*26 Decision will be entered under Rule 50.
In the circumstances of this case the Commissioner was not justified in reconstructing gross income from bookmaking operations at an amount equal to 15 per cent of the gross receipts from bettors.
*450 The respondent determined deficiencies in income tax of petitioners and additions to tax for negligence as follows:
| Addition | ||
| Year | Deficiency | to tax |
| 1948 | $ 3,365.46 | $ 168.27 |
| 1949 | 2,674.22 | 133.71 |
| 1950 | 2,523.04 | 126.15 |
The questions presented are: (1) Did the respondent properly increase the petitioners' distributive shares of income from bookmaking partnerships for the taxable years 1948, 1949, and 1950? (2) Are the petitioners liable for an addition to tax due to negligence for each of the taxable years?
FINDINGS OF FACT.
Petitioners, husband and wife, are residents of Dade County, Florida. They filed joint income tax returns for the years 1948, 1949, and 1950 with the collector of internal revenue for the district of Florida. The returns were filed on the cash receipts and disbursements basis.
Petitioner*27 H. T. Rainwater will hereinafter be referred to as petitioner. He has been engaged in the business of bookmaking since 1936. During the years 1948, 1949, and 1950 he conducted this business in Miami, Florida. He accepted wagers on horse races being run at racetracks throughout the United States. Winning bettors were paid in accordance with the payoff prices calculated by the mutuel machines at various racetracks, except that the odds were limited so as not to exceed 20 to 1 on win bets, 8 to 1 on place bets, and 4 to 1 on show bets. By a device known as "insurance" a bettor could double the limit of the foregoing odds by paying an amount equal to 10 per cent of his wager.
During the taxable years petitioner operated his bookmaking business in partnership form. He was a member of the following partnerships during that period: Rainwater and Brace, Rainwater and Moncrief, Rainwater and Turner, Rainwater and Fitzpatrick, and Rainwater and Parrott. These partnerships, although operating *451 more or less simultaneously, were separate and distinct from one another.
The agreement between petitioner and each of his partners provided that petitioner supplied the capital and bore*28 all net losses; profits were divided on a 50-50 basis; petitioner's partners performed services connected with soliciting and accepting wagers, making payoffs to winning bettors, and managing the details of the business; and losses for one month were carried over to the following month in determining the amount of profit, if any, of the second month. The only exception to this arrangement occurred in the case of the partnership Rainwater and Parrott. Parrott owned the building in which the betting room was located. Parrott performed no services other than those of a supervisory nature. His contribution to the partnership consisted of making available an advantageous location for a betting room. The Parrott partnership paid rent to Parrott for the use of the betting room in his building. The actual operation of the Parrott handbook was carried on by one or sometimes two employees whose salaries were paid by petitioner.
The Brace partnership did its business in an open betting room at 1040 Biscayne Boulevard. The Moncrief partnership succeeded the Brace partnership and operated at the same location. The Parrott partnership operated an open betting room at the Airway Bar at 8727*29 Northwest Seventh Avenue. The Fitzpatrick partnership was located at 107 Northwest 20th Street. This was not an open room and Fitzpatrick transacted most of his business by telephone. The Turner partnership was located at 539 Northwest 59th Street. This was not an open room and Turner transacted his business by telephone.
Petitioner did not solicit or accept bets from customers. He maintained his office at his home where all transactions were communicated to him by his partners by telephone. Petitioner maintained a separate "sixty-line" betting sheet for each partnership for each day. Before each race each partner would telephone petitioner and list the bets that had been received. Petitioner would thereupon enter on the appropriate sixty-line sheet the amount of each bet and the number of the horse. Each partner informed petitioner as to the amount of payoffs and expenses which were paid each day. The expenses consisted of amounts paid for scratch sheets, racing forms, rent, electricity, telephone, supplies, food and drinks, wages, and taxi fares for customers. Petitioner entered on top of the sixty-line sheet for each partnership the total amount of expenses for each *30 day, but made no breakdown to show the portion of the total expended for any particular item. Some expenses, such as wire service, were paid by petitioner personally. These expenses were allocated among the various partnerships, and the petitioner notified each partner of the allocation *452 to him which was to be entered on the corresponding sixty-line sheet maintained by the partner.
At the time of telephoning the bets to petitioner, the partners would give the initials of the customers making the bets. By recording the initials of the bettors the partners could identify and contact them if necessary. The bettors in the betting room at the Airway Bar were given a ticket when they placed a bet, a duplicate of which was retained by the employee receiving the bet, and initials of bettors were not taken.
Each partner maintained a sixty-line betting sheet identical to that maintained by petitioner, except that the partner showed at the top of his sheets a breakdown of expenses for the day. After each race both petitioner and his partners computed the amount of payoffs to the winning bettors and each entered such payoffs in the "out" column located on the right-hand side of the*31 sixty-line sheets.
At the end of each day petitioner totaled the bets received and the amounts paid out by each partnership for the day. Included in the amounts paid out were the expenses which had been paid during the day. Each partner also totaled receipts and payouts for the day. Petitioner then compared his net win or loss figure with each partner by telephone. In the event of discrepancy, the individual bets were rechecked until the error was discovered.
After verifying the totals for each partnership, petitioner entered the totals in a daily summary sheet. This sheet contained four columns headed "in," "out," "win," and "loss." A separate daily summary sheet was maintained for each partnership. Entries were made to these daily summary sheets at the end of each day or on the following morning. The "in" figure for each day represented total receipts for the day including amounts paid by customers as insurance. The "out" figure represented payoffs to winning bettors together with the day's cash expenditures for expenses. The daily entry to the win or loss column, as the case might be, was the difference between the previous two totals.
During the taxable years petitioner*32 did not record as an expense any payments made to police or sheriffs or any payments for fines. In 1936 he had deducted such payments and upon audit was notified by a revenue agent that they were not deductible. Since that time he has not attempted to deduct them or to include them as part of his expenses.
Petitioner's daily summary sheets included all amounts of receipts and all payoffs and expenses. No payoffs or expenses that were not actually paid were included in the daily summary sheets, nor were any receipts omitted from those records.
*453 Petitioner's wife occasionally operated petitioner's end of the business. She recorded the betting transactions in the same manner as did petitioner. No persons other than petitioner or his wife ever made entries to his sixty-line betting sheets or to the daily summary sheets.
Petitioner divided profits with his partners once a month. The profit division was based upon the amount of profit shown in the daily summary sheets. In the event that one of the partners disagreed with the monthly profit figure, petitioner referred him to the daily summary sheets. In the event a partnership sustained a loss for one month, requiring such*33 loss to be offset against the profit of the following month, petitioner at the time of dividing profits in the second month referred to the daily summary sheet for the previous month in ascertaining the amount of the loss to be offset.
At the end of each year petitioner turned over to his accountant, Lloyd Grace, the daily summary sheets for each partnership. Grace prepared partnership returns for each partnership, as well as petitioner's individual returns. Grace computed the income of each partnership by subtracting the total "out" figure from the total "in" figure. Since the total "out" figure included all expenses, he did not itemize the amount of expenses 1 but merely described their nature on the face of each partnership return.
At the end of each day or on the following day, petitioner and his partners destroyed the original sixty-line betting sheets of each partnership. His reason for so doing *34 was to avoid their seizure by the police in the event of a raid and their use as evidence against him. The bookmaking business was illegal and petitioner had previously experienced raids, in the course of which the police searched for his sixty-line betting sheets.
Petitioner furnished each partner with a "bank roll" which was kept at a fixed amount. In the event of losses, petitioner furnished additional cash; in the event of profits, he collected the excess. These daily adjustments had no effect on the computation of profit at the end of the month.
During a substantial part of the years 1948, 1949, and 1950 Miami Beach was closed to bookmaking and most of the customers at the open betting rooms at Biscayne Boulevard and the Airway Bar were from the Beach.
On September 16, 1949, the petitioner borrowed $ 5,000 from the First Federal Savings and Loan Association of Miami for use in paying off winning bettors.
*454 B. H. Moncrief, one of petitioner's partners, was a plasterer prior to August 1949. At that time he became petitioner's partner in the bookmaking business. The profits realized by the Moncrief partnership were disappointing and it was terminated in September 1950. *35 Moncrief returned to his occupation as a plasterer.
Jack Turner became one of petitioner's partners in the bookmaking business in January 1948. This partnership was not successful and was terminated on June 6, 1948. Turner withdrew at that time because petitioner insisted he accept bets from a bettor who was "pretty good" and won consistently. In the return filed for the partnership of Turner and Rainwater for the taxable year January 1, 1948, to June 6, 1948, this partnership reported "Net winnings" of $ 2,824 as shown on the summary sheets, deducted expenses for scratch sheets, forms, wire service, and telephone in the amount of $ 856.60, and reported a net profit of $ 1,867.40.
George W. Parrott entered the bookmaking business for the first time in 1948 when he became a partner of petitioner. The profits of the partnership were not as high as Parrott had anticipated. Parrott remained a partner because the betting room brought business to his bar which was located downstairs in the same building and because he received rent for the use of the room.
Petitioner did not follow a policy of limiting all bets over a certain amount. In a few instances, when the amount bet on one*36 horse was substantial, the petitioner did "lay off" a portion of this amount with other bookmakers. As a general rule, however, he did not follow this practice.
In the joint returns of petitioner and his wife for the years 1948, 1949, and 1950 the income from partnerships was reported to be as follows:
| 1948 | |||
| Parrott & Rainwater | $ 1,174.23 | ||
| Fitzpatrick & Rainwater | 2,807.77 | ||
| Turner & Rainwater | 933.70 | ||
| Rainwater & Rainwater | 1,116.36 | ||
| Brace & Rainwater | Loss | 301.65 | |
| Total income | $ 5,730.41 | ||
| 1949 | |||
| Rainwater & Rainwater | $ 361.24 | ||
| Fitzpatrick & Rainwater | 1,627.78 | ||
| Moncrief & Rainwater | 1,208.96 | ||
| $ 3,197.98 | |||
| Losses: | |||
| Parrott & Rainwater | $ 126.07 | ||
| Brace & Rainwater | 420.85 | ||
| $ 546.92 | |||
| Net profit from partnership | $ 2,651.06 | ||
| 1950 | |||
| Fitzpatrick & Rainwater | $ 1,848.47 | ||
| Rainwater & Rainwater | 1,681.44 | ||
| $ 3,529.91 | |||
| Loss from: | |||
| Moncrief & Rainwater | 429.88 | ||
| Rainwater & Parrott | 191.35 | ||
| 621.23 | |||
| Net income for year 1950 | $ 2,908.68 |
*455 In determining the deficiencies the respondent used as a starting point the amount of gross receipts shown on the summary sheets of each partnership for each of the taxable*37 years and determined that 85 per cent of the gross receipts represented payoffs to winning bettors and that 15 per cent constituted gross profit. From the gross profit thus determined he deducted expenses estimated by the petitioner to have been incurred for rent, scratch sheets, racing forms, wire service, telephone, etc., in arriving at the amount of net profit. The net profit thus determined for each partnership was as follows:
| Brace and Rainwater: | ||
| September to December 1948 | $ 1,114.67 | |
| January to December 1949 | 4,098.74 | |
| Moncrief and Rainwater: | ||
| August to December 1949 | 7,452.37 | |
| January to December 1950 | 14,350.64 | |
| Parrott and Rainwater: | ||
| January to December 1948 | 23,382.46 | |
| January to December 1949 | 9,195.59 | |
| January to October 3, 1950 | 4,123.10 | |
| Turner and Rainwater: | ||
| January to June 6, 1948 | 6,008.48 | |
| Fitzpatrick and Rainwater: | ||
| January to December 1948 | 5,945.55 | |
| January to December 1949 | 9,152.04 | |
| January to December 1950 | 7,849.47 |
Petitioner was convicted of violating the prohibition laws during the prohibition era. He was sentenced to 2 years in prison as the result of his conviction and served approximately 7 months.
*456 During the course*38 of operating his various handbooks and specifically during the years at issue, the petitioner, H. T. Rainwater, incurred fines in connection with this illegal activity and has made "gifts" to policemen. The various partners were required to share with Rainwater the expenses of paying fines which were incurred in connection with the bookmaking business.
OPINION.
The principal issue is whether the Commissioner, in computing petitioner's distributive share of income from bookmaking partnerships for the years 1948-1950, was warranted in ignoring the profits or losses shown on the daily summary sheets and determining gross income of the partnerships to be equal to 15 per cent of the gross receipts appearing on those sheets. The Commissioner argues that since the underlying sixty-line sheets had been systematically destroyed, petitioner's books and records were inadequate; and that he was therefore justified in determining income by some other method. He used the 15 per cent figure, because at race tracks 15 per cent of the amounts bet are retained by the track and the remaining 85 per cent divided among the winning bettors. The burden was on the petitioner to prove that the Commissioner*39 was in error, and we think that he has carried that burden in this case.
True, petitioner had destroyed the sixty-line sheets and thus has made the Commissioner's task of auditing the returns immeasurably more difficult than it should be. This is conduct that is not to be condoned. Perhaps the Treasury should seek and the Congress should provide it with appropriate and effective sanctions, civil or criminal or both, against taxpayers who fail to keep or who do away with important records bearing on their liability. But, under the law as it now stands we are not empowered to approve deficiencies merely because records have been destroyed. Of course, the destruction of records is a factor that may be taken into account in various circumstances such as the determination of fraud, and it may justify the Commissioner in using some reasonable method of reconstructing a taxpayer's income, with the burden upon the taxpayer to show that the Commissioner is in error. On the record before us, however, we think that the Commissioner's method was wholly arbitrary as applied in this case, and that petitioner has discharged his burden of proof.
In the case of betting at race tracks it is a *40 matter of indifference to the track as to which horse wins. The track withholds 15 per cent of the total amount bet, and the remaining 85 per cent is divided among the winning bettors. In the case of a bookmaker, such as petitioner, the results of each race are of crucial importance. If he *457 has received a disproportionate number of bets on a horse that wins, he not only has no profit, but will sustain losses. And the record before us is persuasive that there were many months in which various of the partnerships in fact sustained losses. One of the petitioner's partners, Moncrief, found the operation so unprofitable that he returned to his trade as a plasterer. Another partner, Turner, also terminated his relationship with petitioner for somewhat similar reasons. On one occasion petitioner had to borrow $ 5,000 in order to pay losses.
The Government attempted to support its position by calling an expert witness who had been the general manager of a syndicate that was a clearing house for from 28 to 55 bookmakers operating handbooks in Miami Beach hotels. This witness testified that the percentage of profit realized by these bookmakers ranged from about 11 per cent during*41 the summer to about 17 per cent during the winter. However, the testimony of this witness, on the whole, was more damaging to the Government than it was helpful. The witness made it clear that skill played an important part in the successful operation of a handbook, and that "greedy" bookmakers, who do not "lay off" when they become overloaded on some horses are likely to lose money. The bookmakers under his jurisdiction were expertly supervised, and when any one of them showed a tendency to lose he was given instruction in the operation of the handbook. The testimony as to petitioner's partnerships indicated that it was not their practice to make "lay offs," and we are left with the distinct impression from the Government's expert witness that the profit experience of his syndicate was not a fair index to use in evaluating the profits of petitioner's partnerships.
There is a final element of pivotal significance in this case, namely, the testimony that the daily summary sheets, upon which the returns were based, were in fact used by petitioner and his partners in arriving at a division of profits each month. We found this testimony credible. Here then was a situation where *42 the partners, dealing with petitioner at arm's length, accepted the figures on the daily summary sheets in their monthly accounting with him. Taking into consideration the entire record, the arbitrary character of respondent's determination, the persuasive evidence that the partnerships in fact sustained many losses, the nature of petitioner's operation, and the fact that the daily summary sheets were themselves used as a basis for division of profits between the partners, we are satisfied that the respondent's determination cannot be sustained. We do not, of course, have any special knowledge or sophistication with respect to the type of activity involved herein. Conceivably, a different result might be *458 reached on a different record. But on the record before us, which must be used as the basis for decision, it is clear that the Commissioner's determination cannot stand.
The returns as to one of the partnerships, however, do disclose incorrect reporting in one respect, and an adjustment must be made to correct the error. The returns for Turner and Rainwater for the period January 1, 1948, to June 6, 1948, reported "Net winnings" of $ 2,824, deductions for scratch sheets, *43 forms, wire service, and telephone of $ 856.60, and a net profit of $ 1,867.40. 2 However, the testimony was quite plain that in arriving at "Net winnings" the expenses had already been deducted. It is obvious that to allow them again would result in a double deduction. The claimed deductions of $ 856.60 must therefore be disallowed.
The 5 per cent addition to tax asserted under section 293 (a) of the Internal Revenue Code of 1939 was not justified.
Decision will be entered under Rule 50.
Footnotes
1. In the return of Turner and Rainwater for 1948, hereinafter mentioned, he did erroneously itemize expenses.↩
2. Apart from the impropriety of taking any such deduction here, there was in any event a mistake in arithmetic since the difference between the "Net winnings" figure and the deductions claimed is $ 1,967.40.↩