T.C. Memo. 1998-332

UNITED STATES TAX COURT

JAMES W. HARRIS AND DORTHY R. HARRIS, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 4394-97. Filed September 22, 1998.

James W. Harris, pro se.

Kay Hill, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: Petitioners petitioned the Court to

redetermine respondent's determination of a $13,931 deficiency in

their 1992 Federal income tax, a $2,357 addition thereto under

section 6651(a)(1), and a $2,786 accuracy-related penalty under

section 6662(a). Following the parties' concessions, we must

decide:
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1 We have given no consideration to documents that

petitioners attached to their brief. These documents are not

evidence. Rule 143(b); West 80th St. Garage Co. v. Commissioner,

12 B.T.A. 798, 800 (1928); Boyd Gaming Corp. v. Commissioner,

T.C. Memo. 1997-445; see also Saunders v. Commissioner, T.C.

Memo. 1992-361, and the cases cited therein.

1. Whether petitioners understated their taxable interest

income by $11,801. We hold they did.

2. Whether petitioners overstated their deductible rental

loss by $48,129. We hold they did.

3. Whether, without consideration of the interest income

and the rental loss mentioned above, petitioners understated

their gross income by $17,014. We hold they did not.

4. Whether petitioners are liable for the addition to tax

and accuracy-related penalty determined by respondent under

sections 6651(a)(1) and 6662(a), respectively. We hold they are.

Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for the year in issue. Rule

references are to the Tax Court Rules of Practice and Procedure. 

Dollar amounts are rounded to the nearest dollar.

FINDINGS OF FACT1

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

The stipulations of fact and the exhibits submitted therewith are

incorporated herein by this reference. Petitioners are husband

and wife. They resided in Soldotna, Alaska, when they petitioned

the Court. They were experiencing financial difficulties during
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the relevant period; among other things, they were unable to pay

their obligations timely, and they lost property in foreclosure.

Petitioners filed a 1992 joint Federal income tax return on

April 19, 1995, reporting the following items of income:

Wages 

$66,451

Taxable interest income 

2,015

Business income or (loss) 

(73,129)

Unemployment compensation 

4,664

Other income--Jury duty 

37

Petitioners claimed that their taxable income was zero and that

their tax liability was zero. Petitioners claimed they were due

a refund of $4,504, which represented the amount of Federal

income tax that was withheld from wages paid to Ms. Harris.

Petitioners reported the $2,015 of interest income to

reflect their receipt of $1,832 in Alaskan permanent fund

dividends. Petitioners erroneously reported the $2,015 amount,

rather than the correct $1,832 amount, and they erroneously

reported that the dividends were interest. The parties agree

that petitioners should have reported the $1,832 amount as

miscellaneous income.

Petitioners received 1992 Forms 1099-INT, Interest Income,

in the amounts and from the payers set forth below:

National Bank of Alaska (NBA) $11,880

Alaskan Federal Credit Union 28

Internal Revenue Service 76 
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2 Petitioners paid NBA a fee for the services that it

rendered in connection with the escrow account.

 11,984

Petitioners concede that their 1992 gross income includes $28 of

interest paid by the Alaskan Federal Credit Union and $76 of

interest paid by the Internal Revenue Service. Petitioners

dispute that their 1992 gross income includes the $11,880 of

interest reported on the Form 1099-INT issued to them by NBA. 

NBA reported that petitioners were paid $11,880 in interest on an

account (the account) at its bank. Petitioners had opened the

account in 1987 in connection with their sale of a home to Dale

and Kathy Turner on September 10, 1987. Petitioners sold the

home to the Turners for $129,000, and the Turners agreed to pay

petitioners the selling price through monthly installments of at

least $960. The Turners agreed that any outstanding balance owed

to petitioners would bear interest at 10.5 percent per annum. 

When petitioners had owned the home, they borrowed money from

Seafirst Mortgage Corp. (Seafirst) using the home as collateral. 

When petitioners sold the home to the Turners, petitioners did

not satisfy this debt, which then equaled $98,600, opting to

continue making monthly payments on it. Petitioners' debt to

Seafirst bore interest at 10.5 percent per annum.

The account was an escrow account, and NBA was the

escrowee.2 The Turners agreed to make the monthly payments due

petitioners on the sale directly to NBA in its capacity as
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3 Union Planters ascertained that petitioners had paid it

$9,833 of interest in 1992 on their debt to it. Union Planters

issued a 1992 Form 1098, Mortgage Interest Statement, to

petitioners reflecting this amount.

escrowee, and NBA was generally directed to remit identical

amounts to Seafirst to apply to the debt owed it by petitioners. 

Following petitioners' sale of the home, Seafirst assigned

petitioners' debt to Union Planters National Bank (Union

Planters). NBA collected $13,495 from the Turners in 1992, and

it distributed $13,369 to Union Planters on behalf of

petitioners. NBA ascertained that $11,880 of the $13,495 amount

was interest, and it issued petitioners (and respondent) a Form

1099-INT reflecting this amount.3 Respondent determined that

petitioners failed to include in income the $11,880 of interest

shown on the Form 1099-INT, and, accordingly, that their interest

income for 1992 was understated by $11,801; i.e., the $11,984

total amount reported on the three Forms 1099-INT issued to

petitioners, less the $183 amount reported on petitioners' tax

return as interest from sources other than the Alaskan permanent

fund ($2,015 - $1,832).

As to the claimed loss of $73,129, Harris Enterprises is

Mr. Harris' sole proprietorship through which he rented (as

lessor) approximately 20 mini storage units in a

6,000-square-foot building. On one or two other occasions,

Harris Enterprises also rented two other buildings for use as

space in which to hold auctions or flea markets. According to
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petitioners' tax return, Harris Enterprises' income and expenses

for 1992 were as follows:

Income: $18,448

Expenses:

Advertising $5,275

Depreciation 28,280

Insurance 4,475

Mortgage interest 26,874

Office expense 420

Repairs and maintenance 3,408

Taxes and licenses 8,310

Utilities 5,135

Water well replacement 6,500

Gravel parking lot 2,900 (91,577)

Net loss (73,129)

The $18,448 of gross income included approximately $500 from the

occasional rental of the buildings for auctions or flea markets;

the rest of the gross income was attributable to the rent of the

storage units. As to the claimed depreciation, $912 was claimed

on a computer, and the rest was claimed on the buildings. 

Petitioners' tax return reports that the computer was purchased

in 1986 at a cost of $6,525, and that the buildings were

purchased in 1986 at a total cost of $520,000.

Respondent determined that petitioners were not entitled to

deduct any of the $42,955 amount claimed for the business

expenses reported as advertising, gravel parking lot, water well

replacement, and depreciation. As to the first three expenses,

respondent determined that petitioners had not established that

those expenses were paid or incurred during the taxable year, or
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4 As to the gravel parking lot and water well replacement,

respondent determined alternatively that those items were capital

assets which had to be depreciated over their useful lives.

that the expenses were ordinary and necessary to Harris

Enterprises' business.4 As to the depreciation expense,

respondent determined that petitioners had not proven their cost

or other basis in the underlying assets, or that the assets were

depreciable. With respect to respondent's recomputed loss of

$30,174 ($73,129 - $42,955), respondent determined that section

469 applied to limit petitioners' current deduction to $25,000.

Exclusive of the business and interest adjustments,

respondent also determined that petitioners understated their

1992 gross income by $17,014. Respondent calculated this

understatement on the bases of respondent's analysis of

petitioners' cash transactions during 1992. The understatement,

as determined by respondent through the analysis, represents the

excess of petitioners' estimated cash expenditures over the

available funds which petitioners were estimated to have based on

known taxable and nontaxable sources. For purposes of this

analysis, respondent referenced a publication of the U.S.

Department of Labor that listed the average annual expenditures

of residents of the United States, and, relying on this

publication, estimated that petitioners' personal living expenses

equaled $36,714. Respondent's analysis did not take into account

any cash that petitioners may have had on hand at the beginning
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or end of 1992. Respondent's analysis also was based on the

assumption that petitioners spent $63,297 in cash on the

expenses, other than depreciation, which they claimed on their

return for Harris Enterprises.

OPINION

We decide the subject issues seriatim. We bear in mind that

petitioners bear the burden of proof, Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933), and that Congress has

required taxpayers to keep sufficient records to substantiate any

deduction that is otherwise allowed by the Code, sec. 6001; see

also New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). 

We also bear in mind that deductions are strictly a matter of

legislative grace, and that petitioners must prove their

entitlement to the disputed deductions. Rule 142(a); INDOPCO,

Inc. v. Commissioner, 503 U.S. 79, 84 (1992); Rockwell v.

Commissioner, 512 F.2d 882, 886 (9th Cir. 1975), affg. T.C. Memo.

1972-133; see also New Colonial Ice Co. v. Helvering, supra at

440 ("a taxpayer seeking a deduction must be able to point to an

applicable statute and show that * * * [the taxpayer] comes

within its terms"). Petitioners rely mainly on the testimony of

Mr. Harris to attempt to meet their burden of proof.

1. Taxable Interest Income

Respondent determined that petitioners failed to include in

their gross income $11,801 of interest income received by NBA on
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their behalf. According to petitioners, this amount is not

includable in their gross income because the Turners paid the

interest directly to Union Planters. 

We agree with respondent. Contrary to petitioners'

assertion, the Turners did not pay Union Planters directly. 

They remitted their payments to NBA, which collected the payments

on behalf of petitioners. NBA, in turn, remitted the payments to

Union Planters to apply to the debt owed it by petitioners. 

Instead of requiring that the Turners obtain third-party

financing for their purchase of the home, petitioners personally

financed the Turners' purchase, allowing them to wrap their debt

to petitioners around the debt that petitioners already owed

Union Planters. In such a wraparound situation, petitioners'

gross income includes the interest that the Turners paid NBA on

petitioners' behalf. See sec. 1.61-7(a), Income Tax Regs.

2. Deductible Rental Loss

Respondent determined that petitioners were entitled to

deduct only $25,000 of the $73,129 loss that they reported for

Harris Enterprises. Respondent generally determined that

petitioners had not substantiated $42,955 of the expenses which

went into the reported loss, and, with respect to the recomputed

loss of $30,174, that petitioners were limited by section 469

from deducting currently more than $25,000. Petitioners argue

that they should be allowed to deduct the reported loss in full. 
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Petitioners assert that the Code does not detail specifically the

records that must be kept by a sole proprietor like Mr. Harris

and that section 469 was not meant to apply to a small business

like Harris Enterprises.

We agree with respondent that petitioners may not deduct the

disputed amounts. First, we are unpersuaded that petitioners

incurred or paid the amounts claimed for advertising, gravel

parking lot, and water well replacement, or that petitioners had

a depreciable basis in the buildings for which depreciation was

claimed. The regulations mandate that taxpayers "shall keep such

permanent books of account or records * * * as are sufficient to

establish the amount of gross income, deductions, credits, or

other matters required to be shown by such person in any return

of such tax". Sec. 1.6001-1(a), Income Tax Regs. Petitioners

did not comply with this mandate. They did not submit any

credible record to support their claim to any of the disputed

deductions. Nor did they submit canceled checks or bona fide

receipts. Although Mr. Harris testified vaguely as to these

expenditures, we decline to rely on this self-serving and

uncorroborated testimony. Ruark v. Commissioner, 449 F.2d 311,

312 (9th Cir. 1971), affg. per curiam T.C. Memo. 1969-48; Clark

v. Commissioner, 266 F.2d 698, 708-709 (9th Cir. 1959), affg. in

part and remanding T.C. Memo. 1957-129; Tokarski v. Commissioner,

87 T.C. 74, 77 (1986). We hold that petitioners have failed to
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meet their burden of proof in substantiating the questioned

deductions. In so holding, we note that we have not applied the

rule of Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir.

1930), under which the Court may approximate the amount of a

deductible expense when evidence shows that a taxpayer incurred

it, because we have no basis upon which to make such an estimate. 

See Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985).

As to the applicability of section 469, section 469 was

enacted by Congress as part of the Tax Reform Act of 1986,

Pub. L. 99-514, sec. 501(a), 100 Stat. 2085, 2233, to require

that passive losses generally be used currently to offset only

passive income. Passive losses include most losses from a rental

activity. Sec. 469(c)(2). In the case of rental real estate

activities, taxpayers like petitioners are allowed to deduct

currently losses up to $25,000. Sec. 469(i).

Harris Enterprises is a rental real estate activity; thus,

section 469 applies to limit to $25,000 petitioners' deduction

for any resulting loss. Although petitioners invite the Court to

carve out an exception for small businesses, we decline to do so. 

We find nothing in the text of section 469, or its legislative

history, that supports petitioners' bald assertion that the

section does not apply to small businesses.

We sustain respondent's determination on this issue.

3. $17,014 Understatement of Gross Income

Respondent determined that petitioners had an additional

understatement of income equal to $17,014. Petitioners argue
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that they did not. According to petitioners, respondent's

analysis is flawed because the estimated living expenses used

therein to calculate the purported understatement were much

greater than their actual living expenses. 

We agree with petitioners that respondent's determination on

this issue is wrong, but we do so mainly for different reasons. 

Respondent's determination is based erroneously on the assumption

that petitioners paid all $63,297 of the expenses which they

deducted for Harris Enterprises. As we have held above, however,

petitioners did not pay the amounts claimed for advertising

($5,275), gravel parking lot ($2,900), and water well replacement

($6,500). When these nonpayments are factored into respondent's

analysis, the understatement drops to a mere $2,339 ($17,014 -

$14,675). Seeing further that respondent's analysis failed to

give proper regard to the fact that petitioners were financially

handicapped during the relevant years, we believe that it is

reasonable to conclude that petitioners spent $2,339 less in cash

expenditures than the amount that was set forth in respondent's

analysis. We hold for petitioners on this issue.

4. Additions to Tax/Accuracy-Related Penalty

Respondent determined an addition to tax under section

6651(a), asserting that petitioners failed to file timely a 1992

Federal income tax return, and that they did not show that their

failure was due to reasonable cause. In order to avoid this

addition to tax, petitioners must prove that their failure to

file was: (1) Due to reasonable cause and (2) not due to willful
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neglect. Sec. 6651(a)(1); Rule 142(a); United States v. Boyle,

469 U.S. 241, 245 (1985). A failure to file timely a Federal

income tax return is due to reasonable cause if the taxpayer

exercised ordinary business care and prudence, and, nevertheless,

was unable to file the return within the prescribed time. Sec.

301.6651-1(c)(1), Proced. & Admin. Regs. Willful neglect means a

conscious, intentional failure or reckless indifference. United

States v. Boyle, supra at 245. 

As to the accuracy-related penalty, section 6662(a) imposes

such a penalty equal to 20 percent of the portion of an

underpayment that is attributable to, among other things,

negligence. In order to avoid this penalty, petitioners must

prove that they were not negligent, i.e., that they made a

reasonable attempt to comply with the provisions of the Code, and

that they were not careless, reckless, or in intentional

disregard of rules or regulations. Sec. 6662(c); see also Bixby

v. Commissioner, 58 T.C. 757, 791-792 (1972). Petitioners were

negligent if they displayed a lack of due care or failed to do

what a reasonable and prudent person would do under similar

circumstances. Allen v. Commissioner, 925 F.2d 348, 353 (9th

Cir. 1991), affg. 92 T.C. 1 (1989).

On the basis of our careful review of the record, we hold

that petitioners are liable for both the addition to tax and the

accuracy-related penalty determined by respondent. Petitioners

filed their 1992 tax return on April 19, 1995, and they have not

provided a satisfactory explanation for their failure to file
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5 We note that petitioners make various protester type

arguments in their brief as to why they are not subject to

Federal income tax. These shopworn arguments as to the validity

of the Federal income tax regime have been universally rejected

by every court that has considered them. We reject these

arguments without further discussion.

timely. The facts at hand also do not establish that petitioners

made a reasonable attempt to comply with the provisions of the

Code. The Code requires that taxpayers keep sufficient records

to substantiate their claimed deductions, and we find that

petitioners did not make a reasonable effort to comply with that

requirement.

In reaching all our holdings herein, we have considered all

arguments made by the parties for contrary holdings, and, to the

extent not addressed above, find them to be without merit.5 To

reflect the foregoing,

 Decision will be entered

 under Rule 155.