Burris v. Commissioner

T.C. Memo. 2001-49

UNITED STATES TAX COURT

HOWARD L. BURRIS, SR. AND BARBARA J. BURRIS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 11776-99. Filed February 28, 2001.

Howard L. Burris, Sr., pro se.

Michele A. Yates and William J. Gregg, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Judge: This case was assigned to Chief Special

Trial Judge Panuthos pursuant to Rules 180, 181, and 183.1 The

Court agrees with and adopts the opinion of the Special Trial

Judge, which is set forth below.

1
Unless otherwise indicated, 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.
 - 2 -

OPINION OF THE SPECIAL TRIAL JUDGE

PANUTHOS, Chief Special Trial Judge: Respondent determined

deficiencies in petitioners’ Federal income taxes and negligence

penalties under section 6662(a) as follows:2

Year Deficiency Sec. 6662(a)

1990 $51,417 $10,283
1991 50,542 10,108
1993 36,903 7,381

After the notice of deficiency was issued, respondent

acknowledged that the deficiencies and penalties were overstated

for 1991 and 1993. Respondent asserts the deficiencies and

penalties for 1991 and 1993 are as follows:

Year Deficiency Sec. 6662(a)

1991 $48,307 $9,661
1993 30,072 6,014

2
At the time of filing the petition, petitioner
requested, and the Court granted, a request for small tax case
status pursuant to sec. 7463. The Court notes that the petition
reflects for each taxable year an amount in dispute including
penalties of less than $50,000. After commencement of trial, it
became apparent that for each of the taxable years 1990 and 1991,
the deficiencies and penalties placed in dispute exceeded the
limit ($50,000) permitted under sec. 7463. Accordingly, the
small tax case status was discontinued pursuant to sec. 7463(d)
and Rule 173. By order dated Apr. 18, 2000, the caption was
amended by deleting the letter “S” from the docket number.
 - 3 -

The issues for decision are:3 (1) Whether petitioners are

entitled to deduct various business expenses in excess of the

amounts allowed by respondent; (2) whether petitioners failed to

include interest and dividends as income; (3) whether petitioners

may deduct interest payments in excess of the amounts allowed by

respondent; (4) whether petitioners are entitled to an investment

tax credit for 1993; and (5) whether petitioners are liable for

the accuracy-related penalty pursuant to section 6662(a).

FINDINGS OF FACT

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

The stipulated facts and the related exhibits are incorporated

herein by this reference. At the time of filing the petition in

this case, petitioners resided in Washington, D.C. Any

references to petitioner are to Howard L. Burris, Sr.

Petitioner received a degree in geology from West Point.

Before 1990, petitioner worked as a consultant to various

3
Respondent determined that petitioners failed to
include $1 of income in 1993 from Social Security. Respondent
disallowed deductions of $15,597 from Schedule E, Supplemental
Income and Loss, for 1991. Petitioners did not present evidence
as to these issues. As a result, petitioner is deemed to have
conceded these issues. See Rules 142(a), 149(b); Pearson v.
Commissioner, T.C. Memo. 2000-160.

The notices of deficiency contain adjustments to
petitioners’ itemized deductions, alternative minimum tax,
employment tax, and dependency exemption deductions. These are
computational adjustments which will be affected by the outcome
of the other issues to be decided, and we do not separately
address them.
 - 4 -

corporations. During the period at issue, petitioner worked as a

consultant to the Federal Reserve. As a consultant, petitioner

acted as an intermediary for the Federal Reserve and secured

financing for various projects, such as a high speed train and a

hospital. Petitioner received a percentage of the financing as a

fee for his efforts.

Between 1989 and 1994, petitioner attempted to secure $3.5

billion in financing for a Texas high speed train project to

connect Houston, Dallas, and Austin. Petitioner met with various

bank and trust representatives in Europe in an effort to finance

the train project.

Petitioners engaged in other side businesses between 1990

and 1993. In the 1940's, petitioner Barbara J. Burris (Mrs.

Burris) inherited from her father, B.H. Jester, a plot of land in

Austin, Texas. The land was developed under the names Jester

Development and Jester Estate Development (collectively, Jester).

Jester planned to build 1,100 houses on 1,000 acres of land.

Jester continued construction in 1990 and 1991, but construction

ceased at some point in the early 1990's due to the discovery

that the golden cheek warbler, an endangered species, inhabited

the property. Petitioners also owned interests in oil and gas

holdings during the years at issue.
 - 5 -

Petitioners filed joint Federal income tax returns for the

years in issue. Petitioners claimed the following expenses as

deductions on Schedules C, Profit or Loss From Business:4

1990 1991 1993

Depreciation $51,222 $30,703 $31,203
Legal and professional 73,232 42,228 33,733
Travel 61,601 100,601 18,638
Entertainment and meals 12,636 25,693 20,294

On Schedules A, Itemized Deductions, petitioners claimed

deductions as follows:

1990 1991 1993

Home mortgage interest $20,180 $32,741 $7,497
1
Investment interest 34,265 40,770 30,662
Real estate taxes 9,352 13,147 9,920
Charitable contributions 8,548 4,583 3,521
2
Other expenses 13,783 10,392 1,219
Medical and dental --- --- 5,473
3
Total 86,128 100,865 58,292
1
Petitioners reported investment interest of
$41,232, but deducted $40,770 due to the limitation of
sec. 163(d)(1).
2
On their amended return, petitioners reported
other expenses of $10,658. These amounts will be
affected by computational adjustments.
3
Although $100,865 is the total Schedule A
amount reflected on petitioners’ 1991 return, the
correct total amount is $101,633.

Petitioners also reported investment income of $52,345 in 1990,

$40,770 in 1991, and $62,239 in 1993. Petitioners claimed an

investment tax credit of $3,151 in 1993.

4
Petitioners claimed other expenses for each year that
are not at issue.
 - 6 -

Respondent issued a notice of deficiency on April 1, 1999.

The notice5 (1) disallowed some of the deductions claimed on

Schedule C; (2) determined that petitioner failed to report

dividend and interest income of $95 in 1990, $5,493 in 1991, and

$253 in 1993; and (3) made adjustments to petitioners’ itemized

deductions on Schedule A. As to the itemized deductions on

Schedule A, the notice of deficiency indicated the following:

It is determined that interest expense deduction of
$76,098.00, $84,638.00 and $67,297.00 respectively for the
taxable years ended December 31, 1990, 1991 and 1993 is
allowable instead of $86,128.00, $100,865.00 and $58,292.00
respectively as shown on your tax returns for the taxable
years ended December 31, 1990, 1991 and 1993. Accordingly,
your taxable income is increased $10,030.00 and $16,227.00
for the taxable years ended December 31, 1990 and 1991, and
your taxable income is decreased $9,005.00 for the taxable
year ended December 31, 1993.[6] [Emphasis added.]

Respondent also determined that petitioner was liable for the

accuracy-related penalty pursuant to section 6662(a).

Respondent served petitioners with interrogatories and a

request for production of documents on January 27, 2000.

Petitioners failed to respond to the formal discovery, and

respondent filed motions to compel responses to interrogatories

5
Although the explanation in the notice of deficiency
appears to disallow the claimed investment credit, the notice
does not contain an adjustment to this item.
6
The decrease in income for 1993 is due to a
carryforward of disallowed interest under sec. 163(d) from 1991.
The carryforward amount will be affected by our holding with
respect to 1991 and can be accounted for in the Rule 155
computation.
 - 7 -

and production of documents on March 22, 2000. At the hearing on

these motions, the Court ordered petitioners to respond to the

interrogatories in writing by March 31, 2000, or the answers

provided orally in Court at such hearing would be deemed

petitioners’ answers. The Court also ordered petitioners to

produce to respondent by March 31, 2000, all documents

petitioners intended to use at the trial. Any documents not

produced would not be permitted to be used at trial. Petitioner

stated that he contested only the Schedule C deductions for 1990.

Petitioners did not provide further written answers to the

interrogatories, nor did they produce additional documents.7

Respondent argued in a trial memorandum and at trial: (1)

Petitioners are not entitled to the various Schedule C deductions

because they failed to substantiate the amounts claimed; and (2)

as to the interest deductions, respondent reclassified the home

mortgage interest as investment interest, and then disallowed

part of the interest deduction pursuant to section 265(a)(2). At

trial, respondent argued for the first time that part of the

7
Despite the Court’s rulings, the parties presented
evidence and testified about issues which appear to have been the
subject matter of the discovery proceeding. Petitioner and
respondent raised the omitted income and interest issues at
trial. We deem the issues to have been tried by consent and
properly before this Court.
 - 8 -

investment interest should be disallowed under section

163(d)(1).8

OPINION

A. General

The record in this case is confused, disorganized, and

fraught with inconsistent assertions and theories. Petitioners’

reporting of their activities and subsequent explanation of the

activities at trial created a muddle of incomprehensible

information. Respondent’s determination and assertions at trial

created further confusion.

While the determination and the record in this case have

made fact finding difficult, we nevertheless have carefully

reviewed this record to analyze the issues and make findings and

conclusions. We shall discuss in detail the inconsistencies as

we address each adjustment.

B. Schedule C Expenses

1. Sections 162(a) and 274(a)

Section 162(a) permits a deduction for the ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on a trade or business. An expense must be directly

connected with, or proximately result from, a trade or business

8
Respondent’s agent, before applying the limitation of
sec. 163(d)(1), calculated the amount of investment interest
deductions as $34,131 in 1990, $27,732 in 1991, and $28,388 in
1993.
 - 9 -

of the taxpayer. See Kornhauser v. United States, 276 U.S. 145,

153 (1928); O’Malley v. Commissioner, 91 T.C. 352, 361 (1988),

affd. 972 F.2d 150 (7th Cir. 1992). Expenses that are personal

in nature are generally not allowed as deductions. See sec.

262(a). Deductions are a matter of legislative grace, and

taxpayers must comply with the specific requirements for any

deduction claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S.

79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435,

440 (1934).

A taxpayer is required to maintain records sufficient to

establish the amount of his income and deductions. See sec.

6001; sec. 1.6001-1(a), (e), Income Tax Regs. A taxpayer must

substantiate his deductions by maintaining sufficient books and

records to be entitled to a deduction under section 162(a).

When a taxpayer establishes that he has incurred a

deductible expense, but is unable to substantiate the exact

amount, we are, in some circumstances, permitted to estimate the

deductible amount. See Cohan v. Commissioner, 39 F.2d 540, 543-

544 (2d Cir. 1930). We can estimate the amount of the deductible

expense only when the taxpayer provides evidence sufficient to

establish a rational basis upon which the estimate can be made.

See Vanicek v. Commissioner, 85 T.C. 731, 743 (1985).

Section 274(d) supersedes the general rule of Cohan v.

Commissioner, supra, and we cannot estimate the taxpayer’s
 - 10 -

expenses with respect to certain items. See Sanford v.

Commissioner, 50 T.C. 823, 827 (1968), affd. per curiam 412 F.2d

201 (2d Cir. 1969). Section 274(d) imposes strict substantiation

requirements for gifts, travel, entertainment, and meal expenses.

See sec. 1.274-5T(a), Temporary Income Tax Regs., 50 Fed. Reg.

46014 (Nov. 6, 1985). To obtain a deduction for a travel, meal,

or entertainment expense, a taxpayer must substantiate by

adequate records or sufficient evidence to corroborate the

taxpayer’s own testimony the amount of the expense, the time and

place where it was incurred, the business purpose of the expense

and, in the case of entertainment, the business relationship to

the taxpayer of each person entertained. See sec. 274(d); sec.

1.274-5T(b), Temporary Income Tax Regs., 50 Fed. Reg. 46016 (Nov.

6, 1985). If a taxpayer is unable to fulfill the requirements of

section 274(d), then he is not entitled to the deduction.

2. Depreciation

Section 167(a) permits a depreciation deduction for the

exhaustion, wear and tear of property used in a trade or

business. Petitioner claimed depreciation deductions of

$51,222 in 1990, $30,703 in 1991, and $31,203 in 1993.

Petitioner failed to demonstrate that the depreciated properties

were used in his trade or business. Further, petitioner did not

identify the properties he depreciated. We are unable to

estimate an amount for depreciation deductions because petitioner
 - 11 -

failed to provide evidence upon which we can make a rational

estimate. See Vanicek v. Commissioner, supra. We sustain

respondent’s determination on this issue.

3. Legal and Professional Fees

Petitioners deducted $73,232 in 1990, $42,228 in 1991, and

$33,733 in 1993 for legal fees. Generally, legal fees may be

deductible under section 162(a) if they are connected to a

taxpayer’s trade or business. See Guill v. Commissioner, 112

T.C. 325, 328-329 (1999); Davis v. Commissioner, T.C. Memo. 1999-

250.

Petitioner generally testified that he incurred more than

$32,000 in legal fees in connection with his consulting work for

the Federal Reserve Board. Petitioner did not provide any

additional details regarding the legal fees, such as the dates,

attorneys retained, and how the legal expenses were incurred in

his trade or business.9 Petitioner also did not produce

documents at trial to establish that he incurred these expenses.

We are unable to estimate an amount for legal fees because

petitioner failed to provide evidence upon which we can make a

rational estimate. See Vanicek v. Commissioner, supra. We hold

for respondent on this issue.

9
Petitioner’s testimony as to the legal fees was so
vague that we do not know the year or years in which petitioner
incurred the $32,000.
 - 12 -

4. Travel, Entertainment, and Meals

Petitioners deducted travel expenses of $61,601 in 1990,

$100,601 in 1991, and $18,638 in 1993. Petitioners also deducted

entertainment and meal expenses of $12,636 in 1990, $25,693 in

1991, and $20,294 in 1993. Petitioner generally testified that

he traveled to Europe to meet with various representatives of

banks and trusts to secure funding for the Texas high speed train

project. He did not provide any other detail regarding his

travel, entertainment, and meal expenses. Petitioners’ primary

argument is that Price Waterhouse, their tax preparer, would not

have listed the deductions unless the deductions were proper,

and, therefore, they are entitled to deduct petitioner’s travel,

entertainment, and meal expenses.

Petitioner did not produce documents to support the claimed

deductions for travel, entertainment, and meals. Petitioner

provided several theories as to why the documents were

unavailable: First, petitioner forwarded the documents to

support his deductions to Price Waterhouse. According to

petitioner, Price Waterhouse, as part of its document retention

policy, destroyed the documents.10 Second, petitioner’s

secretary died in the early 1990's, and, therefore, petitioner

10
At trial, Michael A. Halpert, a revenue agent for the
Internal Revenue Service, testified that Price Waterhouse
provided him with credit card statements and a spreadsheet of
travel expenses for tax year 1991.
 - 13 -

could not locate the documents from his office. Third,

petitioner relocated boxes of documents from his office to his

personal residence after his secretary died. Petitioner claims

that his basement was flooded and some of the boxes were

destroyed.

Petitioner failed to meet the strict substantiation

requirements of section 274(d). Petitioner did not establish

through either documents or testimony the amount of each expense,

the time and place where it was incurred, the business purpose of

the expense and, in the case of entertainment expenses, the

business relationship to the taxpayer of each person entertained.

See sec. 274(d); sec. 1.274-5T(b), Temporary Income Tax Regs., 50

Fed. Reg. 46016 (Nov. 6, 1985). Petitioner’s scant testimony

that he traveled to Europe to meet with banks and trusts falls

short of the rigors of section 274(d). We sustain respondent’s

determinations as to these items.

C. Interest and Dividend Income

Respondent determined that petitioners failed to report

dividend and interest income of $95 in 1990, $5,493 in 1991, and

$253 in 1993. Petitioners do not dispute that they received the

amounts in each year. Petitioners have not presented any

arguments that such income is not subject to tax.

Section 61(a)(4) and (7) defines gross income as including

income from any source, including interest and dividends.
 - 14 -

Petitioners were required to include the interest and dividends

as part of their gross income, and they do not dispute that they

received such amounts. We hold for respondent on this issue.

D. Interest Deductions (Schedule A)

With respect to the tax years 1990 and 1991, respondent

argues that the deduction claimed as home mortgage interest is

actually investment interest and that petitioner is not entitled

to deduct (1) part of the interest pursuant to section 265(a)(2)

and (2) part of the interest pursuant to section 163(d). In the

deficiency notice, respondent provided no such explanation for

the disallowance, nor did respondent specify whether the home

mortgage interest, investment interest, or a combination of the

two was disallowed. Further, the amounts disallowed in the

notice do not coincide with the amounts claimed on the return.

Respondent incorrectly classified the total claimed itemized

deductions as “interest expenses”. One cannot tell from review

of the notice what was allowed or disallowed. No further

explanation is provided in the notice, nor did respondent provide

a breakdown of the items allowed and disallowed.

Rule 142 provides:

(a) General: The burden of proof shall be upon
the petitioner, except as otherwise provided by statute
or determined by the Court; and except that, in respect
of any new matter, increases in deficiency, and
affirmative defenses, pleaded in the answer, it shall
be upon the respondent. As to affirmative defenses,
see Rule 39.
 - 15 -

It is only in respondent’s trial memorandum that respondent

raised the reclassification of home mortgage interest to

investment interest, and the section 265(a)(2) disallowance, and

not until trial did respondent rely on the limitation of

investment interest under section 163(d). The notice of

deficiency does not reflect any of those theories. Accordingly,

such theories are a “new matter”. See Achiro v. Commissioner, 77

T.C. 881, 889-891 (1981); Wayne Bolt & Nut Co. v. Commissioner,

93 T.C. 500, 507-508 (1989). Petitioner is required to present

different evidence to rebut respondent’s new theories. Although

it is not clear from the notice, the payment of interest does not

appear to be at issue. Rather, to contest respondent’s theories,

petitioners would be required to present evidence relating to

motives of investment and the relationship of petitioners’ total

investments and respective borrowing. Further, petitioners would

be required to establish that their intent in securing the loans

was not to purchase or carry tax-exempt securities. See, e.g.,

Mariorenzi v. Commissioner, T.C. Memo. 1973-141, affd. 490 F.2d

92 (1st Cir. 1974). Therefore, respondent has the burden of

proof as to the interest issue. We address each of respondent’s

theories below.

1. Classification of Interest

In the case of a cash basis taxpayer, section 163(a) allows

for a deduction of all interest paid during the taxable year.
 - 16 -

Individual taxpayers are not permitted to deduct personal

interest. See sec. 163(h)(1). Personal interest does not

include investment interest or qualified residence interest

(QRI). See sec. 163(h)(2)(B), (D).

QRI can arise from either acquisition indebtedness, home

equity indebtedness, or pre-October 13, 1987, indebtedness. See

sec. 163(h)(3)(A), (D). Acquisition indebtedness is any

indebtedness secured by the qualified residence of the taxpayer

and is incurred in acquiring, constructing, or substantially

improving any qualified residence of the taxpayer. See sec.

163(h)(3)(B). The aggregate amount of acquisition indebtedness

cannot exceed $1 million for any period. See sec.

163(h)(3)(B)(ii). Acquisition indebtedness also includes

indebtedness to refinance the qualified residence, so long as the

indebtedness satisfies the requirements of section 163(h)(3)(B).

Home equity indebtedness is any indebtedness secured by a

qualified residence to the extent the total amount of the

indebtedness does not exceed the fair market value of the

qualified residence, less the amount of acquisition indebtedness

of the qualified residence. See sec. 163(h)(3)(C)(i). The

aggregate amount of home equity indebtedness is limited to

$100,000 for any period. See sec. 163(h)(3)(C)(ii).

Pre-October 13, 1987, indebtedness is any indebtedness which

was incurred on or before October 13, 1987, and which was secured
 - 17 -

by a qualified residence on October 13, 1987, and at all times

thereafter before the interest is paid or accrued. See sec.

163(h)(3)(D)(iii)(I). Pre-October 13, 1987, indebtedness also

includes debt that is incurred after October 13, 1987, and is

used to refinance the pre-October 13, 1987, debt. See sec.

163(h)(3)(D)(iii)(II). Pre-October 13, 1987, indebtedness is

treated as acquisition indebtedness, but it is not subject to the

$1 million limitation. See sec. 163(h)(3)(D)(i). Also, a

taxpayer is not limited in how he uses the funds from a pre-

October 13, 1987 debt, while he is limited in the use of the

funds with acquisition and home equity indebtedness.

A qualified residence is either a taxpayer’s primary

residence or second residence. See sec. 163(h)(4)(A)(i); sec.

1.163-10T(p)(3), Temporary Income Tax Regs., 52 Fed. Reg. 48410

(Dec. 22, 1987).

Investment interest is any interest allowable as a deduction

which is paid or accrued on indebtedness properly allocable to

property held for investment. See sec. 163(d)(3)(A). Investment

interest does not include QRI. See sec. 163(d)(3)(B). A

taxpayer may deduct investment interest up to the amount of net

investment income. See sec. 163(d)(1). QRI is not subject to

the investment interest limitation of section 163(d)(3)(B). See

sec. 1.163-10T(b), Temporary Income Tax Regs., 52 Fed. Reg. 48410

(Dec. 22, 1987).
 - 18 -

Petitioner deducted home mortgage interest of $20,180 in

1990, $32,741 in 1991, and $7,497 in 1993. Respondent argues

that the mortgage interest is investment interest. Petitioner

testified that he “placed a mortgage on it [petitioners’

residence] to bail out some of these items [other debts]”.

Respondent did not establish that the indebtedness at issue was

not QRI. Further, respondent did not present additional evidence

to prove that the indebtedness at issue was not secured by

petitioners’ qualified residence. There is nothing in this

record which would lead us to the conclusion that respondent’s

characterization of the interest as investment interest is

correct.

We are also unable to discern when the debt was incurred.

Respondent’s agent, Michael A. Halpert, testified that he

“reviewed the petitioner statements he received from banks and

other lending institutions reflecting the amount of interest he

had paid in the respective years”. Respondent did not produce

any of these documents at trial, and the record is silent as to

when petitioners purchased their residence. It is possible that

the debt could qualify as pre-October 13, 1987, debt, in which

case the use of the funds from the indebtedness is not relevant

to our inquiry. Respondent failed to establish that the interest

was not QRI. We hold for petitioners on this issue.
 - 19 -

2. Section 265(a)(2)

Respondent disallowed part of the investment interest

pursuant to section 265(a)(2). Section 265(a)(2) provides that a

taxpayer is not entitled to a deduction for interest on

indebtedness incurred or continued to purchase or carry

obligations on which the interest is tax exempt. The purpose of

section 265(a)(2) is to prevent a taxpayer from obtaining a

double tax benefit by deducting interest on borrowed funds used

by the taxpayer to purchase or carry securities bearing tax-

exempt interest. See Denman v. Slayton, 282 U.S. 514, 515

(1931); Levitt v. United States, 517 F.2d 1339, 1343 (8th Cir.

1975); Jacobson v. Commissioner, 28 T.C. 579 (1957); Estate of

Norris v. Commissioner, T.C. Memo. 1981-368.

The mere fact that a taxpayer carries or purchases

securities concurrently with his increase in indebtedness is

insufficient to apply section 265(a)(2). See Levitt v. United

States, supra at 1344; Mariorenzi v. Commissioner, 490 F.2d 92,

93 (1st Cir. 1974), affg. T.C. Memo. 1973-141. In interpreting

section 265(a)(2), the courts require a “sufficiently direct

relationship” between the carrying or purchasing of tax-exempt

securities and the indebtedness. Wisconsin Cheeseman, Inc. v.

United States, 388 F.2d 420, 422 (7th Cir. 1968); Swenson Land &

Cattle Co. v. Commissioner, 64 T.C. 686, 696 (1975). “Here we

are not applying a mechanical rule but are insisting upon a
 - 20 -

connection between the tax-exempt securities and the loans before

interest deductibility is disallowed.” Wisconsin Cheeseman, Inc.

v. United States, supra at 423. If the tax-exempt securities are

used for collateral for the indebtedness or the proceeds of the

borrowing are directly traceable to the purchase of tax-exempt

securities, then section 265(a)(2) will apply. See Levitt v.

Commissioner, supra at 1345; Wisconsin Cheeseman, Inc. v. United

States, supra at 422; Kirchner, Moore & Co. v. Commissioner, 54

T.C. 940 (1970), affd. 448 F.2d 1281 (10th Cir. 1971); Bishop v.

Commissioner, 41 T.C. 154 (1963), affd. 342 F.2d 757 (6th Cir.

1965). If neither factual setting exists, then we must examine

the facts of each case to determine whether a sufficiently direct

relationship exists between the indebtedness and tax-exempt

securities. See Estate of Norris v. Commissioner, supra.

Respondent’s agent, Mr. Halpert, testified why he applied

section 265(a):

When I first inspected the return prior to even
contacting the petitioner, I noticed that there was a large
amount of investment interest expense claimed on Schedule A
as well as a substantial amount of tax exempt interest
income reported on the front page of the 1040. This in
itself leads to at least asking questions, leading up to
section 265(a).

Respondent did not provide any additional evidence to establish a

direct relationship between the indebtedness and the tax-exempt

interest. The record does not establish when the debt was

incurred, nor does it reflect a connection of the indebtedness
 - 21 -

and tax-exempt interest beyond the mere fact that petitioners

reported tax-exempt interest while claiming deductions for

interest.

We also have credible testimony from petitioner that

petitioners’ only source of tax-exempt interest was from Mrs.

Burris’ inheritance. The record does not indicate that

petitioners used tax-exempt securities as collateral for the

indebtedness at issue, nor that petitioners incurred indebtedness

to purchase tax-exempt securities. Respondent improperly applied

section 265(a)(2), and we hold for petitioners on this issue.

3. Section 163(d)

Respondent argued at trial that part of the investment

interest deductions should be disallowed under section 163(d)(1).

Section 163(d)(1) provides that a deduction of investment

interest may not exceed net investment income. Net investment

income is defined as the excess of investment income over

investment expenses. See sec. 163(d)(4)(A). Investment income

includes gross income from property held for investment and any

net gain from the disposition of property held for investment.

See sec. 163(d)(4)(B). Property held for investment includes

property which produces income of a type described in section

469(e)(1). See sec. 163(d)(5)(A). Section 469(e)(1) property

includes gross income from interest, dividends, annuities, and
 - 22 -

royalties not derived in the ordinary course of a trade or

business.

Petitioners reported investment income of $52,345 in 1990,

$40,770 in 1991, and $62,239 in 1993. We held above that

petitioners underreported interest and dividends of $95 in 1990,

$5,493 in 1991, and $253 in 1993. The omitted amounts constitute

investment income, and the actual amounts of investment income

reportable by petitioners are $52,440 for 1990, $46,263 in 1991,

and $62,492 in 1993. Petitioners claimed investment interest

expenses of $34,265 in 1990, $41,232 in 1991, and $30,662 in

1993. For all of the years at issue, the net investment income

exceeds the claimed investment interest expenses. Therefore,

petitioners may deduct investment interest expenses of $34,265 in

1990, $41,232 in 1991, and $30,662 in 1993.

E. Investment Tax Credit

Petitioners claimed an investment tax credit of $3,151 in

1993. Sections 38 and 46 provide for the allowance of a business

credit, which in part is comprised of the investment credit. See

sec. 38(a). The investment tax credit is the sum of the

rehabilitation credit, energy credit, and reforestation credit.

See sec. 46.

Although respondent argues that petitioners are not entitled

to an investment tax credit of $3,215 for 1993, respondent’s

notice of deficiency does not contain an adjustment to income tax
 - 23 -

to reflect the disallowed credit.11 Since respondent seeks to

increase the amount of deficiency, respondent has the burden of

proof to establish that petitioners are not entitled to the

investment tax credit. See Rule 142. Respondent failed to

present evidence at trial as to this issue and is deemed to have

conceded the issue. See Rules 142(a), 149(b); Pearson v.

Commissioner, T.C. Memo. 2000-160.

F. Accuracy-Related Penalty

Respondent determined petitioners are liable for the

accuracy-related penalty under section 6662(a) for 1990, 1991,

and 1993. The accuracy-related penalty is equal to 20 percent of

any portion of an underpayment of tax required to be shown on the

return that is attributable to the taxpayer’s negligence or

disregard of rules or regulations. See sec. 6662(a) and (b)(1).

“Negligence” consists of any failure to make a reasonable attempt

to comply with the provisions of the Internal Revenue Code and

also includes any failure to keep adequate books and records or

to substantiate items properly. See sec. 6662(c); 1.6662-

3(b)(1), Income Tax Regs. “Disregard” consists of any careless,

reckless, or intentional disregard. See sec. 6662(c).

An exception applies to the accuracy-related penalty when

the taxpayer demonstrates (1) there was reasonable cause for the

11
We note that respondent’s calculation appears to be
incorrect, as petitioners claimed a credit of $3,151 on their
1993 Federal income tax return.
 - 24 -

underpayment, and (2) he acted in good faith with respect to such

underpayment. See sec. 6664(c). Whether the taxpayer acted with

reasonable cause and in good faith is determined by the relevant

facts and circumstances. The most important factor is the extent

of the taxpayer’s effort to assess his proper tax liability. See

Stubblefield v. Commissioner, T.C. Memo. 1996-537; sec. 1.6664-

4(b)(1), Income Tax Regs. Section 1.6664-4(b)(1), Income Tax

Regs., specifically provides: “Circumstances that may indicate

reasonable cause and good faith include an honest

misunderstanding of fact or law that is reasonable in light of

* * * the experience, knowledge, and education of the taxpayer.”

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

It is the taxpayer’s responsibility to establish that he is

not liable for the accuracy-related penalty imposed by section

6662(a). See Rule 142(a); Tweeddale v. Commissioner, 92 T.C.

501, 505 (1989).

Petitioners appear to argue that they relied on their tax

preparer, Price Waterhouse. Under certain circumstances,

reliance by a taxpayer on the advice of a competent adviser can

be a defense to the accuracy-related penalty. See United States

v. Boyle, 469 U.S. 241, 250-251 (1985); Ewing v. Commissioner, 91

T.C. 396, 423–424 (1988), affd. without published opinion 940

F.2d 1534 (9th Cir. 1991). However, reliance on professional

advice, standing alone, is not an absolute defense to negligence
 - 25 -

but rather a factor to be considered. See Freytag v.

Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th

Cir. 1990), affd. 501 U.S. 868 (1991). It must be established

that the reliance was reasonable, in good faith, and based upon

full disclosure. See Ewing v. Commissioner, supra; Pritchett v.

Commissioner, 63 T.C. 149, 174-175 (1974).

Petitioners failed to establish that they reasonably relied

in good faith upon Price Waterhouse’s advice. Further,

petitioners did not prove that they fully disclosed the facts of

the expenses at issue. Petitioner repeatedly testified that

Price Waterhouse would not have reported the various expenses on

Schedules A and C unless petitioners were entitled to deduct

them. Petitioner’s testimony is insufficient to establish a

defense to the accuracy-related penalty.

Petitioners claimed deductions that they failed to explain

or substantiate. On the basis of the entire record, we conclude

petitioners have not established that any portion of the

underpayment was due to reasonable cause or that they acted in

good faith. Accordingly, we hold petitioners are liable for the

accuracy-related penalty.

To reflect the foregoing,

Decision will be entered

under Rule 155.