bank deposits still in dispute for

         1987, the following schedule reflects for each bank account the date,

         payor, and amount of each bank deposit:
                                     - 21 -
                        Disputed Bank Deposits for 1987
Texas Commerce Bank Account No. 14909839
         Date                      Payor                     Disputed Amount
      06/03/87                   2618 Inc                        $ 419
      07/09/87                   2618 Inc                           438
      08/18/87          TLD Overage-Payoff 1300563874               350
      09/28/87               Fireman's Fund Ins                   5,000
      11/10/87                  Farmers Ins                         742

TexGuarantyBk Account No. 40033653
         Date                      Payor                     Disputed Amount
      04/28/87                   2618 Inc                       $ 2,461
      05/27/87                   2618 Inc                         2,461
      06/29/87                   2618 Inc                         2,461
      07/28/87                   2618 Inc                         2,461
      08/26/87                   2618 Inc                         2,461
      09/16/87           Preferred Risk Group/Heineke             3,534
      09/28/87                   2618 Inc                         2,461
      10/26/87              Stewart Title Austin                 12,826
      10/27/87                   2618 Inc                         2,461
      11/25/87                   2618 Inc                         2,461
      12/28/87                   2618 Inc                         2,461

                                           Total                $45,458


     With regard to the $10,677 in checks not deposited into

petitioner's bank accounts still in dispute for 1987, the following

schedule reflects the date, payor, check number, and amount of each

check.

   Disputed Checks Not Deposited into Petitioner's Bank Accounts for 1987
       Date            Payor          Check No.       Disputed Amount
     01/19/87        2618 Inc           3680              $ 1,893
     01/21/87        2618 Inc           3687                1,169
     02/23/87        2618 Inc           3741                  941
     03/09/87        2618 Inc           3853                  233
     04/01/87        2618 Inc           3928                  358
     05/01/87        2618 Inc           4031                  436
     08/03/87        2618 Inc           4423                  322
     08/21/87        2618 Inc           4510                1,000
     09/08/87        2618 Inc           4595                  376
     10/05/87        2618 Inc           4714                  255
     11/02/87        2618 Inc           4874                  233
     12/02/87        2618 Inc           5040                  217
        --           David Eyre          --                 2,000
        --              Bank             --                    36
        --              Bank             --                   108
        --         Thomas Vandiver       --                 1,100

                                   Total                  $10,677
                                        - 22 -

     With regard to the $44,884 in bank deposits still in dispute for

1988, the following schedule reflects for each bank account the date,

payor, and amount of each bank deposit.

                      Disputed Bank Deposits for 1988
TexGuarantyBk Account No. 00007823
        Date                   Payor                    Disputed Amount
      03/30/88              2618 Inc                        $ 2,461
      04/26/88              2618 Inc                          2,461
      05/13/88              2618 Inc                             46
      05/31/88              2618 Inc                          2,461
      06/20/88              2618 Inc                          2,500
      06/29/88              2618 Inc                          2,461
      08/01/88              2618 Inc                          2,461
      08/22/88     Providence Washington Insurance              450
      09/02/88              2618 Inc                          2,500
      09/12/88              2618 Inc                          2,500
      09/26/88              2618 Inc                          2,000
      10/03/88              2618 Inc                          2,461
      10/07/88              2618 Inc                          2,500
      10/20/88              2618 Inc                          2,461
      11/04/88              2618 Inc                          2,500
      11/08/88              2618 Inc                          2,461
      12/05/88              2618 Inc                          1,230
      12/08/88              2618 Inc                          1,231
      12/29/88      Bank Statement-Missing Item               2,461

TexGuarantyBk Account No. 4003653
         Date                  Payor                    Disputed Amount
      02/11/88               2618 Inc                       $   160
      02/19/88               2618 Inc                         2,461
      02/29/88               2618 Inc                         2,461
      03/09/88               2618 Inc                           101
      04/13/88               2618 Inc                            95

                                   Total                   $44,884


Deductions Allowed by Respondent

     For 1987 and 1988, respondent has conceded certain claimed

business and itemized deductions in addition to the amounts

previously allowed in the notices of deficiency.           The total of the

deductions claimed on petitioner's income tax returns that were
                               - 23 -

previously allowed by respondent combined with the claimed deductions

now conceded is as follows:


             Total Deductions Allowed by Respondent
                                      1987            1988
     Business Deductions:
       Business Interest            $ 32,063        $ 32,598
       Depreciation/Lakeway            4,890          20,770
       Miscellaneous                  48,870         161,234

     Itemized Deductions:
       Mortgage Interest                15,965          27,397
       Taxes                             2,697           5,076

               Total                $104,485          $247,075


Deductions Still in Dispute

     For 1987 and 1988, petitioner still disputes respondent's

disallowance of the following business and itemized deductions

claimed on petitioner’s Federal income tax returns:


                   Deductions Still in Dispute
                                      1987               1988
     Business Deductions:
       Business Interest            $117,074           $37,024
       Bad Debt Deduction             22,826               --
       Miscellaneous                  27,135            21,318

     Itemized Deductions:
       Medical                            --            16,321
       Charitable Contrib.                --             2,300

               Total                $167,035           $76,963


Additional Deductions Claimed by Petitioner and Still in Dispute

     For 1987 and 1988, petitioner on brief, and without properly

raising such items, claims additional deductions, as follows:
                                 - 24 -


           Additional Deductions Claimed by Petitioner

  Business Deductions:                  1987             1988
    Depreciation/Office Equip.       $ 77,393         $ 58,045
    Bad Debt Deduction                   --            127,174
    Payment to TABC                    15,700             --
    NOL Carryforward from 1985         70,000             --

  Itemized Deductions:
    Medical                            15,442                --
    Charitable Contributions            2,300                --

                Total                $180,835         $185,219


                                 OPINION

Unexplained Bank Deposits and Other Funds

     On October 13, 1991, and October 26, 1992, respectively, the

normal 3-year period of limitations for assessment expired with

respect to petitioner’s 1987 and 1988 Federal income tax liabilities.

Accordingly, respondent’s 1987 and 1988 notices of deficiency dated

October 13, 1994, and September 26, 1995, respectively, are timely

only if respondent establishes that petitioner’s 1987 and 1988

Federal income tax returns were fraudulently filed or that there was

omitted on those returns more than 25 percent of petitioner’s correct

gross income for each year.    Sec. 6501(c), (e).

     Generally, bank deposits represent prima facie evidence of

income, and respondent need not prove a likely taxable source of such

income.   Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).    However,

where fraud is at issue, bank deposits will not be treated as taxable

income unless respondent proves a likely taxable source of the bank
                                - 25 -

deposits or disproves nontaxable sources alleged by the taxpayer.

Parks v. Commissioner, 94 T.C. 654, 661 (1990); see Armes v.

Commissioner, 448 F.2d 972, 974-975 (5th Cir. 1971), affg. in part,

revg. in part and remanding T.C. Memo. 1969-181.

     Funds received by a taxpayer as a mere agent or conduit of a

corporation are not treated as taxable income.   See Estate of

Lashells v. Commissioner, 208 F.2d 430, 435 (6th Cir. 1953), affg. in

part, revg. in part and remanding a Memorandum Opinion of this Court;

Rehtorik v. Commissioner, T.C. Memo. 1996-532; Ishijima v.

Commissioner, T.C. Memo. 1994-353.

     Respondent has the burden to prove fraud by clear and convincing

evidence and the burden to prove an omission of more than 25 percent

of gross income by a preponderance of the evidence.   Sec. 7454(a);

Rule 142(b); Peters v. Commissioner, 51 T.C. 226, 230 (1968).

     On the basis of our findings of fact as to the source and the

use of the funds that petitioner received during the years in issue,

in the paragraphs below we first explain our conclusions as to the

taxability to petitioner of each of the disputed bank deposits in the

cumulative amount of $45,458 for 1987 (see supra p. 21) and of

$44,884 for 1988 (see supra p. 22), and the $10,677 in disputed

checks not deposited into petitioner's bank accounts for 1987 (see

supra p. 21).   We then explain our conclusions as to the taxability

to petitioner of cash withdrawals from the Club, the receipt of the

stock of 2618 Inc, and petitioner's liability as guarantor of the

$705,000 debt obligation to TexCommBk.
                                - 26 -

                Deposits and Other Checks Relating to
             the $55,753 TexAmBkSW Loan -- 1987 and 1988

     Respondent argues that petitioner failed to pass through to

TexAmBkSW and should be taxed on $4,228 in 1987 and $402 in 1988 that

petitioner received from 2618 Inc in order to pay interest due on the

$55,753 TexAmBkSW loan (see supra p. 7).   Petitioner argues that he

passed through the disputed funds to TexAmBkSW and should not be

taxed thereon.   For 1987 and 1988, evidence in the record indicates

that petitioner paid $7,254 and $10,361, respectively, to TexAmBkSW

(see supra pp. 14-15), and no evidence indicates that petitioner or

2618 Inc owed any separate debt obligation to TexAmBkSW other than

the above $55,753 loan on which interest was due.   We conclude that

petitioner, on behalf of 2618 Inc, passed through the disputed $4,228

and $402 to TexAmBkSW as payments on the $55,753 loan and that these

disputed funds should not be treated as taxable income to petitioner.


                   Deposits Relating to the $275,000
                  TexGuarantyBk Loan -- 1987 and 1988

     Respondent argues that petitioner failed to pass through to

TexGuarantyBk $22,149 in 1987 (see supra p. 8) and $29,5321 in 1988

that petitioner received from 2618 Inc in order to pay interest due

on the $275,000 TexGuarantyBk loan.   Petitioner argues that he passed




1
      This $29,532 represents $12,251 that petitioner allegedly
failed to pay as interest to TexGuarantyBk on the $275,000 loan,
and the $17,281 that petitioner received from 2618 Inc and used
for personal purposes (see supra pp. 7-8).
                                  - 27 -

through the disputed funds to TexGuarantyBk and should not be taxed

thereon.

     With regard to 1987, evidence in the record indicates that

petitioner in 1987 paid funds to TexGuarantyBk that exceeded the

$22,149 that petitioner received from 2618 Inc to pay on the $275,000

TexGuarantyBk loan (see supra pp. 14-15).     We conclude that the

amount of $22,149 in dispute for 1987 was received by petitioner on

behalf of 2618 Inc, was paid by petitioner to TexGuarantyBk, and

should not be treated as taxable income to petitioner.

     With regard to the disputed $29,532 in deposits for 1988,

evidence indicates that petitioner in 1988 made total interest

payments of $12,251 to TexGuarantyBk on the $275,000 loan (see supra

p. 15).    Other evidence indicates that petitioner did not pay to

TexGuarantyBk all of the funds that he received from 2618 Inc to pay

on this loan.    We conclude that the amount of $17,281 or the

difference between the total $29,532 that petitioner received in 1988

from 2618 Inc with regard to interest due on the $275,000 loan and

the $12,251 in interest that petitioner paid to TexGuarantyBk should

be treated as taxable income to petitioner.


          $12,826 in Deposits Relating to Payne & Potter -- 1987

     Respondent argues that the $12,826 deposited into petitioner's

bank accounts (see supra p. 19) in connection with the disposition of

real estate held by Payne & Potter should be taxable to petitioner as
                                 - 28 -

ordinary income.   Petitioner argues that the real estate that was

held by Payne & Potter was sold at a loss.

     No credible evidence in the record supports a finding that Payne

& Potter or petitioner incurred a loss with respect to any real

estate held by Payne & Potter, and we are satisfied that the real

estate activities of Payne & Potter constituted the source of this

$12,826.   We conclude that this $12,826 deposited into petitioner's

bank accounts should be taxable to petitioner as ordinary income

received in connection with petitioner's interest in Payne & Potter.


           $12,000 in Deposits Relating to Legal Fees -- 1988

     Respondent argues that $12,000 in disputed deposits constituted

legal fees paid to petitioner by 2618 Inc and not funds received by

petitioner to make payments on the $55,753 TexAmBkSW loan

transaction, as alleged by petitioner.2   Respondent notes that the

$12,000 in deposits was received by petitioner after the maturity

date of the $55,753 loan and that, on checks representing $9,500 of

the disputed $12,000, the funds were described as legal fees.

     Consistent with the credible evidence, we conclude that the

$12,000 constituted taxable legal fees to petitioner.




2
      This $12,000 in alleged legal fees represents the sum of
the disputed bank deposits at TexGuarantyBk, account No.
00007823, that were dated 6/20/88, 9/2/88, 9/12/88, 9/26/88, and
10/7/88 (see supra p. 20).
                                 - 29 -

                  Remaining Disputed Bank Deposits and
                      Other Checks -- 1987 and 1988

       With regard to the remaining $16,9323 disputed bank deposits and

other checks for 1987 and the remaining $2,9504 disputed bank

deposits for 1988, we conclude that the deposits should be treated as

taxable income to petitioner.    Petitioner’s law practice constitutes

the likely taxable source of these deposits.


Cash Withdrawals From the Club -- 1987 and 1988

       Respondent argues that the $6,721 and $4,699 that petitioner

withdrew from the cash registers of the Club in 1987 and 1988 were

used for personal purposes and constituted taxable income to

petitioner.    Petitioner argues that only $320 of the cash withdrawals

(represented by receipts reflecting the handwritten notation "draw")

should be taxable to him and that the remaining cash withdrawals were

used to recruit dancers for the Club and should not be taxable to

him.



3
      This $16,932 represents the sum of the following: The
disputed bank deposits at TexCommBk, account No. 14909839, that
were dated 8/18/87, 9/28/87, and 11/20/87; the disputed bank
deposit at TexGuarantyBk, account No. 40033653, that was dated
9/16/87; and the disputed checks not deposited into petitioner's
bank accounts that were dated 1/19/87, 1/21/87, and 8/21/87, plus
four other undated checks made payable to petitioner totaling
$3,244 (see supra pp. 19-20).
4
      This $2,950 represents the sum of the disputed bank
deposits at TexGuarantyBk, account No. 00007823, that were dated
8/22/88 and 11/4/88 (see supra p. 20).
                                - 30 -

      Petitioner's testimony on this issue was not credible and was

contradicted by other employees of the Club.   The above cash

withdrawals from the Club in the amounts of $6,721 and $4,699 are to

be treated as taxable income to petitioner.


Valuation of 2618 Inc's Stock as of September 20, 1988

     Fair market value is defined as the price at which property

would change hands between a willing buyer and a willing seller,

neither being under any compulsion to buy or sell and both having

reasonable knowledge of relevant facts.   United States v. Cartwright,

411 U.S. 546, 551 (1973).   The valuation of property involves a

question of fact.   Commissioner v. Scottish Am. Inv. Co., 323 U.S.

119, 123-125 (1944); Hamm v. Commissioner, 325 F.2d 934, 938 (8th

Cir. 1963), affg. T.C. Memo. 1961-347.

     In the absence of arm's-length sales near the valuation date,

closely held stock generally is to be valued on the basis of such

factors as the corporation's net worth, prospective earning power,

and dividend-paying capacity.   Estate of Andrews v. Commissioner, 79

T.C. 938, 940 (1982).

     Petitioner does not appear to dispute the treatment of his

receipt of the stock of 2618 Inc as taxable income.   As indicated,

petitioner’s purported purchase of the stock was a sham.   Petitioner

received the outstanding stock of 2618 Inc in payment of legal fees

owed to him in excess of $500,000, and the value of the stock

petitioner received constitutes taxable income to petitioner.
                                - 31 -

     Petitioner, however, argues that because of the ongoing

litigation over issuance to 2618 Inc of the mixed beverage and SB

permits, the stock of 2618 Inc had no value when he received the

stock in 1988.   Petitioner argues that the possibility was high that

the Club would be required to close as a topless dance club and

that that possibility eliminated any future income and goodwill value

associated with the Club's operations and with the stock of 2618 Inc.

Petitioner did not call an expert witness with regard to the value of

the stock of 2618 Inc.

     As explained, in the notice of deficiency for 1988, respondent

determined that the stock of 2618 Inc had a value of $1.5 million

when petitioner received it.   At trial, respondent's expert used a

discounted cash-flow analysis and arrived at alternative values for

the stock of 2618 Inc.   Assuming that the Club would receive an SB

permit and continue operating indefinitely beyond the projected March

31, 1990, termination date, respondent’s expert first valued the

stock at $1,140,000.   In the alternative, assuming that the Club

would not receive an SB permit and would be required to close as of

March 31, 1990, respondent’s expert valued the stock of 2618 Inc at

$230,000.   Both of the valuations of respondent's expert assume that

the Club would operate with mixed beverage permits.

     The evidence establishes that on September 20, 1988, petitioner

received all the outstanding stock of 2618 Inc, not in a legitimate

purchase transaction, but in payment of the over $500,000 in legal

fees owed to petitioner by 2618 Inc and by Helmle.    In the months
                                - 32 -

proximate to the valuation date and in spite of litigation pending

over the SB and mixed beverage permits, petitioner and others viewed

2618 Inc and the Club as constituting a profitable business

enterprise.   In correspondence and other documents, petitioner

consistently represented the value of 2618 Inc at or exceeding $1

million.   Offers from third parties apparently were received to

purchase the Club or the stock of 2618 Inc at a price exceeding $1

million.

     A report prepared by Helmle that petitioner used during hearings

held in 1989 relating to the SB permit stated that 2618 Inc with an

SB permit would have a value of $2 million and could earn net profits

each year of over $1 million.   Helmle also stated in the report that

since 1980, the Club had average annual sales of alcoholic beverages

of over $2 million.

     Petitioner testified that, in his opinion, the Club in 1991 had

a value of $1.1 million and that in 1997, at the time of trial of

these cases, the Club had a value of $2.1 million.

     As indicated, we have found that petitioner's acquisition of the

stock of 2618 Inc did not become effective until September 20, 1988,

with the Club’s receipt of the mixed beverage permits from TABC.

Thus, the dispute involving the mixed beverage permits was resolved

simultaneously with petitioner’s receipt of the stock, and we do not

regard that dispute as having any significant effect on the value of

the stock of 2618 Inc as of the date petitioner received the stock.
                                - 33 -

     However, as of September 20, 1988, the date on which petitioner

received the stock, we regard the continuing dispute and litigation

involving the SB permit as having a significant effect on the value

of the stock of 2618 Inc that petitioner received.   Without the SB

permit, the Club's continued operation as a viable business was not

likely.   Litigation involving the SB permit was not resolved until

1990 when the Club finally received the SB permit.

     Respondent's expert’s valuation of $1,140,000 does not take into

account the unresolved dispute over the SB permit and the possibility

the Club would be required to close on March 31, 1990.   On the other

hand, respondent's expert’s alternative valuation of $230,000 does

not adequately reflect the possibility that the SB permit dispute

would be resolved favorably and that the Club would be able to

operate indefinitely.

     Respondent's expert acknowledges that in his opinion, risks

associated with the SB permit litigation might well place the value

of the stock of 2618 Inc between his $230,000 and $1,140,000

alternate valuation figures.

     We conclude that respondent's expert’s $1,140,000 valuation for

the stock of 2618 Inc should be reduced by a discount of 50 percent

to reflect risks associated with the litigation over the SB permit.

We conclude that the proper value of the stock of 2618 Inc that

petitioner received on September 20, 1988, was $570,000.   This amount

is further supported or corroborated by the approximate $500,000 in

legal fees that were owed to petitioner and for which the stock was
                                - 34 -

transferred to petitioner and by the $500,000 face amount of the

promissory note that nominally was associated with petitioner's

receipt of the stock.

     This $570,000 is the additional amount that petitioner is

required to report as taxable income for 1988 with regard to his

receipt of ownership of the stock of 2618 Inc.


Alleged Discharge of Indebtedness Income -- 1988

     Generally, the difference between the face value of a debt and

the amount paid in satisfaction of a debt is treated as taxable

income to the debtor from discharge of the indebtedness.   Sec.

61(a)(12); United States v. Kirby Lumber Co., 284 U.S. 1, 3 (1931);

Babin v. Commissioner, 23 F.3d 1032, 1034 (6th Cir. 1994), affg. T.C.

Memo. 1992-673.   The inclusion in a taxpayer's income of an amount

associated with discharge of a debt is based on the increase in the

debtor’s assets and net worth as a result of the discharge of the

debt.   Dallas Transfer & Terminal Warehouse Co. v. Commissioner, 70

F.2d 95, 96 (5th Cir. 1934), revg. 27 B.T.A. 651 (1933).

     Respondent argues that petitioner did not in good faith contest

the nature and amount of his liability as guarantor of Payne &

Potter's $705,000 promissory note and that petitioner realized

discharge of indebtedness income of $349,500 when that liability was

settled.

     Petitioner argues that his liability under the guaranty

constituted a mere contingent liability, that he contested in good
                                 - 35 -

faith the nature and amount of the liability, and that he should not

be required to report discharge of indebtedness income in connection

with settlement of this liability.

     In Landreth v. Commissioner, 50 T.C. 803, 812-813 (1968), we

distinguished the situation involving a guarantor of a debt from that

of a primary obligor on a debt, and we concluded that a guarantor of

a debt, upon the payment of the debt by the primary obligor, does not

realize discharge of indebtedness income when relieved of an

obligation under a guaranty.    We stated as follows:


     The situation of a guarantor is not like that of a debtor
     who as a result of the original loan obtains a nontaxable
     increase in assets. * * * Where a debtor is relieved of
     his obligation to repay the loan, his net worth is
     increased over what it would have been if the original
     transaction had never occurred. This real increase in
     wealth may be properly taxable. However, where the
     guarantor is relieved of his contingent liability, either
     because of payment by the debtor to the creditor or because
     of a release given him by the creditor, no previously
     untaxed accretion in assets thereby results in an increase
     in net worth. * * * [Id. at 813; citations omitted.]


     On the evidence before us, we conclude that the discharge of the

balance due on Payne & Potter's $705,000 debt obligation to TexCommBk

may have resulted in discharge of indebtedness income to Payne &

Potter but not to petitioner.    When petitioner’s contested liability

as guarantor of the debt obligation was settled, petitioner did not

realize an increase in net worth, and petitioner is not to be charged

with discharge of indebtedness income with regard thereto.

See id.; Whitmer v. Commissioner, T.C. Memo. 1996-83.
                                - 36 -


2618 Inc's Subchapter S Election -- 1988

     By amended answer, respondent argues that due to the $91,668

improper deduction claimed for legal fees on 2618 Inc’s tax return

for 1988 (which under our findings is to be treated as payments of

principal on the $275,000 TexGuarantyBk loan), 2618 Inc’s income for

1988 should be increased by $91,668, and petitioner should now be

charged with $91,668 in additional flow-through income from 2618 Inc.

     Petitioner counters that because Helmle did not sign the consent

to elect S corporation status, 2618 Inc did not make a valid S

corporation election for 1988, and petitioner should not be required

to report as flow-through income the $91,668 increase to the income

of 2618 Inc.   For the same reason, petitioner now seeks to remove

from his reported taxable income for 1988 the $32,326 in S

corporation flow-through income from 2618 Inc that was reported on

his 1988 Federal income tax return.

     Respondent argues that the attempted S election made on behalf

of 2618 Inc on March 15, 1988, was valid because, during all of 1988,

petitioner, not Helmle, was the sole person in control of 2618 Inc.

     Section 1362(a) provides that small business corporations may

elect to be governed by the provisions of subchapter S and thereunder

to be taxed as flow-through entities.    Sec. 1362(a).   For such an

election to be valid, all shareholders of the corporation, as of the

date the election is made, are required to consent to the election.
                                 - 37 -

Sec. 1362(a)(2); Wilson v. Commissioner, 560 F.2d 687, 689 (5th Cir.

1977), affg. T.C. Memo. 1975-92.

       Also, if an S election is to be effective for the current year

in which the election is made, section 1362(b)(2)(B) provides that

each person who was a shareholder at any time during the year (before

the time the election is made) is required to consent to the

election.    Sec. 1362(b)(2)(B); sec. 18.1362-2(b), Temporary Income

Tax Regs., 48 Fed. Reg. 3591 (Jan. 26, 1983).

       We note that during at least part of 1988, petitioner and TABC

treated Helmle as an owner of the stock of 2618 Inc.    Until September

of 1988, TABC would not issue mixed beverage permits to the Club

because of Helmle's continuing ownership interest in 2618 Inc, and

Helmle certainly considered himself an owner of the stock of 2618

Inc.    In 1988, petitioner actively sought a buyer for Helmle's

interest in 2618 Inc.

       On the evidence, Helmle is to be considered a beneficial owner

of the stock of 2618 Inc during a part of 1988, and Helmle’s consent

therefore was necessary for the 2618 Inc's S election to be effective

for 1988.    See sec. 1362(b)(2)(B); Wilson v. Commissioner, supra;

sec. 18.1362-2(b), Temporary Income Tax Regs., supra.

       Respondent suggests that the duty of consistency prevents

petitioner from now contradicting the treatment of 2618 Inc on

petitioner's 1988 Federal income tax return as an S corporation.      The

duty of consistency is generally applicable to prevent a taxpayer

from taking inconsistent positions in different taxable years when
                                 - 38 -

one of the tax years is closed with regard to assessment.   Herrington

v. Commissioner, 854 F.2d 755, 757 (5th Cir. 1988), affg. 87 T.C.

1087 (1986).   With regard to petitioner's 1988 tax year, respondent

seeks to apply the doctrine where only one taxable year is involved,

where respondent audited the 1988 income tax return of 2618 Inc and

where respondent issued a no-change report.   In this case, we decline

to apply the duty of consistency to petitioner with regard to this

adjustment.

     The absence of Helmle's consent makes the attempted S election

by 2618 Inc invalid for 1988, and petitioner is not required to

report the additional $91,668 in flow-through income from 2618 Inc

that represented nondeductible repayments on a loan.

     Petitioner’s attempt, however, on brief, to raise a new issue

and to remove from his taxable income the $32,326 in flow-through

income from 2618 Inc that petitioner did report on his 1988 Federal

income tax return is rejected.   Petitioner’s claim in this regard

constitutes a claim for refund with regard to an item not properly

raised by petitioner as a new issue under our Rules.   Rule 41.
                                 - 39 -

Deductions Still in Dispute and Additional
Deductions Claimed by Petitioner

     As indicated above (see supra p. 21), petitioner still disputes

respondent’s disallowance of $167,035 and $76,963 in business and

itemized deductions claimed on petitioner's respective 1987 and 1988

Federal income tax returns.    Petitioner also seeks to claim herein

additional business and itemized deductions of $110,835 and $185,219

for 1987 and 1988 (see supra p. 22), respectively.    Based on our

findings of fact, our conclusions as to the above claimed deductions

are set forth below.


        Claimed Business Interest Deductions -- 1987 and 1988

     Petitioner argues that the entire $117,074 for 1987 and $37,024

for 1988 in claimed business interest (see supra p. 21) is deductible

as such.   For 1987, the $117,074 claimed business interest consists

of $76,361 paid on petitioner’s guaranty to TexCommBk and $40,713

paid to other banks.   For 1988, the $37,024 in disputed business

interest consists of $19,139 paid on petitioner's guaranty to

TexCommBk and $17,885 paid to other banks.   Alternatively, with

respect to the $76,361 for 1987 and the $19,139 for 1988 that were

paid to TexCommBk, petitioner argues that he is entitled to a

business bad debt deduction.

     The evidence is incomplete and confusing with regard to many of

the payments petitioner made to various banks.   In attempting to

substantiate the claimed business interest deduction, petitioner

merely identified checks to various banks that in total approximated
                                 - 40 -

the amount of business interest reported on his income tax returns.

The evidence does not identify the portion of the payments that

constitutes interest as distinguished from principal.

     The $76,361 and $19,139 that petitioner paid to TexCommBk as

guarantor does not give rise to the payment of interest by

petitioner.   Rather, such payments by petitioner as guarantor of

Payne & Potter's debt obligation to TexCommBk are to be treated in

their entirety as the payment by petitioner of his obligation under

the guaranty, and they give rise to a debt obligation of Payne &

Potter in favor of petitioner.   In effect, petitioner is to be

treated as having made a loan to Payne & Potter.   See Putnam v.

Commissioner, 352 U.S. 82, 85 (1956); Southern Pac. Transp. Co. v.

Commissioner, 75 T.C. 497, 565-566 (1980).

     Petitioner's guaranty of Payne & Potter's debt obligation was

not made in the course of petitioner's trade or business.    Petitioner

practiced law as an attorney.    He did not engage in real estate

development outside of his involvement as a 50-percent owner of the

stock of Payne & Potter.   Petitioner's investment in and his guaranty

of the $705,000 debt obligation of Payne & Potter constituted

investment, not ordinary business, activity.   Accordingly, due to

Payne & Potter's insolvency, petitioner is entitled only to a

nonbusiness bad debt deduction for the $76,361 and the $19,139 paid

to TexCommBk in 1987 and 1988, respectively, on his guaranty,

deductible as short-term capital losses.   Sec. 1.166-9(b), Income Tax

Regs.
                                  - 41 -

     With regard to the $40,713 and $17,885 balance for 1987 and

1988, respectively, of the claimed business interest in dispute, no

credible evidence supports the treatment of these amounts as payments

of interest, and we disallow the claimed deductions for these

amounts.


           Claimed $22,826 Business Bad Debt Deduction -- 1987

     Petitioner argues that he is entitled to a $22,826 business bad

debt deduction (see supra p. 21) relating to an alleged $150,000 loan

made by him to Payne & Potter apart from his guaranty on the $705,000

debt obligation to TexCommBk.    The evidence does not support the

existence of any separate loan of $150,000 made by petitioner to

Payne & Potter.    Petitioner's testimony on this item was not

credible.    Petitioner's claimed deduction for a $22,826 business bad

debt was properly disallowed.


       Remaining Claimed Business Deductions -- 1987 and 1988

     No evidence supports the remaining $27,135 and $21,318 in

business deductions that petitioner claims for 1987 and 1988,

respectively (see supra p. 21).    These deductions were properly

disallowed by respondent.


              Itemized Deductions Still in Dispute -- 1988

     Petitioner argues that he is entitled to the claimed itemized

deductions for medical expenses of $16,321 and charitable

contributions of $2,300 (see supra p. 21).
                                  - 42 -

     No evidence supports these claimed deductions, and they are

disallowed.


        Additional Deductions Claimed on Brief -- 1987 & 1988

     On posttrial brief only, petitioner claims additional business

and itemized expenses for 1987 and 1988 of $110,835 and $185,219,

respectively (see supra p. 22).    These claimed additional expenses

relate to completely unsubstantiated alleged depreciation, bad debts,

payments to TABC, a net operating loss, medical expenses, and

charitable contributions.   These claimed deductions were not properly

raised by petitioner in his petition or by motion.   Rule 41.   No

credible evidence supports these claimed deductions, and they are

disallowed.

     We also note that for fraud purposes, a taxpayer is generally

required to present probative evidence of deductions not previously

claimed on his income tax return before respondent bears any burden

of proof with regard to alleged additional deductions.   See United

States v. Bender, 218 F.2d 869 (7th Cir. 1955); Rivera v.

Commissioner, T.C. Memo. 1979-343.

Fraud for 1987 and 1988

     To establish fraud, respondent has the burden of proving by

clear and convincing evidence that a taxpayer underpaid his Federal

income taxes and that the taxpayer's underpayment was due to

fraudulent intent.   Sec. 7454(a); Rule 142(b); Clayton v.
                                - 43 -

Commissioner, 102 T.C. 632, 646 (1994); Recklitis v. Commissioner, 91

T.C. 874, 909 (1988).

     With regard to fraudulent intent, respondent is required to

prove that a taxpayer intended to evade taxes by conduct intended to

conceal, mislead, or otherwise prevent the collection of taxes.      Zell

v. Commissioner, 763 F.2d 1139 (10th Cir. 1985), affg. T.C. Memo.

1984-152; Parks v. Commissioner, 94 T.C. at 661; Hebrank v.

Commissioner, 81 T.C. 640, 642 (1983).   Because direct evidence of

fraud is not generally available, fraud often must be established by

circumstantial evidence.   Clayton v. Commissioner, supra at 647;

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

     Courts have developed certain indicia of fraud, including the

following:   (1) Understatements of income; (2) inadequate books and

records; (3) failure to file income tax returns; (4) implausible or

inconsistent explanations of behavior; (5) concealed assets; (6)

failure to cooperate with tax authorities; (7) dealing in cash; and

(8) filing false documents.   Bradford v. Commissioner, 796 F.2d 303,

307-308 (9th Cir. 1986), affg. T.C. Memo. 1984-601.   The level of

sophistication and intelligence of taxpayers may also be considered.

See Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).

     For the years before us, where respondent proves that any part

of a taxpayer's underpayment of income tax is due to fraud, fraud is

presumed with respect to the entire underpayment unless a taxpayer
                               - 44 -

proves otherwise by a preponderance of the evidence.   Sec.

6653(b)(2).


          Corrected Income and Deductions for 1987 and 1988

     The following schedules reflect for 1987 and 1988 our findings

and conclusions as to petitioner's correct total income and

deductions including income previously reported by petitioner and

deductions previously allowed by respondent:


                     Items of Income for 1987
               Description                               Amount
Conceded Bank Deposits                                  $234,453
Conceded Checks Made Payable to Petitioner                20,311
Bank Deposits Relating to Payne & Potter                  12,826
Miscellaneous Bank Deposits and Other Checks              16,932
Cash Withdrawals from the Club                             6,721

                                   Total                $291,243


                   Deductions Allowed for 1987
               Description                               Amount
Allowed Business Deductions:
     Business Interest                                   $32,063
     Depreciation/Lakeway                                  4,890
     Miscellaneous                                        48,870
Allowed Itemized Deductions:
     Mortgage Interest                                    15,965
     Taxes                                                 2,697
Nonbusiness Bad Debt Relating to Guaranty                  3,000

                                   Total                $107,485
                                 - 45 -

                     Items of Income for 1988
                Description                                  Amount
Conceded Bank Deposits                                      $182,338
Funds Relating to $275,000 TexGuarantyBk Loan                 17,281
Bank Deposits Relating to Legal fees                          12,000
Miscellaneous Bank Deposits                                    2,950
Cash Withdrawals from the Club                                 4,699
Reported Flow-through Income                                  32,526
Reported Value of Assets of 2618 Inc                          35,000
Value of Stock of 2618 Inc                                   570,000

                                     Total                  $856,794


                 Deductions Allowed for 1988
               Description                                  Amount
Allowed Business Deductions:
     Business Interest                                      $ 32,598
     Depreciation/Lakeway                                     20,770
     Miscellaneous                                           161,234
Allowed Itemized Deductions:
     Mortgage Interest                                       27,397
     Taxes                                                    5,076
Nonbusiness Bad Debt Relating to Guaranty                     3,000

                                     Total                  $250,075


     Based on the above figures, the schedule below compares the

total income, deductions, and losses reported on petitioner’s Federal

income tax returns for 1987 and 1988 with the corrected amounts

therefor based on our findings and reflects large understatements of

taxable income and large underpayments of tax on petitioner's 1987

and 1988 Federal income tax returns as filed:


                            1987                       1988
                     Reported Corrected         Reported Corrected

     Total Income    $241,692    $291,243       $224,303    $856,794
     Deductions       247,968     107,485        232,646     250,075

     Income (Loss)   $ (6,276)   $183,758       $ (8,343)   $606,719
                                  - 46 -


We are satisfied that respondent has shown the existence of

underpayments for both years by clear and convincing evidence.

Accordingly, the first element of the fraud addition to tax is

established for both 1987 and 1988.


                 Fraudulent Intent for 1987 and 1988

     Petitioner argues that he should be regarded as an

unsophisticated taxpayer, that he handled his tax matters in an

inattentive manner, and that because of large deductions he assumed

were available to him he innocently estimated he owed no Federal

income taxes for 1987 and 1988.    Petitioner further argues that he

filed his Federal income tax returns without much thought and that

any underreporting of his correct income that was reflected on his

tax returns was inadvertent.

     For 1987 and 1988, petitioner substantially underreported his

correct income, and for 1987, petitioner overstated his allowable

deductions.

     Petitioner failed to maintain adequate books and records for his

law firm, and he failed to provide that adequate books and records be

maintained for 2618 Inc, for the Club, and for Payne & Potter.

Petitioner's inadequate records and his inconsistent and ever-

changing explanations complicated greatly respondent’s audit and

resolution of the issues in these cases.   Petitioner failed to

cooperate with respondent during respondent’s audit and during parts

of these proceedings.
                                - 47 -

     Petitioner submitted to banks and other businesses and

governmental entities false copies of his income tax returns and

false financial and other information.

     For 1988, petitioner reported gross receipts of $189,788,

disregarding a Form 1099 from 2618 Inc reflecting nonemployee

compensation to petitioner of $281,176.

     We are not persuaded by petitioner's arguments that he

innocently and inattentively bungled his tax affairs.   In light of

the evidence, we view petitioner's assertions of ignorance and

unsophistication as simply another attempt by petitioner to obscure

the facts.

     For 1987 and 1988, we conclude that the increases to

petitioner's taxable income that we have sustained herein (relating

to bank deposits, disputed checks not deposited into petitioner's

bank accounts, cash withdrawals from the Club, and deductions that we

have not allowed) are attributable to fraud.

     For 1988, we note that the increase to petitioner's taxable

income relating to petitioner's receipt of the stock of 2618 Inc is

also attributable to fraud.   We view petitioner's failure to report

any amount as income in connection with his receipt of the stock as

part of petitioner's fraudulent conduct.   We recognize the

difficulties in valuing the stock.   Our valuation, however, is

supported by petitioner's representations as to the value of 2618 Inc

and by the outstanding legal fees in excess of $500,000 for which the
                                  - 48 -

stock was received.   Also, petitioner's receipt of the stock in

payment for legal services was disguised as a purchase and sale.

     Respondent has established by clear and convincing evidence that

petitioner fraudulently underreported and underpaid his Federal

income taxes for 1987 and 1988.    We conclude that the fraud addition

to tax applies to the entire underpayment for each year.    Sec.

6653(b)(2).

     Because petitioner fraudulently filed his 1987 and 1988 Federal

income tax returns, the period of limitations does not bar assessment

of income tax for those years.    Sec. 6501(c)(1).

     Petitioner makes no separate argument for 1987 and 1988

regarding the substantial understatement addition to tax.    In light

of our findings and conclusions herein regarding petitioner’s failure

to report his correct income for 1987 and 1988, we sustain

respondent’s determination of the substantial understatement

addition.

     To reflect the foregoing,


                                      Decisions will be entered

                                 under Rule 155.