                  T.C. Memo. 2003-152



                UNITED STATES TAX COURT



     DAVID M. AND TERI L. SAYKALLY, Petitioners v.
      COMMISSIONER OF INTERNAL REVENUE, Respondent

  COMPUTER POWER SOFTWARE GROUP, INC., Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket Nos. 555-00, 1821-00.     Filed May 27, 2003.

     P has extensive technical expertise in the
computer software industry. P’s wholly owned
corporation, C, was engaged in the marketing of
software products. P and C entered into an agreement
whereby P agreed to have research and development (R&D)
done in order to create developed technology. Under
the agreement, P would own the developed technology and
license it to C in exchange for royalties. P intended
that C would market the developed technology to its
customers. P deducted his 1995 and 1996 R&D
expenditures on Schedules C. R disallowed P’s R&D
deductions on the ground that they were not incurred in
a trade or business.

     Held: At all times, P intended to market the
developed technology through C. P did not have the
objective intent to use the developed technology in an
activity that would constitute his own trade or
                               - 2 -

     business and is not entitled to a current deduction for
     his R&D expenses.

          Held, further, Ps did not adequately substantiate
     other deductions disallowed by R.

          Held, further, Ps are not liable for accuracy-
     related penalties associated with the deduction of R&D
     expenses. Ps are liable for accuracy-related penalties
     with respect to their failure to substantiate other
     disallowed deductions.


     Robert R. Rubin, for petitioners.

     Kathryn K. Vetter, for respondent.


             MEMORANDUM FINDINGS OF FACT AND OPINION


     RUWE, Judge:   These cases were consolidated by motion of the

parties for purposes of trial, briefing, and opinion.   In docket

No. 1821-00, respondent determined a deficiency in Federal income

tax of $103,250 and a section 6662(a)1 accuracy-related penalty

of $20,650 for the taxable year 1996 with respect to

petitioner Computer Power Software Group, Inc. (CPSG, Inc.).    In

docket No. 555-00, respondent determined deficiencies in

petitioners David M. and Teri L. Saykally’s2 income taxes, an

addition to tax pursuant to section 6651(a)(1), and accuracy-




     1
      All section references are to the Internal Revenue Code in
effect for the taxable years at issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure.
     2
      Petitioners David M. and Teri L. Saykally filed joint
Federal income tax returns for the taxable years at issue.
                              - 3 -

related penalties pursuant to section 6662(a) for the taxable

years 1994, 1995, and 1996 as follows:

                              Addition to Tax     Penalties
     Year      Deficiency     Sec. 6651(a)(1)     Sec. 6662(a)

     1994       $11,729               $253          $2,346

     1995        16,769                 --           3,354

     1996       634,289                 --         126,858

For convenience, we refer to David M. and Teri L. Saykally as

petitioners and David M. Saykally as petitioner throughout this

opinion.

     After concessions,3 the remaining issues to be decided are

as follows:

     (1) Whether petitioners are entitled to deduct expenses

claimed for research and development for taxable years 1995 and

1996 in the respective amounts of $67,534 and $1,421,645;

     (2) Whether petitioners are entitled to deduct certain

expenses on their Schedules C, Profit and Loss From Business, for

the taxable years 1994, 1995, and 1996; and




     3
      The parties have conceded that there will be no deficiency
in tax due from or overpayment in tax due to petitioner CPSG,
Inc. Therefore, an accuracy-related penalty under sec. 6662(a)
will not be imposed. Accordingly, the parties have resolved all
the issues in docket No. 1821-00.

     With respect to petitioners in docket No. 555-00, respondent
has conceded, inter alia, that petitioners are not liable for the
sec. 6651(a)(1) addition to tax for the taxable year 1994.
                               - 4 -

     (3) Whether petitioners are liable for accuracy-related

penalties pursuant to section 6662 for the taxable years 1994,

1995, and 1996.

                         FINDINGS OF FACT

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

The stipulation of facts, stipulations of settled issues, and the

attached exhibits are incorporated herein by this reference.    At

the time of filing the petition, petitioners resided in Granite

Bay, California.

Research and Development Expenses

     Petitioner has extensive familiarity with, and technical

expertise in, the computer software industry spanning more than

30 years.   In 1991, Computer Power Group Limited (CPG) hired

petitioner on a contract basis to provide it with consulting

services.   CPG is a large professional services company organized

under the laws of Australia.   CPG was in the business of

providing professional computer programmers to companies to

create business software.   Additionally, CPG was involved in the

worldwide marketing of several lines of business software

applications.   CPG was losing money on the marketing of its

software applications.   Petitioner was hired on a short-term
                               - 5 -

basis to provide consulting services to CPG to identify why CPG

was losing money and how to stop such losses.4

     After conducting onsite inspections and reviewing pertinent

information, petitioner reported to CPG’s chief executive officer

regarding his ideas on how to stop the “profit bleed”.     In

response, CPG attempted to hire petitioner to implement his

ideas.   Instead of becoming an employee of CPG, the parties

agreed to move the marketing of CPG’s software out from under CPG

and agreed that petitioner would organize his own corporation to

market CPG’s software products for a stated royalty.

Consequently, petitioner organized CPSG, Inc.

     CPSG, Inc. is a computer software corporation that was

organized in November 1992, pursuant to the laws of the State of

California.   During the taxable years at issue, petitioner owned

all the outstanding shares of CPSG, Inc., and was its president,

chief operating officer, and sole director.

     Beginning in 1992, CPG was a party to contracts with three

Australian syndicates that were engaged in software development

(the syndicates).   The syndicates were Australian tax-advantaged

research and development partnerships.   The syndicates provided

financing to CPG for the development of new software technology.

The syndicates raised approximately $20 million for CPG’s



     4
      Petitioner was known in the computer industry as a
turnaround specialist.
                                - 6 -

software research and development work.      Approximately 75 percent

of the money raised, or $15 million was supposed to be used for

the development of CPG’s software.      In return, the syndicates

owned the rights to the software technology and licensed those

rights to CPG.

     On August 10, 1993, petitioner, CPSG, Inc., and CPG entered

into a Software Marketing and Management Agreement (the

management agreement) whereby CPSG, Inc. licensed certain rights

to market CPG’s software technology and products, including

InTEXT, Today, and Operating Control Systems.5     The management

agreement contemplated that CPSG, Inc. would form three

subsidiaries, InTEXT Systems, Inc., Today Systems, Inc., and

Operating Control Systems, Inc., to market specific lines of

CPG’s software products.

     The management agreement purported to grant CPSG, Inc. the

right to market CPG’s software products as they existed before

the development work funded by the syndicates.      In exchange,

CPSG, Inc. agreed to pay CPG a royalty.      Under the terms of the

management agreement, CPG agreed to use its best efforts to

provide funds for software product development; the funds were to

be obtained from the syndicates.




     5
        The agreement had a retroactive effective date of Sept. 30,
1992.
                                   - 7 -

       Appendix II to the management agreement was a Software

Marketing Agreement (submarketer agreement) by and between CPSG,

Inc. and CP Software Export Pty Ltd., an entity affiliated with

CPG.       Under this agreement, CPSG, Inc. would acquire a sublicense

to market certain software products developed with funding from

the syndicates in exchange for royalty payments.       Despite

extensive negotiations, this agreement was never executed by the

parties.       Although the agreement was never executed, the parties

decided to operate as if it had been.

       In or about May 1995, CPG informed CPSG, Inc. that the

syndicates’ development funding would terminate in July 1995.         In

or about July 1995, the syndicates’ development funding

terminated.       The planned development and improvement of the

software was not completed.       No new marketable and competitive

products resulted from the underfunded and unfinished

development.       Without additional development funding, CPSG, Inc.

and its subsidiaries would lose their current customers and would

not have software products to attract new customers.

       On July 7, 1995, the syndicates notified CPSG, Inc. to cease

and desist marketing CPG’s software technology purportedly

licensed from CPG.6      The syndicates took the position that CPSG,


       6
      By the terms of the submarketer agreement, CPSG, Inc. was
granted an exclusive license to the newly developed software
technology. However, pursuant to par. 2.4, the management
agreement provided that its terms could not violate the operating
                                                   (continued...)
                                - 8 -

Inc. had no rights to the technology for which they had provided

funding.    Essentially, the syndicates, through their

representative, informed CPSG, Inc. that the management agreement

by and between CPG and CPSG, Inc. to market the software

technology conferred no rights on CPSG, Inc. as the syndicates

had not approved the agreement.

     Petitioner decided to continue the development without

funding from the syndicates.    Petitioner believed he would have

more negotiating leverage with respect to the developed software

if he finished development in his own name, instead of in the

name of CPSG, Inc.    Petitioner’s reasons supporting this decision

were:    (1) CPSG, Inc., as a marketing entity, had no development

capability; petitioner was the only person who had the skill set

to do the development; (2) it was prudent to create intellectual

rights outside of CPSG, Inc. because (i) CPG could cancel the

submarketer agreement in 1997 for no reason and, at other times

as stated in the agreement; (ii) the syndicates took the position

that they could modify or terminate CPSG, Inc.’s rights to the

newly developed software technology because the grant from CPG

was in conflict with the rights of the syndicates; and (iii) CPG

controlled the syndicates and could cause the syndicates to



     6
      (...continued)
terms governing the syndicates. The terms of the syndicates
forbade the grant of exclusive rights to the improved technology
without explicit permission of the syndicates.
                                 - 9 -

require CPG to terminate the management agreement; (3) CPSG, Inc.

did not have the financial resources to fund the development; and

(4) petitioner had the financial resources to develop the

software technology.

     On October 1, 1995, petitioner, in his individual capacity,

entered into a development agreement with his wholly owned

corporation, CPSG, Inc.    According to the terms and conditions of

the development agreement, petitioner covenanted to provide

software research and development to improve, enhance, modify,

and change the software technology in his reasonable discretion

and at his sole expense.     The contract granted CPSG, Inc. the

right to cancel the agreement at anytime with 1 month’s notice.

The product of petitioner’s R&D efforts was what the parties

termed the “developed technology”.       Pursuant to the terms of the

contract, petitioner retained all rights, title, and interest in

the developed technology.7    Simultaneously, under the development

agreement, petitioner granted CPSG, Inc. a nonexclusive license

to the developed technology in exchange for 36 quarterly payments

in an amount equal to the greater of 10 percent or $26,250 from

the sale, grant of licenses, or commercialization of products

that incorporated the developed technology during the period



     7
      Petitioner testified that this was one of the primary
reasons for conducting the development on his own behalf;
personal ownership rights, outside of CPSG, Inc., would give him
leverage over CPG and the syndicates.
                              - 10 -

January 31, 1997, through December 31, 2005.8   Petitioner

intended that the developed technology would be marketed through

CPSG, Inc.

     On October 1, 1995, CPSG, Inc., Computer Power Software

Group Australia Pty Ltd.9 (CPSGAus), and petitioner entered into

a service agreement whereby CPSGAus agreed to provide

administrative and payroll services to petitioner in his efforts

to develop the software technology.    CPSGAus hired some of the

Australian development staff that had been formerly employed by

the syndicates to continue the research and development on

petitioner’s behalf.   CPSGAus invoiced CPSG, Inc. for these

costs.   CPSG, Inc. paid the costs associated with the research

and development on petitioner’s behalf and recorded petitioner’s

indebtedness for the expenses on CPSG, Inc.’s accounting system.

     Petitioner monitored the work performed by the Australian

development “team” via telephone, a visit to Australia, and

electronic mail communications.   Additionally, petitioner helped

solve technical programming problems, prioritized tasks of the


     8
      The minimum quarterly payments of $26,250 were due and
owing to petitioner regardless of whether CPSG, Inc. generated
any income from the developed technology. The development
agreement contemplated that petitioner would receive, at the very
least, $945,000 over the term of the agreement (36 quarters).
     9
      Petitioner formed CPSGAus in 1994 to manage CPSG, Inc.’s
business activities in Australia. CPSGAus provided development,
sales, support, and administrative services to CPSG, Inc.’s
subsidiaries: InTEXT Systems, Inc., Operating Control Systems,
Inc., and Today Systems, Inc.
                               - 11 -

programmers, and was involved in beta testing the developed

software.

       Petitioner chose to secure development funding through CPSG,

Inc.    In order to memorialize his indebtedness to CPSG, Inc., on

October 1, 1995, petitioner signed an unsecured, interest-bearing

promissory note in favor of CPSG, Inc. for an amount not to

exceed $1.4 million.    According to the terms of the note,

petitioner is personally liable for the amounts expended by CPSG,

Inc. up to the stated maximum ($1.4 million), the principal of

which is due on October 1, 2005.    The interest rate was set

quarterly to the prime rate and was payable in annual

installments beginning on December 31, 1996.

       CPSG, Inc. did not have sufficient cash to advance all the

research and development costs to which petitioner obligated

himself.    Accordingly, petitioner arranged for Uniplex Software,

Inc.10 (Uniplex Software) to lend funds to CPSG, Inc.   Uniplex

Software advanced to CPSG, Inc. a total of $1.15 million in

payments of $750,000 and $400,000 on February 5 and July 11,

1996, respectively.    On October 1, 1996, CPSG, Inc. executed a

promissory note to memorialize the loans made by Uniplex

Software, not to exceed $1.15 million.    Pursuant to the terms of


       10
      CPSG Ventures owned 50.1 percent of Uniplex Software, and
IMI owned 49.9 percent. IMI is a United Kingdom publicly traded
corporation. Petitioner owned 70 percent of CPSG Ventures, a
general partnership, and Karan Erickson, an officer of CPSG,
Inc., owned 30 percent.
                             - 12 -

the note, interest was set quarterly at the prime rate and was to

be paid during the term of the note with the principal due on

October 1, 2005.

     Effective January 1, 1996, petitioner granted Uniplex

Software a nonexclusive worldwide license for a renewable 3-year

term to part of the developed technology.    Effective July 8,

1996, CPSG, Inc. and Uniplex Software entered into a Software

License Agreement (source code license) whereby CPSG, Inc.

provided Uniplex Software with a worldwide, perpetual,

nonexclusive license to the InTEXT proprietary software.     In

exchange, Uniplex Software covenanted to pay CPSG, Inc. $500,000

for the source code license, $350,000 initial license prepayment,

and a 2-percent royalty on Uniplex Software’s net revenue from

the distribution of the software until CPSG, Inc. received

$300,000, and thereafter a 1-percent royalty of the net revenue

from distribution of the software.    The source code license

provided Uniplex Software with security for the $1.15 million

unsecured loan made to CPSG, Inc.

     Annual sales of the InTEXT developed technology were

approximately $1.5 million during the years at issue.    Annual

sales of the Operating Control System developed technology were

approximately $1 million for the subject years.    Annual sales of

the Today developed technology approximated $2 million during the

period 1995 through 1997.
                                    - 13 -

      During 1995 and 1996, CPSG, Inc., by and through its wholly

owned subsidiaries, paid $67,543 and $1,361,006 of research and

development costs on behalf of petitioner.           These costs included:

      Description               1995                 1996

      Salaries1               $28,584           $1,076,850
      Contract labor           20,947               46,451
      Building rent             5,644               54,293
      Commissions               4,250                3,306
      Telephone                   428               33,001
      Entertainment               106                  659
      Equipment rental          6,052               68,379
      Repairs/maintenance       1,036               26,086
      Freight                     497                  265
      Janitorial                  -0-                  426
      Recruiting fees             -0-                4,187
      Travel                      -0-                3,016
      Services                    -0-               13,495
      Dues & subscriptions        -0-                1,500
      Electricity                 -0-               14,218
      License fees                -0-               12,050
      Small equipment             -0-                  573
      Office supplies             -0-                1,761
      Postage/misc.               -0-                  491

      1
        The category “Salaries” represents the cumulative amount paid to
individuals living in Australia.

CPSG, Inc. used its accounting system to track these costs.

CPSG, Inc. initially deducted these research and development

costs on its Federal income tax return for the year ended

September 30, 1996.      CPSG, Inc. subsequently amended its 1996

return eliminating the deduction.

      Petitioners attached Schedules C for a computer software

development business named “DMS Development Co.” to their 1995

and 1996 returns.      For the years at issue, petitioners reported
                                      - 14 -

no income on these Schedules C.           Petitioners deducted the

following research and development expenses on these schedules:11

     Description                   1995                1996

     Salaries                 $28,584            $1,076,850
     Contract labor            20,947                 46,451
     Building rent               5,644                54,293
     Commissions                 4,250                 3,306
     Telephone                     428                33,001
     Meals/entertainment           106                   329
     Equipment rental            6,052                68,379
     Repairs/maintenance         1,036                26,086
     Freight                       497                   265
     Janitorial                    -0-                   426
     Recruiting fees               -0-                 4,187
     Travel                        -0-                 3,016
     Services                      -0-                13,495
     Dues & subscriptions          -0-                 1,500
     Electricity                   -0-                14,218
     License fees                  -0-                12,050
     Small equipment               -0-                   573
     Office supplies               -0-                 1,761
     Postage/misc.                 -0-                   491
                                                    1
     Interest                      -0-                60,967
                               2
       TOTAL                     67,543           1,421,645
     1
       The parties agree that $30,020 of this interest is not deductible on
Schedule C, but it is deductible as investment interest.

      2
        The parties stipulated that petitioners deducted $67,543 in research
and development expenses. However, the column totals to $67,544 and the
notice of deficiency and petitioners’ 1995 return state $67,534 as the amount
deducted.

     CPSG, Inc. paid the following amounts to petitioner as

minimum royalties pursuant to the development agreement:

          Date         Amount                    For Period

     01/28/97           $52,500             1/31/97   and 4/30/97 (Advance)
     03/31/97           105,000             6/30/97   - 3/31/98
     12/30/98             78,750            6/30/98   - 12/31/98
                       1
     12/20/99            108,150            3/31/99   - 12/31/99
       TOTAL            344,400
      1
        The $108,150 amount included the royalty payment of $105,000 plus
interest of $3,150 for the period 03/31/99 to 12/31/99. On or about Aug. 1,


     11
      The deduction of these research and development expenses
in 1996 substantially eliminated an approximately $1.4 million
capital gain realized from the sale of Unify Corp. stock.
                                     - 15 -
1997, CPSG, Inc. informed petitioner that it was unable to make the minimum
royalty payments under the development agreement. The $3,150 is presumably
accrued interest for the period of nonpayment of minimum royalties.

The $52,500 paid on January 28, 1997, included the January 31,

1997, minimum royalty payment as contemplated under the

development agreement as well as an advance payment for the April

30, 1997, minimum royalty payment.

      Petitioner paid CPSG, Inc. the following amounts as interest

on his $1.4 million indebtedness to CPSG, Inc.:

       Date               Amount                 For Period
                                          1
      12/29/96          $30,947.27            10/1995 - 09/1996
      03/31/98          138,541.27            10/1/96 - 12/31/97
      12/30/98          117,092.59                 1998
      12/21/99          111,595.20                 1999
        TOTAL           398,176.33

      1
        For the period Oct. 1995 to Sept. 1996, the record fails to state the
actual days upon which interest accrued.

Other Schedule C Expenses

      On their Schedules C, petitioners reported the following

amounts as receipts and expenses for a consulting business named

“CPSG Ventures”12 for the years at issue:

                          1994                 1995                1996

      Receipts          $194,317          $67,565              $72,118
      Expenses            79,881           30,912               79,349
      Net profit/loss    114,436           36,653               (7,231)

The receipts reported for CPSG Ventures for 1994 on petitioners’

Schedule C consisted of the following items:

      CPSG, Inc. reimbursements1                   $61,640


      12
      “CPSG Ventures” is the name of both a partnership in which
petitioner was a general partner and petitioner’s Schedule C
business. See supra note 10.
                                   - 16 -
                                                 2
      CPSG, Inc.                                 40,000
      Walker Interactive Systems3                16,000
      Uniplex Software Systems, Inc.             75,000
      Granite Bay Montessori reimbursements       1,591
      Miscellaneous                                  86
        TOTAL                                   194,317

      1
        Petitioner submitted expense reports to CPSG, Inc. for his travel and
other expenses that he incurred on its behalf and CPSG, Inc. reimbursed him
for these expenses.

      2
        The $40,000 was for a charitable contribution made by CPSG, Inc. on
behalf of petitioner.
      3
       Petitioner was a member of the board of directors of Walker
Interactive Systems.

The receipts reported for CPSG Ventures for 1995 on petitioners’

Schedule C consisted of the following items:

      CPSG, Inc. reimbursements                 $53,187
      Walker Interactive Systems                 10,500
      Airline ticket refund                       3,878
        TOTAL                                    67,565

The receipts reported for CPSG Ventures for 1996 on petitioners’

Schedule C consisted of the following items:

      CPSG, Inc. reimbursements                 $53,618
      Walker Interactive Systems                 18,500
        TOTAL                                    72,118

Petitioners claimed as deductions the following expenses on their

Schedules C for CPSG Ventures for the taxable years listed:

      Description               1994          1995           1996

      Depreciation            $5,017      $10,053             -0-
      Car & truck                 --        5,799          $5,807
      Interest                   386           --              --
      Legal/professional       1,374           79              30
      Office expense             905           --             202
      Supplies                   970          865          12,604
      Travel                  54,644           --          41,870
      Meals                    2,353        4,439           1,900
      Utilities                9,995        9,457          16,861
      Auto-Std rate            4,133           --              --
      Auto taxes                 104           --              --
      Miscellaneous               --          220              75
        TOTAL                 79,881       30,912          79,349
                                - 17 -

The above-listed expenses included amounts that were reimbursed

by CPSG, Inc. for expenses such as travel and entertainment,

supplies, and telephone.   Additionally, these expenses included

amounts not reimbursed by CPSG, Inc.      In the notice of

deficiency, respondent allowed deductions for expenses to the

extent they were reimbursed by CPSG, Inc.      Additionally,

respondent allowed the car and truck expenses as itemized

deductions.

Charitable (Double) Deduction

     On December 29, 1996, petitioners donated $60,000 to the

Granite Bay Montessori School.    On their 1996 income tax return,

petitioners erroneously claimed a double deduction of $120,000.

The parties have stipulated that petitioners are entitled to

claim only a $60,000 charitable deduction with respect to the

donation to the school for 1996.    The only issue that remains

with regard to this item is whether petitioners are liable for

the accuracy-related penalty associated with the erroneous

deduction.

                                OPINION

     Determinations of the Commissioner in a notice of deficiency

are generally presumed correct, and the burden is on the taxpayer

to show that the determinations are incorrect.13     Rule 142(a);


     13
      Sec. 7491 does not apply in this case to shift the burden
of proof or production to respondent because the examination of
                                                   (continued...)
                                 - 18 -

Welch v. Helvering, 290 U.S. 111, 115 (1933).     Deductions are a

matter of legislative grace, and the taxpayer generally bears the

burden of proving entitlement to such claimed deductions.

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

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

Furthermore, a taxpayer is required to maintain records

sufficient to establish the amount of his income and deductions.

Secs. 274(d), 6001; sec. 1.6001-1(a), (e), Income Tax Regs.

A.   Section 174--Research and Development Deductions

      With regard to the claimed research and development (R&D)

expenses for 1995 and 1996, the notice of deficiency states:

           Schedule C - DMS Loss
           Year                   9512           9612
           Claimed on return   $67,534        $1,421,645
           Allowed per audit      -0-             -0-
           Adjustment            67,534        1,421,645

           You have not shown that these expenses were
           ordinary and necessary expenses paid or incurred
           in connection with carrying on a trade of
           business.

           Since you have not established that the expenses
           claimed were paid or incurred for research and
           experimental expenditures in connection with your
           trade or business, they are not deductible.

           Loss is limited to amount of capital you have at
           risk.




      13
      (...continued)
the returns at issue commenced before the statute’s effective
date.
                               - 19 -

      To resolve this issue, we must look to the statute granting

deductions for expenses related to R&D and the cases interpreting

it.   Section 174(a)(1) provides:

      SEC. 174(a).   Treatment as Expenses.--

           (1) In general.--A taxpayer may treat research or
      experimental expenditures which are paid or incurred by him
      during the taxable year in connection with his trade or
      business as expenses which are not chargeable to capital
      account. The expenditures so treated shall be allowed as a
      deduction.

      To qualify for a deduction, the expenditures must be (1)

qualifying, (2) paid or incurred in connection with the

taxpayer’s trade or business, and (3) reasonable.      Sec. 174(e);

sec. 1.174-2, Income Tax Regs.      R&D expenditures which are not

deductible under section 174(a) must be charged to a capital

account.   Sec. 1.174-1, Income Tax Regs.

      The term “research or experimental expenditures” as used in

section 174 means expenditures “incurred in connection with the

taxpayer’s trade or business which represent research and

development costs in the experimental or laboratory sense.”      Sec.

1.174-2(a)(1), Income Tax Regs.      Section 174 allows a taxpayer to

claim a deduction for expenditures paid or incurred for research

carried on in his behalf by another person or organization.      Sec.

1.174-2(a)(8), Income Tax Regs.

      In this case, respondent does not argue or allege that the

expenses in question are not “research and development costs in

the experimental or laboratory sense” or that the amounts claimed
                              - 20 -

are unreasonable.   Respondent’s position is that petitioner did

not pay or incur the research expenses in connection with his own

trade or business and that petitioner did not have the objective

intent to prospectively enter into his own trade or business with

the developed technology.

     Petitioners argue that “There was a realistic prospect that

* * * [petitioner] would enter a trade or business involving the

software he developed.”   (Emphasis added.)   Petitioners do not

argue that at the time petitioner incurred the R&D expenses, he

was already engaged in a trade or business; petitioners’ focus is

solely upon the prospective probability that petitioner would

engage in a trade or business with the developed technology.14

In its petition, CPSG, Inc. alleged that if the Court determines

that Mr. and Mrs. Saykally are not entitled to the claimed R&D

deductions, then CPSG, Inc. is so entitled.   CPSG, Inc. abandoned

this argument. Ryback v. Commissioner, 91 T.C. 524, 566 n.19

(1988).   Therefore, we express no opinion as to this issue.

     The Trade or Business Requirement

     With respect to section 174, the U.S. Supreme Court has

interpreted the trade or business requirement expansively.     Snow

     14
      Petitioners argue that petitioner was “capable of
exploiting the new products;” “At the time the section 174
expenses were paid, there was a realistic prospect that
petitioner would enter a trade or business involving the new * *
* products;” and that he “intended to market the Developed
Technology to new customers as well as existing customers of
CPSG.” (Emphasis added.)
                              - 21 -

v. Commissioner, 416 U.S. 500 (1974).   The Court held that

section 174 allowed deductions for R&D expenditures not only for

“on-going” and established businesses, but also for new

businesses despite the fact that no trade or business was being

conducted at the time the expenses were incurred.15   Id.

     This expansive interpretation allowing R&D deductions for

expenses incurred prior to engaging in a trade or business is

tempered by the requirement that there must be a “realistic

prospect” that the taxpayer will subsequently enter into a trade

or business utilizing the technology developed.   Diamond v.

Commissioner, 92 T.C. 423, 439 (1989), affd. 930 F.2d 372 (4th

Cir. 1991); see I-Tech R&D Ltd. Pship. v. Commissioner, T.C.

Memo. 2001-10, affd. sub nom. Lewin v. Commissioner, ___ Fed.

Appx. ___ (4th Cir. 2003).   “If those prospects are not

realistic, the expenditures cannot be ‘in connection with’ a

business of the taxpayer” so as to satisfy section 174.     Spellman

v. Commissioner, 845 F.2d 148, 149 (7th Cir. 1988), affg. T.C.

Memo. 1986-403.   “Whether activities in connection with a product



     15
      In Commissioner v. Groetzinger, 480 U.S. 23, 36 (1987),
the Court stated that to determine whether or not an income-
producing endeavor constitutes a trade or business “‘requires an
examination of the facts in each case.’” (quoting Higgins v.
Commissioner, 312 U.S. 212, 217 (1941)). “We accept the fact
that to be engaged in a trade or business, the taxpayer must be
involved in the activity with continuity and regularity and that
the taxpayer’s primary purpose for engaging in the activity must
be for income or profit. A sporadic activity, a hobby, or an
amusement diversion does not qualify.” Id. at 35.
                                - 22 -

are sufficiently substantial and regular to constitute a trade or

business” is a factual determination.     I-Tech R&D Ltd. Pship. v.

Commissioner, supra; see Green v. Commissioner, 83 T.C. 667, 687

(1984).     However, in no event is a deduction appropriate where

the taxpayer acts solely in an investor capacity.     Green v.

Commissioner, supra; see Higgins v. Commissioner, 312 U.S. 212

(1941); I-Tech R&D Ltd. Pship. v. Commissioner, supra; Universal

Research & Dev. Pship. No. 1, et al. v. Commissioner, T.C. Memo.

1991-437.

     Whether a taxpayer has a realistic prospect of using the

fruits of R&D expenditures in a future business of his own

involves a two-part test.     “[A] taxpayer demonstrates such a

[realistic] prospect by manifesting both the objective intent to

enter such a business and the capability of doing so.”16     Kantor

v. Commissioner, 998 F.2d 1514, 1518 (9th Cir. 1993), affg. in

part and revg. in part T.C. Memo. 1990-380; see Zink v. United

States, 929 F.2d 1015 (5th Cir. 1991); Spellman v. Commissioner,

supra; Levin v. Commissioner, 832 F.2d 403, 406-407 (7th Cir.

1987), affg. 87 T.C. 698 (1986).     Generally, in determining

whether there is a “realistic prospect,” we look solely to the

period during which the expenditures were incurred.     Kantor v.


     16
      A taxpayer manifests his “capability” to enter into a
business by his technical expertise to market the new technology
and his financial ability to conduct the business. Scoggins v.
Commissioner, 46 F.3d 950, 953 (9th Cir. 1995), revg. T.C. Memo.
1991-263.
                               - 23 -

Commissioner, supra at 1520 (“our inquiry is limited to the tax

year in which a taxpayer incurs its research expenditure and

claims the section 174 deduction”); Diamond v. Commissioner, 930

F.2d 372, 374-375 (4th Cir. 1991), affg. 92 T.C. 423, 439 (1989);

Levin v. Commissioner, supra at 406 n.3 (“The tax treatment in

1979 depends on circumstances in 1979, not on what happened

later”).

     “In order to qualify for the section 174 deduction, a

taxpayer’s existing or prospective business must be its own and

not that of another entity.”   Kantor v. Commissioner, supra at

1519; see Levin v. Commissioner, supra; Green v. Commissioner,

supra.   There is a distinction drawn in tax law between engaging

in one’s own business and investing in a business of another.

Kantor v. Commissioner, supra at 1519; see Whipple v.

Commissioner, 373 U.S. 193, 202 (1963); Higgins v. Commissioner,

supra at 218.   When it appears “at the time of the research that

a taxpayer’s activities in connection with a new technology were

unlikely to amount to any more than those of an investor, courts

have denied the deduction.”    Kantor v. Commissioner, supra at

1519; see Zink v. United States, supra; Spellman v. Commissioner,

supra; Levin v. Commissioner, supra; Diamond v. Commissioner,

supra; I-Tech R&D Ltd. Pship. v. Commissioner, supra.

     To determine whether the taxpayer manifests the objective

intent to enter into a business of his own with the fruits of
                                - 24 -

R&D, we look to the facts and circumstances of the case.       Of

course, we examine any and all contracts and agreements in the

record.   See Kantor v. Commissioner, supra at 1519 (the

“agreements, and other facts which existed at that time,

sufficiently establish” that the taxpayer did not have the

objective intent of entering into a business); Levin v.

Commissioner, supra at 406.     “[T]he ‘right question’ is ‘whether

the * * * [taxpayer] reasonably anticipated availing [itself] of

the privileges [it] possessed on paper.’” LDL Research & Dev. II,

Ltd. v. Commissioner, 124 F.3d 1338, 1345 (10th Cir. 1997)

(quoting Levin v. Commissioner, supra at 406), affg. T.C. Memo.

1995-172.   We must examine “the expectations of the parties”.

Levin v. Commissioner, supra at 406.     “The legal entitlement must

be backed by a probability of the firm’s going into business.

This ordinarily will be so only when it is in the venture’s

private interest to manufacture and sell any products that the

development effort produces.”     Id. at 407.   “Courts have

repeatedly held that while the probability of a firm’s going into

its own business will satisfy section 174, the mere possibility

of its doing so will not.”    Kantor v. Commissioner, supra at

1520.

     At the time petitioner incurred the R&D expenditures, he did

not have the objective intent to enter into a future business of

his own with the developed technology.    Rather, petitioner’s
                                - 25 -

purpose for engaging in the R&D was to create the developed

technology that could be licensed to CPSG, Inc. for use in CPSG,

Inc.’s existing business.17   For example, petitioner testified as

follows:

          Q:   Okay. And had no further development had
          taken place, what would have happened to CPSG?

          A:   It would have been literally out of business.
          Our [software] products would have been 1992 ilk.
          I’m sure you appreciate just reading the trade
          press how quickly technology moves in this
          industry, and it would have had obsolete products
          that they could no – not only could they not have
          sold them to any new customers, their own customer
          base would have immediately started looking for
          alternative technology. A large part of the
          revenue for these companies came from customer
          support, customer upgrade kinds of revenue, and if
          they hadn’t – if they hadn’t had any improvement
          to the product, the customers would have no reason
          to spend that money, so CPSG would have simply
          been out of business.

          *      *      *       *        *      *      *

          Q:   How did you decide whether to do * * * [the
          development work] as an employee of CPSG or –- or
          as your Schedule C?

          A:   * * * I was concerned that CPSG really didn’t
          have any leverage in a discussion with Computer
          Power Group. If they cancelled the marketing
          agreement, if they cancelled the sublicense –- or
          the submarketer agreement, Computer –- CPSG was
          out of business.
               So, my thought was to create some
          intellectual property ownership outside of
          Computer Power Software Group, and the idea being


     17
      CPSG, Inc.’s initial return position was to deduct the R&D
expenditures on its tax return. CPSG, Inc. ultimately amended
its return, eliminating the deduction, which petitioners then
claimed on their individual tax return.
                                  - 26 -

        that, you know, you own the TV but I own the TV
        changer, so we better cooperate in resolving any
        differences.
             And so that was the thought was to kind of
        create an ownership that I would have personally
        which would help us in protecting CPSG as well.

        *      *        *         *        *      *      *

        A:   * * * And again, having the intellectual
        property ownership in my hands personally meant at
        least we were going to have a discussion about it.


A corporate resolution passed by CPSG, Inc.’s board of directors

stated that petitioner “may undertake such reasonable research

and development activities on * * * [CPSG, Inc.’s] behalf in

order to render and maintain the Company’s products as

commercially viable”.       Indeed, on brief petitioners proposed that

we find that “It was clear to petitioner that in order to save

the business of CPSG more development had to be performed;”

“Petitioner believed that by creating intellectual property

rights outside of the CPSG/CPG/Syndicate relationship he would

have more negotiating leverage regarding any technology that he

developed;” and “Petitioner believed that if he had rights to the

technology he developed and CPG had rights to the underlying

technology, CPG and the Syndicates would have to cooperate with

him.”   On brief, petitioners explained that “When Syndicate

funding ended, additional development had to be done for the

business of CPSG to survive.”
                               - 27 -

     There is no evidence in the record, not even petitioner’s

testimony, that he intended to engage in a business of his own

with the developed technology.   “The fact that a taxpayer may

have taken an active role in directing the research does not, by

itself, place a taxpayer in a trade or business.”    I-Tech R&D

Ltd. Pship. v. Commissioner, T.C. Memo. 2001-10 (citing Green v.

Commissioner, 83 T.C. at 690).   There is no evidence in the

record of any specific plans or forecasts relating to the

probability that petitioner might engage in the marketing of the

developed technology.   Id.   There is no evidence that petitioner

actually marketed the developed technology.   Indeed, it would

have been counterintuitive for petitioner to market the developed

technology to outsiders; CPSG, Inc. was already an established

software marketing entity with existing customers.   All the

publications and marketing materials relating to the developed

technology were created on behalf of CPSG, Inc., not petitioner.

If petitioner himself marketed the developed technology, he would

be competing with his solely owned corporation.   Indeed on brief,

petitioners argued “CPSG was in absolutely the best position in

the universe to market the * * * [Developed Technology].    Not

only was it reasonable for petitioner to attempt to use CPSG to

market the new products, it would have been asinine for him not

to have done so.”
                                 - 28 -

     The record does not demonstrate that petitioner’s R&D

activities amounted to anything more than the development of

property rights that he intended to license to CPSG, Inc. for use

in CPSG, Inc.’s business.     As such, petitioner’s activities

amounted to nothing more than those of a prudent investor.18

“‘[T]he management of investments is not a trade or business for

purposes of section 174.”     Spellman v. Commissioner, 845 F.2d at

150 (quoting Green v. Commissioner, 83 T.C. at 688).

     For the aforesaid reasons, we find that at the time

petitioner incurred the R&D expenditures, he did not have an

objective intent to engage in his own trade or business with the

developed technology.

     Petitioners argue that the Court of Appeals for the Ninth

Circuit’s19 opinion in Scoggins v. Commissioner, 46 F.3d 950 (9th

Cir. 1995), revg. T.C. Memo. 1991-263, supports their contention

that petitioner had a realistic prospect of using the R&D in a

future business of his own.     The facts in Scoggins are similar to

the instant case in some respects.        Both cases involve R&D where

the person (in Scoggins a partnership) performed the R&D by


     18
      There is no evidence of how much time petitioner devoted
to this R&D endeavor. Clearly, petitioner monitored the R&D
process via telephone, one visit to Australia, and electronic
mail communications. However, petitioners do not allege, and we
cannot find, that petitioner’s activities during the time the R&D
expenditures were made were sufficient to constitute a trade or
business.
     19
          To which this case is appealable.
                             - 29 -

contracting the work to others.   In both cases property rights to

the technology resulting from the R&D were retained by the person

or partnership responsible for performing the R&D and in both

cases the owner of those property rights in the technology

licensed the technology to a user in return for a royalty.    Both

petitioner and the partners in Scoggins also had expertise in the

type of technology that was the subject of the R&D.   Finally, in

both cases it was clear that neither petitioner nor the

partnership was engaged in a trade or business at the time that

the R&D expenditures were paid or incurred.   Despite these

similarities, we disagree that Scoggins is dispositive of the

section 174 issue.

     The primary focus of the Court of Appeals’ opinion in

Scoggins, does not appear to have been whether the taxpayers had

the objective intent to enter into a business of their own with

the fruits of the R&D expenditures. Indeed, after reciting the

facts, the Court stated:

       There is no question that Scoggins and Christensen
       had the objective intent to enter into the
       business of marketing the reactor if the reactor
       proved successful. The only question is whether
       they had a realistic prospect of engaging in the
       business as a partnership, or whether by virtue of
       the agreement with the corporation, they had
       deprived the partnership of the capability of
       doing so. [Id. at 953.]

The Court of Appeals then analyzed the taxpayers’ “capability” of

engaging in a trade or business with the fruits of R&D.   In doing
                                 - 30 -

so, the Court considered the taxpayers’ technical expertise,

their financial ability to conduct the business, and whether

their contractual obligations precluded the likelihood of using

the R&D in a future business.     Id.     The Court concluded that the

taxpayers had the capability to use the R&D in a future

business.20   In contrast, in the instant case we have found that

petitioner failed the first part of the realistic prospect test

because he had no objective intent to use the R&D in a future

business of his own.

B.   Other Schedule C Expenses

      In the notice of deficiency, respondent disallowed some of

the expenses that petitioners claimed and deducted on their

Schedules C for the taxable years 1994 and 1996.21       The amounts

of the adjustments at issue are $18,241 and $25,731,

respectively.   In the notice of deficiency, respondent claimed

that petitioners had not “established a business purpose for the

expenses claimed.”




      20
      There is a question whether petitioner had the right to
use the developed technology. His use may have depended upon the
enforceability of the terms of the contract between CPG and CPSG,
Inc. which petitioner testified could be canceled by CPG.
Indeed, this potential problem was one of the reasons why
petitioner decided to structure the R&D contract the way he did.
      21
      Additionally, respondent determined that petitioners were
entitled to deduct an additional $22,275 from their 1995 return.
We presume 1995 is not at issue, since respondent allowed
petitioners a greater deduction than was claimed.
                                - 31 -

     Respondent argues that petitioners failed to substantiate

the expenses deducted in excess of the amount allowed by

respondent.22   Petitioners argue that:     (1) The notice of

deficiency and respondent’s court papers do not provide

petitioners with notice of which expenses were denied, and (2)

petitioners have sufficiently substantiated the deduction of

expenses claimed.   For the reasons detailed below, we believe

petitioners failed to carry their burden.

     Petitioner testified that he received payments for, inter

alia, consulting services performed on behalf of CPSG Ventures.23

Assuming this to be true, we find that petitioners have not

proven entitlement to the disallowed deductions.       We do not find

petitioners’ argument that respondent failed to identify which

deductions were denied persuasive.       Respondent allowed

petitioners to deduct expenses to the extent that they received

reimbursement from CPSG, Inc.    Petitioners are in the unique

position to know those expenses for which they received


     22
      Respondent permitted deductions for reimbursed employee
expenses to the extent such reimbursements were included in
petitioners’ Schedules C gross receipts for the years at issue.
The amounts reimbursed by CPSG, Inc. were $61,640 and $53,618 for
1994 and 1996, respectively.
     23
      For example, on their 1994 return, petitioners reported
$194,317 in gross receipts for CPSG Ventures on which petitioners
claimed an expense deduction of $79,881, leaving a net profit of
$114,436. From the $79,881 in expenses claimed, respondent
allowed $61,640 as a deduction, an amount equal to that which
petitioners included in gross income as reimbursements received
from CPSG, Inc.
                               - 32 -

reimbursement.   The difference between the reimbursed expenses

and the claimed expenses is the expenses for which respondent

denied a deduction.   The category of expenses denied becomes an

important matter as the substantiation requirements vary

depending upon the type of expense claimed as a deduction.

     Generally, ordinary and necessary expenses paid or incurred

in carrying on a trade or business are deductible by an

individual engaged in the trade or business.     Sec. 162(a); sec.

1.162-1(a), Income Tax Regs.   “The determination of whether an

expenditure satisfies the requirements of section 162 is a

question of fact.”    Shea v. Commissioner, 112 T.C. 183, 186

(1999) (citing Commissioner v. Heininger, 320 U.S. 467, 475

(1943)).

     Deductible expenses are subject to substantiation.     Secs.

6001, 274(d).    The basic substantiation requirement is set forth

in section 6001 and provides in pertinent part:

       SEC. 6001. NOTICE OR REGULATIONS REQUIRING
       RECORDS, STATEMENTS, AND SPECIAL RETURNS.

            Every person liable for any tax imposed by
       this title, or for the collection thereof, shall
       keep such records * * * and comply with such rules
       and regulations as the Secretary may from time to
       time prescribe. * * *

The regulations provide that “any person subject to tax * * *

shall keep such permanent books of account or records * * * as

are sufficient to establish the amount of * * * deductions.”

Sec. 1.6001-1(a), Income Tax Regs.      In the event that a taxpayer
                               - 33 -

establishes that deductible expenses have been paid, but he is

unable to substantiate the precise amount, the court may estimate

the amount of such deduction bearing heavily against the

taxpayer.    Cohan v. Commissioner, 39 F.2d 540, 543-44 (2d Cir.

1930).   However, the court cannot make such an estimate unless

the taxpayer presents sufficient evidence to provide a reasonable

basis upon which to make the estimate.    Vanicek v. Commissioner,

85 T.C. 731, 743 (1985).

     The court’s ability to estimate reasonably the amount of a

deduction is curtailed in the case of certain classes of

expenses.    Section 274(d) limits the Court’s estimating ability.

Sanford v. Commissioner, 50 T.C. 823, 827 (1968), affd. per

curiam 412 F.2d 201 (2d Cir. 1969); see Golden v. Commissioner,

T.C. Memo. 1993-602.    Section 274(d) provides:

     SEC. 274(d) Substantiation Required.--No deduction or
     credit shall be allowed--

                 (1) under section 162 or 212 for any traveling
            expense (including meals and lodging while away from
            home),

                 (2) for any item with respect to an activity which
            is of a type generally considered to constitute
            entertainment, amusement, or recreation * * *

                 (3) for any expense for gifts, or

                 (4) with respect to any listed property (as
            defined in section 280F(d)(4)),

     unless the taxpayer substantiates by adequate records
     or by sufficient evidence corroborating the taxpayer’s
     own statement * * *. [Emphasis added.]
                                  - 34 -

See sec. 1.274-5T, Temporary Income Tax Regs., 50 Fed. Reg. 46014

(Nov. 6, 1985).   As applicable here, “listed property” includes

expenses associated with computer equipment and cellular

telephones.    Sec. 280F(d)(4).

     To substantiate a deduction under section 274(d), a taxpayer

must maintain adequate records or present other corroborative

evidence to show, inter alia, the amount of the expense, the date

upon which it was incurred, and the business purpose for the

expenditure.   Sec. 1.274-5T(b), Temporary Income Tax Regs., 50

Fed. Reg. 46014 (Nov. 6, 1985).      To substantiate a deduction by

means of adequate records, the taxpayer must present some type of

documentary evidence.   Sec. 1.274-5T(c)(2)(i), Temporary Income

Tax Regs., 50 Fed. Reg. 46017 (Nov. 6, 1985).

     The parties stipulated that reimbursements received from

CPSG, Inc. were “primarily” for travel and entertainment,

supplies, and telephone expenses.      Respondent allowed as a

deduction the full amount of the expenses associated with the

reimbursements.   Additionally, respondent allowed petitioners to

deduct their automobile expenses as an itemized deduction.

     The substantiation requirements of sections 6001 and 274(d)

require, at a minimum, that petitioners substantiate the expenses

deducted.   Some of the items for which deductions were claimed
                              - 35 -

are section 280F(d)(4) “listed property”.24    These items, as

previously stated, require strict substantiation.    Here,

petitioners failed to detail the expenses denied, the amounts of

those expenses, and the business purpose for those expenses.     We

are not required to, and shall not, guess.

     Petitioners have failed to substantiate sufficiently the

expenses claimed in excess of the amount respondent allowed in

the notice of deficiency.   Furthermore, petitioner’s vague

testimony that all the expenses claimed were for business

purposes is not sufficient.   “It is well settled that we are not

required to accept petitioner’s self-serving testimony in the

absence of corroborating evidence.”    Jacoby v. Commissioner, T.C.

Memo. 1994-612 (citing Lerch v. Commissioner, 877 F.2d 624, 631-

632 (7th Cir. 1989), affg. T.C. Memo. 1987-295); see Geiger v.

Commissioner, 440 F.2d 688, 689 (9th Cir. 1971), affg. per curiam

T.C. Memo. 1969-159; Niedringhaus v. Commissioner, 99 T.C. 202,

212 (1992).   “There must be sufficient evidence in the record to

permit the Court to conclude that a deductible expense was

incurred in at least the amount allowed.”     Jacoby v.

Commissioner, supra (citing Williams v. United States, 245 F.2d

559, 560 (5th Cir. 1957)) (emphasis added).    To permit


     24
      Petitioner testified that part of the deductions claimed
and disallowed were for computer equipment and cellular
telephone. See sec. 280F(d)(4)(A)(v); Vaksman v. Commissioner,
T.C. Memo. 2001-165; Nitschke v. Commissioner, T.C. Memo. 2000-
230.
                                 - 36 -

petitioners a deduction for the amounts shown on their 1994 and

1996 returns, without definitive evidence showing the amounts

expended and the purposes of the expenditures, would be “unguided

largesse”.      See Jacoby v. Commissioner, supra.

      Since petitioners failed to identify their deductions and

the specific amounts, the knowledge of which is unique to them,

we uphold respondent’s determination that petitioners are not

entitled to claim deductions in excess of those amounts

determined in the notice of deficiency.

C.   Accuracy-Related Penalties

      Respondent determined penalties pursuant to section 6662 in

the amounts of $2,346, $3,354, and $126,858 for the taxable years

1994, 1995, and 1996, respectively.       Respondent based his

determination on negligence or disregard of the tax rules and

regulations and/or a substantial understatement of income tax.

Respondent’s determination is presumed correct, and the burden

lies with petitioners to demonstrate that respondent’s penalty

determination was in error.25     Rule 142(a).

     Section 6662(a) imposes a 20-percent penalty on the portion

of an underpayment of tax attributable to, inter alia, negligence

and/or a substantial understatement of income tax.       Sec. 6662(a)

and (b).      “Underpayment” is defined as the amount by which the

tax imposed exceeds the excess of the sum of the amount shown by


      25
           See supra note 13.
                                - 37 -

the taxpayer on his return plus the amounts not so shown

previously assessed (or collected without assessment) over the

amount of rebates made.   Sec. 6664(a).

     “Negligence” is defined as “any failure to make a reasonable

attempt to comply with the provisions of this title” and

“disregard” means “any careless, reckless, or intentional

disregard.”   Sec. 6662(c).   Similarly, caselaw defines negligence

as a lack of due care or “‘the failure to do what a reasonable

and ordinarily prudent person would do under the circumstances.’”

Freytag v. Commissioner, 89 T.C. 849, 887 (1987) (quoting

Marcello v. Commissioner, 380 F.2d 499, 506 (5th Cir. 1967),

affg. on this issue 43 T.C. 168 (1964) and T.C. Memo. 1964-299)),

affd. 904 F.2d 1011 (5th Cir. 1990), affd. 501 U.S. 868 (1991).

Pursuant to the regulations, “‘Negligence’ also includes any

failure by the taxpayer to keep adequate books and records or to

substantiate items properly.”    Sec. 1.6662-3(b)(1), Income Tax

Regs.

     There is a “substantial understatement” of tax if “the

amount of the understatement for the taxable year exceeds the

greater of” (1) 10 percent, or (2) $5,000.    Sec. 6662(d)(1)(A).

An “understatement” means the excess of the amount of tax

required to be shown on the return for the year over the amount

of tax shown on the return.   Sec. 6662(d)(2)(A).   However, as

applicable here, the amount of the understatement is reduced by
                              - 38 -

that portion of the understatement which is attributable to any

item if the relevant facts affecting the item’s tax treatment are

adequately disclosed on the return or a statement attached to the

return and there is a reasonable basis for the tax treatment of

such item.   Sec. 6662(d)(2)(B).

     Section 6664(c) provides an exception to the penalty imposed

under section 6662(a).   “No penalty shall be imposed under this

part with respect to any portion of an underpayment if it is

shown that there was a reasonable cause for such portion and that

the taxpayer acted in good faith with respect to such portion.”

Sec. 6664(c)(1).   The determination of whether the taxpayer acted

with reasonable cause and in good faith is made on a case-by-case

basis, contemplating all of the relevant facts and circumstances.

Sec. 1.6664-4(b)(1), Income Tax Regs.

     With respect to the deduction of R&D expenses, we cannot

find under the facts before us that petitioners acted

unreasonably by claiming the section 174 deductions.    The facts

of this case are unique, and petitioner testified that he relied

upon the advice of a tax professional.   See id.   Accordingly,

penalties associated with such deductions are not appropriate.

     With respect to the penalties relating to the other

disallowed deductions claimed on petitioners Schedules C for the

tax years 1994 and 1996, petitioners failed to substantiate the

deductions claimed.   As previously stated, petitioners are in the
                              - 39 -

unique position to determine for which expenses CPSG, Inc.

reimbursed them.   The balance are those deductions which

respondent denied.   Incomplete copies of credit card statements

and petitioner’s self-serving testimony are not sufficient to

substantiate the deductions claimed.    Accordingly, petitioners

have failed to demonstrate that they were not negligent in

claiming these disallowed deductions.    Xuncax v. Commissioner,

T.C. Memo. 2001-226; see sec. 1.6662-3(b)(1), Income Tax Regs.

     Lastly, we turn to whether a penalty is appropriate due to

the double charitable contribution deduction claimed by

petitioners on their 1996 return.   The evidence demonstrates that

petitioners made a mistake in preparing their 1996 return.    On

brief, petitioners argued that, relying upon Rev. Proc. 96-58,

1996-2 C.B. 390, they had made adequate disclosure of the

charitable contribution deduction by completing the charitable

contribution portion of Schedule A, Itemized Deductions.    Rev.

Proc. 96-58, supra, provides that additional disclosure of facts

is not necessary to fall within the auspices of section

6662(d)(2)(B), which allows for the reduction in the amount of

the understatement, provided that the forms and attachments are

completed in a clear manner and in accordance with their

instructions.   Rev. Proc. 96-58, sec. 4.01, supra.   Although Rev.

Proc. 96-58 is applicable to whether a taxpayer has disclosed

sufficient facts to be entitled to reduce the amount of the
                                - 40 -

understatement, it “does not apply with respect to any other

penalty provision (including the negligence or disregard

provisions of the §6662 accuracy-related penalty).”       We agree

with respondent that a prudent taxpayer would have been warned of

a potential problem with his return by an additional $60,000

deduction.   Thus, we find that respondent’s imposition of a

penalty for an erroneously claimed double deduction was

substantially justified.

     To reflect the foregoing,



                                           Decisions will be entered

                                      under Rule 155.




Reporter’s Note: This report was modified by Order dated Sept. 4, 2003.
