                           T.C. Memo. 1999-285



                         UNITED STATES TAX COURT



                    ANDY RATAICZAK, Petitioner v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



       Docket No. 2335-97.               Filed August 27, 1999.



       Andy Rataiczak, pro se.

       Stephen J. Neubeck, for respondent.



                           MEMORANDUM OPINION

       GALE, Judge:    Respondent made the following determinations

with respect to petitioner’s 1993 and 1994 Federal income taxes:

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

1993         $16,649                    ---            $3,330
1994           8,820                   $2,205           1,764
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Unless otherwise noted, all section references are to the

Internal Revenue Code in effect for the years in issue, and all

Rule references are to the Tax Court Rules of Practice and

Procedure.

      We must decide the following issues:     (1) Whether petitioner

had unreported income.    We hold that he did, to the extent

provided below.    (2) Whether petitioner is entitled to a

depreciation deduction for towing equipment for each of the years

in issue.    We hold that he is.    (3) Whether petitioner is liable

for an addition to tax under section 6651(a).      We hold that he

is.   (4) Whether petitioner is liable for accuracy-related

penalties under section 6662(a).      We hold that he is not.

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

incorporate by this reference the stipulation of facts and

attached exhibits.    At the time of filing the petition,

petitioner resided in Quaker City, Ohio.

      From March 1990 to September 1994, petitioner operated a

service station in Barnesville, Ohio.      The station had four

gasoline pumps, a diesel and kerosene pump, and two service bays.

In addition to fuel sales, petitioner sold miscellaneous items

such as chips, candy, soda pop, and tobacco.      Also, petitioner

sold and installed tires and other auto parts in connection with

the station’s service and repair business.      Petitioner closed the

service station in September 1994 because he was unable to make a
                                - 3 -

profit from its operation.   Upon closing the station, petitioner

was able to return some, but not all, of his inventory.     At the

time of trial, petitioner still owed suppliers for debts that

arose during the years in issue.   Petitioner kept his books and

records for his business under the cash receipts and

disbursements method of accounting.

Introduction

     In the notice of deficiency, respondent determined that

petitioner had unreported income in the amounts of $62,400 in

1993 and $43,918 in 1994.    Respondent used the percentage markup

method, under which respondent applied a percentage markup to

petitioner’s cost of purchases to compute petitioner’s gross

receipts.   When a taxpayer fails to keep adequate books and

records, respondent is authorized by section 446 to reconstruct

the taxpayer’s income using any reasonable method.     See Petzoldt

v. Commissioner, 92 T.C. 661, 686-687 (1989); Rungrangsi v.

Commissioner, T.C. Memo. 1998-391.      The percentage markup method

is, in general, a permissible method.     See Bollella v.

Commissioner, 374 F.2d 96 (6th Cir. 1967), affg. T.C. Memo. 1965-

162; Rungrangsi v. Commissioner, supra.

     Petitioner’s fuel sales are not at issue in this case.

Respondent’s determinations of unreported income were based on

sales of tires and auto parts, as well as chips, candy, soft

drinks, and tobacco.   With respect to these items, respondent
                               - 4 -

determined, and the parties agree, that petitioner’s costs of

purchases exceeded reported receipts.     For 1993, petitioner's

reported receipts from auto service and repairs, including the

sale of parts and fluids (e.g., oil, coolant, brake fluid, etc.),

totaled $23,688 whereas his cost of purchases for these items

totaled $69,493.1   Similarly, his reported receipts from the sale

of chips, candy, soft drinks, and tobacco totaled $6,658 whereas

his cost of purchases for these items totaled $8,686.     For 1994,

reported receipts from the first category totaled $6,348 whereas

cost of purchases totaled $41,209.     In the second category,

reported receipts were $2,744 whereas cost of purchases totaled

$3,939.

     Petitioner has the burden of proof.     See Rule 142.   We found

petitioner to be a credible witness, and we find that he has

carried his burden of proof with respect to some of the issues

before us.

Chips, Candy, Soft Drinks, and Tobacco

     With respect to chips, candy, soft drinks, and tobacco, we

sustain respondent’s determinations.     For these items, respondent

applied a markup of 25 percent, which was determined using (1)


     1
       The parties' stipulation incorrectly states that these
figures were $83,402 and $101,073, respectively, for 1993. The
other evidence in the record makes clear that the foregoing
figures were the correct figures for 1992, not 1993. The Court
may disregard a stipulation where it is clearly contrary to the
evidence in the record, and we do so here. See Cal-Maine Foods,
Inc. v. Commissioner, 93 T.C. 181, 195-196 (1989).
                               - 5 -

industry data compiled and published by Robert Morris Associates,

and (2) information provided by petitioner and two of

petitioner’s suppliers.   Petitioner does not dispute respondent’s

use of a 25-percent markup for these items.   Further, petitioner

did not present any evidence to show that respondent’s

determinations were otherwise in error.

Auto Service and Repairs, Including Sale of Parts and Fluids

     With respect to receipts from auto service and repairs,

including the sale of parts and fluids (e.g., oil, coolant, brake

fluid, etc.), we sustain respondent’s determinations only in

part.   Although the percentage markup method is generally

acceptable, see Bollella v. Commissioner, supra, the particular

facts and circumstances of this case raise two questions:    (1)

Whether respondent chose an acceptable markup percentage, and (2)

whether respondent applied the markup properly.    Although we

agree with respondent’s choice of a 22.8-percent markup, we find

that respondent did not apply the markup properly and therefore

that petitioner did not receive all the income that respondent

determined.

     Did Respondent Choose an Acceptable Markup?

     Respondent applied a markup of 22.8 percent, which was

determined using industry data compiled and published by Robert

Morris Associates.   The 22.8-percent figure represented the 1993

average gross profit for gasoline service stations with total
                                - 6 -

assets between $0 and $500,000.   Petitioner estimated that he

charged an average markup of between 7 and 8 percent in the sale

of tires and other parts.   However, the documentary evidence in

the record does not support this estimate.

     The parties stipulated as evidence six invoices from

petitioner’s service station written in 1993; however, there is

evidence with respect to the applicable wholesale cost with

respect to only two of these invoices.   One of the invoices, to

Anco, dated January 22, 1993, shows that petitioner charged $105

for tires.   Petitioner contends that the wholesale cost for these

tires at the time of sale was approximately $100, for a markup of

approximately 5 percent.    Respondent contends that the wholesale

cost was $95 and concedes that the markup on tires was no more

than 10 to 10.5 percent.    Petitioner’s cost of labor was included

in the retail price of the tires.   The other invoice, also to

Anco, dated August 21, 1993, shows that petitioner charged

$152.35 for a power steering pump, and that he charged an

additional $30 for labor to install the pump.   Respondent

contends that the wholesale cost of the pump was $133.80 at the

time of trial, based on a phone call to a local wholesaler.

Using the cost at the time of trial, the markup that petitioner

charged Anco for the power steering pump was $48.55 ($152.35 +

$30 labor - $133.80 current cost), or 36.3 percent ($48.55 ÷

$133.80).    If the time-of-trial wholesale price were adjusted for
                               - 7 -

inflation to approximate the wholesale price in August 1993, the

percentage for petitioner’s markup would be higher.      Although the

22.8-percent deemed markup rate used in respondent’s

determination is substantially higher than the 10.5-percent

markup rate that has been documented for one sale of tires,

respondent’s deemed rate is substantially lower than the markup

of at least 36.3 percent for the power steering pump.     In

addition, in computing his retail price for tires and other

parts, petitioner charged lower markups for his preferred

customers, and Anco was one of his preferred customers.     Thus,

the markups for which petitioner has produced any evidence were

lower than average.   Upon review of the evidence he has

presented, we conclude that petitioner has failed to demonstrate

error in respondent’s use of a 22.8-percent markup rate to

reconstruct his gross sales figure.    See Petzoldt v.

Commissioner, supra; Rungrangsi v. Commissioner, supra.

     Did Respondent Apply the Markup Properly?

     To determine petitioner’s gross profit for the years in

issue, respondent multiplied petitioner’s cost of purchases by

the 22.8-percent markup.   However, petitioner has provided

evidence of at least two errors in this approach:   First,

petitioner did not receive payment during the years in issue for

all of the items that he sold, due to unpaid accounts receivable;
                               - 8 -

and second, petitioner did not sell all of the items included in

the cost of purchases, due to theft loss and unsold inventory.2

     There is no dispute in this case that petitioner used the

cash basis method of accounting for his business, and that he was

not required to take into income any accounts receivable that

were not paid (and therefore were not actually or constructively

received) during the years in issue.   See sec. 446(c)(1);

Fankhanel v. Commissioner, T.C. Memo. 1998-403; sec. 1.446-

1(c)(1)(i), Income Tax Regs.   In the notice of deficiency,

respondent determined that petitioner had unpaid accounts

receivable of $7,393 in 1993 and $2,517 in 1994.   Petitioner,

however, testified that he had unpaid accounts receivable in the

amount of $25,000 in total during the years in issue.

Petitioner’s testimony was credible, and we accept it.

Accordingly, we estimate and find that he had unpaid accounts

receivable in the amount of $12,500 in each of the years in




     2
        In addition, our finding that respondent’s computation of
petitioner’s gross profit contains errors is buttressed by the
fact that the weight of other evidence in this case goes against,
and we do not believe, the conclusion that petitioner earned
profits of the size determined by respondent during the years at
issue. We found petitioner to be an honest and forthright
witness. His testimony was plausible. He closed down the
service station before the end of the second year in issue
because it was not profitable. Almost 4 years later, he was
still indebted to his suppliers and attempting to repay them.
There is not a scintilla of evidence that petitioner’s net worth,
bank accounts, life style, or spending habits were altered in
such a way as to suggest he was skimming cash from the business.
                               - 9 -

issue.   Thus, petitioner’s gross profit should be reduced by

$12,500 in each of the years in issue.

     In the notice of deficiency, respondent applied the

percentage markup to petitioner’s entire cost of purchases during

the years in issue.   However, petitioner testified that he

suffered theft losses of between $1,000 and $4,000 during 1993.

We accept petitioner’s testimony, which was corroborated by some

documentary evidence, and find that petitioner suffered losses

from theft in the amount of $3,000 for tires and other parts

during 1993.   Thus, petitioner’s cost of purchases to which the

22.8-percent markup is applied should be reduced by $3,000 in

1993.

     In addition, we find that petitioner is entitled to a theft

loss deduction in the amount of $3,000 during 1993.    In general,

in the case of theft of inventory, a taxpayer may either account

for the loss as a reduction to closing inventory and a

corresponding increase to cost of goods sold, or claim a

deduction under section 165 and make a corresponding decrease to

opening inventory or purchases.   See generally National Home

Prods., Inc. v. Commissioner, 71 T.C. 501, 528 (1979); B.C. Cook

& Sons, Inc. v. Commissioner, 59 T.C. 516, 522-523 (1972)

(Tannenwald, J., concurring); sec. 1.165-8(e), Income Tax Regs.;

IRS Pub. 538, Accounting Periods and Methods (1993).     In this

case, petitioner’s purchases have been decreased by the amount of
                               - 10 -

the theft, and therefore petitioner may claim the deduction.    In

general section 165(a) allows a deduction for any loss sustained

during the taxable year.3   Section 165(c)(1) limits the deduction

to, among other things, losses incurred in a trade or business.

Petitioner’s loss qualifies.   Thus, petitioner is entitled to a

loss deduction of $3,000 in 1993.

     Petitioner testified that in 1994, after he closed the

service station, he kept some inventory that he was unable to

return, and returned some inventory.    Any inventory that

petitioner kept or returned would not have been sold, and thus

would not have contributed to gross sales.    The only evidence in

the record with respect to the value of unsold inventory is

petitioner’s testimony that he kept a case of spark plugs for

which he paid $1,000.   We accept this testimony, and therefore

petitioner’s cost of purchases to which the 22.8-percent markup

is applied should be reduced by $1,000 in 1994.

Depreciation

     In the notice of deficiency, respondent disallowed

depreciation deductions for a tow truck and its engine in the

amounts of $1,592 for 1993 and $1,137 for 1994.    Respondent

determined that petitioner had not proven that this equipment was

used in a trade or business or for the production of income.    In


     3
       Any loss arising from theft is treated as sustained in the
year discovered. See sec. 165(e). We find that petitioner
discovered the loss in 1993.
                              - 11 -

general, section 167(a) authorizes a depreciation deduction for

the exhaustion, wear and tear of property used in a trade or

business or held for the production of income.   Petitioner

testified that he earned approximately $2,000 of income from his

towing operation during each of the years in issue.   Although

petitioner did not separately account for this income, we found

petitioner’s testimony to be credible.   Moreover, respondent’s

determination in the notice of deficiency requires us to believe

that petitioner, who operated a service station, owned towing

equipment but did not use it in his trade or business or for the

production of income.   We find that he did and hold that

petitioner is entitled to the deductions for depreciation that

were disallowed by respondent.

Addition to Tax and Accuracy-Related Penalties

     For petitioner’s 1994 tax year, respondent determined an

addition to tax under section 6651(a) in the amount of $2,205.

In general, section 6651(a) applies in the case of failure to

timely file a return, unless it is shown that the failure was due

to reasonable cause and not willful neglect.   Petitioner filed

his 1994 tax return more than 4 months after the due date, and

there is no evidence of reasonable cause.   Therefore, petitioner

is liable for an addition to tax under section 6651(a) for 1994.

     For petitioner’s 1993 and 1994 tax years, respondent

determined accuracy-related penalties under section 6662(a) in
                               - 12 -

the amounts of $3,330 and $1,764, respectively.      Section 6662(a)

applies in the case of negligence or disregard of rules or

regulations.   See sec. 6662(b)(1).     “Negligence” includes the

failure to keep adequate books and records.      See sec. 1.6662-

3(b), Income Tax Regs.   We note that although petitioner did not

keep formal inventories for any of the items he sold except for

fuel, his records were adequate enough to allow the parties to

stipulate his costs of purchases in each of the separate

categories.    Moreover, petitioner will be relieved of the penalty

under section 6662(a) if there was reasonable cause for the

underpayment and he acted in good faith.      Sec. 6664(c)(1).

Reasonable cause and good faith include “an honest

misunderstanding of fact or law that is reasonable in light of

the experience, knowledge and education of the taxpayer.”        Sec.

1.6664-4(b)(1), Income Tax Regs.   Further, “Reliance on * * *

professional advice * * * constitutes reasonable cause and good

faith if, under all the circumstances, such reliance was

reasonable and the taxpayer acted in good faith.”      Id.   We find

that petitioner acted with reasonable cause and in good faith

based on his experience, knowledge and education, and on the fact

that he reasonably relied on an accountant in filing his tax

returns.   Therefore, he is not liable for the accuracy-related

penalty under section 6662(a).
                        - 13 -

To reflect the foregoing,

                                 Decision will be entered

                            under Rule 155.
