T.C. Memo. 1996-500

UNITED STATES TAX COURT

KONDAMODI S. RAO AND B. SATYAVENI RAO, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 4468-94. Filed November 6, 1996.

Sanford Amdur, for petitioners.

Robert W. Mopsick, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge: Respondent determined deficiencies in and

additions to petitioners' Federal income tax as follows:

 Additions to Tax 

 Sec. Sec. Sec. Sec. Sec. Sec. 

 6653 6653 6653 6653 6653 6653 Sec.

Year Deficiency (a)(1) (a)(1)(A) (a)(1)(B) (b)(1) (b)(1)(A) (b)(1)(B) 6661

1986 $65,075 --- $2,025 * --- $18,434 ** $16,269

1987 33,648 --- 453 * --- 18,448 ** 8,412 

1988 24,644 $412 --- --- $12,296 --- --- 6,161

* 50 percent of the interest due on the portion of the underpayment due to negligence.

** 50 percent of the interest due on the portion of the underpayment due to fraud.
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1 Respondent conceded the additions to tax for fraud for B.

Satyaveni Rao (Mrs. Rao) at trial.

All section references are to the Internal Revenue Code in effect

for the years in issue. All Rule references are to the Tax Court

Rules of Practice and Procedure.

Petitioner Kondamodi S. Rao, hereinafter referred to as Dr.

Rao or petitioner, omitted gross income from his sole

proprietorship psychiatry practice in 1986, 1987, and 1988. 

Petitioners deducted losses on their joint Federal income tax

returns in 1986, 1987, and 1988 from the operation of Forest Park

Medical Center (the medical center). After concessions, the

issues for decision are:

(1) Whether Dr. Rao1 is liable for the additions to tax for

fraud pursuant to section 6653(b)(1)(A) and (B) for 1986 and 1987

and section 6653(b)(1) for 1988;

(2) whether petitioners have substantiated deductions from

the operation of the medical center for 1986, 1987, and 1988 in

amounts greater than that allowed by respondent; and, if so,

(3) whether petitioners had amounts "at risk" under section

465 to enable them to deduct losses from the operation of Forest

Park Medical Center; and, if so,

(4) whether the passive loss rules under section 469 either

restrict or disallow petitioners' losses from the operation of

the medical center;
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(5) whether petitioners are liable for additions to tax for

negligence under section 6653(a)(1)(A) and (B) for 1986 and 1987

and section 6653(a)(1) for 1988; and

(6) whether petitioners are liable for additions to tax for

substantial understatement of income tax under section 6661 for

1986, 1987, and 1988.

FINDINGS OF FACT

Petitioners Kondamodi S. Rao and B. Satyaveni Rao are

husband and wife. They resided in Mountain Lakes, New Jersey, at

the time the petition in this case was filed. Petitioners timely

filed joint Federal income tax returns for 1986, 1987, and 1988. 

Prior to the expiration of time prescribed by section 6501(a) for

the assessment of income tax due for each of the years 1986,

1987, and 1988, petitioners and respondent executed written

agreements pursuant to section 6501(c)(4) extending the period

for the assessment of tax due for the years in issue. Respondent

timely issued a statutory notice of deficiency whereby she

determined that petitioners fraudulently failed to report

Schedule C gross receipts in the amounts of $50,130, $63,890, and

$49,681 for the years 1986, 1987, and 1988, respectively.

Respondent further determined that petitioners were not entitled

to deduct Schedule E rental losses from the operation of the

medical center of $102,548, $25,000, and $25,000, for the years

1986, 1987, and 1988, respectively. Respondent further

determined that petitioners were liable for the addition to tax
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for negligence only with respect to the disallowed medical center

losses and that petitioners were liable for the addition to tax

for substantial understatement of income tax.

Dr. Rao

Dr. Rao was born on May 14, 1946, in India. He graduated

from medical school in Kurnool, India, and finished his

internship in 1970. Dr. Rao "was very established * * * making a

lot of money" while he worked in India. Petitioners came to the

United States in 1975. Dr. Rao completed 5 years of training in

the field of child psychiatry at Brookdale Hospital. 

Dr. Rao was married and had two children by 1980. He lived

in Bayside (Queens), New York, and was a full-time employee of a

hospital where he did his residency/fellowship training. From

1979 until the end of 1981, after finishing his residency/

fellowship training, Dr. Rao worked in at least two private

clinics in Queens doing consultation work in the field of

psychiatry. 

Dr. Rao's Schedule C Income

During the years in issue, Dr. Rao worked as a psychiatrist

at his private practice office located in Mountain Lakes, New

Jersey, and as a member of the staff of Saint Clares-Riverside

Medical Center in Denville, New Jersey. Petitioners maintained

three bank accounts at Midlantic National Bank (Midlantic), a

money market account and a checking account, both used in

petitioner's psychiatric practice, and an account in the name of
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Kondamudi Enterprises, Inc., used to make mortgage payments on

the medical center. A fourth account at Chase Manhattan Bank

(Chase) was used to pay an equipment loan from Chase during the

years in issue. 

On petitioners' income tax returns for the years 1986, 1987,

and 1988, petitioners reported on Schedule C gross receipts from

Dr. Rao's private practice of psychiatry in the amounts of

$135,162, $170,569, and $212,522, respectively. In fact, Dr. Rao

received gross receipts from his psychiatry practice during the

years 1986, 1987, and 1988 in the amounts of $175,507, $220,408,

and $259,637, respectively. Petitioners failed to report

Schedule C gross receipts from Dr. Rao's psychiatry practice in

the years 1986, 1987, and 1988 in the amounts of $40,345,

$49,839, and $47,115, respectively. 

Dr. Rao's Record Keeping 

Petitioner kept no books or records; he did not reconcile

his checking accounts against bank statements or check bank

deposits against his monthly bank statement. Petitioner did not

deduct outstanding checks from his checking account to determine

the amount of funds available in the checking account. 

Petitioner never received any instruction in bookkeeping or

accounting in a school, nor had petitioner ever practiced with

another professional. 
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Dr. Rao's Accountant

Petitioners authorized their accountant, Victor Raclaw, to

act as their representative before the Internal Revenue Service

(the IRS). Dr. Rao was referred to Mr. Raclaw through a dentist,

Dr. Sudhakar Shetty, who rented space from Dr. Rao at the medical

center. Mr. Raclaw started doing tax-related work for Dr. Rao in

either 1982 or 1983. Mr. Raclaw prepared Federal income tax

returns on behalf of petitioners for the tax years 1986, 1987,

and 1988. Mr. Raclaw earned 120 credits towards a bachelor's

degree from Brooklyn College and City College. He does not have

a college degree, nor is he a certified public accountant. 

To prepare the tax returns, Dr. Rao provided Mr. Raclaw with

Forms 1099, Forms W-2, bank statements, deposit slips, and

canceled checks. To determine Schedule C income, Mr. Raclaw

asked Dr. Rao if he had received income from sources other than

Form 1099 payers, and Dr. Rao responded that he received most of

his income from insurance providers and Forms 1099. Mr. Raclaw

also asked Dr. Rao if he received cash from private patients. 

Dr. Rao said most of his income was from insurance carriers, and

"there was very little cash". Some of the expenses on

petitioners' Schedules E were averages, not specific

expenditures. 
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Mr. Raclaw prepared a two-page schedule of the tax

information for the tax year 1986 that was a summary of

petitioners' Forms 1099, interest, money market, and Form W-2

income. This schedule was Mr. Raclaw's only workpaper for

petitioners' 1986 tax year. The information contained in the

two-page schedule was derived by Mr. Raclaw from petitioners'

bank statements. In calculating the total amount of Schedule C

income for petitioner, Mr. Raclaw totaled the Forms 1099 that

were received by petitioner. Mr. Raclaw did not prepare a

writeup, a cash receipts journal, or a cash disbursements

journal. As part of his preparation of petitioners' tax returns,

Mr. Raclaw performed an income versus deposit analysis together

with an analysis of petitioners' Forms W-2, Forms 1099, and

Schedule E income in an attempt to verify petitioners' total

income for the years in issue. Mr. Raclaw made the determination

to report income for all the years in issue based upon the Forms

1099 received from the insurance carriers. Dr. Rao did not

examine his Federal income tax returns before signing them.

The IRS Audit

Revenue Agent Randall Gardner (agent Gardner) was assigned

to work on the Rao audit in November of 1988. The audit

encompassed the 3-year period from 1986 through 1988. As agent

Gardner was an inexperienced agent, Roy Schwarmann (agent
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Schwarmann), a revenue agent with 20 years of experience with the

IRS, acted as his mentor during the course of the audit,

providing guidance and assistance where and when needed.

Petitioner received an IRS audit notice in November 1988

from agent Gardner and turned the audit notice over to Mr. Raclaw

to contact the IRS directly. All communications subsequent to

the audit notice were exclusively between agents Gardner and

Schwarmann and Mr. Raclaw, acting on behalf of petitioners. The

initial appointment and many subsequent appointments were

canceled by Mr. Raclaw. Agent Gardner prepared a case activity

record indicating the activity on this case and the number of

canceled appointments. 

Mr. Raclaw indicated that he would get the requested

information concerning petitioners' tax records to agent Gardner. 

Mr. Raclaw never furnished the documents to agent Gardner, who

was forced to issue a summons to obtain the documents.

Agents Gardner and Schwarmann first met with Dr. Rao and Mr.

Raclaw on August 30, 1989. Agent Gardner examined income and

expense issues and also looked at bank statements. Petitioner,

when asked to produce bank account information, showed agent

Gardner information regarding two Midlantic Bank accounts, the

money market account and checking account. Agent Gardner became

aware that Dr. Rao received payments from sources other than
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2 The 2-year time lag between meetings was not explained in

the record.

insurance companies; i.e., from individual patients, by analyzing

items that were deposited into Dr. Rao's bank accounts. Dr. Rao

denied to agents Gardner and Schwarmann that he had received

payments from individual patients or from any source other than

Form 1099 payers. 

A second meeting was held on October 23, 1991,2 at agent

Gardner's office. Dr. Rao, Mr. Raclaw, and agents Gardner and

Schwarmann were present. Mr. Raclaw was taken by surprise when

agent Gardner stated to Dr. Rao that there were omissions of

income. At this meeting, Mr. Raclaw learned, for the first time,

that Dr. Rao had a bank account at Chase. However, this account

only was used to pay an equipment loan made by Chase. 

Forest Park Medical Center

Dr. Rao decided to set up a medical center which provided

numerous medical services under one roof. On October 10, 1980,

Dr. Rao entered into a contract for sale for the purchase of a

two-story building (the building) located at 86-22 85th Street,

Woodhaven (Queens), New York, from Al DiFranco, Inc. The

building has 6,000 square feet with 3,000 square feet upstairs

and 3,000 square feet downstairs. On December 18, 1980, by a

bargain and sale deed, Al DiFranco, Inc., conveyed the property
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to petitioners. The purchase price of the building was $120,000,

which included seller financing and the assumption of an existing

mortgage. 

Dr. Rao decided to borrow money for improvements to the

building. Upon application for a loan to Columbia Savings & Loan

Association (Columbia), the bank told Dr. Rao that it would not

make a loan to him on a personal basis, but rather would make a

loan to a corporation. Dr. Rao formed Kondamudi Enterprises,

Inc. (Kondamudi). Kondamudi was formed for the purpose of

obtaining the loan from Columbia. On September 11, 1981,

Kondamudi obtained a building loan mortgage from Columbia in the

amount of $120,000 at 18 percent interest per annum. 

Approximately $43,000 was to retire existing debt on the medical

center, and the remaining $77,000 was designated for

improvements. Petitioners established a bank account in the name

of Kondamudi at Midlantic National Bank to pay off the Columbia

loan. The loan payment was approximately $2,400 per month. Mr.

Raclaw prepared the corporate tax returns for Kondamudi. 

On May 17, 1981, Dr. Rao entered into a contract with, and

employed, general contractor Kostas Tsichlis (Tsichlis) to make

improvements to the medical center. Tsichlis furnished

petitioner with a $70,000 estimate for improvements to the

medical center. Though improvements to the medical center were
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3 The record does not establish what part of the loan was

used to purchase equipment.

made by Tsichlis and paid for by petitioner, their actual cost

has not been established. By 1982, the first floor of the

medical center was complete, including dental equipment,

ophthalmology equipment, and x-ray equipment. The second floor

facility was intended to be expanded by petitioner into a

physical therapy center; however, it was not completed. Most of

petitioner's expenditures went to the remodeling and purchase of

equipment located on the first floor. No further renovations

have been made at the medical center since 1983.

Petitioners maintained a Chase bank account in the name of

the medical center for the purpose of paying a $50,0003 equipment

loan provided by Chase. Dr. Rao transferred funds monthly from

his Midlantic money market account into the Chase account in

order to make the loan payments. 

Dr. Rao entered into an agreement with Tilden Financial

Corp. for the lease of dental equipment in the amount of $38,180. 

Petitioner was the chief individual responsible for

operating the medical center. He paid for all expenses incurred

in the operation of the medical center. Such expenses included

maintenance, x-ray supplies and film, gloves, and supplies for

all doctors and a nurse. 
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4 This lease was entered into through Dr. Rao's

corporation, Kondamudi.

Physicians and a dentist working at the medical center paid

rent to Dr. Rao either every time they came in for a session, or

on a monthly basis. The medical center is still available for

rental to physicians. Petitioner rented the upstairs portion to

the Forest Park Senior Citizens Center since May of 1986.4

In order to calculate the medical center's expenses, as

reported on Schedule E, Mr. Raclaw conferred with Dr. Rao to

determine his monthly expenses for medical supplies, utilities,

paper goods, other supplies, and payments to an assistant who

worked there. 

Petitioners reported the medical center's gross income and

deductions and claimed the following losses on Schedules E for

the years in issue:

 1986 1987 1988

Rents received $45,000 $46,800 $104,550

Expenses:

 Advertising 950 --- ---

 Auto & travel 600 240 ---

 Cleaning & maint. 1,100 2,400 3,750

 Insurance 2,628 2,782 3,175

 Mortgage interest 59,719 16,182 58,196

 Repairs 7,558 3,100 9,202

 Supplies 3,600 2,000 2,186

 Taxes 6,698 6,811 12,191

 Utilities 5,951 6,000 5,510

 Telephone 1,118 1,263 2,489

 Office expense 2,370 4,185 2,680

 Salary 12,000 12,000 12,000

 Water 422 512 1,580
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 Other 1,800 --- ---

 Depreciation 41,034 22,370 23,834

Total expenses $147,548 $79,845 $136,793

Net Loss ($102,548) ($33,045) ($32,243)

Loss claimed ($102,548) ($25,000) ($25,000)

For 1986 and 1987, the claimed losses relate solely to the

medical center. For 1988, the claimed loss includes $10,105 of

deductions for some undetermined rental activity. In her notice

of deficiency, respondent allowed petitioners deductions equal to

the gross income reported each year for the medical center. 

OPINION

1. Preliminary Matters

Respondent on brief renews her objection to the admission

into evidence of a 1995 video tape. The tape was authenticated

at trial as representing the medical center's physical layout and

equipment during the years in issue. We hold the tape is

admissible.

Petitioner moved to dismiss the civil fraud addition to tax. 

Our decision makes that motion moot.

2. Civil Fraud Issue

 A. Parties' Positions

Respondent argues that Dr. Rao committed fraud in his

admitted failure to include all of his income from his psychiatry

practice. Respondent points out that Dr. Rao is a highly

educated businessman. Respondent argues that Dr. Rao reported

income only as reported on Forms 1099; lied to IRS agents about
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payments he received directly from patients; attempted to conceal

the existence of two bank accounts; omitted substantial amounts

of income over a 3-year period; and was uncooperative with IRS

agents because his representative canceled many meetings. 

Respondent further argues that Dr. Rao cannot shift

responsibility to his accountant since he did not provide him

with all the information necessary to prepare accurate returns.

Petitioners argue that Dr. Rao has not committed fraud

because the omissions from income were caused by his return

preparer on whom Dr. Rao reasonably relied; no bank accounts into

which income was deposited were concealed from the IRS agents;

Dr. Rao has no accounting or financial expertise; Mr. Raclaw's

cancellation of appointments cannot be considered lack of

cooperation by Dr. Rao; and Dr. Rao provided his accountant with

all the information necessary to compute gross income.

 B. The Law of Fraud

The addition to tax in the case of fraud is a civil sanction

provided primarily as a safeguard for the protection of the

revenue and to reimburse the Government for the heavy expense of

investigation and the loss resulting from a taxpayer's fraud. 

Helvering v. Mitchell, 303 U.S. 391, 401 (1938). Respondent has

the burden of proving, by clear and convincing evidence, an

underpayment for each year and that some part of the underpayment

was due to fraud. Sec. 7454(a); Rule 142(b); Katz v.

Commissioner, 90 T.C. 1130, 1143 (1988); Otsuki v. Commissioner,
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53 T.C. 96, 105 (1969). For 1986 and 1987, section 6653(b)(1)(A)

provides for a 75-percent addition to tax on the portion of the

underpayment which is attributable to fraud, and section

6653(b)(1)(B) provides for an addition equal to 50 percent of the

interest payable on such portion. For 1988, section 6653(b)(1)

provides for a 75-percent addition to tax on the portion of the

underpayment that is attributable to fraud.

Fraud is intentional wrongdoing on the part of the taxpayer

with the specific purpose to evade a tax believed to be owing. 

McGee v. Commissioner, 61 T.C. 249, 256 (1973), affd. 519 F.2d

1121 (5th Cir. 1975). The existence of fraud is a question of

fact to be resolved from the entire record. Gajewski v.

Commissioner, 67 T.C. 181, 199 (1976), affd. without published

opinion 578 F.2d 1383 (8th Cir. 1978). Respondent's burden is

met if she shows that petitioner intended to evade taxes known to

be owing by conduct intended to conceal income, mislead, or

otherwise prevent the collection of taxes. Stoltzfus v. United

States, 398 F.2d 1002, 1004 (3d Cir. 1968); Rowlee v.

Commissioner, 80 T.C. 1111, 1123 (1983). Respondent must meet

this burden through affirmative evidence because fraud is never

imputed or presumed. Toussaint v. Commissioner, 743 F.2d 309,

312 (5th Cir. 1984), affg. T.C. Memo. 1984-25; Beaver v.

Commissioner, 55 T.C. 85, 92 (1970). Petitioners' entire course

of conduct can be indicative of fraud. Stone v. Commissioner, 56

T.C. 213, 224 (1971); Otsuki v. Commissioner, supra at 105-106. 
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 C. Underpayment of Tax

Petitioners have conceded an underreporting of Schedule C

gross income of $40,345, $49,839, and $47,115 for the years 1986,

1987, and 1988, respectively. This underreporting creates an

underpayment of tax for all 3 years. Consequently, the first

part of the test for fraud is satisfied.

 D. Fraudulent Intent

Respondent must also prove that a portion of such

underpayment was due to fraud. Professional Servs. v.

Commissioner, 79 T.C. 888, 930 (1982).

Because direct proof of a taxpayer's intent is rarely

available, fraud may be proven by circumstantial evidence and

reasonable inferences may be drawn from the relevant facts. 

Spies v. United States, 317 U.S. 492, 499 (1943); Stephenson v.

Commissioner, 79 T.C. 995, 1006 (1982), affd. 748 F.2d 331 (6th

Cir. 1984). An intent to conceal or mislead may be inferred from

a pattern of conduct, Spies v. United States, supra at 499, or

from a taxpayer's entire course of conduct, Stone v.

Commissioner, 56 T.C. 213, 223-224 (1971).

Over the years, courts have developed a nonexclusive list of

factors that demonstrate fraudulent intent. These badges of

fraud include: (1) Understating income, (2) maintaining

inadequate records, (3) failing to file tax returns, (4)

implausible or inconsistent explanations of behavior, (5) 

concealment of income or assets, (6) failing to cooperate with
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tax authorities, (7) engaging in illegal activities, (8) an

intent to mislead which may be inferred from a pattern of

conduct, (9) lack of credibility of the taxpayer's testimony,

(10) filing false documents, and (11) dealing in cash. See Douge

v. Commissioner, 899 F.2d 164, 168 (2d Cir. 1990); Bradford v.

Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), affg. T.C.

Memo. 1984-601; Recklitis v. Commissioner, 91 T.C. 874, 910

(1988). Although no single factor is necessarily sufficient to

establish fraud, the combination of a number of factors

constitutes persuasive evidence. Solomon v. Commissioner, 732

F.2d 1459, 1461 (6th Cir. 1984), affg. per curiam T.C. Memo.

1982-603. We note that some conduct and evidence can be

classified under more than one factor and not all badges are

applicable in every case. The sophistication, education, and

intelligence of the taxpayer are relevant to this determination. 

Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).

 a. Petitioner's Sophistication and Experience

Dr. Rao is a medical doctor and also manages the medical

center. He has no experience in accounting or tax return

preparation. Based upon these facts, we shall not hold Dr. Rao

to either a higher or lower standard while evaluating his

actions.

 b. Consistent and Substantial Understatements of Income

The mere failure to report income is not sufficient to

establish fraud. Merritt v. Commissioner, 301 F.2d 484, 487 (5th
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Cir. 1962), affg. T.C. Memo. 1959-172; Parks v. Commissioner, 94

T.C. 654, 664 (1990). However, consistent and substantial

understatement of income may be strong evidence of fraud. Marcus

v. Commissioner, 70 T.C. 562, 577 (1978), affd. without published

opinion 621 F.2d 439 (5th Cir. 1980). Moreover, a pattern of

consistent underreporting of income, when accompanied by other

circumstances indicating an intent to conceal income, justifies

the inference of fraud. Holland v. United States, 348 U.S. 121,

137 (1954). Dr. Rao concedes that gross income of $40,345,

$49,839, and $47,115 was omitted from his 1986, 1987, and 1988

Federal income tax returns, respectively. Therefore, he has

consistently and substantially understated his income. However,

Dr. Rao has made no attempt to conceal his income; all of his

income was deposited into one of two bank accounts, and these

bank records were given to his tax return preparer and the IRS

agents.

 c. Failure To Maintain Adequate Books and Records

Failure to maintain adequate books and records of income is

indicative of fraud. Truesdell v. Commissioner, 89 T.C. 1280,

1302 (1987); Gajewski v. Commissioner, 67 T.C. at 200. 

Petitioner kept no books or records. Dr. Rao attempts to blame

his tax return preparer for failing to instruct him on

bookkeeping requirements when, in fact, there is no evidence that

he requested such instruction. 
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 d. Intent To Mislead

Misleading statements to an investigating agent may be

evidence of fraud. Gajewski v. Commissioner, supra at 200.

Dr. Rao did mislead the IRS agents when he told them that he

received no income directly from patients and that all of his

income was from insurance companies or third party providers. 

 e. Credibility of Dr. Rao's Testimony

A taxpayer's lack of credibility, inconsistent testimony, or

evasiveness are factors in considering the fraud issue. 

Toussaint v. Commissioner, 743 F.2d at 312. Dr. Rao's testimony

was basically consistent and credible. Even if Dr. Rao's

testimony is not credible in all respects, we may still be left

with no more than a suspicion of fraud. See Jenkins v.

Commissioner, T.C. Memo. 1995-563. 

 f. Other Factors

Dr. Rao provided his accountant, Mr. Raclaw, with all of the

information necessary to compute gross income for his Schedule C

business. A taxpayer's reliance upon his accountant to prepare

accurate returns may indicate an absence of fraudulent intent. 

Marinzulich v. Commissioner, 31 T.C. 487, 490 (1958). However,

the taxpayer must provide his accountant "with all of the data

necessary for maintaining complete and accurate records". 

Merritt v. Commissioner, 301 F.2d 484, 487 (5th Cir. 1962), affg.

T.C. Memo. 1959-172. Dr. Rao willingly provided Mr. Raclaw with
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whatever information he requested. Mr. Raclaw was provided with

Forms 1099, bank statements, and deposit slips from the two

accounts into which Dr. Rao deposited income. There is no

allegation of any income's not being deposited into the two bank

accounts. Mr. Raclaw decided to calculate gross income by

totaling the Forms 1099 rather than preparing a cash receipts

journal. Though obviously in error--he missed substantial

amounts of income--Mr. Raclaw believes he reconciled total

deposits to total income. We find that Dr. Rao relied on Mr.

Raclaw to prepare his tax returns accurately and that he supplied

Mr. Raclaw with all the information necessary to properly compute

gross income.

Respondent argues that Dr. Rao misled his accountant by

telling him that he only received income from third-party payers,

such as insurance companies. Respondent is mistaken. When asked

by respondent's counsel "How did you go about determining the

income on the Schedule C's that you filed with the tax returns",

Mr. Raclaw answered:

I went over the 1099, all the 1099s that he received,

asked pertinent questions pertaining to other income,

if he [Dr. Rao] received any income from any other

sources, and the response was that he received most of

his income from insurance -- insurance providers and

the 1099s.

Mr. Raclaw did not testify that Dr. Rao told him that "all" or

"almost all" of his income came from insurance and Form 1099
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issuers; Mr. Raclaw used the word "most" to describe income from

Form 1099 issuers, which is true. Dr. Rao may, or may not have,

intentionally confused his accountant; the record is not clear,

and clear and convincing proof is required to prove fraud.

We hold that respondent has not shown, by clear and

convincing evidence, that Dr. Rao intended to omit gross income

from his tax returns. We are bothered by Dr. Rao's attempt to

mislead the IRS agents and lack of record keeping, but we shall

not sustain respondent's determination of fraud when we are only

left with a suspicion of fraud. Green v. Commissioner, 66 T.C.

538, 550 (1976); see Comparato v. Commissioner, T.C. Memo. 1993-

52. 

3. Substantiation of Schedule E Expenses

Respondent allowed petitioners Schedule E deductions equal

to the gross rents reported in each of the years in issue, that

is, $45,000, $46,800, and $104,550 for the years 1986, 1987, and

1988, respectively. Respondent disallowed deductions in excess

of gross rents as being unsubstantiated. Petitioners' burden of

proving that respondent's determinations in her deficiency notice

are erroneous includes the burden of substantiation. See

Hradesky v. Commissioner, 65 T.C. 87, 89-90 (1975), affd. per

curiam 540 F.2d 821 (5th Cir. 1976). Deductions are a matter of

legislative grace; petitioners have the burden of showing that

they are entitled to any deduction claimed. New Colonial Ice Co.
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v. Helvering, 292 U.S. 435, 440 (1934). Section 6001 requires

taxpayers to maintain adequate records from which their tax

liability may be determined. Petzoldt v. Commissioner, 92 T.C.

661, 686 (1989). 

Petitioners offered no evidence or argument concerning the

$10,105 of deductions taken for an undetermined rental activity. 

We hold that petitioners have abandoned that portion of the

substantiation issue.

Petitioners have offered nothing other than vague testimony

by Dr. Rao to substantiate expenses other than interest,

equipment lease payments, and depreciation. We hold that these

other expenses are not substantiated. "We know of no rule that

uncontradicted testimony must be accepted by a court finding the

facts, particularly where, as here, the testimony is given by

interested parties." Wood v. Commissioner, 338 F.2d 602, 605

(9th Cir. 1964), affg. 41 T.C. 593 (1964).

Petitioners proved that they bought the medical center

building in 1980 for $120,000. Dr. Rao testified that in the

early 1980's he borrowed $70,000 from Columbia to make

improvements to the medical center and $50,000 from Chase to

purchase equipment. However, no invoices or canceled checks were

offered to substantiate any improvements or equipment purchases. 

We do not know exactly what equipment was purchased, how much the
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5 Pictures and a videotape in evidence show equipment

exists at the time the pictures and videotape were taken, but

they do not establish cost or when the equipment was placed into

service.

6 Petitioners classified the lease payments as interest.

7 Due to petitioners' overall lack of substantiation, we

need not address the issue of whether petitioners can deduct

interest payments made on behalf of their corporation.

equipment cost, or when it was placed in service.5 In order to

support a deduction for depreciation, a taxpayer must establish a

property's depreciable basis by showing the cost of property, its

useful life or recovery period, and the previously allowable

depreciation. E.g., Delsanter v. Commissioner, 28 T.C. 845, 863

(1957), affd. in part, revd. in part, and remanded per curiam 267

F.2d 39 (6th Cir. 1959). We hold that petitioners have not

substantiated their depreciation deductions. 

Petitioners leased $38,180 of equipment from Tilden

Financial Corp. Petitioners rely on a schedule of lease payments 

entered into evidence to show they paid $14,445 in 1986 and

$11,170 in 1987.6 Petitioners rely on what appears to be a

computerized schedule from Columbia to support interest

deductions on Kondamudi's $120,000 loan.7 The schedule shows

interest payments of $16,182 in 1987 and $18,614 in 1988. No

canceled checks or Forms 1098 were offered to substantiate

petitioners' interest deductions. These amounts, although

questionable, are the only amounts substantiated by petitioners.
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Respondent, by allowing petitioners to deduct amounts equal to

the medical center's gross rents, had allowed deductions in

excess of those substantiated by petitioners. Therefore, we hold

that petitioners have not substantiated deductions in the

aggregate in excess of that allowed by respondent. 

The issues of limitation of loss under section 465 and

section 469 passive loss limitations are thus rendered moot and

need not be addressed.

4. Substantial Understatement

Section 6661 provides for a 25-percent addition to tax on

any substantial understatement. Pallottini v. Commissioner, 90

T.C. 498 (1988). A substantial understatement is one that

exceeds the greater of 10 percent of the tax required to be shown

on the return or $5,000. Sec. 6661(b)(1). The amount of the

understatement, for purposes of section 6661, is to be reduced by

the portion attributable to any item for which there was

substantial authority or any item that was adequately disclosed. 

Sec. 6661(b)(2)(B).

Petitioners have not argued that they had either substantial

authority or adequate disclosure on their tax returns; rather,

they argue that the Commissioner abused her discretion by not

waiving the addition to tax. The Secretary may waive all or part

of a section 6661 addition to tax upon a showing by the taxpayer

that there was reasonable cause for the understatement and that
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the taxpayer acted in good faith. Petitioners have the burden of

persuading the Court that in refusing to waive this addition to

tax, respondent has exercised this discretion "arbitrarily,

capriciously, or without sound basis in fact." Mailman v.

Commissioner, 91 T.C. 1079, 1084 (1988). In determining whether

petitioners had reasonable cause and acted in good faith, the

Court primarily looks to the extent of the taxpayers' efforts to

assess their proper tax liability. Id. at 1084; sec. 1.6661-6(b),

Income Tax Regs.

Petitioners attempt to blame their accountant for all their

underreporting. The cause of petitioners' problems is an absence

of record keeping and an unexplained failure to provide even the

most basic documentary evidence, such as canceled checks, Forms

1098, invoices, and promissory notes. These shortcomings are not

the fault of petitioners' accountant; he was not hired to perform

these services. Dr. Rao testified that he did not even examine

the tax returns before signing them; he cannot now claim that

such action is reasonable and in good faith. We hold that the

Commissioner did not abuse her discretion in not waiving the

substantial understatement addition to tax under section 6661.

5. Negligence

 For 1986 and 1987, section 6653(a)(1)(A) generally imposes

an addition to tax equal to 5 percent of the entire underpayment

if any part of it was due to negligence or disregard of rules or
- 26 -

regulations. Section 6653(a)(1)(B) imposes a further addition to

tax in an amount equal to 50 percent of the interest payable with

respect to the portion of the underpayment which is attributable

to negligence or disregard of rules or regulations. For 1988,

section 6653(a)(1) only provides for the 5-percent addition to

tax. For purposes of section 6653(a)(1), the term "negligence"

includes any failure to make a reasonable attempt to comply with

the provisions of the Code, and the term "disregard" includes any

careless, reckless, or intentional disregard. Sec. 6653(a)(3). 

Negligence also has been defined as a lack of due care or the

failure to do what a reasonable and ordinarily prudent person

would do under the circumstances. See Crocker v. Commissioner,

92 T.C. 899, 916 (1989); Neely v. Commissioner, 85 T.C. 934,

947-948 (1985). Failure by a taxpayer to keep adequate records

may justify imposition of the addition to tax for negligence. 

See Lysek v. Commissioner, 583 F.2d 1088, 1094 (9th Cir. 1978),

affg. T.C. Memo. 1975-293; Crocker v. Commissioner, supra at 917. 

Failure to maintain adequate records also indicates disregard of

the rules or regulations that require a taxpayer to keep

permanent records sufficient to establish, inter alia, the

taxpayer's gross income and deductions. See Crocker v.

Commissioner, supra at 917. Respondent only asserts the

additions to tax for negligence to the extent that Schedule E

expenses are disallowed. Petitioners failed to keep or maintain
- 27 -

adequate records, as described above. They are liable for the

additions to tax for negligence for all the years in issue.

To reflect the foregoing and concessions of the parties, 

Decision will be entered

under Rule 155.