T.C. Memo. 2004-82
UNITED STATES TAX COURT
NICK KIKALOS AND HELEN KIKALOS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 11486-01. Filed March 23, 2004.
John J. Morrison, for petitioners.
Ronald T. Jordan, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge: Respondent determined a deficiency in
petitioners’ Federal income tax for the taxable year 1997 of
$105,296 and a penalty under section 6662(a)1 in the amount of
1
All section references are to the Internal Revenue Code in
effect for the year at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
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$21,059.20. After concessions,2 the issues presented for our
consideration are: (1) Whether petitioners’ income was
understated and (2) whether petitioners are subject to section
6662(a) penalties for substantial understatement of tax or
negligent disregard of the rules or regulations.
FINDINGS OF FACT3
Petitioners Nick Kikalos and Helen Kikalos resided in
Hammond, Indiana, at the time their petition was filed. In the
statutory notice of deficiency, respondent determined that
petitioners had unreported income from the following sources:
(1) Coupon and buy-down reimbursement payments from tobacco
companies; (2) rack and promotional payments; (3) vendor refunds
and reimbursements; and (4) insurance recovery payments.
During 1997, Nick Kikalos4 (petitioner) owned and operated
four retail stores under the name of Nick’s Liquor Mart (Nick’s
Liquors) in Hammond, Indiana, selling cigarettes, beer, liquor,
wine, and other products. During the year at issue, cigarette
manufacturers employed “buy-down” programs to lower the cost of
cigarettes at which retailers, including Nick’s Liquors, sold to
2
Respondent conceded $23,244 of the $224,620 gross receipts
adjustment, as well as an adjustment of $19,652 with respect to
unreported income from H&L Display Co.
3
The parties’ stipulation of facts is incorporated by this
reference.
4
Petitioner Helen Kikalos is a party to this case by reason
of the fact that she filed a joint Federal income tax return with
Nick Kikalos for the year under consideration.
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consumers. A buy-down is a discount given to a retailer for each
carton of cigarettes sold during a given promotional period.
Cigarette manufacturers expected the retailers to pass along
the buy-down discounts to the customers. The manufacturers used
different approaches to verify this expectation. Some of the
manufacturers’ sales representatives, during periodic sales
calls, confirmed that retailers complied. Other cigarette
manufacturers required the retailers to take inventories to
reconcile with the amount of buy-down payments. In such cases,
the buy-down amounts were computed by taking the change in
inventory for a given buy-down period and adding the total
cigarette purchases during the same period. When required,
Nick’s Liquors performed this accounting and furnished it to
cigarette manufacturers before they paid the buy-downs. Such
accountings were not audited or verified by the cigarette
manufacturers. Lastly, a number of cigarette manufacturers paid
buy-down discounts to retailers based on the number of cartons
purchased during a given buy-down period.
Because of delays in processing the buy-down information,
Nick’s Liquors received buy-down payments weeks or months after
the transactions with the ultimate consumer. Thus, some buy-down
checks received by Nick’s Liquors in 1997 contained payments with
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respect to 1996 sales activity, and some buy-down checks received
in 1998 contained payments with respect to 1997 sales activity.
Nick’s Liquors also accepted or honored paper coupons
presented by customers. Petitioner submitted the coupons to each
cigarette manufacturer for reimbursement of the face value of the
coupon, plus postage costs.
Petitioner reported $653,164 in coupon and buy-down income
on his 1997 Federal income tax return. During the audit
examination, petitioner provided respondent with four worksheets5
detailing coupon and buy-down and rack and promotional income.
Each worksheet included summary totals for all four stores. One
worksheet reflected coupon and buy-down income totaling $777,848,
while the remaining worksheets reflected a total of $521,695.
To protect the Government’s interest, the revenue agent
based her examination on the worksheet that reflected $777,848 of
coupon and buy-down income. Despite requests by the revenue
agent, petitioner did not furnish respondent with adequate
records to substantiate the amount of coupon and buy-down income
recorded by each store on a daily, monthly, or annual basis.
5
The record is unclear as to why petitioner provided four
separate summary worksheets to the revenue agent. Petitioner did
not adequately explain why they were substantially similar with
one inconsistency as to the total.
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Further, he did not provide adequate records to reconcile coupon
and buy-down reimbursement payments with amounts reported as
coupon and buy-down income.
The revenue agent used records she requested and received
directly from cigarette manufacturers in an attempt to reconcile
the $777,848 coupon and buy-down income total with associated
payments received from cigarette manufacturers. Some cigarette
manufacturers provided summary schedules of buy-down payments
made to petitioner. Others provided copies of buy-down checks
sent to petitioner. Many of the records the revenue agent
received were incomplete and/or inaccurate, and the revenue agent
was unable to reconcile petitioner’s return to the available
records. As a result, respondent determined that petitioner’s
coupon and buy-down income was $777,848 and therefore understated
by $124,684.
Petitioner reported $16,736 in promotional income on his
1997 Federal income tax return consisting of $11,284 in “rack and
promotional income”, and $5,452 of “8 cent coupon” income
reimbursement payments from cigarette manufacturers for the cost
of mailing paper coupons. The summary worksheets provided by
petitioner reflected total rack and promotional income of
$63,940. Additional documents revealed that petitioner received
$5,452 in “8 cent coupon” income and $523 in postage income.
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Petitioner entered into a promotional contract with R.J.
Reynolds Tobacco Co. (R.J. Reynolds) having an effective date of
January 1, 1996, and no specific term or ending date. Pursuant
to the contract, petitioner was to receive quarterly promotional
payments of $13,164 upon meeting certain sales volume
requirements set by R.J. Reynolds. During 1997, petitioner
negotiated a $13,164 check issued by R.J. Reynolds to purchase a
cashier’s check. The check was dated October 27, 1997, and was
for the same amount as called for in the promotional contract.
Based on petitioner’s records, respondent determined that
petitioner’s rack and promotional income totaled $69,915 ($63,940
+ $5,452 + $523). Respondent also determined that petitioner
underreported rack and promotional income by $53,179 ($69,915
less $16,736 reported).
During the examination, Mercantile National Bank
(Mercantile), informed respondent that during 1997, petitioner
acquired 31 cashier’s checks totaling $809,734. Petitioner
exchanged cash and negotiated third party checks he received from
business-related and personal sources for the cashier’s checks.
Petitioner, by using third party checks and cash less than
$10,000 in amount to purchase the cashier’s checks, tried to
avoid the reporting of cash transactions exceeding $10,000 to the
Internal Revenue Service. Petitioner did not inform his
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accountant of the existence of the cashier’s checks or record the
receipt of the third party checks in the accounting records for
Nick’s Liquors.
During 1997, Nick’s Liquors engaged in “bulk sales”, which
were large, nonitemized orders taken over the phone. The
employee taking a bulk sales order recorded it on paper and made
a copy that was sent to the office of Nick’s Liquors. The
employee personally delivered the order to the customer. Payment
received for the order would either be mailed or delivered to
petitioner in the form of a check. Some of the checks that
petitioner received for bulk sales were used to purchase
cashier’s checks. Respondent determined that petitioner’s gross
receipts were underreported by $25,425 with respect to these
checks. Petitioner did report $6,569 of the bulk sales checks as
income.
During 1997, petitioner used checks received for
reimbursements and refunds from commercial vendors totaling
$3,007 to buy cashier’s checks. Respondent determined that
petitioner’s gross receipts did not include these checks.
Petitioner did not provide adequate records to substantiate that
these payments were properly included in income.
Petitioner also used two payments from insurance companies
to Nick’s Liquors to buy cashier’s checks. One of the checks was
dated December 10, 1996, in the amount of $894. The other check,
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in the amount of $165, was dated January 13, 1997. Respondent
determined that petitioner failed to include those checks
totaling $1,059 in gross receipts. Petitioner did not provide
respondent records to substantiate that these payments were
properly included in income.
Before their 1997 tax year, petitioners were notified on
several occasions that their records were inadequate. In the
case of Kikalos v. Commissioner, T.C. Memo. 1998-92, revd. in
part 190 F.3d 791 (7th Cir. 1999), this Court found that
petitioner’s records with respect to Nick’s Liquors were
inadequate for 1990, 1991, and 1992. In that opinion it was
noted that petitioner had been advised to retain adequate records
before his 1990 and 1991 tax years. Further, on June 9, 1995,
petitioner entered into a records retention agreement with the
Internal Revenue Service agreeing that he would maintain certain
records. Petitioner did not adequately comply with his June 9,
1995, agreement.
OPINION
We consider here whether petitioner has shown that
respondent’s determination is in error. Respondent determined
that petitioner failed to report business income from several
sources. In spite of numerous warnings, petitioner did not
maintain adequate records for 1997. Petitioner knowingly
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permitted this situation, and also purchased cashier’s checks in
such a manner so as to conceal certain activity from the
Government.
Pursuant to section 61(a), gross income includes income from
whatever source derived. Sec. 61(a); Cabirac v. Commissioner,
120 T.C. 163, 167 (2003). In addition, taxpayers are required to
keep permanent records that are sufficient to establish the
amount of gross income, deductions, credits, or other amounts on
their tax returns. See sec. 6001; sec. 1.6001-1, Income Tax
Regs. In this case, petitioner bears the burden of showing that
respondent’s determination is in error.6 Rule 142(a); Welch v.
Helvering, 290 U.S. 111, 115 (1933). Because the disputed items
of income adjustments concern several different sources, we
examine each source separately.
I. Coupon and Buy-Down Income
Respondent determined that petitioner failed to report
$124,684 of coupon and buy-down income. At trial and on brief,
respondent bolstered his determination by offering an alternate
computation to measure petitioner’s total coupon and buy-down
income.
6
With respect to the determination of underreported income,
no question has been raised with respect to the burden of proof
under sec. 7491(a). Even if petitioner had raised the issue, his
failure to keep adequate records and substantiate items has not
met the conditions for placing the burden on respondent. See
sec. 7491(a)(2).
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As a first step, respondent reviewed copies of third party
checks that petitioner used to purchase cashier’s checks. During
1997 petitioner purchased in excess of $800,000 in cashier’s
checks with cash, and negotiated third party business and
personal checks. Petitioner testified that he purchased the
cashier’s checks to protect his money in case of a bank failure.
He also testified that one of his objectives in using third party
checks to purchase cashier’s checks was to prevent the bank from
reporting cash transactions exceeding $10,000 to the Internal
Revenue Service. Significantly, petitioner failed to provide any
documentation to show that the third party checks used to
purchase cashier’s checks were included in business gross
receipts. Finally, petitioner’s accountant testified that she
had no knowledge of the existence of the cashier’s checks.
Because petitioner presented no evidence to account for the
third party checks, respondent designated checks from cigarette
manufacturers, and not related to other types of income, as
coupon and buy-down receipt checks. Checks totaling $531,605 fit
into that category.
In addition, petitioner’s accountant made a $400,746
accounting entry in petitioner’s October 1997 records with
respect to checks received from cigarette manufacturers.
Respondent accepted that entry as reflecting payments received
from cigarette manufacturers. Because no activity was recorded
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in the account until the October 1997 entry was made,
respondent concluded that the $400,746 was an accumulation of
coupon and buy-down payments received by Nick’s Liquors for the
period of January through October 1997.
Third, petitioner admitted that $73,392 of coupon and buy-
down income from 1996 activity had been reported in 1997.
Further, respondent calculated that $100,810 of coupon and buy-
down income for 1997 activity was reported in 1998. Due to usual
time delays in processing reimbursement payments, respondent
based this figure on petitioner’s reported November and December
1997 coupon and buy-down income.
Lastly, respondent made a downward adjustment of $63,940 to
prevent duplication with respect to rack and promotional income.
Respondent’s calculation, which is on the basis of evidence in
the record of this case, resulted in $895,829 of coupon and buy-
down income for 1997. Respondent’s calculation is summarized as
follows:
Payments received in 1997:
Coupon and buy-down checks used
to acquire cashier’s checks $531,606
Other amounts deposited and
recorded in financial records 400,746
932,352
Adjustments:
1996 income reported in 1997 (73,392)
1997 income reported in 1998 100,810
Rack and promotional income
(duplicate adjustment) (63,940)
1997 coupon and buy-down income 895,830
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Subtracting the $653,164 reported by petitioner, respondent
arrived at unreported coupon and buy-down income of $242,666
($895,830 - $653,164). Despite the fact that respondent’s
calculation reflected almost twice as much unreported income as
the $124,684 amount determined originally, respondent does not
seek an increased deficiency. Petitioner argues that
respondent’s alternate calculation of coupon and buy-down income
is a new theory raised for the first time on brief, that it
violates principles of fair play and justice, and it should not
be considered by the Court. Respondent asserts that the trial
was a de novo proceeding, and the administrative record is
irrelevant.
Respondent’s calculation is not a new theory. It is merely
a mathematical analysis of evidence before the Court and offered
in support of respondent’s determination. Petitioner’s dilemma
here is one of his own making. On the basis of the state of
petitioner’s records, neither he nor respondent may properly
substantiate his income and/or establish that the determination
was in error. Petitioner was well aware of his obligation to
maintain adequate records and knowingly failed to do so.
Petitioner devotes much of his brief to criticizing the
means by which respondent arrived at his determination and/or
supplementary calculation. This criticism focuses on the lack of
adequate documentation used by respondent in the determination
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and calculation. While petitioner’s criticisms are to some
extent valid, petitioner has not provided records or a more
reliable means to account for his business income. Moreover, the
lack of records is due to petitioner’s design.
Petitioner also makes the theoretical argument that coupon
and buy-down income was accounted for at the point of sale.
Respondent counters that petitioner did not provide adequate
records to show that employees consistently followed the point of
sale procedure for recording coupon and buy-down income.
Therefore, petitioner has not met his burden of establishing that
respondent’s determination was in error.
Unlike other consumer transactions, petitioner could not use
a cash method of accounting for coupon and buy-down income
because of the delay in receiving reimbursement payments.
Therefore, petitioner appears to have used a hybrid accounting
method. Revenues from consumer purchases and other sources were
recorded on a cash basis, and coupon and buy-down income was
reported on an accrual basis. Petitioner testified that
employees accounted for coupon and buy-down income by ringing up
on the cash register the full price of the carton or pack of
cigarettes sold, while collecting from the customer the
discounted price. The transaction also would include ringing up
the amount of the buy-down or coupon. As a result, petitioner
maintained that the full amount of revenue for each cigarette
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sale was recorded at the time of purchase. Therefore, any
subsequent reimbursement received by petitioner for the discounts
had no effect on income.
Petitioner, however, failed to provide adequate
documentation to show that these procedures were consistently
followed. Petitioner did supply records to corroborate
petitioner’s assertions for 2 days’ worth of sales activity for a
single store. However, during the year at issue Nick’s Liquors
operated four locations with aggregate gross receipts from
cigarette sales totaling several million dollars. Given the
volume of cigarette transactions generated by the four Nick’s
Liquors stores, the records provided by petitioner are not
sufficient evidence to establish that coupons and buy-downs were
consistently and completely recorded in all four stores.7
Petitioner’s testimony that the coupon and buy-down point of sale
procedure was consistently followed, by itself, is not sufficient
to carry his burden. Accordingly, we hold that petitioner failed
to report coupon and buy-down income of $124,684 for 1997, as
determined by respondent.
II. Promotional Income
Petitioner reported $16,736 of promotional income for 1997.
Respondent determined that petitioner received $69,915 of
7
It is somewhat curious that petitioner was able to provide
only 2 days of tapes for a single store. That is certainly too
small a sample to provide insight into the universe we consider.
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promotional income and that his gross income was understated by
$53,179. The $69,915 amount is composed of three components.
The first and second components are $5,452 of “8 cent coupon”
income and $523 of postage income. Petitioner reported the
$5,452 of “8 cent coupon” income as a portion of the total
$16,736 of promotional income reported on his 1997 return.
Petitioner conceded that he failed to report $523 in postage
income.
The remaining $63,940 (third component) was derived from the
worksheets provided by petitioner. The rack and promotional
income shown on all four worksheets totaled $63,940. Respondent
points out that petitioner’s promotional contract with R.J.
Reynolds was in effect during 1997, a fact that supports
respondent’s determination. Petitioner argues that the
worksheets are unreliable due to the fact that he was in the
process of learning how to use a computer and made input errors.
In addition, petitioner asserts that the R.J. Reynolds
promotional contract was not in effect during 1997 and that he
did not receive any payments under the contract.
During 1997 petitioner received a check from R.J. Reynolds
for $13,164, the quarterly amount called for in the promotional
contract. Although the record does not reflect the specific
purpose for the payment, it coincides with the amount called for
in the promotional contract. Quarterly payments of $13,164 would
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result in annual promotional income of $52,656 from the R.J.
Reynolds contract ($13,164 x 4). Adding this annualized figure
to petitioner’s reported promotional income of $16,736 and
conceded postage income of $523 results in a total of $69,915,
the amount of respondent’s determination.
Petitioner contends: (1) He made input errors; (2)
respondent did not produce a 1997 Form 1099 from R.J. Reynolds to
petitioner; and (3) respondent failed to receive evidence from
R.J. Reynolds to prove that the payments were made under the
promotional contract. Respondent, however, does not bear the
burden of showing that the determination is correct. Petitioner
has the burden of establishing that the determination is
erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. at 115.
This is another instance where petitioner’s failure to maintain
records is the root of the problem. We cannot allow petitioner
to hide behind his own contrivance in this setting. Accordingly,
we hold that petitioner failed to report promotional income of
$53,179.
III. Bulk Sales Income
Respondent determined that $25,425 in third party checks
used by petitioner to purchase cashier’s checks were from Nick’s
Liquors bulk sales customers. Because the checks had not been
accounted for in petitioner’s records, respondent determined
$25,425 in bulk sales was not included in income for 1997.
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Petitioner did verify that $6,569 in bulk sales was included in
income. Respondent conceded the $6,569 so that $18,856 remains
in dispute.
Petitioner argues his combination of substantiation of
$6,569 in bulk sales and the testimony offered about the
procedures employed for recording bulk sales is sufficient to
show that all bulk sales were properly recorded. Petitioner also
argues that the burden of reviewing a large amount of register
tapes was too great to substantiate all bulk sales transactions.
Despite having access to records that could substantiate all
bulk sales, petitioner failed to offer this evidence. Petitioner
had register tapes available, and self-serving testimony does not
suffice to satisfy petitioner’s burden. We are not required to
accept such testimony. Niedringhaus v. Commissioner, 99 T.C.
202, 212 (1992). Accordingly, we hold that petitioner failed to
report $18,856 of bulk sales income, the amount of respondent’s
determination net of concessions.
IV. Vendor Refunds and Reimbursements Income
Respondent also determined that $3,007 in third party checks
used to purchase cashier’s checks was attributable to vendor
refunds and reimbursements not included in petitioner’s 1997
gross income. Petitioner argues that the payments were included
in income, but he has not provided any records to substantiate
these assertions. Taxpayers are required to keep permanent
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records that are sufficient to establish the amount of gross
income, deductions, credits, or other amounts on their tax
returns. See sec. 6001; sec. 1.6001-1, Income Tax Regs.
Petitioner failed to keep records so as to show respondent’s
determination is erroneous. Accordingly, we hold that petitioner
failed to report vendor refunds and reimbursement income of
$3,007 for 1997.
V. Insurance Recoveries
Finally, respondent determined that two of the third party
checks totaling $1,059 were attributable to insurance recoveries
not reported as income for 1997. The checks were from insurance
companies, in the amounts of $894 and $165, and dated December
10, 1996, and January 13, 1997, respectively.
With respect to the $894 check, petitioner argues that the
check cannot be attributable to his 1997 income because it must
have been received in 1996. Respondent argues that this check
was one of several checks petitioner used to purchase a cashier’s
check on January 14, 1997. Because petitioner purchased a
cashier’s check on January 7, 1997, and did not use the $894
check, respondent maintains that petitioner must not have
received the check until after January 7, 1997. Therefore, the
check must be attributable to petitioner’s 1997 tax year.
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Section 451(a) provides the general rule that “any item of
gross income shall be included in the gross income for the
taxable year in which received by the taxpayer, unless, under the
method of accounting used in computing taxable income, such
amount is to be properly accounted for as of a different period.”
Petitioner, who reports this type of income on the cash method,
must report income in the year it is actually or constructively
received. See sec. 1.451-1(a), Income Tax Regs. We agree with
petitioner that a check mailed on December 10, 1996, would likely
have been received by petitioner during 1996 and thus be
includable in 1996 income.
With respect to the $165 check, respondent contends that the
insurance recovery relates to a claim made by Cigarette City, a
company owned by petitioner’s children. Petitioner contends that
he reimbursed Cigarette City for the amount of the check.
Petitioner, however, has not provided any credible evidence other
than his own self-serving testimony that the reimbursement
occurred. Accordingly, we hold that petitioner underreported his
insurance reimbursement income by $165.
VI. Accuracy-Related Penalties Under Section 6662 for Negligence
or Disregard of the Rules or Regulations
Section 6662 provides for a 20-percent penalty on any
understatement of tax attributable to negligence or disregard of
the rules or regulations, or any substantial understatement of
income tax. Pursuant to section 6662(c), negligence includes any
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failure to make a reasonable attempt to comply with the Internal
Revenue Code including a careless, reckless, or intentional
disregard of the Code.
Section 7491(c) applies to examinations which commence after
July 22, 1998. Pursuant to this section, respondent has the
burden of production with respect to the liability of any
individual for any penalty or addition to tax. See sec. 7491(c).
“[F]or the Commissioner to meet his burden of production, the
Commissioner must come forward with sufficient evidence
indicating that it is appropriate to impose the relevant
penalty.” Higbee v. Commissioner, 116 T.C. 438, 446 (2001). In
Higbee, we found that respondent met his burden of production for
the negligence penalty by showing that petitioners failed to keep
adequate books and records or to substantiate properly the items
in question. Id. at 449. Consequently, we conclude that
respondent has met his burden of production for his determination
of the accuracy-related penalty based on negligence or disregard
of rules or regulations.
Pursuant to section 6662(c), negligence includes any failure
by a taxpayer to keep adequate books or records. See sec.
1.6662-3(b), Income Tax Regs. For the purposes of this section,
a taxpayer is negligent when he or she fails “to do what a
reasonable and ordinarily prudent person would do under the
circumstances.” Korshin v. Commissioner, 91 F.3d 670, 672 (4th
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Cir. 1996)(quoting Schrum v. Commissioner, 33 F.3d 426, 437 (4th
Cir. 1994), affg. T.C. Memo. 1995-46).
The record reflects that petitioner failed to maintain
adequate records after repeatedly being advised to do so by
respondent. In the case of Kikalos v. Commissioner, T.C. Memo.
1998-92, we found that petitioner’s records were inadequate for
1990, 1991, and 1992. In that case, we noted that before the
years at issue, petitioner was advised that his records were
inadequate. After repeated warnings by respondent, on June 9,
1995, petitioners agreed to and signed a records retention
agreement with the Internal Revenue Service. The agreement
specifically identified records that petitioner was to maintain
going forward. Despite the warnings and the agreement,
petitioner still made the choice not to maintain adequate
records. Further, we find significant petitioner’s testimony
that his practice of purchasing cashier’s checks was partly
designed to conceal large cash transactions from the Government.
Petitioners’ actions are not what a reasonable and
ordinarily prudent person would do under the circumstances and
constitute negligence. Accordingly, we hold that petitioner is
subject to the accuracy-related penalty under section 6662(a).
To reflect the foregoing,
Decision will be entered
under Rule 155.