Toberman v. Commissioner

T.C. Memo. 2000-221

UNITED STATES TAX COURT

GERALD E. AND NANCY J. TOBERMAN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 22289-97. Filed July 24, 2000.

Daniel W. Schermer, for petitioners.

John C. Schmittdiel, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

THORNTON, Judge: Respondent determined a $1,194,503

deficiency in petitioners’ 1993 Federal income tax and a

$238,901 accuracy-related penalty pursuant to section 6662(a).1

1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the year in issue, and
(continued...)
 - 2 -

The issues for decision are: (1) Whether the notice of

deficiency is entitled to a presumption of correctness; (2)

whether petitioners had ordinary unreported income due to

forgiveness of indebtedness as determined by respondent; (3)

whether petitioners are entitled to a net operating loss

carryover in the amount of $3,992,234; and (4) whether

petitioners are liable for an accuracy-related penalty under

section 6662.

FINDINGS OF FACT

The parties have stipulated some of the facts, which are so

found. The stipulation of facts is incorporated herein by this

reference. When they filed their petition, petitioners were

married and resided in Key Biscayne, Florida. References to

petitioner are to petitioner husband.

Petitioner’s Business Holdings

From 1986 through 1993, petitioner held extensive business

interests, including two solely owned S corporations, Bonnevista

Terrace, Inc. (Bonnevista), and Castle Towers, Inc. (Castle

Towers), which owned and operated mobile home parks in Minnesota

and Indiana. Bonnevista was incorporated on June 30, 1966, and

elected status as an S corporation on July 20, 1966. Castle

1
(...continued)
all Rule references are to the Tax Court Rules of Practice and
Procedure.
 - 3 -

Towers was incorporated on May 22, 1979, and elected status as an

S corporation on December 29, 1986.

Petitioner also owned and operated marinas on Lake

Minnetonka in Minnesota through a number of wholly owned

corporations.2 To acquire the marinas, petitioner personally

guaranteed bank loans used to acquire the marinas and pledged the

mobile home parks as collateral. Initially, petitioner was

successful in the marina business. During a drought in 1988 or

1989, however, water levels at the marinas fell significantly.

Boaters began removing their boats from the marinas, and the

cash-flow from petitioner’s marina business practically stopped.

During the drought, Bonnevista and Castle Towers were

generating positive cash-flows from the mobile home parks. These

funds were used to help keep the marinas operating temporarily.3

Eventually, however, petitioner lost both the marinas and the

mobile home parks.4

2
These wholly owned corporations include: St. Albans Bay
Marina & Yacht Club, Inc.; Tonka Bay Marina & Yacht Club, Inc.;
Shorewood Marina & Yacht Club, Inc.; Maxwell Bay Marina, Inc.;
and Smith’s Bay Marina, Inc.
3
The record does not reveal the nature and amount of these
transactions.
4
The record is unclear as to exactly when or in what manner
petitioner lost these businesses, or exactly when any of the
various corporations may have actually gone out of existence.
 - 4 -

Loans From Bonnevista and Castle Towers to Petitioner

After filing Form 1120S, U.S. Income Tax Return for an S

Corporation, for its 1991 taxable year, Bonnevista filed no

subsequent income tax return.5 The balance sheet attached to the

1991 Form 1120S reflects loans to petitioner of $2,148,481 as of

the beginning of the tax year and $2,244,164 as of yearend.

After filing Form 1120S for its 1990 taxable year, Castle

Towers filed no subsequent return.6 The balance sheet attached to

its 1990 Form 1120S reflects yearend loans to petitioner of

$633,329.

Petitioner’s Ownership Interest in Fantastic Foods

In 1993, petitioner was president and majority stockholder

of Fantastic Foods, Inc., which holds exclusive rights to Dairy

Queen franchises in two counties in Florida. The corporation has

several affiliated corporations also known as Fantastic Foods.

The 1992 Federal corporate income tax return of one of those

affiliated corporations, Fantastic Foods, Inc. (Delaware),

indicates that it is wholly owned by petitioners’ son, William

5
The 1991 Form 1120S, U.S. Income Tax Return for an S
Corporation, does not indicate that it is the final return of
Bonnevista Terrace, Inc. (Bonnevista).
6
The 1990 Form 1120S does not indicate that it is the
final return of Castle Towers, Inc. (Castle Towers). On Schedule
E, Supplemental Income and Loss, of their 1991 joint Federal
income tax return, petitioners reported both passive and
nonpassive income from Castle Towers.
 - 5 -

Toberman, and that as of the end of 1992, the corporation owed

petitioner $457,072.

Bankruptcy Proceeding

In 1990, petitioner filed for relief under chapter 11 of the

United States Bankruptcy Code. On May 21, 1991, petitioner’s

bankruptcy case was dismissed for petitioner’s failure to file a

disclosure statement and plan of reorganization as directed by

the United States Bankruptcy Court.

Judgments Against Petitioner

Before 1993, a number of judgments were entered against

petitioner in favor of various creditors.

IRS Collection Information Statement

In 1993, petitioner submitted to the Internal Revenue

Service (IRS) Form 433-A, Collection Information Statement for

Individuals (CIS), signed and verified by petitioner on March 3,

1993, as true, correct, and complete. On the CIS, petitioner

reported that he had a net worth of approximately $389,650.7 On

the CIS, petitioner reported no outstanding loans from either

Bonnevista or Castle Towers. On the CIS, petitioner disclosed

neither his ownership interests in Fantastic Foods nor any

receivables from Fantastic Foods (Delaware). Petitioner reported

7
The Collection Information Statement for Individuals (CIS)
indicates that as of Mar. 3, 1993, petitioner had assets
comprising $50 cash and real estate worth $850,000 (subject to
encumbrances of $460,000), and had $400 of credit card debts.
 - 6 -

on the CIS, under the category “Other information relating to

your financial condition”, that there were no court proceedings

or repossessions.

Petitioner’s Claimed Net Operating Loss Deduction

For taxable year 1993, petitioners claimed a net operating

loss deduction of $3,992,234, comprising net operating loss

carryovers from prior years in the following amounts:

Year Amount

1986 $134,414
1987 424,283
1988 306,907
1989 1,627,007
1990 1,417,445
1991 82,178
3,992,234

Respondent’s Determinations

Respondent determined that for taxable year 1993 petitioners

had unreported ordinary income of $2,781,810 from discharge of

the debts owed by petitioner to Bonnevista and Castle Towers.8

Respondent also disallowed petitioners’ claimed net operating

loss deduction.

8
The notice of deficiency charges petitioner with
unreported cancellation of indebtedness income based on the
$2,148,481 loan due from petitioner to Bonnevista at the
beginning of 1991, rather than the $2,244,164 due at the end of
1991. On brief, respondent states that although the facts
support using the larger, more recent, loan balance to compute
petitioner’s 1993 cancellation of indebtedness income, respondent
has not amended his position to assert an increased deficiency.
 - 7 -

OPINION

I. Whether the Notice of Deficiency Is Entitled to a Presumption
of Correctness

As a general rule, the Commissioner’s determinations are

presumed correct, and the taxpayer has the burden of proving them

incorrect. See Rule 142(a); United States v. Janis, 428 U.S.

433, 441-442 (1976); Welch v. Helvering, 290 U.S. 111, 115

(1933); Feldman v. Commissioner, 20 F.3d 1128, 1132 (11th Cir.

1994), affg. T.C. Memo. 1993-17. Petitioners argue that

respondent’s determination is entitled to no presumption of

correctness because it was arbitrary and capricious.

The Court of Appeals for the Eleventh Circuit, to which this

case is appealable absent stipulation, has stated that the

presumption of correctness adheres once the Commissioner has made

a “minimal” evidentiary showing linking the taxpayer to the

alleged income-producing activity. Blohm v. Commissioner, 994

F.2d 1542, 1549 (11th Cir. 1993), affg. T.C. Memo. 1991-636.9 The

9
Petitioners’ reply brief states that because this case was
tried in St. Paul, Minn., and because petitioners have ties to
Minnesota, they “assume that a stipulation to appeal the case to
the Eighth Circuit will be a routine matter.” See sec.
7482(b)(2). We need not linger long over petitioners’
assumption, however, for we discern no essential difference in
the standards applied in the Eleventh and Eighth Circuits in
determining whether the statutory notice is supported by an
adequate evidentiary foundation to sustain the presumption of
correctness. Cf. Page v. Commissioner, 58 F.3d 1342, 1347 (8th
Cir. 1995) (the presumption of correctness fails “where the
Commissioner makes the assessment without any foundation or
supporting evidence” (Emphasis added.)), affg. T.C. Memo. 1993-
(continued...)
 - 8 -

Commissioner may support his determination on the basis of any

admissible evidence and need not rely on the evidence used in

making the administrative determination. See Jackson v.

Commissioner, 73 T.C. 394, 400 (1979). This conclusion is a

natural consequence of the well-established principle that “a

trial before the Tax Court is a proceeding de novo; our

determination of a petitioner’s tax liability must be based on

the merits of the case and not any previous record developed at

the administrative level.” Id. (citing Greenberg’s Express, Inc.

v. Commissioner, 62 T.C. 324, 328 (1974)); see also Gatlin v.

Commissioner, 754 F.2d 921, 923 (11th Cir. 1985), affg. T.C.

Memo. 1982-489. An exception to this rule against looking

behind the notice of deficiency may apply in the rare case where

the Commissioner introduces no substantive evidence but simply

rests on the presumption of correctness regarding his

determination that a taxpayer has unreported income. See Jackson

v. Commissioner, supra at 401. As discussed below, this is not

such a case.

9
(...continued)
398; Day v. Commissioner, 975 F.2d 534, 537 (8th Cir. 1992)
(“Courts have occasionally declined to accord a presumption of
correctness to a deficiency notice when the Commissioner fails to
introduce any substantive evidence linking the taxpayer to the
income generating activity in question.” (Emphasis added.)),
affg. in part, revg. in part on other grounds and remanding T.C.
Memo. 1991-140.
 - 9 -

A. Discharge of Indebtedness Income

Stipulated evidence--specifically, Bonnevista’s 1991 Federal

income tax return and Castle Tower’s 1990 Federal income tax

return--shows that as of December 31, 1991, petitioner owed

Bonnevista $2,244,164, and that as of December 31, 1990, he owed

Castle Towers $633,329. Petitioners have stipulated that

Bonnevista and Castle Towers filed no subsequent Federal income

tax returns. These corporations failed, however, to provide

respondent the notification that would have been required if they

had ceased to exist.10

The stipulated evidence shows that in March 1993 when he

submitted his financial statement to the IRS, petitioner

represented under penalties of perjury–-and does not now

dispute--that he no longer owed these liabilities. Petitioner

does not argue, and has adduced no evidence to show, that he

directly repaid these loans.

10
If an S corporation ceases to exist, it thereby
terminates its election under sec. 1362(a) to be taxed as an S
corporation and is required to attach to its return for the
taxable year in which the termination occurs a notification that
a termination has occurred and the date of termination. See sec.
1.1362-2(b)(1), Income Tax Regs. In addition, if the corporation
has ceased to exist, box F(2) of Form 1120S, indicating a final
return, must be checked. See Instructions for Form 1120S; see
also sec. 1.6037-1(a)(5), Income Tax Regs. (the return of an S
corporation shall include, inter alia, information as is required
by the instructions issued with respect to the form). The last
returns presented by Bonnevista and Castle Towers, as stipulated
into evidence, include no attachments notifying the Commissioner
that a termination has occurred, nor is box F(2), indicating a
final return, checked on either return.
 - 10 -

In these circumstances, it was not arbitrary for respondent

to conclude that Bonnevista and Castle Towers were still in

existence in March 1993, and that petitioner’s debts to the

corporations were discharged when petitioner first represented to

respondent that he no longer owed the debts previously reported

to be owing to his wholly owned corporations. We conclude that

respondent has made the requisite minimal evidentiary showing

linking petitioner to the discharge of indebtedness income in

question. Accordingly, the presumption of correctness remains

intact, and petitioner bears the burden of rebutting the

presumption by showing that the inference of gross income from

discharge of indebtedness was unreasonable. See Page v.

Commissioner, 58 F.3d 1342, 1347-1348 (8th Cir. 1995), affg. T.C.

Memo. 1993-398; Blohm v. Commissioner, supra at 1549.

B. Net Operating Loss Deduction

As regards respondent’s determination disallowing

petitioners’ claimed net operating loss deduction for lack of

substantiation, the requirement that respondent make a predicate

evidentiary showing is inapplicable; petitioners bear the burden

of proving their right to, and the amount of, the claimed

deduction. See Amey & Monge, Inc. v. Commissioner, 808 F.2d 758,

761 (11th Cir. 1987), affg. T.C. Memo. 1984-642; Gatlin v.

Commissioner, supra at 923.
 - 11 -

II. Discharge of Indebtedness Income

Generally, discharge of indebtedness gives rise to gross

income to the obligor. See sec. 61(a)(12); sec. 1.61-12(a),

Income Tax Regs. The general rationale for this rule is that

discharge of indebtedness enriches the obligor by freeing up

assets otherwise needed to repay the debt. See United States v.

Kirby Lumber Co., 284 U.S. 1, 3 (1931); Milenbach v.

Commissioner, 106 T.C. 184, 202 (1996); Cozzi v. Commissioner, 88

T.C. 435, 445 (1987). A debt is deemed to be discharged as soon

as it becomes clear, on the basis of a practical assessment of

all the facts and circumstances, that it will never have to be

paid. See Cozzi v. Commissioner, supra at 445. Any identifiable

event that fixes with certainty the amount to be discharged may

be taken into consideration. See id. The event may or may not

be overt; “ultimately, it is the actions of the taxpayer in the

context of the circumstances of a case” that determine whether an

abandonment or discharge of indebtedness has taken place. Id. at

446. The taxpayer bears the burden of proving that there was no

valid debt, that a discharge of debt did not occur, and that the

year of the discharge determined by the Commissioner is

erroneous. See Rule 142(a); Waterhouse v. Commissioner, T.C.

Memo. 1994-467; Carlins v. Commissioner, T.C. Memo. 1988-79.
 - 12 -

A. Was Petitioner a “Net Lender” to Bonnevista and Castle
Towers?

Petitioners do not dispute that sometime before 1992,

Bonnevista and Castle Towers made loans to petitioner. Rather,

petitioners argue that “there were loans going both ways between

Mr. Toberman on the one hand and Bonnevista and Castle Towers on

the other hand” and that “if the loans were netted out,

Mr. Toberman would have been a net lender.” Therefore,

petitioners argue, there was no debt to forgive.

Except for petitioner’s vague and uncorroborated testimony,

there is no proof that he was a “net lender” to Bonnevista and

Castle Towers. Petitioners have failed to provide any

documentary evidence of any indebtedness from Bonnevista or

Castle Towers to petitioner. We are not obligated to accept

petitioner’s self-serving and uncorroborated testimony in this

regard, see Day v. Commissioner, 975 F.2d 534, 538 (8th Cir.

1992), affg. in part, revg. in part and remanding T.C. Memo.

1991-140; Tokarski v. Commissioner, 87 T.C. 74 (1986), and we do

not.

B. Did Petitioner Repay the Loans?

Petitioners do not argue that petitioner ever repaid the

loans in question directly. Rather, they argue that petitioner

personally guaranteed third-party loans to Bonnevista and Castle

Towers, and that these guaranties ultimately resulted in

judgments against him. Petitioners failed to corroborate the
 - 13 -

amount and nature of petitioner’s guaranties of his corporations’

debts. Although the record contains notices of judgment against

petitioner, the notices generally provide no explanation of the

specific circumstances of the judgments or of the underlying

debts giving rise to them. The notices that do provide

explanations do not establish that the underlying debts related

either to Bonnevista or Castle Towers. In at least one instance,

the evidence clearly indicates that the judgment against

petitioner was for his own debts, rather than those of Bonnevista

or Castle Towers.11 In short, petitioners have failed to show

that petitioner repaid, directly or indirectly, Bonnevista’s or

Castle Towers’ loans to him.

C. When Did the Discharges of Indebtedness Occur?

Petitioners contend that if there was any discharge of

indebtedness, it must have occurred in 1992 rather than 1993,

because Bonnevista and Castle Towers went out of business in

1992. The record does not support this contention, which is

contradicted in part by petitioners’ own petition, which alleges

that Bonnevista was involved in litigation with creditors until

1997. Petitioner testified vaguely that he “lost” Bonnevista and

11
A Federal District Court order, dated Sept. 22, 1992,
entering judgment of $832,806 against petitioners and various
other parties, not including Bonnevista or Castle Towers, in
favor of Holroyd Enterprises, Inc., indicates that the underlying
debt on which the judgment was based was a promissory note
executed by petitioner and secured by a mortgage on the Shorewood
Marina & Yacht Club.
 - 14 -

Castle Towers in 1992. There is no evidence in the record,

however, as to the manner in which petitioner “lost” Bonnevista

or Castle Towers, or when the corporations might actually have

ceased to exist. Petitioner testified unconvincingly that he did

not know what happened to the business records of either

Bonnevista or Castle Towers. We cannot assume that the missing

evidence would have been favorable to petitioners; to the

contrary, the usual inference is that the evidence would be

adverse. See Pollack v. Commissioner, 47 T.C. 92, 108 (1966),

affd. 392 F.2d 409 (5th Cir. 1968).

Relying on petitioner’s representations in the

March 3, 1993, CIS that he no longer owed the debts, respondent

determined that the debts were discharged on that date.

Petitioner has failed to show that respondent’s determination was

unreasonable. Cf. Cozzi v. Commissioner, supra at 447-448 (where

it is impossible to identify one, and only one event, that

clearly fixes the time of a discharge of indebtedness, the burden

is on the taxpayer to prove that the event determined by the

Commissioner to fix the time is unreasonable).

D. Do Petitioners Qualify for the Insolvency Exception?

Petitioners argue that they qualify for the exclusion under

section 108(a)(1)(B), which generally provides that gross income

does not include amounts from discharge of indebtedness if the
 - 15 -

discharge occurs when the taxpayer is insolvent. To claim the

benefit of the insolvency exclusion, the taxpayer:

must prove (1) with respect to any obligation claimed to be
a liability, that, as of the calculation date, it is more
probable than not that he will be called upon to pay that
obligation in the amount claimed and (2) that the total
liabilities so proved exceed the fair market value of his
assets.

Merkel v. Commissioner, 109 T.C. 463, 484 (1997), affd. 192 F.3d

844 (9th Cir. 1999).

Petitioner claims that he was insolvent “by at least two to

three million dollars” in 1993 when his debts to Bonnevista and

Castle Towers were discharged. In support of this contention,

petitioner relies on the vague and conclusory testimony of

himself and his accountant. Petitioner has failed to provide any

details, however, as to either the specific liabilities he claims

to have owed or the fair market value of his assets in 1993. His

testimony in this regard is contradicted by his admission in the

CIS, which he signed on March 3, 1993, representing that he had a

positive net worth of approximately $389,650--an amount that

appears to have been understated by at least the value of his

ownership interests in Fantastic Foods and his $457,072

receivable from Fantastic Food (Delaware), as reported on that

entity’s 1992 Federal corporate income tax return. We conclude

and hold that petitioners have failed to establish that they

qualify for the insolvency exception under section 108(a)(1)(B).
 - 16 -

E. Should Petitioners’ Income From Discharge of
Indebtedness Be Treated as Ordinary Income?

Petitioners argue that respondent erred in treating the

entire amount of discharge of indebtedness income as ordinary

income rather than as capital gain. Petitioners cite section

316, which generally defines a dividend as a distribution out of

a corporation’s earnings and profits. Petitioners argue that

Bonnevista and Castle Towers had no earnings and profits, and

therefore any distribution to petitioner could not have been a

dividend. Respondent’s answering brief, citing section 1368,

among other statutory provisions, argues that petitioners had

ordinary income from the discharge of indebtedness.12

The forgiveness of a shareholder’s debt by an S corporation

is considered a distribution of property. See Haber v.

Commissioner, 52 T.C. 255, 262 (1969), affd. per curiam 422 F.2d

198 (5th Cir. 1970); see also sec. 301(c); sec. 1.301-1(m),

Income Tax Regs. The tax treatment of a distribution of property

12
In the notice of deficiency, respondent treated the
income from discharge of indebtedness as ordinary. In opening
statements at trial, both parties addressed the proper
characterization under subch. S rules of any income from
discharge of indebtedness. The parties were directed to file
seriatim briefs. In their opening brief, petitioners addressed
the characterization issue with only cursory legal analysis. In
his brief in answer, respondent addressed the issue more
thoroughly, with citations to the appropriate subch. S rules. In
reply, petitioners argue that respondent’s brief improperly
asserts new issues relating to subch. S distributions.
Petitioners’ arguments are without merit. See Pagel, Inc. v.
Commissioner, 91 T.C. 200, 211-212 (1988), affd. 905 F.2d 1190
(8th Cir. 1990).
 - 17 -

by an S corporation depends upon whether the corporation has

accumulated earnings and profits. Compare subsec. (b) with

subsec. (c) of sec. 1368. If the S corporation has no

accumulated earnings and profits, the distribution is nontaxable

to the extent of the shareholder’s adjusted basis in the stock.

See sec. 1368(b)(1). Distributions in excess of adjusted basis

are treated as gains from the sale or exchange of property. See

sec. 1368(b)(2). If the S corporation has accumulated earnings

and profits, then distributions, in some circumstances, are

treated as dividends and thus as ordinary income. See sec.

1368(c)(1) and (2).

Petitioners argue that Bonnevista and Castle Towers had no

accumulated earnings and profits in 1993, because the

corporations were not then in existence. Petitioners argue

alternatively that earnings and profits did not exceed the

retained earnings reported by Bonnevista and Castle Towers on

Schedules L, Balance Sheets, of the last Federal income tax

returns that they filed (i.e., Bonnevista’s 1991 Form 1120S and

Castle Tower’s 1990 Form 1120S).13

Petitioners’ arguments are without merit. In the first

instance, as previously discussed, petitioners failed to

13
On Schedule L of its 1991 Form 1120S, Bonnevista reported
negative yearend retained earnings of $626,228. On Schedule L of
its 1990 Form 1120S, Castle Towers reported yearend retained
earnings of $218,623.
 - 18 -

establish that Bonnevista and Castle Towers were not in existence

in 1993. Moreover, retained earnings as reported on Schedule L

of Form 1120S do not necessarily equate to the S corporation’s

earnings and profits. See sec. 312; sec. 1.312-6, Income Tax

Regs.; IRS Publication 589, Tax Information on S Corporations 14

(1994, for use in preparing 1993 returns) (“If a corporation has

accumulated E&P, the retained earnings and accumulated E&P

usually will not be the same because of the special rules for

figuring retained earnings.”).14

Under current law, S corporations generally do not generate

current earnings and profits. See sec. 1371(c). An S

corporation can have accumulated earnings and profits, however,

that may arise in various ways, including: (1) As a carryover

from years in which it was a C corporation before it became an S

corporation, see Cameron v. Commissioner, 105 T.C. 380, 384

(1995), affd. 111 F.3d 593 (8th Cir. 1997); (2) as S corporation

earnings for taxable years prior to 1983, see H. Conf. Rept. 104-

737, at 227 (1996), 1996-3 C.B. 741, 967;15 and (3) as the result

14
Even if Bonnevista’s and Castle Towers’ reported retained
earnings did correlate with their accumulated earnings and
profits, there is no reason to believe that earnings and profits
of Bonnevista and Castle Towers as of the end of 1991 and 1990
respectively would accurately represent their earnings and
profits as of 1993, when petitioner’s debt was discharged.
15
H. Conf. Rept. 104-737, at 227 (1996), 1996-3 C.B. 741,
967, describing then-current law, states:

(continued...)
 - 19 -

of certain reorganizations and the like. See sec. 1371(c)(2);

see also Eustice & Kuntz, Federal Income Taxation of S

Corporations, sec. 8.08[8][b], at 8-62 (3d ed. 1993).16

Bonnevista and Castle Towers each elected S corporation

status sometime after their incorporation. We infer that each

corporation was a C corporation before electing S status.

Moreover, Bonnevista was an S corporation for taxable years prior

to 1983. Petitioners have failed to show that Bonnevista and

Castle Towers did not have accumulated earnings and profits

arising from their C corporation operations before electing S

status, that Bonnevista had no accumulated earnings and profits

from S corporation operations for taxable years prior to 1983, or

15
(...continued)
under the subchapter S rules in effect before revision
in 1982, a corporation electing subchapter S for a
taxable year increased its accumulated earnings and
profits if its earnings and profits for the year
exceeded both its taxable income for the year and its
distributions out of that year’s earnings and profits.
As a result of this rule, a shareholder may later be
required to include in his or her income the
accumulated earnings and profits when it is distributed
by the corporation. The 1982 revision to subchapter S
repealed this rule for earnings attributable to taxable
years beginning after 1982 but did not do so for
previously accumulated S corporation earnings and
profits.
16
In 1996, Congress eliminated certain pre-1983 accumulated
earnings and profits for certain S corporations that existed
before 1983, effective for the first taxable year beginning after
Dec. 31, 1996. See Small Business Job Protection Act of 1996,
Pub. L. 104-188, sec. 1311, 100 Stat. 1755, 1784. Accordingly,
this legislative provision is inapplicable to the instant case.
 - 20 -

that Bonnevista and Castle Towers had no accumulated earnings and

profits as the result of reorganizations and the like.

Accordingly, section 1368(c) is the applicable provision for

determining the tax treatment of the distributions to petitioner

arising from the discharge of his indebtedness to Bonnevista and

Castle Towers.

Under section 1368(c), distributions are deemed to come

first from the S corporation’s so-called accumulated adjustments

account (AAA), which is intended to measure the corporation’s

accumulated taxable income that has not been distributed to

shareholders. See sec. 1368(e); Williams v. Commissioner, 110

T.C. 27, 30 (1998). The AAA is increased by the S corporation’s

income and is decreased by its losses and nontaxable

distributions to shareholders. See secs. 1367 and 1368. The AAA

is reduced first by current-year losses and deductions before

considering shareholder distributions for the year. See Williams

v. Commissioner, supra at 34. Distributions that do not exceed

the AAA, like distributions from S corporations with no earnings

and profits, are treated as tax free to the extent of the

shareholder’s adjusted stock basis and then as capital gains.

See sec. 1368(c)(1); sec. 1.1368-1(c), Income Tax Regs. Amounts

distributed in excess of the AAA are next treated as dividends,

and thus as ordinary income, to the extent of the S corporation’s

accumulated earnings and profits. See sec. 1368(c)(2).
 - 21 -

Petitioners have failed to establish that any AAA existed

for either Bonnevista or Castle Towers at the time of the

discharge of petitioner’s indebtedness in 1993.17 In the absence

of such evidence, it is not unreasonable to assume that in 1993

there was no AAA for either of these financially troubled

corporations, especially since prior losses have the effect of

reducing the AAA. See secs. 1367 and 1368.

Furthermore, as previously discussed, petitioners have

failed to show that Bonnevista and Castle Towers had accumulated

earnings and profits in 1993 less than the amount determined by

respondent to represent ordinary income from the discharge of

petitioner’s indebtedness by each of these corporations.

Accordingly, we sustain respondent’s determination that the

discharge of petitioner’s indebtedness to Bonnevista and Castle

Towers gave rise to ordinary income.

III. Net Operating Loss Deduction Carryover

On their 1993 Federal income tax return, petitioners claimed

a net operating loss deduction of $3,992,234, comprising net

operating loss carryovers for each of the years 1986 through

1991. In the case of net operating loss deductions, as with

other deductions, petitioners bear the burden of proving their

entitlement to the claimed deductions. See Rule 142(a); Jones v.

17
On its 1991 Form 1120S, Bonnevista reported no AAA. On
its 1990 Form 1120S, Castle Towers reported AAA of $248,028 as of
Dec. 31, 1990.
 - 22 -

Commissioner, 25 T.C. 1100, 1104 (1956), revd. and remanded on

other grounds 259 F.2d 300 (5th Cir. 1958); Leitgen v.

Commissioner, T.C. Memo. 1981-525, affd. per curiam without

published opinion 691 F.2d 504 (8th Cir. 1982).

Petitioners failed to produce any books or records

supporting the claimed losses. Instead, petitioners presented

their individual Federal income tax returns for the years 1986

through 1992, which show losses arising principally from rental

properties and S corporations that petitioner owned, and some–-

but not most--of the relevant S corporation returns. Petitioners

also rely upon their accountant’s testimony regarding his return

preparation procedures.

The testimony of petitioners’ accountant is insufficient to

establish either the fact or amount of any net operating loss.

See Williams v. Commissioner, T.C. Memo. 1990-266. The tax

returns are merely a statement of petitioners’ position and do

not constitute proof of the claimed losses.18 See Wilkinson v.

Commissioner, 71 T.C. 633, 639 (1979); Roberts v. Commissioner,

62 T.C. 834, 837 (1974); Seaboard Commercial Corp. v.

Commissioner, 28 T.C. 1034, 1051 (1957).

18
Petitioners’ Federal income tax return for 1987
specifically notes that the return is tentative and will be
amended. There is no evidence that any amended return was ever
filed.
 - 23 -

Petitioners have failed to sustain their burden of proof as

to the claimed net operating loss deduction.

IV. Section 6662 Penalty

Respondent determined that petitioners are liable for the

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

imposes a 20-percent penalty on any portion of an underpayment

that is attributable to negligence. Negligence is the lack of

due care or failure to do what a reasonable and ordinarily

prudent person would do under the same circumstances. See Neely

v. Commissioner, 85 T.C. 934 (1985). A taxpayer’s failure to

keep adequate books and records may constitute negligence. See

Crocker v. Commissioner, 92 T.C. 899, 917 (1989); sec. 1.6662-

3(b), Income Tax. Regs.

No penalty shall be imposed under section 6662(a) with

respect to any portion of an underpayment if it is shown that

there was reasonable cause and that the taxpayer acted in good

faith. See sec. 6664(c). Whether a taxpayer acted with good

faith depends upon the facts and circumstances of each case. See

sec. 1.6664-4(b)(1), Income Tax Regs. The burden of proof is

upon the taxpayer. See Rule 142(a); Bixby v. Commissioner, 58

T.C. 757, 791-792 (1972).

Petitioners argue that the negligence penalty should not

apply because they relied upon the services of their accountant.

Reliance on the advice of an accountant or other professional tax
 - 24 -

adviser does not necessarily demonstrate reasonable cause unless

the reliance was reasonable and the taxpayer acted in good faith,

which requires, among other things, that the advice be based on

all pertinent facts and circumstances and on no unreasonable

factual or legal assumptions. See sec. 1.6664-4(b)(1) and (c),

Income Tax Regs. If the taxpayer fails to provide the accountant

with the information necessary for preparing the return, the

taxpayer is liable for the penalty. See Johnson v. Commissioner,

74 T.C. 89, 97 (1980), affd. 673 F.2d 262 (9th Cir. 1982).

Petitioners failed to prove that they provided their

accountant complete information for preparing their 1993 joint

Federal income tax return. In addition, petitioners failed to

show that they kept adequate books and records to substantiate

their claimed net operating loss deduction. With regard to both

the discharge of indebtedness income and the claimed net

operating loss deduction, petitioners failed to show that they

had reasonable cause or acted in good faith.

Accordingly, respondent’s determination of an accuracy-

related penalty under section 6662(a) is sustained.

Decision will be entered

for respondent.