                       T.C. Memo. 2017-159



                 UNITED STATES TAX COURT



 MICHAEL E. KOHN AND CATHERINE K. KOHN, Petitioners v.
   COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 20771-96.                       Filed August 14, 2017.


Michael E. Kohn and Catherine K. Kohn, pro sese.

Thomas C. Pliske and Catherine S. Tyson, for respondent.
                                         -2-

[*2]         MEMORANDUM FINDINGS OF FACT AND OPINION


       GALE, Judge: Respondent determined the following deficiencies and

accuracy-related penalties under section 6662(a),1 with respect to petitioners’ 1991

and 1992 taxable years:2

                                                     Penalty
                       Year       Deficiency       sec. 6662(a)
                       1991        $46,727           $9,332
                       1992          36,067            7,213

       In an amendment to his answer, respondent conceded the section 6662(a)

accuracy-related penalty for 1992 and instead asserted that petitioners are liable

for a $26,935 section 6663 fraud penalty for that year.

       Following concessions by the parties,3 the issues for decision are:




       1
       Unless otherwise indicated, section references are to the Internal Revenue
Code of 1986, as in effect for the years at issue, all Rule references are to the Tax
Court Rules of Practice and Procedure, and all dollar amounts are rounded to the
nearest dollar.
       2
       The Court stayed proceedings pending the resolution of a criminal
investigation involving Mr. Kohn and upon the subsequent illness of petitioners’
former counsel, since withdrawn.
       3
        At trial petitioners conceded that they failed to report $5,147 of taxable
interest income for 1991.
                                        -3-

[*3] (1) whether petitioners failed to report discharge of indebtedness income of

$16,232 for 1991 arising from Mr. Kohn’s interest in Mazur & Raben (a law firm

partnership);

      (2) whether petitioners failed to report $28,4044 of capital gain for 1991

arising from a deemed distribution of money from Mazur & Raben to Mr. Kohn

pursuant to section 752(b);

      (3) whether petitioners are entitled to deduct Mr. Kohn’s $30,287

distributive share of a partnership loss for 1991 arising from his interest in Mazur

& Raben;

      (4) whether petitioners are entitled to a $117,738 cost of goods sold expense

as reported on their Schedule C, Profit or Loss from Business, for the Kohn

Partnership (a law firm partnership) for 1991;

      (5) whether petitioners are liable for an accuracy-related penalty under

section 6662(a) for 1991;




      4
        In the notice of deficiency respondent determined pursuant to secs. 752(b)
and 731(a)(1) that Mr. Kohn received a $31,596 distribution in excess of his basis
in his Mazur & Raben partnership interest, resulting in capital gain. However, on
brief respondent calculates the basis for 1991 as $3,192 higher than in the notice
of deficiency, effectively conceding $3,192 of the unreported capital gain he
determined for 1991.
                                        -4-

[*4] (6) whether petitioners are entitled to deduct Mr. Kohn’s $537 distributive

share of a partnership loss for 1992 arising from his interest in Mazur & Raben;

      (7) whether petitioners are entitled to a $121,065 casualty loss deduction for

1992; and

      (8) whether petitioners are liable for a fraud penalty under section 6663 with

respect to their underpayment of tax for 1992.

                              FINDINGS OF FACT

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

this reference the stipulation of facts and the accompanying exhibits. Petitioners

are husband and wife, and they resided in Missouri when they filed their timely

petition.

I.    Petitioners’ Education and Background

      Mrs. Kohn received a B.A. from Stanford University and a J.D. from Saint

Louis University School of Law. At the time of trial Mrs. Kohn was a practicing

attorney specializing in estate planning and small business counseling and was

admitted to the United States Tax Court Bar. She has rendered tax advice to

clients on occasion.

      Mr. Kohn received an undergraduate degree, as well as joint J.D. and

M.B.A. degrees, from Saint Louis University. Thereafter he received an LL.M.
                                       -5-

[*5] degree from the New York University School of Law taxation program. Mr.

Kohn returned to St. Louis sometime in 1980 and began work as an associate in

the tax division at Bryan, Cave, McPheeters & McRoberts (Bryan Cave), where he

specialized in partnership taxation. At the end of 1987 Mr. Kohn left Bryan Cave

and joined the Mazur & Raben law firm as a general partner, commencing

January 1, 1988. Mazur & Raben at all times had 10 or fewer partners, each of

whom was a natural individual.5

II.   Mr. Kohn’s Involvement with Mazur & Raben

      A.    Mazur & Raben’s Formation, Liabilities, and Dissolution

      The Mazur & Raben law firm partnership was formed by four attorneys in

St. Louis during the summer of 1983. Those four attorneys entered into and

guaranteed a lease of office space with Grosvenor, International (Grosvenor

property) in 1983. In 1984 the same partners signed and guaranteed a $400,000

promissory note at Centerre Bank National Association, later succeeded by The

Boatmen’s National Bank of St. Louis (Boatmen’s), for leasehold improvements to

the Grosvenor property. In 1985 Mazur & Raben admitted several new partners,


      5
        Given Mazur & Raben’s composition and the absence of any indication
that it made an election under sec. 6231(a)(1)(B)(ii), Mazur & Raben was a small
partnership pursuant to sec. 6231(a)(1)(B) from its inception to its dissolution.
Thus the provisions of secs. 6221 to 6234 do not apply to the partnership.
                                       -6-

[*6] one of whom signed a lease for office space with the Forsythe Group

(Forsythe property).6 Mazur & Raben’s partners thereupon took out a $500,000

loan with Lindell Trust (Lindell) for leasehold improvements to the Forsythe

property.

      Mr. Kohn joined Mazur & Raben as a general partner on January 1, 1988, at

which point David Jones was the managing partner. Upon joining Mazur & Raben

Mr. Kohn did not sign a partnership agreement. At some point after Mr. Kohn

joined the partnership, Mazur & Raben entered into a line of credit loan

arrangement with Lindell which Mr. Kohn guaranteed along with his partners.

During his tenure at Mazur & Raben Mr. Kohn did not guarantee the lease

agreements for the Grosvenor or Forsythe property, nor did he guarantee the

Boatmen’s or Lindell leasehold improvement loan.

      Mazur & Raben dissolved between late May and mid-June of 1989, at

which time four of its former partners, including Mr. Kohn, formed a new

partnership under the name “Frankel, Kaiser, Kohn and Jones”. However, Mr.

Kohn withdrew from that partnership on June 30, 1989, whereupon it dissolved.




      6
       New office space was deemed necessary because of problems with the air
conditioning at the Grosvenor property.
                                        -7-

[*7] Mr. Kohn worked briefly with another law firm and then commenced working

in a law practice with Mrs. Kohn.

      Upon Mazur & Raben’s dissolution Mr. Jones assumed responsibility for

winding up the partnership’s affairs by collecting accounts receivable and settling

pending lawsuits brought against the partnership by Grosvenor, International;

Boatmen’s; Forsythe Group; and Lindell. This process continued from mid-June

of 1989 into 1992. In order to create a fund (Mazur & Raben settlement fund) out

of which to make partial payments to settle with the aforementioned creditors, on

March 7, 1991, Mazur & Raben’s former partners signed a “Settlement Agreement

and Mutual Release” (Mazur & Raben settlement agreement). Mr. Kohn agreed to

pay $55,000 as part of the Mazur & Raben settlement agreement, constituting

6.2% of the Mazur & Raben settlement fund. The Mazur & Raben settlement

agreement included a provision entitled “Special Tax Allocation”, which

provided:

             In recognition of the contribution by each of the various
      Partners to the settlement of the Lawsuits, to each Partners’ [sic]
      allocation of income and loss for the year in which the Closing
      occurs[7] shall be credited the percentage of loss created by the
      settlement and satisfaction of the Lawsuits equal to the pro-rata

      7
      “Closing” for this purpose occurred when the funds from the Mazur &
Raben settlement fund were distributed to creditors in settlement of the lawsuits in
1991.
                                         -8-

[*8] contribution by such Partner to the fund created by the terms of
     this Agreement. It is specifically recognized that this is a special
     allocation of losses made by the Partners in recognition of the
     contributions to the settlement of the Lawsuits and in lieu of and in
     substitution for the allocation of losses pursuant to the respective
     interests of the Partners in the Law Partnerships.

      Between March 7 and 8, 1991, Mazur & Raben’s former partners entered

into a settlement agreement with Lindell (Lindell settlement agreement) to resolve

the lawsuit that Lindell had filed against the partners, including Mr. Kohn. At that

time Mazur & Raben’s outstanding indebtedness to Lindell was $572,597; Mazur

& Raben agreed to pay $370,000 to settle the Lindell debt and Lindell forgave the

balance. The $55,000 that Mr. Kohn agreed to pay into the Mazur & Raben

settlement fund was specifically allocated to the Lindell settlement agreement, and

Mr. Kohn paid that amount to Lindell by means of a $10,000 cash payment on

March 18, 1991, and the execution of a $45,000 promissory note to Lindell

payable over two years.8 Petitioners paid $15,000 of the principal on the note later


      8
        At trial Mr. Kohn testified that he paid $55,000 to Lindell in addition to the
$55,000 that he contributed to the Mazur & Raben settlement fund. However, this
claim is contradicted by Mazur & Raben’s accountant’s workpapers, which show
that the Lindell debt was settled exclusively by partner funds contributed to the
Mazur & Raben settlement fund, $55,000 of which was specifically earmarked as
having been contributed by Mr. Kohn. Furthermore, petitioners have failed to
produce any evidence substantiating an additional payment of $55,000 to Lindell
apart from the one documented in the accountant’s workpapers. Thus, we decline
to accept Mr. Kohn’s self-serving testimony to this effect.
                                        -9-

[*9] in 1991 and paid the remaining $30,000 balance in 1992. In 1991 Mazur &

Raben also settled its $151,480 outstanding indebtedness to Boatmen’s; Mazur &

Raben paid $92,274 to settle the debt and Boatmen’s forgave the balance. In the

aggregate, Lindell and Boatmen’s forgave $261,803 of Mazur & Raben’s

indebtedness in 1991.

      B.     Mazur & Raben’s Forms 1065 and Mr. Kohn’s Schedules K-1

      Mazur & Raben filed Forms 1065, U.S. Partnership Return of Income, and

Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., for 1988

through 1991 which reflect the income and tax items resulting from its operations

until late spring 1989 and the winding up of its affairs thereafter.9 Mr. Kohn

received a Schedule K-1 from Mazur & Raben for each year from 1988 through

1991.10 For each of those years Mr. Kohn reported his share of the income and tax




      9
       Although the partnership name on the Forms 1065 and Schedules K-1 for
1989 through 1991 is reported as “Frankel, Kaiser, & Jones”, the 1989 Form 1065
indicates that the firm was “formerly Mazur & Raben”. Petitioners contend,
respondent has not disputed, and we are convinced that the 1989, 1990, and 1991
Forms 1065 reflect the winding up of Mazur & Raben.
      10
       The parties do not address and the record does not disclose whether Mr.
Kohn received a 1992 Schedule K-1 from Mazur & Raben.
                                           - 10 -

[*10] items as reflected on the Schedules K-1 on his personal tax return (which he

filed jointly with Mrs. Kohn).11

        For 1988 through 1991 Mr. Kohn’s Mazur & Raben Schedules K-1 reported

as follows:

                           1988            1989           1990           1991
                       Schedule K-1    Schedule K-1   Schedule K-1   Schedule K-1
 % Interest
  profits/losses         10.962%          16.88%        16.88%             6.2%
 Capital
  contributions             ---              ---          ---          $55,000
 Liabilities             $95,460         $125,475      $123,045             ---
                                                                       1
 Income                    46,388            ---            426            16,232
 Loss                      (3,804)          (6,567)         (34)       (30,287)
 Other
  deductions                ---             (3,584)       ---               ---
 Distributions            (98,084)        (34,377)        ---               ---
        1
            Cancellation of indebtedness income.

        Mazur & Raben’s 1990 Form 1065 reported total liabilities of $724,077 as

of the end of the year, comprising $151,480 of the Boatmen’s indebtedness and

$572,597 of the Lindell indebtedness. Mazur & Raben’s 1991 Form 1065



        11
       There was one exception: the $16,232 of cancellation of indebtedness
income allocated to Mr. Kohn on the 1991 Schedule K-1, as further discussed
infra.
                                         - 11 -

[*11] reported total liabilities of $724,077 as of the beginning of the year and zero

liabilities as of the end of the year.

III.   The Kohn Partnership

       As noted, after Mazur & Raben’s dissolution in 1989, Mr. Kohn--after brief

stints with two other firms--commenced a law practice with Mrs. Kohn in

September 1989. Mr. and Mrs. Kohn referred to the law firm as the “Kohn

Partnership” (and so designated it on their letterhead), but they reported the results

of its operations for 1991, 1992, and 1993 on a Schedule C (as more full described

infra pp. 15-17) rather than a Schedule E, Supplemental Income and Loss.

IV.    Petitioners’ Docks at Harbor Point Marina and the Flood of 1993

       On February 3, 1993, petitioners purchased four floating boat docks for

$144,600 from Harbor Consultants, Inc., a company controlled by a former client

of Mr. Kohn’s, Jerry Jaycox. The docks were at the Harbor Point Marina12 in St.

Charles County, Missouri, near the confluence of the Missouri and Mississippi

Rivers. Mr. Jaycox had promised petitioners upon purchasing the docks that he




       12
          The Harbor Point Marina was a condominium arrangement, referred to in
trial testimony as a “dockominium”, where each boat slip and dock was
individually owned and other portions of the marina were common elements
jointly owned by the dock owners.
                                        - 12 -

[*12] would rent them during 1993 and then by yearend either buy them back

himself or secure a third party to do so.

      In the spring through fall 1993 the Missouri and Mississippi Rivers flooded

so severely that the President determined St. Charles County warranted assistance

under the Disaster Relief and Emergency Assistance Act.

      On October 4, 1993, Mr. Jaycox informed Mr. Kohn that he had secured a

purchaser for petitioners’ docks. Mr. Jaycox asked petitioners to sign a document

entitled “Sale Contract” which listed petitioners’ names, the specific dock units to

be sold, and a sale price of $142,000. Petitioners signed the document and

returned it to Mr. Jaycox that day. On October 5, 1993, Mr. Kohn received a fax

of a sale contract with the same terms listing Mr. and Mrs. John Blackstock as the

purchasers. Upon receiving the contract, Mr. Kohn on the same day faxed a copy

to his contact at the Bank of Alton, which had financed petitioners’ purchase of

the docks, to “let him know that the loan would be paid off * * * very quickly”.

Transcript of record at 424, Blackstock v. Kohn, St. Louis County Mo. Cir. Ct.

(1997) (No. 685655).13

      13
        Mr. Kohn made this statement in his testimony in a 1997 St. Louis County
Circuit Court action in which the Blackstocks alleged that Mr. Kohn had
committed fraud and professional malpractice, among other things, for his role in
advising them to claim casualty loss deductions with respect to their Harbor Point
                                                                      (continued...)
                                        - 13 -

[*13] On October 15, 1993, petitioners signed their joint Federal income tax

return for 1992, claiming a $121,065 casualty loss deduction on the four Harbor

Point docks on Schedule A, Itemized Deductions, as further detailed in an attached

Form 4684, Casualties and Thefts. Respondent received the return on October 19,

1993. On October 22, 1993, petitioners closed on the sale of the docks to the

Blackstocks for $142,000. Petitioners did not make any improvements to the

docks while they owned them.

V.    Mr. Kohn’s Engagement by the Blackstocks

      During the late summer and early fall of 1993 Mr. Kohn was seeking clients

in the St. Charles County area by holding informational seminars on claiming

casualty loss deductions for flood-damaged property. Mr. Kohn met Mr.

Blackstock, a fellow dock owner at Harbor Point Marina, at one such seminar on

September 21, 1993. Sometime between that date and October 22, 1993, Mr.

Blackstock engaged Mr. Kohn to prepare amended returns for 1989, 1990, 1991,




      13
        (...continued)
docks (Blackstock lawsuit). At the trial in the instant case respondent initially
sought to introduce excerpts from Mr. Kohn’s testimony in the Blackstock lawsuit.
When petitioners objected on the grounds of completeness, the parties stipulated a
significantly larger portion of the transcript of the trial in the Blackstock lawsuit,
with respect to which neither party reserved any objection. We treat Mr. Kohn’s
statements therein as party admissions under Fed. R. Evid. 801(d)(2)(A).
                                       - 14 -

[*14] and 1992 on behalf of the Blackstocks in order to claim casualty loss

deductions.14

      Sometime on October 22, 1993, after closing on the sale of petitioners’

docks, Mr. Kohn met with Mr. Blackstock to discuss the preparation of the

Blackstocks’ amended returns, at which time Mr. Blackstock informed Mr. Kohn

that he intended to claim a casualty loss deduction on the four docks the

Blackstocks had just purchased from petitioners. As a result of this discussion Mr.

Kohn prepared amended Federal and Missouri income tax returns on behalf of the

Blackstocks for 1989 through 1992, claiming casualty loss deductions on 17

docks, including the four that the Blackstocks had purchased from petitioners and

for which petitioners had claimed a casualty loss deduction on the 1992 return

they signed a week before. On October 29, 1993, Mr. Kohn signed the amended

returns as a return preparer and presented them to Mr. Blackstock.




      14
         Pursuant to sec. 165(i) a taxpayer may elect to deduct a casualty loss
attributable to a federally declared natural disaster for the year immediately
preceding the taxable year in which the disaster occurred. If such an election is
made, the casualty will be treated as having occurred in the taxable year for which
the loss is claimed. Sec. 165(i)(2). Furthermore, pursuant to sec. 172 an
individual may carry back an unused casualty loss as a net operating loss
deduction to each of the three taxable years preceding the taxable year of the
casualty.
                                        - 15 -

[*15] By June of 1995 respondent had commenced an audit of the Blackstocks’

amended returns and challenged the claimed casualty loss deductions for the four

docks the Blackstocks had purchased from petitioners on the grounds that the

Blackstocks did not own the docks at the time of the casualty (i.e., the flood).

Respondent ultimately disallowed the casualty loss deductions.

VI.   Mr. Kohn’s 2002 Criminal Conviction

      On October 3, 2002, Mr. Kohn pleaded guilty to and was convicted of one

count of violating section 7212 for obstructing the administration of the internal

revenue laws by creating fictitious debenture transactions to reduce clients’

Federal income tax and crafting fee arrangements based on tax reduction.

VII. Petitioners’ Returns and Respondent’s Audit

      Petitioners timely filed a joint Federal income tax return for 1991. The

Schedule C attached to the return reported a proprietor and business name of

“MICHAEL E KOHN” and a principal business of “ATTORNEY”, and included a

$64,238 “AMERICAN BANK SETTLEMENT” and a $53,500 “LINDELL

TRUST SETTLEMENT” in cost of goods sold. Petitioners’ 1991 return also

included a Schedule E, which reported a $30,287 nonpassive loss from the
                                       - 16 -

[*16] “FRANKEL, KAISER & JONES” partnership;15 the Schedule E did not

report any cancellation of indebtedness income from the partnership. Petitioners’

1991 return did not report capital gains from any source, partnership or otherwise.

      Petitioners’ 1992 return reported adjusted gross income of $248,082 and, as

previously noted, claimed a $121,065 casualty loss deduction on Schedule A. The

attached Form 4684 specified that petitioners claimed a casualty loss deduction

with respect to “4 DOCK UNITS” acquired on February 3, 1993, and attributed

fair market values to the dock units before and after the casualty of $145,973 and

zero, respectively.16 The foregoing information was reported on Section A of the

Form 4684, the section designated for reporting casualty losses with respect to

personal use property rather than property used in a trade or business or held for

income-producing purposes.

      Petitioners’ 1992 return also included a Schedule E which claimed a $537

nonpassive loss from the “FRANKEL, KAISER & JONES” partnership17 and a



      15
       This partnership was the successor to the Mazur & Raben partnership. See
supra note 9.
      16
        Insofar as the record discloses, petitioners did not obtain an appraisal of
any damage their docks may have sustained as a result of the flooding before filing
their 1992 return.
      17
           See supra note 9.
                                      - 17 -

[*17] Schedule C listing a proprietor and business name of “MICHAEL E KOHN”

and principal business of “ATTORNEY”.

      By 1994 respondent had commenced an audit of petitioners’ 1991 and 1992

returns.

      Petitioners signed a joint Federal income tax return for 1993 on April 1,

1996, which respondent received on April 8, 1996. The 1993 return included a

Schedule C listing a proprietor of “MICHAEL E KOHN”, principal business of

“ATTORNEY”, and gross receipts of $1,185,856.

VIII. Respondent’s Notice of Deficiency and Amendment to Answer

      Respondent issued a notice of deficiency to petitioners on June 27, 1996,

with the following adjustments to petitioners’ 1991 and 1992 returns:

      (a) a disallowance of the $30,287 and $537 “FRANKEL, KAISER &

JONES” partnership loss deductions claimed for 1991 and 1992, respectively;

      (b) a determination that petitioners failed to report Mr. Kohn’s $16,232

distributive share of Mazur & Raben’s discharge of indebtedness income and

capital gain of $31,596 stemming from a deemed distribution in excess of Mr.

Kohn’s basis in his Mazur & Raben partnership interest for 1991;

      (c) a disallowance of the $117,738 of cost of goods sold reported on the

1991 Schedule C;
                                        - 18 -

[*18] (d) a disallowance of the $121,065 casualty loss deduction claimed for

1992; and

      (e) a determination that petitioners were liable for section 6662(a) accuracy-

related penalties for 1991 and 1992.

      Petitioners filed a timely petition for redetermination.

      In an amendment to his answer respondent conceded the section 6662(a)

accuracy-related penalty for 1992 and instead asserted that petitioners were liable

for a section 6663 fraud penalty.

                                       OPINION

      The Commissioner’s determinations as set forth in a notice of deficiency are

generally presumed correct, and the taxpayer bears the burden of proving those

determinations wrong. See Welch v. Helvering, 290 U.S. 111, 115 (1933); see

also Rule 142(a)(1). However, as to the fraud penalty under section 6663, as more

fully discussed infra, the burden of proof rests with the Commissioner to

demonstrate fraud by clear and convincing evidence. See sec. 7454(a); Rule

142(b); Rowlee v. Commissioner, 80 T.C. 1111, 1123 (1983).
                                         - 19 -

[*19] I.     1991

      A.     Partnership Income

      Under section 702(a) a partner must recognize his distributive share of

partnership income or loss; such recognition is reflected in the partner’s adjusted

basis in his partnership interest pursuant to section 705(a). A partner can deduct

his distributive share of partnership loss to the extent of his adjusted basis in his

partnership interest at the end of the partnership year in which the loss occurred.

Sec. 704(d). Section 752(a) provides that any increase in a partner’s share in

partnership liabilities shall be treated as a contribution of money by the partner to

the partnership, increasing the partner’s basis in his partnership interest. See sec.

722. Conversely, any decrease in the partner’s share of the partnership liabilities

is treated as a distribution of money by the partnership to the partner under section

752(b) and results in the recognition of capital gain to the extent the distribution

exceeds the partner’s adjusted basis in his partnership interest. Sec. 731(a)(1).

      In 1991 Mazur & Raben settled its $151,480 Boatmen’s indebtedness with a

payment of $92,274 and its $572,597 Lindell indebtedness with a payment of

$370,000, resulting in a total of $261,803 in cancellation of indebtedness income18

      18
       Neither party disputes that the cumulative $261,803 of indebtedness from
which Mazur & Raben was relieved in 1991 constitutes discharge of indebtedness
                                                                    (continued...)
                                         - 20 -

[*20] and the reduction of Mazur & Raben’s outstanding liabilities from $724,077

at the beginning of 1991 to zero at the end. As a result of these transactions,

respondent contends that petitioners must include in income Mr. Kohn’s $16,232

distributive share, on the basis of his 6.2% contribution to the Mazur & Raben

settlement fund and the special allocation based thereon, of Mazur & Raben’s

discharge of indebtedness income as well as a $123,045 deemed distribution under

section 752(b) of the partnership liabilities allocated to Mr. Kohn on his 1990

Schedule K-1. Respondent argues that the deemed distribution under section

752(b) reduced Mr. Kohn’s adjusted basis in his partnership interest to zero and

triggered a $31,596 capital gain which petitioners must also include in income

under section 731(a)(1). Respondent finally contends that because Mr. Kohn had

no remaining basis in his partnership interest with which to offset his $30,287

distributive share of partnership loss for 1991, petitioners are not entitled to the

deduction they claimed in this amount for 1991 and must increase their income

accordingly.

      Petitioners counter that under Missouri law Mr. Kohn was not personally

liable for any of Mazur & Raben’s debts, and as a result Mr. Kohn had no


      18
       (...continued)
income realized by the partnership.
                                       - 21 -

[*21] partnership liability from which he could have been relieved. Consequently,

petitioners argue that they are not required to recognize any of Mazur & Raben’s

cancellation of indebtedness income and that no deemed distribution of money to

Mr. Kohn was triggered under section 752(b).

             1.    Cancellation of Indebtedness Income

      We begin our analysis by determining whether Mr. Kohn must recognize

any portion of the $261,803 of discharge of indebtedness income Mazur & Raben

realized in 1991. In general, gross income includes income from the discharge of

indebtedness. Sec. 61(a)(12); United States v. Kirby Lumber Co., 284 U.S. 1

(1931). Income realized by a partnership under section 61(a)(12) must be

recognized by the partners as ordinary income under section 702(a)(8). See

Gershkowitz v. Commissioner, 88 T.C. 984, 1008-1009 (1987). The recognition

of such income provides each partner with an increase in the adjusted basis in his

partnership interest under section 705. Id. at 1008.

      Under the Mazur & Raben settlement agreement, each partner, including

Mr. Kohn, agreed that his distributive share of partnership income and loss for

1991 would be calculated according to the percentage of funds that each had

contributed towards the Mazur & Raben settlement fund. Mr. Kohn contributed

$55,000, or 6.2% of the $895,500 total, and thus Mazur & Raben allocated 6.2%,
                                       - 22 -

[*22] or $16,232, of its $261,803 in discharge of indebtedness income to Mr.

Kohn on his 1991 Schedule K-1. Petitioners contend that this allocation lacks

substantial economic effect under section 704(b)(2) because Mr. Kohn was not

personally liable for any of the debt from which Mazur & Raben was relieved, and

therefore this discharge of indebtedness income must be reallocated to Mazur &

Raben’s other partners.

      Petitioners’ attempt to frame this issue as one of substantial economic effect

is misguided. The basic principle that partners must recognize as ordinary income

their distributive share of partnership discharge of indebtedness income is well

established, see Gershkowitz v. Commissioner, 88 T.C. at 1008, and generally

does not implicate the doctrine of substantial economic effect nor does it depend

on a partner’s personal liability on the obligation from which the partnership is

relieved. Indeed, in Gershkowitz we held that partners must recognize their

distributive share of the discharge of indebtedness income realized by a

partnership under section 61(a)(12) even as to nonrecourse debts for which no

partner bore any personal liability. See id. at 1006-1008. Therefore, petitioners’

contention that a partner may only be allocated, or need only recognize, that

portion of a partnership’s discharge of indebtedness income which corresponds
                                        - 23 -

[*23] to those obligations for which the partner is personally liable is without

merit.19

      In sum, petitioners must recognize Mr. Kohn’s 6.2% distributive share, or

$16,232, of Mazur & Raben’s discharge of indebtedness income for 1991,

increasing Mr. Kohn’s adjusted basis in his partnership interest to that extent. See

sec. 705(a)(1). We sustain respondent’s determination to that effect.

             2.    Mr. Kohn’s Share of Mazur & Raben’s Liabilities and Deemed
                   Distribution Under Section 752(b)

      We next consider Mr. Kohn’s share of Mazur & Raben’s liabilities at the

beginning of 1991 and any deemed distribution under section 752(b) that may

have occurred as a result of the elimination of the partnership’s outstanding

liabilities during 1991 when it settled with its creditors. This issue turns on which

version of the regulations under section 752 applies to the Mazur & Raben

liabilities in question. The original regulations, as promulgated in 1956 and

applicable to all partnership liabilities assumed or incurred before January 30,




      19
         Furthermore, we note that even though petitioners strenuously argue that
the allocation of Mazur & Raben’s discharge of indebtedness income to Mr. Kohn
in accordance with the terms of the Mazur & Raben settlement agreement lacks
substantial economic effect and thus must be disregarded, petitioners include this
allocation in their calculation of Mr. Kohn’s adjusted basis in his partnership
interest for 1991. Petitioners cannot have it both ways.
                                        - 24 -

[*24] 1989 (1956 regulations), provide that a partner’s share of recourse20

partnership liabilities is determined in accordance with his ratio for sharing losses

under the partnership agreement. Sec. 1.752-1(e), Income Tax Regs., T.D. 6175,

1956-1 C.B. 298, 300. By contrast, the temporary regulations under section 752,

which apply to all partnership liabilities assumed or incurred between January 30,

1989, and December 27, 1991, sec. 1.752-4T, Temporary Income Tax Regs., 53

Fed. Reg. 53140, 53160-53161 (Dec. 30, 1988), and the final regulations under

section 752, which apply to all partnership liabilities assumed or incurred after

December 28, 1991, sec. 1.752-5, Income Tax Regs., T.D. 8380, 1992-1 C.B. 218,

226, apply an economic risk of loss analysis to determine a partner’s share of

recourse partnership liabilities. Under those versions of the regulations, a

partner’s share of recourse partnership liabilities depends on the extent to which,

taking into consideration all of the facts and circumstances (including personal

guaranties and applicable State law), that partner would be personally obligated to

make a payment to any person or creditor if all of the partnership liabilities

became due and payable in a constructive liquidation scenario. See sec. 1.752-


      20
        In the case of nonrecourse partnership liabilities--i.e., where “none of the
partners have any personal liability with respect to the partnership liability”--each
partner’s share of such liabilities is equal to his share of partnership profits. Sec.
1.752-1(e), Income Tax Regs., T.D. 6175, 1956-1 C.B. 298, 300.
                                         - 25 -

[*25] 1T(d)(3)(D)(1), Temporary Income Tax Regs., 53 Fed. Reg. 53147 (Dec. 30,

1988); sec. 1.752-2(b)(3), Income Tax Regs.

      Petitioners argue that under Missouri law Mr. Kohn was not personally

liable for any partnership debts incurred before his admission to Mazur & Raben,

and thus Mr. Kohn had no share of partnership liabilities from which he could

have received a deemed distribution under section 752(b) for 1991. In 1988, when

Mr. Kohn was admitted to the partnership, Missouri law provided that “[a] person

admitted as a partner into an existing partnership is liable for all the obligations of

the partnership arising before his admission as though he had been a partner when

such obligations were incurred, except that this liability shall be satisfied only out

of partnership property”; i.e., in Missouri a newly admitted partner was not

personally liable for preexisting partnership debts. Mo. Ann. Stat. sec. 358.170

(West 1988). Petitioners’ argument would be colorable if either the temporary or

final regulations under section 752 determined Mr. Kohn’s share of Mazur &

Raben’s liabilities, as the bulk of Mazur & Raben’s debts were incurred before

Mr. Kohn’s admittance to the partnership. However, because the liabilities at

issue were incurred before January 30, 1989,21 the temporary and final regulations

      21
       As of the end of 1990 and the beginning of 1991 Mazur & Raben’s Forms
1065 reported two outstanding liabilities: a $151,480 indebtedness to Boatmen’s
                                                                     (continued...)
                                        - 26 -

[*26] do not govern; instead, the 1956 regulations applicable to liabilities incurred

before January 30, 1989, control. Therefore, Mr. Kohn’s personal liability on

Mazur & Raben’s indebtedness to Boatmen’s or Lindell is irrelevant for purposes

of this analysis.

      We must therefore determine Mr. Kohn’s ratio for sharing losses under the

Mazur & Raben partnership agreement to establish the share, if any, of the

partnership liabilities from which he was relieved in 1991. Mr. Kohn did not sign

the Mazur & Raben partnership agreement upon his admission to the partnership

and there is no written agreement in evidence. However, Mr. Kohn was assigned a

16.88% share of Mazur & Raben’s profits and losses on his 1990 Schedule K-1.

The parties have stipulated that petitioners reported all of Mr. Kohn’s income and

      21
         (...continued)
and a $572,597 indebtedness to Lindell. We have found on the basis of Mr.
Kohn’s and Mr. Jones’ testimony that the Boatmen’s and Lindell leasehold
improvement debts were incurred in 1984 and 1985, respectively. However, Mr.
Kohn testified, and Mr. Jones confirmed, that Mazur & Raben established a line of
credit with Lindell sometime after Mr. Kohn’s admission to the partnership on
January 1, 1988. There is no evidence in the record from which to conclusively
determine which portion of Mazur & Raben’s $572,597 Lindell indebtedness was
attributable to the leasehold improvement loan and which was attributable to the
line of credit. Nonetheless, this issue is immaterial because, even if some portion
of the Lindell indebtedness were attributable to the line of credit, petitioners--who
bear the burden of proof to show error in respondent’s determination--have failed
to offer any evidence showing that the line of credit arrangement with Lindell was
entered into on or after January 30, 1989. We therefore find that the entire Lindell
indebtedness is subject to the 1956 regulations.
                                       - 27 -

[*27] tax items as reported on his Schedules K-1 on their personal income tax

returns.22 Petitioners having failed to show otherwise, we therefore conclude that

Mr. Kohn’s 16.88% share of profits and losses as reported on the 1990 Schedule

K-1 reflects the underlying agreement amongst Mazur & Raben’s partners

regarding Mr. Kohn’s share of partnership losses at that time.

      As discussed supra, Mazur & Raben reported two liabilities on its Forms

1065 for the end of 1990 and beginning of 1991: a $151,480 indebtedness to

Boatmen’s and a $572,597 indebtedness to Lindell, for a total of $724,077. Mr.

Kohn had a 16.88% share of Mazur & Raben’s losses as of the end of 1990;

therefore, as of the end of 1990 and beginning of 1991 Mr. Kohn’s share of Mazur

& Raben’s liabilities was $122,224.23 By the end of 1991 all of Mazur & Raben’s

outstanding liabilities had been eliminated, relieving Mr. Kohn of his $122,224

share of the partnership’s liabilities. Therefore, under section 752(b) Mr. Kohn

received a deemed distribution of $122,224 from Mazur & Raben in 1991.

      The income tax effects of this deemed distribution turn on Mr. Kohn’s

adjusted basis in his Mazur & Raben partnership interest. As discussed supra, a


      22
        With the exception of Mr. Kohn’s share of Mazur & Raben’s cancellation
of indebtedness income for 1991, as discussed supra.
      23
          Mr. Kohn’s Schedule K-1 for 1990 reports his share of partnership
liabilities as $123,045. The record does not explain this discrepancy.
                                         - 28 -

[*28] deemed distribution under section 752(b) reduces a partner’s adjusted basis

in his partnership interest and results in the recognition of capital gain to the

extent that the distribution exceeds the partner’s adjusted basis. See sec.

731(a)(1). Taking into consideration the income and tax items reported on Mr.

Kohn’s 1988-1991 Schedules K-1, we calculate Mr. Kohn’s adjusted basis in his

Mazur & Raben partnership interest for 1991 as follows:24




      24
       With the exception of the $30,287 loss allocated to Mr. Kohn on his 1991
Schedule K-1, which we address infra.
                                          - 29 -

[*29]

    Year                 Item                  Adjustment           Resulting basis
    1988
               Share of liabilities                 $95,460             $95,460
               Income                                46,388             141,848
               Loss                                  (3,804)            138,044
               Distributions                        (98,084)             39,960
    1989
               Additional liabilities                30,015              69,975
               Loss                                  (6,567)             63,408
               Unallowed deduction                   (3,584)             59,824
               Distributions                        (34,377)             25,447
    1990
               Income                                   426              25,873
               Reduction in liabilities              (2,430)             23,443
               Loss                                     (34)             23,409
    1991
               Capital contribution                  55,000              78,409
               COD income                            16,232              94,641
               Reduction in liabilities            (122,224)             (27,583)

        Thus, Mr. Kohn had an adjusted basis of $94,641 in his partnership interest

immediately before the $122,224 deemed distribution under section 752(b) as a

result of the elimination of his share of partnership liabilities in that amount.

Since the deemed distribution exceeded his adjusted basis in his partnership
                                        - 30 -

[*30] interest by $27,583, he was required to recognize capital gain in that amount

for 1991 under section 705(a). We accordingly sustain respondent’s determination

to that effect.

              3.    Mr. Kohn’s Partnership Interest Basis and Loss Allocations

       A partner can deduct his distributive share of partnership loss only to the

extent of his adjusted basis in his partnership interest at the end of the partnership

year in which the loss occurred. Sec. 704(d). Having determined that Mr. Kohn

had no remaining basis in his Mazur & Raben partnership interest as of the end of

1991, we accordingly conclude that petitioners were not entitled to deduct Mr.

Kohn’s $30,287 distributive share of partnership losses for that year and we

sustain respondent’s determination to that effect.

       B.     Cost of Goods Sold

       Petitioners claimed $64,238, described as “AMERICAN BANK

SETTLEMENT”, and $53,500, described as “LINDELL TRUST

SETTLEMENT”, as cost of goods sold on their 1991 Schedule C. Respondent

disallowed both amounts.

       This Court has consistently held that cost of goods sold is not a deduction

(within the meaning of section 162(a)) but is subtracted from gross receipts in the

determination of a taxpayer’s gross income. See Beatty v. Commissioner, 106
                                        - 31 -

[*31] T.C. 268 (1996); Max Sobel Wholesale Liquors v. Commissioner, 69 T.C.

477 (1977), aff’d, 630 F.2d 670 (9th Cir. 1980). Section 1.61-3(a), Income Tax

Regs., provides that in a manufacturing, merchandising, or mining business,

“gross income” means the total sales, less the total cost of goods sold. Cost of

goods sold does not involve the selling of services. Id.; see also Hahn v.

Commissioner, 30 T.C. 195, 197-198 (1958), aff’d per curiam, 271 F.2d 739 (5th

Cir. 1959).

      Petitioners’ Schedule C business for 1991--which Mr. Kohn testified was

the Kohn Partnership--provided legal services and was not engaged in

manufacturing, merchandising, or mining as far as the record discloses. However,

respondent did not dispute petitioners’ characterization of the figures for the

“AMERICAN BANK SETTLEMENT” and “LINDELL TRUST SETTLEMENT”

as cost of goods sold in the notice of deficiency, but rather disallowed them for

lack of substantiation and business purpose. On brief petitioners and respondent

treat the amounts as disputed claims for deductible business expenses under

section 162, and we consider them as such.

      Section 162(a) permits the deduction of ordinary and necessary expenses

paid or incurred in carrying on a trade or business. However, taxpayers must
                                         - 32 -

[*32] maintain books and records sufficient to establish the amounts of any

deductions. Sec. 6001; sec. 1.6001-1(a), Income Tax Regs.

      Petitioners claim, and Mr. Kohn testified, that the $64,238 “AMERICAN

BANK SETTLEMENT” was an ordinary and necessary business expense because

the funds from the American Bank loan were used in part to start the Kohn

Partnership and in part to reimburse Mr. Kohn’s former clients who had been

wrongfully charged for work in process upon Mazur & Raben’s dissolution.25

Respondent argues, inter alia, that petitioners have not substantiated the business

purpose of the American Bank loan. The record contains no documentary

evidence substantiating the existence of any American Bank loan, its amount, or

its ultimate use, and we are not obligated to accept Mr. Kohn’s uncorroborated and

self-serving testimony to that effect.26 See Tokarski v. Commissioner, 87 T.C. 74,


      25
        Petitioners alternatively argue that the contested business expenses may be
deducted under sec. 166 as bad debts. Because petitioners are claiming to have
been the borrowers with respect to the American Bank loan, and the record
establishes that they borrowed money from Lindell to finance the bulk of Mr.
Kohn’s contribution of $55,000 to the Mazur & Raben settlement fund, we are
unable to grasp the nature of their claim to bad debt deductions arising from these
transactions.
      26
        At trial, petitioners offered into evidence a letter written by an Internal
Revenue Service (IRS) Appeals Officer to substantiate the existence and amount
of the American Bank loan. Respondent objected, and we allowed the parties to
address the admissibility of the document on brief. Petitioners have not done so,
                                                                          (continued...)
                                         - 33 -

[*33] 77 (1986). We conclude that petitioners are not entitled to deduct the

$64,238 attributed to the American Bank settlement as an ordinary and necessary

business expense under section 162(a) or to treat it as a cost of goods sold in

computing gross income on their 1991 Schedule C.

      As for petitioners’ claimed deduction (or cost of goods sold adjustment) for

$53,500 described on their 1991 Schedule C as for a “LINDELL TRUST

SETTLEMENT”, we conclude on the basis of our examination of the entire record

that this figure represents the bulk of the $55,00027 that Mr. Kohn paid in 1991

into the Mazur & Raben settlement fund, which was specifically designated to be

paid to Lindell. Petitioners concede on brief that the amount of Mr. Kohn’s

contribution to the Mazur & Raben settlement fund that was paid to Lindell should

not have been deducted by them but instead added to Mr. Kohn’s adjusted basis in

his Mazur & Raben partnership interest. We agree. The $55,000 Mr. Kohn paid

into the Mazur & Raben settlement fund was a contribution to capital of the Mazur

& Raben partnership. We have treated it as an addition to Mr. Kohn’s adjusted

basis in his partnership interest for 1991, see supra p. 29, as part of our



      26
       (...continued)
and we accordingly sustain respondent’s objection and do not admit the document.
      27
           The discrepancy between the two figures is not explained in the record.
                                       - 34 -

[*34] redetermination of his deemed distribution under section 752(b) for 1991.

Consequently, petitioners are not entitled to the $53,500 claimed as cost of goods

sold on their 1991 Schedule C.

      C.     Section 6662 Accuracy-Related Penalty

      Respondent determined an accuracy-related penalty under section 6662(a)

and (b)(1) on the basis of negligence or disregard of rules or regulations for 1991.

Section 6662(a) and (b)(1) imposes a 20% penalty on any underpayment of tax

attributable to negligence or disregard of rules and regulations. “‘[N]egligence’

includes any failure to make a reasonable attempt to comply” with the internal

revenue laws. Sec. 6662(c). It connotes “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), aff’g 43 T.C. 168

(1964) and T.C. Memo. 1964-299), aff’d, 904 F.2d 1011 (5th Cir. 1990), aff’d,

501 U.S. 868 (1991). This 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. Disregard of rules and regulations includes any careless, reckless, or

intentional disregard of the Internal Revenue Code, the regulations, or certain IRS

administrative guidance. Id. subpara. (2).
                                       - 35 -

[*35] No penalty is imposed with respect to any portion of an underpayment if the

taxpayer acted with reasonable cause and in good faith with regard to that portion.

Sec. 6664(c)(1). That determination is made case by case, depending on the facts

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

include the experience, knowledge, and education of the taxpayer. Id.

      At trial Mr. Kohn conceded that petitioners received $5,147 of unreported

interest income as substantiated by Forms 1099-INT, Interest Income. Negligence

is strongly indicated where a taxpayer fails to report income reflected on

information returns, sec. 1.6662-3(b)(1)(i), Income Tax Regs., and petitioners

have not offered any evidence of reasonable cause for their failure to report this

income. Accordingly, the portion of the underpayment attributable to the

unreported interest income for 1991 is due to negligence.

      Petitioners have additionally conceded that the “LINDELL TRUST

SETTLEMENT” adjustment to cost of goods sold should not have been claimed

as such, and have failed to substantiate the existence, amount, or use of any loan

giving rise to the “AMERICAN BANK SETTLEMENT” claimed for 1991.

Petitioners have offered no evidence to demonstrate that they acted with

reasonable cause and in good faith regarding these amounts, particularly in view

of Mr. Kohn’s experience as a tax attorney. Consequently, the underpayment
                                          - 36 -

[*36] attributable to petitioners’ inclusion of the $64,238 “AMERICAN BANK

SETTLEMENT” and the $53,500 “LINDELL TRUST SETTLEMENT” as cost of

goods sold for 1991 is due to negligence.

        As to that portion of the underpayment attributable to petitioners’ failure to

report Mr. Kohn’s distributive share of Mazur & Raben’s discharge of

indebtedness income and to recognize capital gain upon Mr. Kohn’s relief from

his share of Mazur & Raben’s liabilities, petitioners argue that the negligence

penalty is inappropriate because their position is correct; i.e., Mr. Kohn was not

personally liable for any portion of Mazur & Raben’s debts and thus neither

received a deemed distribution under section 752(b) nor had to recognize

discharge of indebtedness income upon their compromise and settlement.

Petitioners do not address that portion of the underpayment attributable to the

disallowed deduction for Mr. Kohn’s distributive share of Mazur & Raben’s 1991

loss.

        As discussed supra, petitioners’ position is incorrect. Further, it is clear

from our review of the record that petitioners “cherry-picked” Mr. Kohn’s Mazur

& Raben Schedule K-1, choosing to report on their 1991 return the items that

provided a tax benefit and ignoring those that had a contrary effect. For example,

on their 1991 return petitioners disregarded Mr. Kohn’s distributive share of
                                        - 37 -

[*37] Mazur & Raben’s cancellation of indebtedness income and the deemed

distribution of Mr. Kohn’s share of the partnership’s liabilities under section

752(b), yet at the same time reported Mr. Kohn’s distributive share of Mazur &

Raben’s losses and included Mr. Kohn’s share of Mazur & Raben’s liabilities in

their calculation of the adjusted basis of his partnership interest. Negligence

includes any failure to make a reasonable attempt to comply with the provisions of

the Internal Revenue Code. Sec. 6662(c). Given Mr. Kohn’s position as an

experienced tax attorney who had specialized in partnership taxation, petitioners’

selective reporting of the items on Mr. Kohn’s Schedule K-1 does not reflect a

“reasonable attempt to comply” with the Internal Revenue Code. See sec. 6662(c).

We therefore find that the portions of the underpayment attributable to petitioners’

erroneous deduction of Mr. Kohn’s distributive share of Mazur & Raben’s

partnership loss, as well as petitioners’ failure to report Mr. Kohn’s distributive

share of Mazur & Raben’s cancellation of indebtedness income and capital gain

under sections 752(b) and 731(a)(1), are due to negligence.

II.   1992

      A.     Partnership Income

      Respondent disallowed the deduction for the $537 distributive share of

Mazur & Raben’s loss that petitioners claimed for 1992 on the grounds that Mr.
                                        - 38 -

[*38] Kohn lacked a sufficient basis in his partnership interest. As discussed

supra, as of the end of 1991 Mr. Kohn had no remaining basis in his Mazur &

Raben partnership interest, and there is no evidence to suggest that Mazur &

Raben earned income or that Mr. Kohn made any further capital contributions to

the partnership in 1992 that would have increased his basis. A partner may claim

his distributive share of a partnership loss only to the extent it does not exceed his

adjusted basis in his partnership interest. Sec. 704(d). Petitioners are therefore

not entitled to deduct Mr. Kohn’s $537 distributive share of partnership loss for

1992.

        B.    Casualty Loss

        Section 165(c)(3) and (h)(1) permits individuals to deduct losses suffered on

the damage or destruction of personal use property28 by reason of fire, storm,

shipwreck, or other casualty to the extent that the loss from each casualty exceeds

$100 and is not compensated for by insurance or otherwise. Section 165(h)(2)


        28
        While Mr. Kohn made vague references to rents received with respect to
the docks in his testimony at trial in the instant case and in the Blackstock lawsuit,
petitioners offered no substantiation of any payments of rent. Moreover,
petitioners claimed the casualty loss purportedly arising from the docks on Section
A of the Form 4684 for 1992, where losses on personal use property are to be
reported, and they did not report any rental income on their Schedule E for 1993.
We treat their return positions as an admission that the docks were personal use
property.
                                        - 39 -

[*39] limits the deduction to the amount by which the aggregate casualty losses

for the taxable year exceed 10% of the individual’s adjusted gross income.

Casualty loss deductions are generally allowed only for the year in which the

casualty takes place. Sec. 165(a). However, section 165(i) provides that any loss

attributable to a disaster occurring in an area subsequently determined by the

President to warrant assistance under the Disaster Relief and Emergency

Assistance Act may, at the election of the taxpayer, be taken into account for the

taxable year immediately preceding the taxable year in which the disaster

occurred. If such an election is made, the casualty resulting in the loss is treated as

having occurred during the taxable year for which the loss is claimed. Sec.

165(i)(2).

      The President determined that in 1993 St. Charles County, where

petitioners’ docks were located, suffered a natural disaster warranting assistance

under the Disaster Relief and Emergency Assistance Act. See Rev. Rul. 94-14,

1994-1 C.B. 72, 76. Taking advantage of section 165(i), petitioners claimed a

$121,065 casualty loss for 1992 for the alleged damage to their docks during the

flood of 1993. Respondent asserts that petitioners did not in fact suffer a loss on

the docks because they were sold in October 1993 for an amount which

approximated what petitioners paid for them in February 1993. Petitioners
                                        - 40 -

[*40] maintain that the casualty loss was appropriate at the time they filed their

1992 return.

      The amount of a casualty loss is generally computed as the excess of the fair

market value of the property immediately before the casualty over the fair market

value of the property immediately after the casualty, limited by the adjusted basis

of the property. Helvering v. Owens, 305 U.S. 468 (1939); sec. 1.165-7(b)(1),

Income Tax Regs. The respective fair market values “shall generally be

ascertained by competent appraisal.” Sec. 1.165-7(a)(2)(i), Income Tax Regs. In

the absence of an appraisal in this case, however, respondent asserts that we may

ascertain the extent of petitioners’ loss, or lack thereof, by comparing the docks’

February 1993 purchase price with their October 1993 sale price.

      This Court has used sale price to ascertain the validity of a casualty loss

claim where the property at issue was sold in close proximity to the casualty. See

Taylor v. Commissioner, T.C. Memo. 1979-261; Woods v. Commissioner, T.C.

Memo. 1960-72. In this instance the President determined that St. Charles County

was affected by a disastrous flood in 1993 from April 15 through May 29, and

from June 10 through October 25. Rev. Rul. 94-14, 1994-1 C.B. at 76. Petitioners

purchased the docks for $144,600 approximately two months before the flood and

sold the docks before the flood’s end for $142,000, without having made any
                                       - 41 -

[*41] improvements.29 Given the proximity to the flood of the docks’ purchase

and sale, we conclude that these prices indicate the fair market value of the docks

immediately before and after the casualty, respectively. Assuming arguendo that

this $2,600 decline in value was attributable to the flood, it would not exceed the

10% adjusted gross income floor provided in section 165(h)(2). The floor in

petitioners’ case would have been at least $24,808, as petitioners reported adjusted

gross income of $248,082 on their 1992 return.30 Consequently, petitioners are not

entitled to any portion of the claimed casualty loss deduction for 1992.

      C.     Fraud Penalty

      Respondent determined that petitioners are liable for a section 6663 fraud

penalty for 1992 with respect to the underpayment of tax attributable to their

claimed casualty loss. In relevant part, section 6663 provides:

      SEC. 6663. IMPOSITION OF FRAUD PENALTY.

             (a) Imposition of Penalty.--If any part of any underpayment of
      tax required to be shown on a return is due to fraud, there shall be



      29
       Petitioners have not claimed, nor is there any evidence of, improvements
made during the period they owned the docks.
      30
       As discussed supra pp. 37-38, petitioners erroneously deducted Mr.
Kohn’s $537 distributive share of Mazur & Raben’s partnership loss in 1992.
Eliminating that deduction would marginally increase the 10% adjusted gross
income floor of sec. 165(h)(2).
                                        - 42 -

[*42] added to the tax an amount equal to 75 percent of the portion of the
      underpayment which is attributable to fraud.

             (b) Determination of Portion Attributable to Fraud.--If the
      Secretary establishes that any portion of an underpayment is
      attributable to fraud, the entire underpayment shall be treated as
      attributable to fraud, except with respect to any portion of the
      underpayment which the taxpayer establishes (by a preponderance
      of the evidence) is not attributable to fraud.

             (c) Special Rule for Joint Returns.--In the case of a joint return,
      this section shall not apply with respect to a spouse unless some part
      of the underpayment is due to the fraud of such spouse.

      The Commissioner bears the burden of proof with respect to the fraud

penalty and must prove by clear and convincing evidence that (1) an

underpayment of tax exists and (2) some portion of the underpayment is due to

fraud. Sec. 7454(a); Rule 142(b); DiLeo v. Commissioner, 96 T.C. 858, 873

(1991), aff’d, 959 F.2d 16 (2d Cir. 1992). “Clear and convincing evidence is that

measure or degree of proof which will produce in the mind of the trier of facts a

firm belief or conviction as to the allegations sought to be established. It is

intermediate, being more than a mere preponderance, but not to the extent of such

certainty as is required beyond a reasonable doubt as in criminal cases. It does not

mean clear and unequivocal.” Ohio v. Akron Ctr. for Reprod. Health, 497 U.S.

502, 516 (1990) (quoting Cross v. Ledford, 120 N.E.2d 118, 123 (Ohio 1954)).
                                        - 43 -

[*43] Consistent with our previous findings, we are satisfied that respondent has

clearly and convincingly established the existence of an underpayment of tax for

1992 relating to petitioners’ claimed casualty loss deduction. Respondent has

clearly and convincingly demonstrated that the docks’ $2,600 diminution in value,

even if attributable to flooding, was far too insubstantial to qualify as a deductible

casualty loss. Respondent must therefore prove clearly and convincingly that

petitioners had the requisite fraudulent intent in claiming that loss. Respondent

satisfies this burden by showing that petitioners “intended to evade taxes known to

be owing by conduct intended to conceal, mislead or otherwise prevent the

collection of taxes.” DiLeo v. Commissioner, 96 T.C. at 874; see also Rowlee v.

Commissioner, 80 T.C. 1111, 1123 (1983). Fraud “does not include negligence,

carelessness, misunderstanding or unintentional understatement of income.”

United States v. Pechenik, 236 F.2d 844, 846 (3d Cir. 1956).

      The existence of fraud is a question of fact to be resolved upon

consideration of the entire record. See DiLeo v. Commissioner, 96 T.C. at 874;

Gajewski v. Commissioner, 67 T.C. 181, 199 (1976), aff’d without published

opinion, 578 F.2d 1383 (8th Cir. 1978). Because fraud can rarely be established

by direct proof of the taxpayer’s intention, fraud may be, and typically is, proved

by circumstantial evidence; indeed, the courts have articulated a nonexclusive list
                                       - 44 -

[*44] of several “badges of fraud” that constitute this circumstantial evidence,

including the taxpayer’s experience and knowledge, especially with respect to tax

laws; his offering implausible or inconsistent explanations (including false

testimony); and his engagement in illegal activities. See, e.g., Bradford v.

Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), aff’g T.C. Memo. 1984-601;

Solomon v. Commissioner, 732 F.2d 1459, 1461-1462 (6th Cir. 1984), aff’g per

curiam T.C. Memo. 1982-603; DiLeo v. Commissioner, 96 T.C. at 875; Parks v.

Commissioner, 94 T.C. 654, 664-665 (1990); Recklitis v. Commissioner, 91 T.C.

874, 910 (1988); Rowlee v. Commissioner, 80 T.C. at 1123; Gajewski v.

Commissioner, 67 T.C. at 199. More generally, fraudulent intent may be inferred

from “any conduct, the likely effect of which would be to mislead or to conceal.”

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

      This case presents one of the rare instances where the fraud is established in

the first instance by direct, not circumstantial, proof. Respondent contends that

petitioners claimed a $121,065 casualty loss deduction on their 1992 return with

fraudulent intent because they knew that the docks they were claiming as

worthless would be sold in a matter of weeks for approximately what they had

paid for them.
                                          - 45 -

[*45] We agree. Petitioners both signed the contract to sell their four docks for

$142,000 on October 4, 1993. While the contract was not signed by the

Blackstocks at that time and the entry for the purchaser was blank, Mr. Kohn

conceded in his testimony that he received a faxed version of the contract the next

day (October 5) with the Blackstocks identified as the purchasers. Petitioners

signed their 1992 return 10 days later on October 15, 1993, on which they took the

position that the four docks had become worthless during 1993 (which gave rise to

a loss that could be claimed for 1992). The sale of the docks closed on October

22, 1993, for a sale price of $142,000.

      Petitioners endeavor to negate any fraudulent intent in the foregoing

chronology by contending that they signed the sale contract at the behest of

Mr. Jaycox because he indicated he had found a purchaser, but that they did not

believe at the time that the docks could be sold because they were worthless.

Thus, their argument goes, they believed the docks were worthless when they

signed the 1992 return on October 15, 1993, and only learned otherwise when the

sale closed just over one week later on October 22, 1993.31 Mr. Kohn testified to

      31
        Alternatively, petitioners argue that fraudulent intent is negated by the fact
that they included the proceeds from the sale of the docks as income on their 1993
return in accordance with the tax benefit rule. We are unpersuaded for several
reasons. First, it is well established that fraud is complete at the time a fraudulent
                                                                          (continued...)
                                       - 46 -

[*46] that effect, but his testimony is flatly contradicted by the sworn testimony he

earlier gave in the Blackstock lawsuit. In the Blackstock lawsuit, Mr. Kohn

testified that on October 5, 1993, when he received the copy of the sale contract

identifying the Blackstocks as purchasers, he immediately faxed it to his contact at

the Bank of Alton, telling him that the loan the Kohns had taken out to purchase

the docks would be quickly paid off. We conclude that Mr. Kohn fully expected


      31
         (...continued)
return is filed despite a taxpayer’s later conduct. Badaracco v. Commissioner, 464
U.S. 386, 394 (1984). Second, Mr. Kohn was an experienced tax attorney and the
tax benefit rule would have dictated inclusion in the 1993 return of the $121,065
loss claimed on the 1992 return, not the sale proceeds--rendering petitioners’
contention implausible. See sec. 111(a). Third, petitioners have not demonstrated
that any such proceeds were included on their 1993 return. They contend that the
proceeds were reported as part of the $1,185,856 in gross receipts reported on the
Schedule C for the Kohn Partnership. Nevertheless, petitioners have not
disaggregated the gross receipts figure on their 1993 Schedule C in any
meaningful way that would demonstrate that the sale proceeds from the docks
were included in reported gross receipts. Moreover, we find it implausible, given
Mr. Kohn’s tax expertise, that he could believe that the appropriate place to
include the sales proceeds from the docks, under the tax benefit rule or otherwise,
was as gross receipts of the Kohn Partnership. As the documents covering the sale
of the docks demonstrate, the docks were owned by petitioners individually. They
were not partnership assets, and there is no evidence that they were used in the
trade or business of the Kohn Partnership. Finally, petitioners did not file their
1993 return until April 1996, after the commencement of the audit of the
Blackstocks’ 1992 return in 1995. By April 1996, then, Mr. Kohn almost certainly
knew (as the Blackstocks’ return preparer) that their casualty loss claim with
respect to the docks was under respondent’s scrutiny. In sum, petitioners’
contentions concerning the reporting of income from the docks’ sale on their 1993
return do not negate fraudulent intent.
                                        - 47 -

[*47] the sale of the docks for $142,000 would soon be consummated when he

signed the 1992 return claiming that the docks had become worthless in 1993.

The casualty loss claimed on this premise substantially reduced the taxes

otherwise due--which as a tax attorney he surely knew.32 We therefore find that

Mr. Kohn intended to evade taxes known to be owing by signing a return that

claimed a loss he knew was fictitious, thereby preventing the collection of taxes.

      As for Mrs. Kohn,33 we have only the evidence that she was an experienced

attorney who had occasionally counseled clients on tax matters; that she signed the

sale contract on October 4, 1993, to sell the docks for $142,000; that she signed

the 1992 return on October 15, 1993, claiming the docks were worthless; and that



      32
         Certain items of circumstantial evidence buttress the finding of fraudulent
intent. First, Mr. Kohn was an experienced tax attorney with an advanced degree
in taxation law. Second, Mr. Kohn pleaded guilty to and was convicted of one
count of violating sec. 7212 for obstructing the administration of the internal
revenue laws. We accordingly hold that Mr. Kohn is liable for the fraud penalty
with respect to the portion of the underpayment attributable to the disallowed
casualty loss for 1992.
      33
        Sec. 6663(c) provides that in the case of a joint return, no fraud penalty is
imposed with respect to a spouse unless some part of the underpayment is due to
the fraud of such spouse. Respondent has contended throughout that both
petitioners are liable for the fraud penalty and petitioners have not addressed sec.
6663(c). In any event, as discussed supra, we find that respondent has shown by
clear and convincing evidence that Mrs. Kohn also had fraudulent intent in
claiming the casualty loss deduction, and thus a portion of the underpayment is
due to her fraud.
                                         - 48 -

[*48] the sale of the docks for $142,000 was consummated on October 22, 1993.

Although Mrs. Kohn testified, she gave no testimony to rebut the obvious

inference from the juxtaposition of her October 4, 1993, signing of a contract to

sell the docks for $142,000 and her signing of the 1992 return on October 15,

1993, that she was fully aware that the docks were not worthless when she signed

the 1992 return. Thus, we are satisfied that Mrs. Kohn is liable for the fraud

penalty with respect to that portion of the underpayment attributable to the

disallowed casualty loss deduction for 1992. See sec. 6663(c).

      Section 6663(b) provides that if any portion of an underpayment is

attributable to fraud, the entire underpayment is treated as attributable to fraud

unless the taxpayer establishes by a preponderance of the evidence that some

portion of the underpayment is not attributable to fraud. We have sustained

respondent’s determination that petitioners are not entitled to deduct Mr. Kohn’s

$537 distributive share of Mazur & Raben’s partnership loss for 1992. As

petitioners have not addressed section 6663(b), the underpayment arising from the

disallowed deduction of Mr. Kohn’s distributive share of Mazur & Raben

partnership loss is also attributable to fraud.
                                  - 49 -

[*49] To reflect the foregoing,


                                           Decision will be entered under

                                  Rule 155.
