                        T.C. Memo. 1997-323



                      UNITED STATES TAX COURT



         CHENG C. AND SUSAN L. KAO, ET AL.,1 Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 2982-94, 2983-94,       Filed July 15, 1997.
                 6667-95.



     Robert H. Solomon and Mark L. Quazzo, for petitioners.

     Rebecca T. Hill and Bryce A. Kranzthor, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     FOLEY, Judge:   Respondent determined the following

deficiencies, additions to tax, and accuracy-related penalties

with respect to petitioners' Federal income taxes:

     1
        Cases of the following petitioners are consolidated
herewith: Kolyn Enterprises Corp., docket No. 2983-94; and KCW
Associates, Inc., docket No. 6667-95.
                                 - 2 -

             Cheng C. and Susan L. Kao, docket No. 2982-94

                                Additions to Tax           Penalty
Year         Deficiency     Sec. 6653(a)(1)   Sec. 6661   Sec. 6662(a)

1988         $186,609          $9,330          $46,652       --
1989          975,338            --               --      $195,068
1990          663,670            --               --       132,734
1991          347,457            --               --        69,491

              Kolyn Enterprises Corp., docket No. 2983-94

                                Additions to Tax           Penalty
Year         Deficiency     Sec. 6653(a)(1)   Sec. 6661   Sec. 6662(a)

1988         $ 182,456         $9,123          $45,614       --
1989         1,125,870           --               --      $225,174
1990           733,023           --               --       146,605
1991           266,566           --               --        53,313

                KCW Associates Inc., docket No. 6667-95

                             Penalty
Year         Deficiency     Sec. 6662(a)

1990         $97,350         $19,470
1991           1,962             392

       All section references are to the Internal Revenue Code in

effect for the years in issue, and all Rule references are to the

Tax Court Rules of Practice and Procedure.         All dollar amounts

are rounded to the nearest dollar.         After concessions, the issues

for decision are as follows:

       1.   Whether petitioners failed to report income.       We hold

that they did to the extent provided below.

       2.   Whether petitioners are liable for additions to tax and

accuracy-related penalties.     We hold that they are.

                           FINDINGS OF FACT

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

the time the petitions were filed, Cheng and Susan Kao resided,
                                - 3 -

and Kolyn Enterprises Corp. and KCW Associates, Inc., each had

their principal place of business, in Los Altos, California.

     Petitioners Cheng and Susan Kao were born and raised in

Taiwan.   In 1964, Cheng Kao moved to the United States to pursue

graduate studies in applied physics at Harvard University.     In

1969, he received a Ph.D.   In 1968, Susan Kao moved to the United

States to pursue graduate studies in chemistry at the University

of Rochester.    She married Dr. Kao in 1970, and they have three

children.   During the years in issue, Mrs. Kao was employed as an

engineer at Intel Corp., and Dr. Kao was employed as president of

Kolyn Enterprises Corp. (Kolyn) and as vice president of KCW

Associates, Inc. (KCW).   Dr. Kao has five younger siblings, four

of whom reside in the United States.    His sister, Yu-Hsia Kao Tu,

resides in Taiwan.

     Kolyn is a closely held corporation that trades in

electronic goods, invests in real estate, and advises Asian

electronics companies.    Dr. and Mrs. Kao together own 52 percent,

and their three children each own 16 percent, of Kolyn's stock.

KCW is a closely held corporation that trades in electronic goods

and invests in real estate.   KCW's stock is held by Dr. Kao and

his relatives.

     During the years in issue, petitioners filed their Federal

income tax returns in a timely manner.   Kolyn's returns, on

Schedule L, reported increases in long-term liabilities.   On

their 1991 returns, the Kaos and Kolyn disclosed, on Forms 8275,
                                 - 4 -

that Kolyn received $790,000.    The disclosures stated that these

funds were not taxable to either Kolyn or the Kaos.   In 1992, the

Internal Revenue Service conducted an audit of Kolyn's 1988,

1989, and 1990 returns.   Agent Jimmy Chan was assigned to the

case.   On January 14, 1992, Agent Chan met with Dr. Kao for

approximately 7 hours to review Kolyn's corporate records.

During the interview, Agent Chan discovered numerous deposits in

Kolyn's accounts.   In response to Agent Chan's questions, Dr. Kao

explained that these deposits were cash gifts from his father.

Dr. Kao refused, however, to provide Agent Chan with any records

to corroborate his explanation.

     Because Dr. Kao failed to provide records to corroborate his

explanation for these and other deposits in petitioners'

accounts, respondent used the bank deposits method to reconstruct

petitioners' income for the years in issue.   After completing

this analysis, respondent issued notices of deficiency to

petitioners and determined for the years in issue that:    (1) KCW

received unreported income of $121,857; (2) the Kaos received

unreported income of $905,502; and (3) Kolyn received unreported

income of $6,777,319, and this amount was taxable to both Kolyn

and the Kaos.   Respondent has subsequently conceded that a

$300,000 deposit into Cheng and Susan Kao's checking account, as

well as funds deposited into two other accounts at World Savings

and Loan, are not taxable to the Kaos.

                                OPINION
                                - 5 -

I.   Unreported Income

      Gross income includes all income from whatever source

derived.   Sec. 61(a).   Every taxpayer is required to maintain

adequate records of taxable income.     Sec. 6001.   If a taxpayer

fails to maintain such records, the Commissioner may reconstruct

income in accordance with a method that clearly reflects the full

amount of income received.    Sec. 446(b); Meneguzzo v.

Commissioner, 43 T.C. 824, 831 (1965).

      Respondent used the bank deposits method to reconstruct

petitioners' income for the years in issue.     Bank deposits are

prima facie evidence of income, Tokarski v. Commissioner, 87 T.C.

74, 77 (1986), and under the bank deposits method, all money

deposited into a taxpayer's bank account during a given period is

assumed to be taxable income, DiLeo v. Commissioner, 96 T.C. 858,

868 (1991), affd. 959 F.2d 16 (2d Cir. 1992).     Respondent's

determinations are presumed to be correct, and petitioners bear

the burden of proving that respondent's bank deposits analysis is

erroneous.   Rule 142(a); Parks v. Commissioner, 94 T.C. 654, 658

(1990).

      Petitioners contend that the funds deposited into their

accounts are not taxable income.    Their contentions are based

primarily on the testimony of Dr. Kao, Ms. Tu, and Jin Cheng Kao

(Dr. Kao's uncle).   Their testimony, however, was vague, evasive,

and otherwise unpersuasive.    Petitioners, in an attempt to

corroborate this testimony, presented dubious documentation,
                                - 6 -

including notes, letters, and records prepared by Dr. Kao or Ms.

Tu.   Some of the documents are not reliable and do not contain

any credible indicia of contemporaneous communications (e.g.,

postmark dates).   Other documents either do not support

petitioners' contentions (e.g., bank records do not establish the

source of funds) or, in some cases, contradict petitioners'

testimony (e.g., bank records indicate that Dr. Kao transferred

funds from overseas to Kolyn, while he testified to the

contrary).   In short, petitioners have failed to meet their

burden of proof.

      We disagree with respondent, however, with respect to

$6,777,319 attributed to the Kaos based on a bank deposits

analysis of Kolyn's accounts.   Respondent's bank deposits

analysis of Kolyn's accounts is not persuasive evidence of the

Kaos' receipt of income.   Respondent has not provided substantive

evidence or a plausible theory to establish that the Kaos

received these funds.   As a result, we reject respondent's

determination that $6,777,319 deposited into Kolyn's accounts is

taxable to the Kaos.    Cf. Weimerskirch v. Commissioner, 596 F.2d

358, 362 (9th Cir. 1979), revg. 67 T.C. 672 (1977) (holding that

the Commissioner's determination was arbitrary and erroneous,

because the Commissioner did not provide "substantive evidence"

linking the taxpayer with the receipt of income).

II.   Additions to Tax and Accuracy-Related Penalties
                                - 7 -

     For the 1988 tax year, respondent determined that

petitioners, pursuant to sections 6653(a)(1) and 6661, were

liable for additions to tax for negligence and substantial

understatements.   For the 1989 through 1991 tax years, respondent

determined that petitioners, pursuant to section 6662(a), were

liable for accuracy-related penalties based on either negligence

or substantial understatements.   As with the deficiencies,

petitioners bear the burden of proving that these determinations

are erroneous.   See Rule 142(a); Bixby v. Commissioner, 58 T.C.

757, 791 (1972).

     A.   Additions to Tax for Negligence

     Section 6653(a)(1), applicable to petitioners' 1988 tax

year, provides that if any part of any underpayment of tax

required to be shown on a return is due to negligence, there

shall be added to the tax an amount equal to 5 percent of the

underpayment.    The term "negligence" is defined as the failure to

exercise the care that a reasonable and ordinarily prudent person

would exercise under the circumstances.     Zmuda v. Commissioner,

731 F.2d 1417, 1422 (9th Cir. 1984), affg. 79 T.C. 714 (1982);

Neely v. Commissioner, 85 T.C. 934, 947 (1985).

     Petitioners offered no plausible explanation for their

failure to report significant amounts of income.    As a result, we

conclude that they are liable for the section 6653(a) additions

to tax.

     B.   Additions to Tax for Substantial Understatement
                                 - 8 -

     Section 6661(a), applicable to petitioners' 1988 tax year,

provides for an addition to tax in the amount of 25 percent of

the amount of any underpayment attributable to a substantial

understatement.    The amount of the understatement generally is

reduced by the portion of the understatement attributable to (1)

the tax treatment of an item if there was substantial authority

for such treatment, or (2) any item with respect to which the

relevant facts affecting the item's tax treatment are adequately

disclosed in the return or in a statement attached to the return.

Sec. 6661(b)(2)(B).    The requirements of adequate disclosure can

be satisfied by providing, on the return, information sufficient

to enable the Commissioner to identify the potential controversy

involved.    Schirmer v. Commissioner, 89 T.C. 277, 285-286 (1987).

     Kolyn's 1988 return reported, on Schedule L, increases in

Kolyn's long-term liabilities.    Petitioners contend that this

information adequately disclosed the funds Kolyn received.    We

conclude that the mere disclosure of an increase in long-term

liabilities was insufficient to enable respondent to identify the

potential controversy (i.e., whether petitioners failed to report

income).    Accordingly, petitioners are liable for the section

6661(a) additions to tax.

     C.    Accuracy-Related Penalties

     Section 6662(a), applicable to petitioners' 1989 through

1991 tax years, imposes an accuracy-related penalty in an amount

equal to 20 percent of the portion of any underpayment to which
                                 - 9 -

the section applies.   The section applies to, among other items,

the portion of an underpayment attributable to (1) negligence or

disregard of rules or regulations, or (2) any substantial

understatement of income tax.    Sec. 6662(b).     Negligence includes

the failure to make any reasonable attempt to comply with the

Internal Revenue Code.   Sec. 6662(c).      No penalty may be imposed

on any portion of an underpayment that is attributable to

negligence if the position is adequately disclosed, the position

is not "frivolous", and the taxpayer has adequate books and

records and has substantiated items properly.       Sec. 1.6662-3(c),

Income Tax Regs.   A "frivolous" position is one that is "patently

improper."   Sec. 1.6662-3(b)(3), Income Tax Regs.

     Petitioners offered no plausible explanation for their

failure to report significant amounts of income.       While the Kaos

and Kolyn disclosed, on Forms 8275, that Kolyn received $790,000

in 1991, they failed to produce adequate books and records and to

substantiate items properly.    As a result, we sustain

respondent's determinations on this issue.

     We have considered all other arguments made by the parties

and found them to be either irrelevant or without merit.

     To reflect the foregoing,


                                              Decisions will be entered

                                         under Rule 155.
