GALE v. COMMISSIONER

T.C. Memo. 2002-54

UNITED STATES TAX COURT

LEE G. GALE, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

LEE GALE, Petitioner v. COMMISSIONER OF
INTERNAL REVENUE, Respondent

Docket Nos. 4448-97, 1422-98. Filed February 27, 2002.

Lee G. Gale, pro se.1

Ramon Estrada and Christine V. Olsen, for respondent.1a

1
Noel W. Spaid, Esq. (Ms. Spaid), filed an Entry of
Appearance and represented petitioner at trial. Ms. Spaid
thereafter filed a Motion to Withdraw as Counsel, which was
granted. Ms. Spaid did not prepare or file any briefs on behalf
of petitioner.
1a
Ramon Estrada handled the pretrial preparation and trial
of these cases and signed the brief and reply brief for
respondent, and Christine V. Olsen signed respondent’s
supplemental brief regarding I.R.C. §461(f).
 - 2 -

MEMORANDUM FINDINGS OF FACT AND OPINION

BEGHE, Judge: Respondent determined the following

deficiencies, late-filing additions, and accuracy-related

penalties with respect to petitioner’s Federal income tax:

Docket Addition to Tax Penalty
No. Year Deficiency Sec. 6651(a)(1) Sec. 6662

4448-97 1992 $244,563 $12,228 $48,913
1422-98 1993 247,317 12,366 49,463
1422-98 1994 61,965 --- 12,393

After concessions, the following issues are to be decided:

(1) Whether litigation settlement proceeds of $797,225 paid

to and placed in petitioner’s attorney’s trust account in 1992,

pending resolution of a fee dispute between petitioner and his

attorney, should be reported as income on petitioner’s 1992

individual income tax return, or whether the amounts should be

reported as income only when paid from the trust account in later

years. We hold that the settlement proceeds were income to

petitioner in 1992.

(2) Whether petitioner is entitled to deduct under section

461(f)2 amounts placed in his attorney’s trust account pending

resolution of the fee dispute between petitioner and his

attorney. We hold that petitioner is entitled to deduct the

2
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the years at issue, and
all Rule references are to the Tax Court Rules of Practice and
Procedure.
 - 3 -

amounts placed in his attorney’s trust account pending resolution

of the fee dispute, but only to the extent that the amounts would

have been deductible if the attorney’s claims had been undisputed

and the amounts held in trust had been paid to the attorney in

satisfaction of the attorney’s claims. Because it has been

established that only $65,685.34 claimed by the attorney for

handling petitioner’s divorce would not have been deductible if

paid, we hold that petitioner is entitled to deduct in 1992,

under section 461(f), $729,220.21.

(3) Whether petitioner is entitled to treat any portion of

the additional $128,275 claimed on his 1992 return as cost of

goods sold. We hold that he is not.

(4) Whether petitioner is entitled to deduct as a business

expense any portion of the additional $128,275 that he wrongly

claimed as a cost of goods sold on his 1992 return. We uphold

respondent’s determination allowing a deduction for $35,000 and

disallowing any deduction for the balance of $93,275.

(5) Whether petitioner may carry forward total net operating

losses of $148,367 from 1990 and 1991 to 1992 and $323,352 from

1992 to 1994. We hold that he may not.

(6) Whether petitioner may deduct depreciation in 1992 that

exceeds the amount allowed by respondent. We hold that he may

not.
 - 4 -

(7) Whether petitioner failed to report various items of

income on his 1992, 1993, and 1994 individual income tax returns.

We hold that he did, although in lesser amounts than determined

by respondent.

(8) Whether petitioner is liable for additions to tax and

accuracy-related penalties under sections 6651(a)(1) and 6662(a),

respectively. We hold that he is liable for both, although in

lesser amounts than determined by respondent.

Respondent’s additional adjustments to petitioner’s

exemptions, itemized deductions, self-employment taxes, and

taxable Social Security benefits are computational and will be

resolved by our holdings on the foregoing issues.

FINDINGS OF FACT

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

The stipulation of facts, first through third supplemental

stipulations of facts, associated exhibits, and oral stipulations

are incorporated by this reference. Petitioner resided in

Newport Beach, California, at the times he filed the petitions in

these cases, which have been consolidated for the purposes of

trial, briefing, and opinion.

Petitioner’s Business and Estate Planning Activities

Over the years, petitioner engaged in several business

activities, including cement hauling, retail gasoline sales,

residential real estate rentals, and truck and equipment rentals.
 - 5 -

Petitioner conducted his hauling business both individually and

as president and sole shareholder of Pyramid Commodities, Inc.

(Pyramid), an S corporation incorporated in California and

licensed by the California Public Utilities Commission (PUC) to

haul cement, rock, and sand in Southern California. Petitioner’s

retail gasoline business was organized as a sole proprietorship

and operated under the name Sherrys Exxon. Petitioner’s

residential real estate and equipment rental activities also were

unincorporated businesses. Petitioner used the cash receipts and

disbursements method of accounting to compute taxable income for

all these activities.

In December 1986, petitioner created the Lee G. Gale Living

Trust (living trust) as part of his estate plan. Petitioner’s

primary purpose in creating the living trust was to avoid or

minimize probate costs. Petitioner had exclusive power to revoke

or amend the living trust during his lifetime. The living trust

instrument designated petitioner as the initial trustee, to be

succeeded by Bruce J. Lurie and/or Ronald Foster if petitioner

became unable or unwilling to serve. Petitioner purported to

fund the living trust by contemporaneously executing a document

entitled “Assignment of Assets to Living Trust” (assignment

document). In the assignment document, petitioner declared that

he assigned to the living trust, without consideration, all the

right, title, and interest that he owned or would thereafter
 - 6 -

acquire in all of his property, whether tangible or intangible,

real, personal, or mixed.

United Ready Mixed Hauling Contract and Subsequent Litigation

In June 1986, petitioner entered into a 5-year contract to

haul cement, rock, and sand (hauling contract) for United Ready

Mixed Concrete Co., Inc., and its affiliates (United Ready Mixed)

on an exclusive basis. The hauling contract contemplated that

Pyramid, as a PUC-licensed hauler, would do the actual hauling.

Petitioner and Pyramid rented office space, purchased or rented

additional trucks and other equipment, and hired and trained new

employees to meet the requirements of the hauling contract.

Petitioner and Pyramid performed hauling services for United

Ready Mixed beginning in June 1986. Later in 1986, United Ready

Mixed refused to allow further performance of the hauling

contract, refused to pay for hauling services previously

received, and terminated the hauling contract.

In 1987, petitioner and Pyramid filed suit against United

Ready Mixed for unpaid receivables and for breach of the hauling

contract (among other things). Judgment was entered in favor of

petitioner and Pyramid in May 1992. In July 1992, there was a

settlement agreement whereby United Ready Mixed agreed to pay

petitioner and Pyramid $782,500 plus interest. Under the terms

of the settlement agreement, United Ready Mixed was required to

make payment by check or wire transfer payable to a trust account
 - 7 -

created by petitioner’s counsel, then Lurie & Hertzberg, and

later Lurie & Zepeda (collectively, Lurie & Zepeda).

In late 1992, Lurie & Zepeda received total settlement

proceeds of $794,905.55 from United Ready Mixed, and deposited

the funds in a client trust account pending resolution of the fee

dispute between Lurie & Zepeda and petitioner, described below.

United Ready Mixed reported the settlement payment as a payment

to petitioner on a 1992 Form 1099-MISC.

Fee Agreement and Dispute Between Petitioner and Lurie & Zepeda

In the 1980s and early 1990s, Lurie & Zepeda represented

petitioner in numerous litigation matters, including the United

Ready Mixed litigation, various lawsuits initiated by the FDIC

against petitioner and others for default on a construction loan,

a joint action by petitioner and others against another law firm

for legal malpractice, lawsuits arising out of a real estate

investment, a divorce proceeding against petitioner’s former

wife, and litigation involving petitioner’s family members.

In 1987, petitioner entered into an hourly written fee

agreement with Lurie & Zepeda. In August 1988, petitioner and

Lurie & Zepeda modified the agreement (as modified, the fee

agreement). In the fee agreement, petitioner agreed to pay Lurie

& Zepeda an amount to cover legal fees and expenses incurred

through June 30, 1988, and Lurie & Zepeda agreed to bill all fees

incurred thereafter at one-half the firm’s normal hourly rate.
 - 8 -

In exchange for the reduced hourly rate, petitioner agreed to pay

a graduated contingency fee that would apply to any recoveries

from petitioner’s various litigation matters in excess of a

specified minimum amount. For a recovery of less than $1

million, Lurie & Zepeda would be entitled to a contingency fee of

25 percent of the amount recovered in excess of $400,000.

Petitioner also granted Lurie & Zepeda a lien against his

recoveries to secure his obligations under the fee agreement.

Shortly after the fee agreement was executed, a fee dispute

arose between petitioner and Lurie & Zepeda. In 1990, to secure

payment of $750,000 in disputed fees then owed to Lurie & Zepeda,

petitioner granted Lurie & Zepeda a lien against some rental real

property he owned.

On the basis of its claims for unpaid legal fees and costs

in connection with the various matters on which it represented

petitioner, Lurie & Zepeda refused to release any of the United

Ready Mixed settlement proceeds to petitioner during 1992. Lurie

& Zepeda released the following amounts from the trust account in

1993 and 1994: (1) $5,500 paid on behalf of petitioner to Max

Binswenger in 1993; (2) $200,000 paid to Lurie & Zepeda for legal

fees in 1993; and (3) $250,000 and $5,391.94 paid to petitioner

directly in 1993 and 1994, respectively. Lurie & Zepeda released

other amounts in later years not at issue in these cases.
 - 9 -

In May 1994, petitioner filed a complaint for legal

malpractice, breach of fiduciary duty, and breach of contract

against Lurie & Zepeda. Lurie & Zepeda filed a cross-complaint

to recover unpaid fees and costs. In May 1995, a default

judgment of $796,352.65 plus interest was entered in favor of

Lurie & Zepeda. After petitioner filed a notice of appeal, the

parties reached a settlement (Lurie & Zepeda settlement) in July

1995, whereby petitioner was permitted to satisfy his obligation

under the judgment by paying Lurie & Zepeda $500,000. The

settlement sum was to be paid by immediate withdrawal of funds

from the United Ready Mixed trust account and by petitioner’s

payment of the balance plus interest before July 9, 1996.

Petitioner fully performed his obligations under the Lurie &

Zepeda settlement in 1996.

Petitioner’s Reporting Positions for Years at Issue

1992 Individual Income Tax Return

By reason of illness of his return preparer, Sidney Binder

(Mr. Binder), petitioner obtained an extension of time to file

his 1992 Form 1040, U.S. Individual Income Tax Return (1992

individual return), until August 16, 1993. Petitioner did not

file his 1992 return until after the extended due date.

Petitioner reported both his personal activities and those

of the living trust on his 1992 individual return. Petitioner

included a Schedule C, Profit or Loss from Business (Sole
 - 10 -

Proprietorship), for a “Rental Truck & Equip” business, in which

he reported gross receipts or sales of $797,225, cost of goods

sold of $925,500, and other expenses of $25,939. Petitioner

derived the $797,225 gross receipts or sales figure from the Form

1099-MISC issued to him by United Ready Mixed for settlement

proceeds paid in 1992 to the Lurie & Zepeda trust account. Mr.

Binder advised petitioner to report the settlement proceeds as

income on his 1992 return to conform with United Ready Mixed’s

reporting of the payment on Form 1099-MISC.

Petitioner’s 1992 return showed a reduction of income for

cost of goods sold, which included the full amount of the United

Ready Mixed settlement proceeds. Petitioner treated the deposit

of the United Ready Mixed settlement proceeds into Lurie &

Zepeda’s trust account as a “cost of goods sold” on the basis of

Mr. Binder’s advice. Mr. Binder advised petitioner that he was

entitled to a “cost of goods sold” reduction for the amount of

the settlement proceeds because petitioner had not physically

received and did not have access to the proceeds in 1992, which

were being held by Lurie & Zepeda pending resolution of its

attorney’s-fee dispute with petitioner.

Petitioner’s “cost of goods sold” reduction also included an

additional $128,275 of other alleged business costs. The parties

agree that petitioner was not entitled to a cost of good sold

reduction in any amount because, among other things, petitioner
 - 11 -

was not in the business of producing goods for sale. However,

petitioner substantiated that $35,000 of the amount wrongly

claimed as cost of goods sold represents deductible business

expenses, and respondent in the notice of deficiency allowed a

deduction of $35,000. Petitioner failed to substantiate with

credible evidence that any of the remaining $93,275 claimed as

cost of goods sold represents deductible business expenses.

Petitioner reported a net operating loss (NOL) carryover of

$148,367 on his 1992 individual return. The NOL carryover

consisted of a $105,740 loss carried forward from 1990 (1990 NOL)

and a $42,627 loss carried forward from 1991 (1991 NOL). The

1990 and 1991 NOLs were due in large part to losses from Sherrys

Exxon reported on Schedule C and to real estate and equipment

rental losses reported on Schedule E, Supplemental Income and

Loss. Petitioner combined the NOL carryovers from 1990 and 1991

with the losses reported in 1992 to arrive at a 1992 NOL

carryforward of $323,352.

Petitioner neither carried back the 1990, 1991, or 1992 NOL

to prior years nor elected to relinquish the NOL carryback

periods on his 1990, 1991, or 1992 individual return.

Petitioner’s returns for taxable years 1987, 1988, and 1989 are

not in the record.

On Schedule E of his 1992 individual return, petitioner

reported a depreciation expense of $15,317, which was
 - 12 -

attributable to his equipment rental activity. The depreciation

detail schedule listed nine pieces of equipment (one computer,

two trucks, three tractors, and three trailers) that generated

the $15,317 depreciation expense reported. According to the 1992

individual return (and prior years’ returns), the computer was

placed in service on May 19, 1986; the trucks and tractors were

placed in service on June 1, 1986; and the trailers were placed

in service on July 9, 1986. The equipment was depreciated under

the Accelerated Cost Recovery System, over a 5-year period, using

the straight-line method, with a half-year convention (except for

the computer), beginning on the date each asset was placed in

service.

1993 Individual and Fiduciary Income Tax Returns

By reason of Mr. Binder’s illness, petitioner obtained an

extension of time to file his 1993 individual income tax return

(1993 individual return). Petitioner did not file his 1993

individual return until after the extended due date.

Instead of filing Form 1040 for 1993, petitioner filed Form

1040EZ, Income Tax Return for Single Filers With No Dependents,

reporting no taxable income. Mr. Binder had advised petitioner

to report all his business and investment activities on Form

1041, U.S. Fiduciary Income Tax Return (1993 fiduciary return),

under the name and taxpayer identification number of the living

trust. As a result, the 1993 fiduciary return reported
 - 13 -

petitioner’s gross income from interest, dividends, and

residential real estate and equipment rental activities.3 The

1993 fiduciary return also included the 1992 NOL carryover of

$323,352, which was largely due to prior year Schedule C losses.

The 1993 fiduciary return was signed by petitioner as fiduciary

or officer representing fiduciary.

1994 Individual and Fiduciary Income Tax Returns

Petitioner timely filed his 1994 Form 1040 (1994 individual

return). Other than Social Security payments of $28,405 reported

as nontaxable, petitioner reported no gross income on his 1994

individual return. Petitioner did, however, report the 1992 NOL

carryover of $323,352.

As he did for 1993, petitioner reported gross income from

interest and his residential real estate and equipment rental

activities on the living trust’s 1994 Form 1041 (1994 fiduciary

return). In addition, the 1994 fiduciary return reflected an NOL

carryover from the 1993 fiduciary return of $525,214. The 1994

fiduciary return was signed by Ronald Foster as fiduciary or

officer representing fiduciary.

Miscellaneous Transactions Not Reported on Petitioner’s Returns

Petitioner opened a bank account at Fidelity Federal Bank in

the name of the living trust (trust bank account) in July 1992.

3
Unlike the returns for prior years, the 1993 individual
return and the 1993 fiduciary return did not include Schedule C
for either Sherrys Exxon or petitioner’s “Rental Truck & Equip.”
activity.
 - 14 -

He maintained the account during the years at issue in these

cases.

J&J Trucking Deposits

During 1992, petitioner deposited four checks, each in the

amount of $1,399.67, into the trust bank account. Three of the

checks were issued by J&J Trucking Co. (J&J Trucking) drawn on

San Diego Trust & Savings Bank, and one was a cashier’s check

issued by the same bank. The check dated October 29, 1992,

contained the notation “Truck Pymt. Sept-92".

During 1993, petitioner deposited into the trust bank

account 10 checks issued by J&J Trucking totaling $15,396.37.

Nine checks were for $1,399.67 and one was for $2,799.34. The

checks dated August 10 and October 5, 1993, noted the account or

transaction number “9204001".

During 1994, petitioner deposited into the trust bank

account 12 checks issued by J&J Trucking, each in the amount of

$1,399.67. However, one of those checks was returned because of

insufficient funds and was not resubmitted in 1994. Four of the

checks bore notations indicating that the payments were

sequentially numbered.

Miscellaneous Items

On October 28, 1993, petitioner paid $17,300 in cash to

repay in full a loan obligation to Bank of America. The record
 - 15 -

does not disclose the source of funds petitioner used to repay

the loan.

During 1994, petitioner deposited $187,574 into the trust

bank account, which included the 12 checks of J&J Trucking

previously described. The 1994 fiduciary return for the living

trust reported total gross income of $58,859, consisting of:

Interest $70, rental income from Onyx property $26,359, and

rental income from 31st Street property $32,430.

Statutory Notice Adjustments and Respondent’s Concessions

1992 Individual Return

On October 7, 1996, respondent issued a notice of deficiency

(1992 notice) to petitioner determining a deficiency, addition,

and penalty for the year ended December 31, 1992. After

concessions,4 respondent has continued to assert adjustments for

the following items: (1) Unreported interest income of $5,599

from J&J Trucking, (2) unsubstantiated NOL carryforward of

$148,367 to 1992, (3) unsubstantiated cost of goods sold

reduction of $890,5005 related to petitioner’s Schedule C

4
Respondent conceded that petitioner was entitled to deduct
capital losses of $3,000, was not subject to tax on $38,048 of
deposits made to the living trust, and was not subject to self-
employment tax because he had no self-employment income in 1992.
5

As previously stated, petitioner claimed an offset for cost of
goods sold of $925,500 on his Schedule C for 1992. The parties
agree that petitioner is not entitled to a reduction for cost of
goods sold because petitioner did not produce goods. However,
petitioner established, and the 1992 notice of deficiency
reflects that respondent allowed, a business deduction for
(continued...)
 - 16 -

activity, (4) excess Schedule E depreciation deductions of

$15,317, and (5) computational adjustments related to personal

exemptions.

1993 and 1994 Individual Returns

On December 2, 1996, respondent issued a letter (no change

letter) in connection with the audit of petitioner’s 1993 and

1994 fiduciary returns, which stated:

Since there was no material change in the tax you
reported, we are accepting your return with the changes
noted. You can contest these changes only when the
result changes the amount of your income tax. Changes
that affect carryovers to future years or periods
cannot be protested at this time because we are not
changing the tax reported on your return. If
additional tax is proposed for a later year based on an
adjustment of a carryover reflected in this report, you
can contest the issue at that time.

On November 19, 1997, respondent issued a notice of

deficiency (1993/1994 notice) to petitioner determining

deficiencies, an addition (1993 only), and penalties for the

calendar years 1993 and 1994. After concessions,6 respondent has

continued to assert adjustments for the following items: (1)

5
(...continued)
$35,000 of the amount petitioner wrongly claimed as a cost of
goods sold.
6
Under the assumption that petitioner would not be entitled
to exclude the United Ready Mixed settlement proceeds from income
in 1992 or deduct the payment made to petitioner’s attorney’s
trust account in 1992, respondent conceded that in 1993
petitioner paid to Lurie & Zepeda and was entitled to deduct from
gross income in arriving at adjusted gross income under sec. 162
$200,000 in legal fees. Respondent also conceded that petitioner
was not subject to tax on $642,698 and $114,839 of deposits made
to the living trust in 1993 and 1994, respectively.
 - 17 -

Unreported interest income of $16,796 from J&J Trucking for 1993

and 1994, (2) unreported income of $17,300 related to a currency

transaction in 1993, (3) an unsubstantiated NOL carryforward of

$323,352 to 1994, (4) unreported rental activity income of

$55,939 in 1994, (5) net trust expenses of $14,000 allowed by

respondent to offset petitioner’s individual income tax liability

in 1994, and (6) computational adjustments related to personal

exemptions and taxation of Social Security benefits received in

1994.

OPINION

Procedural Matters

Before trial, petitioner filed a motion to dismiss the cases

at hand on the three following grounds: (1) The 1992 and

1993/1994 notices were “naked assessments”; (2) the written

acceptance of petitioner’s 1993 and 1994 tax returns after audit

(no change letter) was conclusive of all tax matters for those

years; and (3) petitioner was denied his due process rights under

the Sixth Amendment to the Constitution because he was not

allowed to confront representatives of United Ready Mixed at

trial. We denied petitioner’s motion for the reasons stated

below.

“Naked Assessment” Argument

In general, a deficiency notice is presumed correct and the

taxpayer has the burden of proving it wrong. Rule 142(a)(1);
 - 18 -

Welch v. Helvering, 290 U.S. 111 (1933).7 However, the

presumption of correctness does not apply when the Government’s

determination is a “‘naked’ assessment without any foundation

whatsoever”. United States v. Janis, 428 U.S. 433, 441 (1976).

An appeal of the cases at hand would lie to the Court of

Appeals for the Ninth Circuit, which has held in unreported

income cases that the presumption of correctness applies only if

the Commissioner’s determination is supported by some substantive

evidence that the taxpayer received the unreported income. Rapp

v. Commissioner, 774 F.2d 932, 935 (9th Cir. 1985); Weimerskirch

v. Commissioner, 596 F.2d 358, 360-361 (9th Cir. 1979), revg. 67

T.C. 672 (1977); Petzoldt v. Commissioner, 92 T.C. 661, 687-690

(1989) (discussing Court of Appeals for the Ninth Circuit

authorities). However, once the Commissioner has introduced the

necessary “predicate evidence” concerning the unreported income,

the taxpayer has the usual burden of establishing, by a

preponderance of the evidence, that the Commissioner’s

determination is arbitrary or erroneous. Rapp v. Commissioner,

supra at 935; Petzoldt v. Commissioner, supra at 689. The Court

7
The provision of sec. 7491(a) for shifting the burden of
proof to the Commissioner applies only to Court proceedings
arising in connection with examinations commenced after July 22,
1998, Internal Revenue Service Restructuring and Reform Act of
1998, Pub. L. 105-206, sec. 3001, 112 Stat. 726. In the cases at
hand, the notices of deficiency were issued on Oct. 7, 1996, and
Nov. 19, 1997. We find that the examinations were commenced
before July 23, 1998. Therefore, sec. 7491(a) does not apply to
the cases at hand.
 - 19 -

of Appeals for the Ninth Circuit has described the required

evidentiary foundation as “minimal”. Palmer v. IRS, 116 F.3d

1309, 1312-1313 (9th Cir. 1997).

Petitioner’s motion asserted that the notices in the cases

at hand are “naked assessments” that should not be presumed

correct, because respondent failed to show that petitioner

personally received the United Ready Mixed settlement proceeds in

1992, and respondent did not allow expense deductions to offset

petitioner’s reported (1992 notice) or unreported (1993/1994

notice) income. We disagree.

First, the “naked assessment” notion applies only in

unreported income situations. Petitioner reported the United

Ready Mixed settlement proceeds on his 1992 individual return.

Statements on a Federal tax return are admissions under the

Federal Rules of Evidence and will not be overcome without cogent

evidence that they are wrong. Fed. R. Evid. 801(d)(2); Estate of

Hall v. Commissioner, 92 T.C. 312, 337-338 (1989); Lare v.

Commissioner, 62 T.C. 739, 750 (1974), affd. without published

opinion 521 F.2d 1399 (3d Cir. 1975). Thus, petitioner’s “self-

assessment” provided the predicate evidence necessary to link him

to the tax-generating activity in 1992. See Shriver v.

Commissioner, 85 T.C. 1, 4 (1985).8

8
By a parity of reasoning, petitioner’s admission on his
return that he received the income would satisfy any burden on
respondent under sec. 6201(d) to produce evidence, in addition to
(continued...)
 - 20 -

Regarding the 1993/1994 notice’s determinations of

unreported income, the Commissioner may satisfy the predicate

evidence requirement by showing that the taxpayer was connected

to unexplained bank deposits or cash. Weimerskirch v.

Commissioner, supra at 362; Schad v. Commissioner, 87 T.C. 609,

618-620 (1986), affd. 827 F.2d 774 (11th Cir. 1987); Tokarski v.

Commissioner, 87 T.C. 74 (1986). Here, the record contains ample

evidence of bank deposits and cash transactions to support

respondent’s determination of unreported income.

Second, the “naked assessment” exception to the presumption

of correctness applies only to unreported income; the taxpayer

always has the burden of proving entitlement to deductions.

United States v. Zolla, 724 F.2d 808, 809-810 (9th Cir. 1984).

Thus, the fact that respondent did not allow all of petitioner’s

claimed and unclaimed offsets and deductions does not deprive the

1992 and 1993/1994 notices of the presumption of correctness.

Accordingly, the notices sent to petitioner are adequately

supported and are not “naked assessments”.

Conclusiveness of No Change Letter

The no change letter, which purported to accept petitioner’s

1993 and 1994 fiduciary tax returns as filed, does not resolve

all issues regarding petitioner’s tax liability for those years.

8
(...continued)
the Form 1099-MISC itself, to show that petitioner received the
income.
 - 21 -

A closing agreement is the only statutorily authorized method for

entering into an agreement relating to the taxpayer’s liability

for any taxable period that binds both the Internal Revenue

Service and the taxpayer. Sec. 7121; sec. 301.7121-1(d), Proced.

& Admin. Regs; see Botany Worsted Mills v. United States, 278

U.S. 282, 288 (1929); Estate of Meyer v. Commissioner, 58 T.C.

69, 70-71 (1972). A no change letter is not a closing agreement

under section 7121; thus, respondent is not bound by any

representations in the no change letter. See Miller v.

Commissioner, T.C. Memo. 2001-55.

Constitutional Argument

Petitioner’s due process rights were not violated because

respondent did not produce a witness from United Ready Mixed at

trial. The Sixth Amendment to the Constitution, and

specifically, the accused’s right to be confronted by witnesses,

applies only to criminal proceedings, not to civil proceedings

for the collection of tax or remedial penalties. U.S. Const.

amend. VI; Olshausen v. Commissioner, 273 F.2d 23, 27 (9th Cir.

1959), affg. T.C. Memo. 1958-85. More generally, in this civil

tax litigation, respondent is not required to gather witnesses on

petitioner’s behalf; petitioner is free to subpoena his own

witnesses. Rule 147. Petitioner’s due process rights were not

violated in the cases at hand.
 - 22 -

Inclusion of United Ready Mixed Settlement Proceeds

Petitioner reported the United Ready Mixed settlement

proceeds of $797,225 as gross receipts or sales on his 1992

individual return. Petitioner also offset his gross income with

a reduction of $925,500 described as “cost of goods sold”.

Petitioner included the United Ready Mixed settlement proceeds of

$797,225 in his computation of “cost of goods sold” because,

according to petitioner, the amounts were not available to him in

1992. The funds were not available to him because they were paid

and deposited to the Lurie & Zepeda trust account and withheld

pending resolution of his fee dispute with Lurie & Zepeda. The

balance of the amounts claimed as “cost of goods sold”

represented other alleged business expenses.

In the notice of deficiency, respondent disallowed a

reduction or deduction for all but $35,000 of the “cost of goods

sold” claimed by petitioner. Petitioner now concedes that the

United Ready Mixed settlement proceeds did not constitute a “cost

of goods sold”. Petitioner argues instead that the settlement

funds should have been excluded from his income in 1992 because

he did not have constructive receipt of the funds in 1992 because

of his attorney’s restriction on his use of the funds.

The Court of Appeals for the Ninth Circuit and this Court

have repeatedly held that legal fees paid to recover income,

whether contingent or based on hourly rates, are not offsets in
 - 23 -

arriving at gross income.9 We follow those decisions and treat

proceeds from the United Ready Mixed settlement, unreduced by

attorney’s fees, as gross income to petitioner. See Golsen v.

Commissioner, 54 T.C. 742, 756 (1970), affd. 445 F.2d 985 (10th

Cir. 1971).

Petitioner, however, argues that the funds should not be

included in his income until the restriction on his use of the

funds was lifted. Since petitioner had no use of or even access

to the settlement funds during 1992, he argues that the income

should not be recognized to him until distributed from his

attorney’s trust account beginning in 1993.

Section 451 requires income to be included in the taxpayer’s

gross income in the taxable year of receipt unless the taxpayer’s

accounting method would properly assign the income to a different

tax period. Sec. 451(a). Since petitioner is a cash method

taxpayer, income is taxable to him upon receipt.

9
Compare Sinyard v. Commissioner, 268 F.3d 756 (9th Cir.
2001), affg. T.C. Memo. 1998-364; Benci-Woodward v. Commissioner,
219 F.3d 941, 943 (9th Cir. 2000), affg. T.C. Memo. 1998-395;
Coady v. Commissioner, 213 F.3d 1187 (9th Cir. 2000), affg. T.C.
Memo. 1998-291; Brewer v. Commissioner, T.C. Memo. 1997-542,
affd. without published opinion 172 F.3d 875 (9th Cir. 1999);
Martinez v. Commissioner, T.C. Memo. 1997-126, affd. without
published opinion 83 AFTR 2d 99-362, 99-1 USTC par. 50,168 (9th
Cir. 1998), with Estate of Clarks v. United States, 202 F.3d 854
(6th Cir. 2000); Cotnam v. Commissioner, 263 F.2d 119 (5th Cir.
1959), revg. in part 28 T.C. 947 (1957). See also Kenseth v.
Commissioner, 114 T.C. 399 (2000), affd. 259 F.3d 881 (7th Cir.
2001); Freeman v. Commissioner, T.C. Memo. 2001-254; Banks v.
Commissioner, T.C. Memo. 2001-48.
 - 24 -

Regulations under section 451(a) define the term “receipt”

to include both actual and constructive receipt. Sec. 1.451-

1(a), Income Tax Regs. “Constructive receipt” is defined in

section 1.451-2(a), Income Tax Regs., as follows:

(a) General rule. Income although not actually
reduced to a taxpayer’s possession is constructively
received by him in the taxable year during which it is
credited to his account, set apart for him, or
otherwise made available so that he may draw upon it at
any time, or so that he could have drawn upon it during
the taxable year if notice of intention to withdraw had
been given. However, income is not constructively
received if the taxpayer’s control of its receipt is
subject to substantial limitations or restrictions.
* * *

Petitioner focuses on the language of the regulation in

arguing that he did not have constructive receipt of the income,

because of the restriction placed on his control of the funds by

his attorney. Petitioner argues that his “control of its

receipt” was “subject to substantial limitations or

restrictions”--to wit, his attorney’s refusal to release the

funds to him.

The constructive receipt doctrine prevents a creditor from

“deliberately turn[ing] his back upon the income and thus

select[ing] the year for which he will report it.” Hamilton

Natl. Bank v. Commissioner, 29 B.T.A. 63, 67 (1933); see also

Corliss v. Bowers, 281 U.S. 376, 378 (1930) (“The income that is

subject to a man’s unfettered command and that he is free to
 - 25 -

enjoy at his own option may be taxed to him as his income,

whether he sees fit to enjoy it or not.”).

Petitioner assumes he did not have taxable receipt of the

settlement proceeds because the funds were paid directly from

United Ready Mixed to petitioner’s attorney and did not pass

through his hands. However, taxable receipt is not limited to

physical receipt by the payee. Taxable receipt also occurs when

funds are received by the payee’s agent on the payee’s behalf10

or by a creditor of the payee on account of the payee’s debt.11

10
“[R]eceipt by an agent is receipt by the principal.”
Arnwine v. Commissioner, 696 F.2d 1102, 1107 (5th Cir. 1983),
revg. 76 T.C. 532 (1981). Therefore, any agreement between the
payee and the payee’s agent to defer recognition of the income is
ineffective to defer taxable receipt. Id.; Warren v. United
States, 613 F.2d 591 (5th Cir. 1980) (attempt by farmer through
agreement with cotton gin to defer recognition of income from
sale of cotton ineffective because gin was acting as agent for
farmer in receiving sale proceeds).
11
Old Colony Trust Co. v. Commissioner, 279 U.S. 716, 729
(1929), held that an employer’s payment of the employee’s taxes
constituted receipt by the employee:

The payment of the tax by the employers was in
consideration of the services rendered by the employee
and was a gain derived by the employee from his labor.
The form of the payment is expressly declared to make
no difference. * * * It is therefore immaterial that
the taxes were directly paid over to the Government.
The discharge by a third person of an obligation to him
is equivalent to receipt by the person taxed. * * * We
think therefore that the payment constituted income to
the employee.

See also Young v. Commissioner, 113 T.C. 152 (1999) (applying
rule of Old Colony Trust Co. to sale proceeds paid directly to
taxpayer’s attorney), affd. 240 F.3d 369 (4th Cir. 2001).
 - 26 -

In the cases at hand, petitioner had taxable receipt of the

settlement proceeds, even though he did not physically receive

them. The funds were paid at petitioner’s direction (under the

terms of the settlement agreement signed by petitioner) to

petitioner’s attorney, to be deposited into an attorney/client

trust account. Petitioner’s attorney was acting as petitioner’s

agent or petitioner’s creditor in receiving the settlement

proceeds and depositing them into a trust account pending

resolution of an attorney’s-fee dispute between petitioner and

his counsel unrelated to United Ready Mixed’s liability to

petitioner. There is no need to consider the doctrine of

constructive receipt because petitioner did not delay United

Ready Mixed’s payment.12 As between petitioner and United Ready

Mixed, the settlement amount was fully paid in 1992. United

Ready Mixed retained no interest in the funds after they were

paid, at petitioner’s direction pursuant to the terms of the

settlement agreement, to petitioner’s attorney. Any restriction

12
“Constructive receipt” as defined in sec. 1.451-2(a),
Income Tax Regs., is a legal term of art that applies when
payment has not been effected because of the payee’s postponing
payment. The term “constructive receipt” could also be used in
its vernacular sense for any payment not physically received by
the taxpayer. A taxpayer has “constructive receipt”, in its
vernacular sense, of funds paid directly to the taxpayer’s agents
or creditors. The legal doctrine of constructive receipt defined
in sec. 1.451-2(a), Income Tax Regs., however, does not apply to
completed payments received by a payee’s agents or creditors. We
have used the term “taxable receipt” to distinguish between
physical receipt and nonphysical receipt that the law treats as
received for tax purposes.
 - 27 -

placed on the use of the settlement proceeds after payment by

United Ready Mixed, whether the restriction was placed on the

funds voluntarily by petitioner or through acts by petitioner’s

creditors, does not delay petitioner’s receipt of the income for

income tax purposes. See Harris v. Commissioner, 477 F.2d 812

(4th Cir. 1973) (receipt even though funds placed in escrow due

to taxpayer’s incompetency), revg. 56 T.C. 1165 (1971); Williams

v. Commissioner, 219 F.2d 523 (5th Cir. 1955) (receipt when

payments made to escrow set up by taxpayer); Sproull v.

Commissioner, 16 T.C. 244 (1951) (receipt on payment to trust),

affd. 194 F.2d 541 (6th Cir. 1952); cf. Reed v. Commissioner, 723

F.2d 138 (1st Cir. 1983) (no receipt where escrow arrangement was

bona fide deferred payment agreement between buyer and seller);

Busby v. Commissioner, 679 F.2d 48 (5th Cir. 1982) (no receipt to

seller where payment was made to buyer’s agent).

Respondent admits that at trial he conceded that petitioner

did not have receipt of the United Ready Mixed settlement

proceeds in 1992, because of the restriction placed on the funds

by petitioner’s attorney. However, in his reply brief,

respondent repudiated his concession,13 relying on Sullivan v.

13
In his reply brief, respondent states:

In view of Sullivan, respondent has reexamined the
position taken at trial and on opening brief with
respect to the timing of the taxability of the Ready
Mixed settlement proceeds. Respondent is changing his
position in this case to be consistent with the holding
(continued...)
 - 28 -

Commissioner, T.C. Memo. 1999-341, published the day respondent

filed his opening brief in these cases.

In Sullivan, the taxpayer received an award of $942,112.50

plus interest and costs in a personal injury lawsuit. After

judgment was entered, but before it was paid, a guardian ad litem

was appointed for the taxpayer in connection with a divorce

proceeding instituted by his wife. The attorneys and the

guardian agreed that the judgment proceeds would be deposited in

an interest-bearing escrow account pending the family court’s

directions regarding the disbursement of the funds. Mr. Sullivan

endorsed the check for deposit into the escrow account. This

Court, focusing on Mr. Sullivan’s signature on the check,

determined that the income was taxable to Mr. Sullivan when it

was deposited into the escrow account. In Sullivan, we stated:

although the placing of the check proceeds into escrow
accounts pending resolution of disputes over the amount
of attorney’s fees and the amount of Mrs. Sullivan’s
share of the marital estate was a substantial
restriction over * * * [Mr. Sullivan’s] ultimate
disposition of the judgment proceeds, these
restrictions did not limit * * * [Mr. Sullivan’s] legal
entitlement to the judgment award and interest in 1989.
Because he received and endorsed the check for the
judgment with interest in 1989, that is the year in
which * * * [Mr. Sullivan] must report the entire
amount of interest. [Id.]

13
(...continued)
in Sullivan. Respondent now asserts that the Ready
Mixed settlement proceeds were constructively received
in 1992.
 - 29 -

On the basis of Sullivan--a decision that did not announce a new

rule of law--respondent argued in his reply brief that the United

Ready Mixed settlement proceeds should be taxed as income to

petitioner in 1992.14

Respondent also argues that “Petitioner is not harmed by

respondent’s change in position as respondent’s new position is

consistent with petitioner’s own treatment of the proceeds on his

1992 return”. We disagree with respondent’s statement.

Petitioner may have relied on respondent’s trial and briefing

concession in failing to introduce evidence and submit argument

to support a deduction for amounts paid to his attorney and

placed in trust in 1992 pending resolution of the attorney’s-fee

dispute. Respondent’s change of position after trial created new

legal and factual issues; petitioner did not have an opportunity

to introduce evidence on these new issues because respondent did

not change his position until after the trial was completed.

We have refused to allow the Commissioner to withdraw

factual concessions after trial where there would be prejudice to

the opposing party. See Glass v. Commissioner, T.C. Memo.

1988-550 (“In his brief, respondent seeks to withdraw the

concession. We are not inclined to accept such withdrawal,

14
In his reply brief, respondent states: “In light of
Sullivan, respondent hereby changes the position taken in his
opening brief, and asserts that petitioner received taxable Ready
Mixed settlement proceeds in the amount of $797,225.00 in 1992,
the year such proceeds were deposited into Lurie and Zepeda’s
client trust fund.”
 - 30 -

however, as it would put petitioner at a disadvantage, since it

tried and argued the case in light of the concession.”); Cogan v.

Commissioner, T.C. Memo. 1980-328 (“Petitioners had every right

to rely on the concession of respondent's counsel at trial and we

will not permit respondent to withdraw his concession or attempt

to modify it after trial.”).

In the cases at hand, respondent took the position that

petitioner did not have receipt of the settlement proceeds in

1992 only after the trial commenced. In the notice of

deficiency, respondent took the position that the proceeds were

taxable in 1992. We therefore do not elect to hold respondent to

his trial concession. However, we should ameliorate any harm to

petitioner by requiring respondent to bear the burden of proving

all factual issues arising out of respondent’s change in

position. See Rule 142(a)(1) (burden of proof on petitioner

“except as otherwise provided by statute or determined by the

Court”).

We agree with respondent that the settlement proceeds paid

by United Ready Mixed in 1992 constitute income to petitioner in

1992. There were no restrictions placed by United Ready Mixed on

petitioner’s use of the funds, and the payment was made to

petitioner’s attorney’s trust account at petitioner’s direction

pursuant to the settlement agreement. Petitioner’s counsel was

acting as either petitioner’s agent or petitioner’s creditor in
 - 31 -

receiving and holding the funds. Petitioner thus had taxable

receipt of the income in 1992.

Petitioner’s Section 461(f) Deduction

After respondent withdrew his concession that the amounts

paid by United Ready Mixed to petitioner’s attorney’s trust

account did not constitute gross income to petitioner in 1992,

the Court asked respondent to address in a supplemental brief

whether petitioner is entitled under section 461(f) to a

deduction in 1992 for the amounts paid to petitioner’s counsel

and held in trust pending resolution of the attorney’s-fee

dispute.

Section 461(f) allows a deduction for amounts paid in

connection with a contested claim pending resolution of the

contest. It was enacted in response to cases holding that

accrual method taxpayers could not deduct amounts paid in

connection with contested liabilities because the fact of the

liability had not been established. United States v. Consol.

Edison Co., 366 U.S. 380 (1961); S. Rept. 830, 88th Cong., 2d

Sess. (1964), 1964-1 C.B. (Part 2) 502, 604. However, section

461(f) by its terms applies to both accrual and cash method

taxpayers. Weber v. Commissioner, 70 T.C. 52, 55 n.4 (1978)

(“Respondent initially asserted that this section [461(f)]

applies only to accrual and not cash basis taxpayers, but this
 - 32 -

position has not been discussed on brief and is clearly

erroneous.”).

Section 461(f) allows a deduction only if four elements are

present: (1) The taxpayer must contest an asserted liability,

(2) the taxpayer must transfer money or property to provide for

the satisfaction of the asserted liability, (3) the contest must

continue after the transfer, and (4) a deduction would be allowed

for the transfer under applicable law if the liability were not

contested.

In his supplemental brief, respondent concedes that

petitioner is entitled to a deduction in 1992 under section

461(f) for the amount of legal fees claimed by Lurie & Zepeda in

connection with the United Ready Mixed litigation. Respondent

argues, however, that the United Ready Mixed settlement proceeds

substantially exceed the fees to which Lurie & Zepeda were

entitled in connection with the United Ready Mixed litigation,

and that petitioner failed to prove that he would have been

entitled to a deduction if he had paid the balance of the fees

claimed by Lurie & Zepeda for other legal matters they handled

for him.

There are significant gaps in the record. The record shows

that petitioner owed Lurie & Zepeda $348,114.21 in hourly legal

fees and costs as of November 30, 1992, in connection with the

United Ready Mixed matter, $65,685.34 in legal fees and costs as

of 1995 in connection with petitioner’s divorce (the amount owing
 - 33 -

in 1992 is not in the record), and $103,175.05 as of 1992 in

connection with the so-called Emerald Bay matter. The record

shows that Lurie & Zepeda claimed additional amounts (exceeding

the entire United Ready Mixed settlement proceeds) for

contingency fees in the United Ready Mixed matter and hourly and

contingency fees in numerous other matters. The specific amounts

owing for each matter as of the end of 1992 and the nature of

each of the matters were not established at trial.

Respondent contends that we should allow a deduction only

for the fees petitioner proved at trial would have been

deductible if paid without contest. Respondent argues that

petitioner failed to establish an entitlement to a deduction

exceeding the hourly fees and costs claimed by Lurie & Zepeda as

of November 30, 1992, in connection with the United Ready Mixed

matter ($348,114.21).

We agree with respondent that the record is incomplete.

However, petitioner does not bear the burden of proof here.

Respondent created this issue by withdrawing his trial concession

that the United Ready Mixed settlement proceeds are not taxable

in 1992. As a result of respondent’s change of position after

the completion of the trial, petitioner did not have a full and

fair opportunity to introduce evidence to establish the

deductibility of the amounts claimed by Lurie & Zepeda. It is

appropriate for respondent to bear the burden of proof on new
 - 34 -

issues caused by his change of position. See Rule 142(a)(1).

Therefore, respondent bears the burden of proving which amounts

claimed by Lurie & Zepeda would not have been deductible if paid

without contest.

Respondent had an opportunity at trial to meet his burden of

proof. Respondent called the custodian of records for Lurie &

Zepeda to testify at trial. Respondent could have questioned the

custodian to determine the specific amounts claimed by Lurie &

Zepeda at the end of 1992, for which matters the amounts were

claimed, and whether each of the matters related to deductible

trade or business or investment matters or nondeductible personal

matters. Respondent failed to make the necessary inquiries.

It is undisputed that Lurie & Zepeda asserted a claim for

legal fees exceeding the United Ready Mixed settlement proceeds.

In connection with a later dispute between petitioner and Lurie &

Zepeda in May 1995 (after substantial payments had been made to

Lurie & Zepeda), Lurie & Zepeda recovered a judgment against

petitioner for $796,352.65.

The only amount claimed by Lurie & Zepeda that respondent

has established would not have been deductible if paid without

dispute was the $65,685.34 in legal fees and costs owing as of

1995 in connection with petitioner’s divorce. Legal fees

incurred in connection with petitioner’s divorce generally would

not be deductible. United States v. Patrick, 372 U.S. 53 (1963);
 - 35 -

United States v. Gilmore, 372 U.S. 39 (1963); see also sec. 262

(disallowing deductions for personal, living, and family

expenses). Because petitioner’s divorce was concluded before

1992, we infer that this $65,685.34 was owing in 1992 as well and

deny petitioner a deduction for this amount.

Except for the fees incurred in connection with petitioner’s

divorce, which are clearly not deductible, respondent failed to

establish that any of the fees claimed by Lurie & Zepeda would

not have been deductible if paid without contest. Respondent

adduced evidence of the fees and costs owing on only one other

matter, the Emerald Bay matter for which Lurie & Zepeda claimed

fees of $103,175.05 as of 1992. The Emerald Bay matter involved

a business or investment expense--a dispute over a note payable

in connection with the sale of investment property. Respondent

failed to establish that petitioner would not be entitled to a

deduction if these fees had been paid without contest. Respondent

offered no evidence that petitioner would have been denied a

deduction if any of the other fees claimed by Lurie & Zepeda had

been paid without contest. Therefore, petitioner is entitled to

deduct in 1992 $729,220.21, representing the full $794,905.55 he

paid to Lurie & Zepeda in 1992 (and withheld in trust pending

resolution of the fee dispute) less the $65,685.34 in
 - 36 -

nondeductible fees owing in connection with petitioner’s

divorce.15

Deductibility of Other 1992 Expenses

On his 1992 tax return, petitioner claimed “cost of goods

sold” of $925,500, consisting of $797,225 representing an offset

to the United Ready Mixed settlement proceeds and $128,275

representing other reductions or deductions.

While properly disallowing any cost of goods sold

reduction,16 respondent allowed business expense deductions for

$35,000 of the remaining $128,275 petitioner claimed as cost of

goods sold and disallowed the balance. To substantiate trade or

business expense deductions for the remaining $93,275 which he

wrongly claimed as a cost of goods sold, petitioner provided a

disbursements journal for the year 1992 (1992 disbursements

journal), which listed checks written during the year by category

of expense. The expense categories included: “Onyx”, “Mercedes”,

15
Respondent has conceded that any legal fees petitioner
paid would be deductible as a trade or business expense under
sec. 162 would be deducted “above the line” in arriving at
petitioner’s adjusted gross income under sec. 62(a)(1). See,
e.g., Guill v. Commissioner, 112 T.C. 325 (1999).
16
Petitioner has conceded that it was improper for him to
claim “cost of goods sold”. Petitioner was in the rental truck
and equipment business. Petitioner did not produce goods for
sale to customers. The expenses of engaging in an equipment
rental activity are not a cost of goods sold. The expenses may
be deductible as ordinary trade or business expenses under secs.
62(a)(1) and 162. Petitioner alleges that the amounts he
improperly claimed as cost of goods should constitute deductible
trade or business expenses.
 - 37 -

“Trk Rental”, “Equip. Pmts.”, “Legal”, “Lee Gale Livg Trst”,

“W2P”, “Ofc Rent & Acctg”, “Enttnmnt”, and “Pers”. The 1992

disbursements journal did not provide clear totals for each

category of expense, did not show which expenses made up the

$128,275 additional expense figure, and did not indicate which

expenses had already been reported on Schedule C or E of the 1992

individual return.

As a general rule, the taxpayer has the burden of proving

entitlement to deductions. United States v. Zolla, 724 F.2d at

809-810. The taxpayer must maintain records sufficient to prove

his entitlement to any deductions. Sec. 6001; sec. 1.6001-1(a),

Income Tax Regs.

In the cases at hand, petitioner has not substantiated his

entitlement to business expense deductions for any portion of the

remaining $93,275 which he claimed as a cost of goods sold in

1992. Thus, petitioner was required to substantiate the

disallowed balance of $93,275, which he has attempted to do by

referring us to his 1992 disbursements journal.

We told petitioner at trial that he must provide additional

evidence to support his trade or business expense deductions and

held the record open to give him an opportunity to do this.

Without such evidence, we have no assurance that deductions

already reported in other areas of petitioner’s 1992 individual

return (e.g., Schedule C other expenses of $25,939 and Schedule E
 - 38 -

rental expenses of $52,609) are not being double counted as part

of the mislabeled “cost of goods sold”. Additionally, it appears

that the 1992 disbursements journal tracks personal as well as

business expenses, without clearly differentiating between them.

Petitioner failed to introduce any further documentation or other

evidence to support his deductions. We therefore agree with

respondent’s determination allowing a trade or business expense

deduction for only $35,000 of the $93,275 wrongly claimed by

petitioner as “cost of goods sold”.

Income and Deductions in 1993 and 1994 for Amounts Withdrawn From
Trust Account

Any amounts deducted in 1992 under section 461(f) are

treated as income and subject to taxation in the year recovered

by petitioner, under the tax benefit rule. See, e.g., Hillsboro

Natl. Bank v. Commissioner, 460 U.S. 370 (1983); G.M. Standifer

Constr. Corp. v. Commissioner, 30 B.T.A. 184 (1934) (on

settlement of dispute, taxpayer subject to tax on previously

deducted litigation reserves). To prevent double deductions, no

additional deduction is allowed for amounts paid from the

attorney trust account to the attorneys on account of legal fees

and expenses.
 - 39 -

Petitioner therefore received taxable income in the amounts

of $255,500 in 199317 and $5,391.94 in 1994, for distributions

from the trust account to him (or for his benefit).

NOL Issues

Section 172(a) allows as a deduction for a taxable year the

aggregate of NOL carryovers and carrybacks to that year. For the

years before the Court, an NOL must be carried back to each of

the 3 years preceding the taxable year of loss and carried over

to each of the 15 years following the year of such loss. Sec.

172(b)(1)(A). The entire amount of the NOL must first be carried

to the earliest eligible carryback year. Thereafter, the excess

(if any) of the NOL over the taxable income for each of the prior

taxable years to which such loss was carried must be carried to

each of the succeeding years. Sec. 172(b)(2); sec. 1.172-4(a)(3)

and (b), Income Tax Regs. A taxpayer may, however, elect to

relinquish the carryback period. The election must be made, in a

prescribed manner, by the due date (including extensions) for

filing the taxpayer’s return for the NOL year in which the

election is to be in effect. Sec. 172(b)(3).

Petitioner reported an NOL carryover of $148,367 on his 1992

individual return. The carryover consisted of losses carried

forward from 1990 and 1991. Petitioner combined the NOL

17
Consisting of the $250,000 paid to petitioner and $5,500
paid to Max Binswenger on petitioner’s behalf.
 - 40 -

carryovers from 1990 and 1991 with losses for 1992 to arrive at a

1992 NOL carryover of $323,352, which he subsequently applied to

his 1994 individual return. Petitioner provided nothing more

than his 1990 and 1991 individual income tax returns as proof of

the 1990 and 1991 NOLs. Petitioner did not produce his books and

records for the affected years or any other documentation to

substantiate the claimed losses. Respondent specifically asked

for such documentation in his Request for Production of Documents

(document request), which he served on petitioner in March 1999.

At trial, petitioner offered conflicting testimony regarding

whether or not he had provided substantiation for the NOL

carryovers. Initially, he said that he did not supply records to

respondent substantiating his 1990 and 1991 NOLs after petitions

were filed in these cases, because he did not recall receiving

respondent’s document request. Next, he said that he failed to

produce the requested documentation because he did not have

records going back that far. Finally, petitioner claimed that he

did not provide respondent with the requested documentation

before trial because he had given it to the Internal Revenue

Service agent in connection with the 1992 audit, and the agent

had not returned it.

A tax return is merely a statement of the taxpayer’s claim

and does not establish the truth of the matters set forth

therein. Wilkinson v. Commissioner, 71 T.C. 633, 639 (1979).
 - 41 -

Petitioner’s 1990 and 1991 individual returns do not, by

themselves, adequately substantiate the 1990 and 1991 NOLs.

Petitioner’s explanations for the lack of any further

substantiation are contradictory and incredible. We hold,

therefore, that petitioner did not meet his burden of proof

regarding the 1990 and 1991 NOL carryovers to 1992 and 1994. See

McWilliams v. Commissioner, T.C. Memo. 1995-454.

Even if petitioner had provided the requested documentation,

he did not elect to relinquish the NOL carrybacks from 1990,

1991, and 1992. Under the general rule, the 1990 NOL first

should have been carried back to 1987, 1988, and 1989 before

being carried forward to 1991. Sec. 172(b)(1) and (2).

Similarly, the 1991 NOL should have been carried back to 1988,

1989, and 1990, and the 1992 NOL should have been carried back to

1989, 1990, and 1991. Petitioner stated on the record that no

elections under section 172(b)(3) were filed for any of the

affected years. In addition, there is nothing in the record that

provides any basis from which we could determine the amounts of

the 1990, 1991, and 1992 NOLs that were absorbed in the years

before 1990, the earliest year for which a tax return was

included in the record. Accordingly, petitioner has not shown

that he is entitled to deductions under section 172 for taxable

years 1992 and 1994. See Welch v. Commissioner, T.C. Memo. 1998-

121, affd. 204 F.3d 1228 (9th Cir. 2000).
 - 42 -

Depreciation Issue

Petitioner deducted on his 1992 return depreciation for

property placed in service in 1986. Petitioner indicated on his

return that the property had a 5-year class life and was subject

to the half-year convention.18 Thus, based on the admissions

contained in petitioner’s tax return, the property would have

been fully depreciated in 1991.

At trial, petitioner claimed that his accountant made a

mistake, because the property should have had a 7-year class life

rather than a 5-year class life. Petitioner introduced no

evidence to support his contention that the property should have

had a 7-year class life rather than a 5-year class life and no

evidence that he had not recognized depreciation deductions

totaling the full cost of the property in previous years. See

sec. 1016(a)(2) (basis reduced by all depreciation allowed, but

not less than amount allowable). Petitioner therefore failed to

substantiate his deduction for depreciation, and the deduction is

disallowed.

Unreported Income Issue

Every individual liable for tax is required to maintain

books and records sufficient to establish the amount of his or

18
The convention that petitioner applied to depreciate his
computer is not clear from the record. However, as 5-year
property depreciated using the straight-line method, the computer
should also have been fully depreciated by no later than 1991.
 - 43 -

her gross income. Sec. 6001; DiLeo v. Commissioner, 96 T.C. 858,

867 (1991), affd. 959 F.2d 16 (2d Cir. 1992); sec. 1.6001-1(a),

Income Tax Regs. If the taxpayer fails to maintain or produce

adequate books and records, the Commissioner is authorized to

compute taxable income by any method that clearly reflects

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

(1954). The Commissioner enjoys substantial latitude in

determining which method of computation to apply in order to

reconstruct the income of a taxpayer who fails to maintain or

produce records. Estate of Rau v. Commissioner, 301 F.2d 51, 54

(9th Cir. 1962), affg. T.C. Memo. 1959-117; Petzoldt v.

Commissioner, 92 T.C. at 693. The reconstruction of income need

only be reasonable in light of all the surrounding facts and

circumstances. Giddio v. Commissioner, 54 T.C. 1530, 1533

(1970).

This Court consistently has allowed the use of the bank

deposits method for reconstructing income. Clayton v.

Commissioner, 102 T.C. 632, 647 (1994); DiLeo v. Commissioner,

supra; Estate of Mason v. Commissioner, 64 T.C. 651 (1975), affd.

566 F.2d 2 (6th Cir. 1977). Once there is evidence of actual

receipt of funds by the taxpayer, then the taxpayer has the

burden of proving that all or part of those funds are not

taxable. Tokarski v. Commissioner, 87 T.C. 74 (1986).
 - 44 -

In the cases at hand, respondent used the bank deposits

method to determine that petitioner underreported income for the

years at issue. Because the living trust was established by

petitioner as a revocable trust, of which he was beneficiary and

trustee, respondent attributed income deposited into the trust

bank account or reported on the fiduciary income tax returns to

petitioner. Secs. 61, 671. Petitioner has conceded that all of

the trust’s income was properly taxable to him.

For 1992, petitioner did not file a fiduciary income tax

return. He reported both personal and business income on his

individual income tax return. Respondent’s only assertion of

unreported income for that year related to the J&J Trucking

payments (totaling $5,598.68) that were deposited into the trust

bank account during 1992. Petitioner did not provide any

documentary evidence showing that the periodic J&J Trucking

payments were not income to him. In testimony, petitioner

neither confirmed nor denied receiving the amounts, stating that

“the documents should speak for themselves”. Accordingly,

petitioner has failed to meet his burden of proving that

respondent’s determination was erroneous. See Rule 142(a)(1).

For 1993, petitioner filed separate individual and fiduciary

income tax returns, reporting all his business and personal

income on the fiduciary return. The trust bank account

statements reflected deposits of 10 checks issued by J&J Trucking
 - 45 -

totaling $15,396.37.19 As previously stated, petitioner has

failed to meet his burden of proof on this issue, see Rule

142(a)(1); we therefore hold that the J&J Trucking payments of

$15,396.37 are includable in petitioner’s gross income for 1993.

Petitioner admitted that in 1993 he repaid a loan to Bank of

America of $17,300. Petitioner did not establish the source of

the funds he used to repay this loan. Petitioner testified that

the living trust either had the money on hand or borrowed it to

repay the loan. After reviewing the trust bank account

statements on and around the loan repayment date, we cannot find

a withdrawal or check that approximates the $17,300 payoff

amount. Nor has petitioner provided any loan documentation to

support his suggestion that the Bank of America loan was

satisfied using newly borrowed funds. Respondent determined that

petitioner used unreported income to repay the loan. Because

petitioner has failed to meet his burden of establishing the

source of the funds used to repay the loan, see Rule 142(a)(1),

we sustain respondent’s determination that petitioner used

unreported income to repay the loan.

For 1994, petitioner filed separate individual and fiduciary

income tax returns, reporting all his business and personal

income on the fiduciary return. The trust bank account

19
This is contrary to respondent’s assertion that J&J
Trucking payments totaled $16,796 for 1993.
 - 46 -

statements reflected deposits of 12 J&J Trucking checks for

$1,399.67 each, with one of those checks being returned for

insufficient funds, for net deposits of $15,396.37.20 Petitioner

again has failed to meet his burden of proof on this issue, see

Rule 142(a)(1); we therefore hold that the J&J Trucking payments

of $15,396.37 are includable in petitioner’s gross income for

1994.

Also during 1994, petitioner deposited $187,574 into the

trust bank account, which included the J&J Trucking deposits

previously described. Respondent conceded that $114,839 of those

deposits represented either nontaxable items or taxable amounts

that were already reported by petitioner on his 1994 fiduciary

return. Accordingly, petitioner was left to account for $57,339

of unreported income.21

Our review of the trust bank account statements and copies

of deposited checks indicates that the deposits at issue related

to petitioner’s real property or equipment rental activities.

However, petitioner has not provided any documentary evidence to

show that the amounts were nontaxable. Because petitioner has

failed to meet his burden of proof on this issue, see Rule

20
This is contrary to respondent’s assertion that J&J
Trucking payments totaled $16,796 for 1994.
21
$187,574 deposits minus $114,839 concessions minus
$15,396.37 J&J Trucking payments equals $57,339 (rounded).
 - 47 -

142(a)(1), we hold that deposits of $57,339 are includable in

petitioner’s gross income for 1994 as taxable rents.

Late-Filing Additions to Tax

Section 6651(a)(1) imposes an addition to tax for failure to

file a return by the required filing date, including extensions.

The addition is 5 percent of the amount required to be shown as

tax on the delinquent return for each month the return is late

(not to exceed 25 percent). Id. The taxpayer is excused from

the late-filing addition if he shows that the late filing was due

to reasonable cause and not due to willful neglect, id.; however,

the taxpayer bears the burden of proof on this issue, Rule

142(a)(1); BJR Corp. v. Commissioner, 67 T.C. 111, 131 (1976).

In the cases at hand, petitioner filed his 1992 and 1993

individual tax returns after the extended due date. At trial,

petitioner explained why he had requested the extension but not

why he filed after the extended date. Because petitioner has not

met his burden of proving reasonable cause for the late filings,

he is liable for the section 6651(a)(1) addition to tax. See

Rule 142(a)(1).

Accuracy-Related Penalties

Section 6662 imposes a 20-percent penalty on any portion of

an underpayment of tax that is attributable to, among other

things, negligence or disregard of rules or regulations. Sec.

6662(a) and (b).
 - 48 -

“Negligence” includes any failure to: (1) Make a reasonable

attempt to comply with the provisions of the internal revenue

laws, (2) exercise ordinary and reasonable care in preparing a

tax return, or (3) keep adequate books and records or

substantiate items properly. Sec. 6662(c); sec. 1.6662-3(b)(1),

Income Tax Regs. Negligence is indicated if a taxpayer fails to

include on an income tax return an amount of income shown on an

information return or fails to make a reasonable attempt to

ascertain the correctness of a deduction, credit, or exclusion on

a return that would seem to a reasonable and prudent person to be

“too good to be true” under the circumstances. Sec. 1.6662-

3(b)(1)(i) and (ii), Income Tax Regs. “Disregard” includes any

careless, reckless, or intentional disregard of rules or

regulations. Sec. 6662(c); sec. 1.6662-3(b)(2), Income Tax Regs.

Section 6664 provides an exception to the imposition of

accuracy-related penalties if the taxpayer shows that there was

reasonable cause for any portion of the underpayment, and that

the taxpayer acted in good faith. Sec. 6664(c); United States v.

Boyle, 469 U.S. 241, 242 (1985). Whether a taxpayer has acted

with reasonable cause and in good faith is a factual question.

Sec. 1.6664-4(b), Income Tax Regs. Generally, the most important

factor is the extent to which the taxpayer exercised ordinary

business care and prudence in attempting to assess his proper tax

liability. Id. Reliance on the advice of a professional (such
 - 49 -

as an appraiser, attorney, or accountant) constitutes reasonable

cause and good faith if, under all the circumstances, such

reliance was reasonable and the taxpayer acted in good faith.

Sec. 1.6664-4(b)(1), Income Tax Regs. Petitioner bears the

burden of proving that he is not liable for the accuracy-related

penalties determined in the notices of deficiency. See Rule

142(a)(1).

In the notices of deficiency, respondent determined 20-

percent accuracy-related penalties for each of the years in

issue. We agree in part and disagree in part.

For 1992, petitioner is not liable for any accuracy-related

penalty in connection with any portion of the underpayment

attributable to the disallowance of a deduction or reduction for

the attorney’s fees paid to Lurie & Zepeda. Petitioner acted in

good faith and reasonably relied on his professional tax adviser,

Mr. Binder, to properly report the United Ready Mixed settlement,

a complicated transaction affecting multiple tax years.

Petitioner disclosed the United Ready Mixed proceeds reported on

the 1992 Form 1099-MISC as business income on his 1992 individual

return. Mr. Binder advised petitioner that he could offset the

reported income with a cost of goods sold reduction, inasmuch as

petitioner had not actually received the settlement proceeds in

1992. While it was wrong for petitioner to report a cost of

goods sold reduction rather than a section 461(f) deduction (and
 - 50 -

to deduct the portion representing nondeductible fees), the

notion of offsetting amounts that were never physically received

would not seem to a layman to be “too good to be true”.

Respondent’s contradictory positions at trial and in posttrial

briefs regarding the proper treatment of the United Ready Mixed

settlement proceeds support our finding that petitioner acted

reasonably and prudently when he relied on Mr. Binder regarding

the proper way to report the transaction.

On the other hand, petitioner is liable for an accuracy-

related penalty to the extent that petitioner’s disallowed cost

of goods sold reduction of $93,275 results in an underpayment.

Petitioner offered no evidence to support this claimed cost of

goods sold reduction in excess of the United Ready Mixed

settlement proceeds.

With respect to all years, petitioner is liable for an

accuracy-related penalty to the extent his underpayment is

attributable to the following items: (1) The disallowed net

operating loss carryforward deductions, (2) the disallowed

depreciation deductions, and (3) the unreported income petitioner

is required to recognize. Petitioner’s treatment of these items

was negligent and in disregard of rules and regulations, and his

purported reliance on his accountant was not reasonable.
 - 51 -

To reflect the foregoing,

Decisions will be entered

under Rule 155.