                          T.C. Memo. 1996-234



                        UNITED STATES TAX COURT



                     DEJA VU, INC., Petitioner v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



        Docket No. 3890-94.                       Filed May 22, 1996.


        Edith S. Thomas and Robert E. Miller, for petitioner.

     Alexandra E. Nicholaides and Eric R. Skinner, for

respondent.



                MEMORANDUM FINDINGS OF FACT AND OPINION


     LARO, Judge:     Deja Vu, Inc., petitioned the Court to

redetermine respondent’s determination of the following

deficiencies in Federal income taxes, addition to tax under

section 6651(a)(1), and accuracy-related penalties under section

6662:
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  Taxable
   Year                               Addition to Tax   Penalty
   Ended                                    Sec.          Sec.
   May 31         Deficiencies           6651(a)(1)       6662

    1990             $2,687                 $672          $537
    1991             14,677                  ---         2,935
    1992             16,546                  ---         3,309

Following concessions, we must decide:

     1.    Whether funds advanced by petitioner to a related

corporation are deductible under section 166 as a bad debt.

We hold they are not.

     2.    Whether petitioner is liable for the addition to tax

for delinquency determined by respondent under section

6651(a)(1).     We hold it is.

     3.    Whether petitioner is liable for the accuracy-related

penalties determined by respondent under section 6662.       We hold

it is.

     Unless otherwise stated, section references are to the

Internal Revenue Code in effect for the years in issue.       Rule

references are to the Tax Court Rules of Practice and Procedure.

Dollar amounts are rounded to the nearest dollar.       We refer to

petitioner’s taxable year ended May 31, 1990, as the 1989 taxable

year.     We refer to petitioner’s taxable year ended May 31, 1991,

as the 1990 taxable year.       We refer to petitioner’s taxable year

ended May 31, 1992, as the 1991 taxable year.

                              FINDINGS OF FACT

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

The stipulation of facts and attached exhibits are incorporated
                                - 3 -

herein by this reference.   Petitioner's principal place of

business was in Lansing, Michigan, when it petitioned the Court.

It filed a Form 1120, U.S. Corporation Income Tax Return, for

each year in issue using a fiscal year ended May 31 and an

accrual method of accounting.   Its 1989, 1990, and 1991

Forms 1120 were filed on October 15, 1991, February 27, 1992, and

January 19, 1993, respectively.

     At all times relevant herein, petitioner was a member of an

organization of over 50 businesses that were engaged in the adult

entertainment industry.   All of these businesses were wholly or

partially owned by Harry V. Mohney (Mr. Mohney) either directly

or indirectly through various trusts.

     In 1966, Mr. Mohney began acquiring (and operating as sole

proprietorships) numerous enterprises that were primarily engaged

in adult entertainment.   In the early 1970's, Mr. Mohney

organized each aspect of his businesses as a separate

corporation.   Mr. Mohney also established five domestic trusts,

of which he and his four children were beneficiaries.   Each of

these trusts owned an interest in another domestic trust, the

Durand Trust, which owned all the stock of Dynamic Industries,

Ltd., which owned many of Mr. Mohney's operating companies.

Mr. Mohney, together with three family members and a business

associate, Elizabeth L. Scribner, was also a beneficiary of a

foreign trust that owned all the stock of several foreign holding

companies, which owned all the stock of various foreign and
                                  - 4 -

domestic operating companies including Adult Fun Center, Inc.

(Adult Fun), a domestic corporation.       Prior to the years in

issue, Adult Fun was an adult novelty store with its principal

place of business in Phoenix, Arizona.

     Petitioner operated a live entertainment night club in

Toledo, Ohio.    Petitioner also provided operational, management,

and consulting services to adult entertainment clubs doing

business as "Deja Vu".    Donald Krontz (Mr. Krontz), who served as

petitioner's president during the subject years, made all of

petitioner's executive decisions in consultation with Mr. Mohney.

     In 1990, Adult Fun relocated to a store adjoining petitioner

in Toledo, Ohio, to sell adult lingerie.        Adult Fun solicited

funds from petitioner to remodel its new location and to start-up

its business there.    Beginning on February 9, 1990, petitioner

made unsecured cash advances to Adult Fun that were evidenced by

the following promissory notes (Notes):

          Date           Amount     Interest Rate    Repayment Schedule

     Apr. 13, 1990       $6,117           10%          $150/month
     May 5, 1990          2,000           10%           500/month
     June 6, 1990        17,468           10%           250/month
     Aug. 8, 1990         3,000           10%           200/month
     Oct. 18, 1990        1,000           10%        previously agreed
          Total          29,585

The advances were not, in all instances, contemporaneous with the

execution of a note.    For example, petitioner paid $5,000 to a

construction firm on February 9, 1990, and it paid an additional

amount to the same firm on April 13, 1990.        These funds, which

were paid to remodel Adult Fun’s new location, were reflected in
                                 - 5 -

the note dated April 13, 1990.    Petitioner also advanced $11,968

to Adult Fun on March 9, 1990, for remodeling.            This advance was

reflected in the June 6, 1990, note.

     In addition to the advances above, petitioner made the

following cash advances to Adult Fun:

                      Date                       Amount

                  May 2, 1990                     $150
                  May 29, 1990                     285
                  Aug. 8, 1990                      15
                                         Total     450

Petitioner added these three cash advances onto the note dated

April 13, 1990.

     Petitioner did not require collateral, take back liens or

personal guarantees, or request to examine Adult Fun's books, tax

returns, or financial statements before or after making any of

the advances.   On its books, petitioner recorded the advances as

loans.   Adult Fun recorded the advances as debts.1          Adult Fun did

not make any payments on the Notes.

     Adult Fun began a business under the name “Deja Vu Boutique”

sometime in May or June 1990.    Shortly after it opened,



     1
       Adult Fun’s taxable year ended on Feb. 28. With the
exception of the advances and a $50 payable for State income
taxes, Adult Fun’s balance sheet on Feb. 28, 1991, listed no
liabilities. The balance sheet on Feb. 28, 1991, listed assets
of $20,724, which were the leasehold improvements mentioned
below. Those improvements were the only asset that Adult Fun had
reported on a yearend balance sheet since Feb. 28, 1987. Adult
Fun’s balance sheet on Feb. 28, 1987, listed total assets of
$1,077 and total liabilities of $106,192. Adult Fun listed paid-
in capital of $6,000 on each of its yearend balance sheets from
Feb. 28, 1987 to Feb. 28, 1991.
                               - 6 -

petitioner's management determined that Adult Fun was not doing

well, and petitioner made further advances to Adult Fun.      By

November 1990, Adult Fun ceased its payroll, and released its

employees.   In early 1991, Adult Fun closed its store and

discontinued its business activities.    On April 10, 1992,

petitioner and Adult Fun agreed that petitioner would be assigned

Adult Fun's leasehold improvements on account of the $30,035 in

advances ($29,585 + $450) made by petitioner to Adult Fun.      The

parties agreed that the value of the assigned property was

$21,000.

     For Federal income tax purposes, Adult Fun reported net

operating losses (NOL’s) of $71,032 and $40,083 for its 1985 and

1986 taxable years, respectively.   For its 1987 taxable year,

Adult Fun reported taxable income (before application of any net

operating loss deduction) of $105,115.    All of this income was

attributable to cancellation of debt.    For its 1988 and 1989

taxable years, Adult Fun reported no gross receipts and no

taxable income.   For its 1990 taxable year, Adult Fun reported

total income of $3,662 and a taxable loss (before application of

any net operating loss deduction) of $4,266.

     Petitioner engaged Modern Bookkeeping Services, Inc. (MBS),

another Mohney related entity, to provide it with bookkeeping and

tax preparation services.   MBS retained David Shindel

(Mr. Shindel), a certified public accountant, to prepare

petitioner’s Federal income tax returns.    Mr. Shindel prepared
                                 - 7 -

all of petitioner’s Federal income tax returns that are in issue

herein.

                                OPINION

1.   Bad Debt

     We must decide whether, for the 1991 taxable year, section

166(a) lets petitioner deduct the excess advances of $9,035

($30,035 - $21,000), or whether the advances were contributions

to Adult Fun’s capital.    Whether a payment represents debt or

equity is a question of fact.     Roth Steel Tube Co. v.

Commissioner, supra at 629.     Rule 142(a); Welch v. Helvering,

290 U.S. 111, 115 (1933).

     A taxpayer may deduct worthless debts.      Sec. 166(a).   The

term “debt” connotes a true debtor-creditor relationship that

obligates the debtor to pay the creditor a fixed or determinable

sum of money.   Sec. 1.166-1(c), Income Tax Regs.     Capital

contributions are not debt.    Capital contributions are equity.

Roth Steel Tube Co. v. Commissioner, 800 F.2d 625, 629 (6th Cir.

1986), affg. T.C. Memo. 1985-58; Raymond v. United States,

511 F.2d 185, 189 (6th Cir. 1975); Calumet Indus., Inc. v.

Commissioner, 95 T.C. 257, 284 (1990).

     Courts refer to numerous factors to determine whether a

payment represents debt or equity.       The Court of Appeals for the

Sixth Circuit, to which appeal in this case lies, refers

primarily to 11 factors.    See Roth Steel Tube Co. v.

Commissioner, supra at 630.     These factors are:    (1) The names
                               - 8 -

given to the instruments, if any, evidencing the indebtedness;

(2) the presence or absence of a fixed maturity date and schedule

of payments; (3) the presence or absence of a fixed interest rate

and interest payments; (4) the source of repayments; (5) the

adequacy or inadequacy of capitalization; (6) the identity of

interest between the creditor and stockholder; (7) the security,

if any, for the advances; (8) the corporation's ability to obtain

financing from outside lending institutions; (9) the extent to

which the advances were subordinated to the claims of outside

creditors; (10) the extent to which the advances were used to

acquire capital assets; and (11) the presence or absence of a

sinking fund to provide repayment.     Id.; Raymond v. United

States, supra at 190-191; Austin Village, Inc. v. United States,

432 F.2d 741, 745 (6th Cir. 1970); Berthold v. Commissioner,

404 F.2d 119, 122 (6th Cir. 1968), affg. T.C. Memo. 1967-102;

Smith v. Commissioner, 370 F.2d 178, 180 (6th Cir. 1966), affg.

T.C. Memo. 1964-278.   In distinguishing debt from equity, the

economic substance of the transaction prevails over form.

Byerlite Corp. v. Williams, 286 F.2d 285, 291 (6th Cir. 1960).

     We turn to these factors to determine whether petitioner and

Adult Fun intended to create a debt, and whether their intention

comported with the economic reality of a debtor-creditor

relationship.
                                   - 9 -

     i.     Name of Certificate

                  We look to the name of the certificate evidencing

purported debt to determine the “debt’s” true label.

The issuance of a note weighs toward debt.      Estate of Mixon v.

United States, 464 F.2d 394, 403 (5th Cir. 1972).      The mere fact

that a taxpayer issues a note, however, is not dispositive of

debt.     An unsecured note, with no payments made thereon until

long after the due date, weighs toward equity.      Stinnett's

Pontiac Serv. Inc. v. Commissioner, 730 F.2d 634, 638 (11th Cir.

1984), affg. T.C. Memo. 1982-314.

     Although Adult Fun issued the Notes with respect to the

advances, and the Notes bore a stated interest rate of

10 percent, we give these facts little weight.      The Notes were

unsecured, and Adult Fun did not repay the amounts reflected

therein according to the Notes’ terms.      Petitioner focuses on the

fact that it recorded debt on its books in connection with the

transfer.     We are not impressed.   Under the facts herein,

petitioner’s accounting entry lends little (if any) support for a

finding of debt.     See Raymond v. United States, supra at 185.

This is especially so, given the fact that the parties were

dealing at other than arm's length.

     This factor is neutral.

     ii.     Fixed Maturity Date

     The presence of a fixed maturity date weighs toward debt,

but is not dispositive of a debtor-creditor relationship.
                                - 10 -

American Offshore, Inc. v. Commissioner, 97 T.C. 579, 602 (1991).

The presence of a fixed maturity date may be offset by other

facts in the record.

     The Notes had a set repayment schedule.    The presence of

this schedule, however, is downplayed by the fact that Adult Fun

made no payments in accordance therewith.    Petitioner also did

not pursue collection or inquire as to payment until Adult Fun

was defunct.    The facts at hand indicate that a debtor-creditor

relationship was not contemplated by petitioner or Adult Fun.

The actions of the parties to the Notes speak louder than words.

Their actions are uncharacteristic of a bona fide debtor-creditor

relationship.

     This factor weighs toward equity.

     iii.     Interest Rate and Payments

     The presence of a fixed rate of interest and actual interest

payments weigh toward debt.    The absence of payments in

accordance with the terms of a debt instrument weighs toward

equity.     American Offshore, Inc. v. Commissioner, supra at 605.

     Although the notes bore an interest rate of 10 percent,

Adult Fun made no principal or interest payments to petitioner

(ignoring, for the moment, the transfer of the leasehold

improvements).    The record also indicates that petitioner took no

meaningful steps to enforce any amounts that were due under the

terms of the Notes.

     This factor weighs toward equity.
                                 - 11 -

       iv.   Repayment

       Repayment that is dependent upon corporate earnings weighs

toward equity.     Repayment that is not dependent on earnings

weighs toward debt.      Roth Steel Tube Co. v. Commissioner,

800 F.2d at 632; Lane v. United States, 742 F.2d 1311, 1314 (11th

Cir. 1984); American Offshore, Inc. v. Commissioner, supra at

602.    Purported debt is usually equity when repayment is at the

whim of the vagaries of the business.      Segel v. Commissioner,

89 T.C. 816, 830 (1987).

       Repayment of the advances was dependent solely on the

financial success of Adult Fun.     Immediate repayment was not

available from Adult Fun's existing assets as Adult Fun had

virtually no assets.     At the time petitioner made its advances,

Adult Fun had not yet begun operations and had regularly

sustained losses.     In essence, petitioner gambled that Adult

Fun's operations would be successful and lost.     Advances made

under these conditions are not bona fide debt.

       This factor weighs toward equity.

       v.    Capitalization

       Thin or inadequate capitalization weighs toward equity.

Advances made to a corporation with an excessive debt to equity

ratio are indicative of equity rather than debt.      Roth Steel Tube

Co. v. Commissioner, supra at 632.

       The record indicates that Adult Fun had virtually no assets.

       This factor weighs toward equity.
                                - 12 -

     vi.    Identity of Interest

     Advances made by stockholders in proportion to their

respective stock ownership weighs toward equity.    A sharply

disproportionate ratio between a stockholder’s ownership

percentage in the corporation and the debt owing to the

stockholder by the corporation generally weighs toward debt.

Roth Steel Tube Co. v. Commissioner, supra at 630; Estate of

Mixon v. United States, 464 F.2d 394, 409 (1972); American

Offshore, Inc. v. Commissioner, supra at 604.     Family solidarity

and other legal or economic affiliations may neutralize the

significance of any disproportionate ratio.     See C. M. Gooch

Lumber Sales Co. v. Commissioner, 49 T.C. 649 (1968).

     Although petitioner did not have a direct stock interest in

Adult Fun, petitioner and Adult Fun shared a legal and economic

relationship as parts of Mr. Mohney's larger enterprise.    Indeed,

petitioner's president testified that all of petitioner’s

executive decisions were made in consultation with Mr. Mohney.

     This factor weighs toward equity.

     vii.     Presence or Absence of Security

     The absence of security for purported debt weighs toward

equity.     Roth Steel Tube Co. v. Commissioner, supra at 632;

Lane v. United States, 742 F.2d 1311, 1317 (11th Cir. 1984);

Raymond v. United States, 511 F.2d 185, 191 (6th Cir. 1975);

Austin Village, Inc. v. United States, supra at 745.
                               - 13 -

     Petitioner did not receive (nor did it attempt to receive)

any type of security interest or personal guarantees for its

advances.    If Adult Fun’s business did not prosper, petitioner

could only recover its advances from its share of the proceeds

which remained after obligations to secured creditors were

satisfied.   Indeed, when petitioner accepted an assignment from

Adult Fun in 1992, all that remained were various leasehold

improvements.   Mr. Krontz explained that he did not require

security because of the relationship between Adult Fun and

petitioner as members of Mr. Mohney's enterprises, their physical

proximity to each other, and his business relationship with Adult

Fun's president.   We find this testimony unpersuasive of a bona

fide debtor-creditor relationship.      We do not believe that an

outside lender would have loaned substantial sums to Adult Fun in

an arms-length transaction under the facts at hand.     Once again,

the actions of the parties to the Notes speak louder than words,

and those actions do not support a true debtor-creditor

relationship with respect to the advances.

     This factor weighs toward equity.

     viii.    Inability to Obtain Financing

     The question of whether a transferee could have obtained

comparable financing is relevant in measuring the economic

reality of a transfer.    Estate of Mixon v. United States,

464 F.2d at 410; Nassau Lens Co. v. Commissioner, 308 F.2d 39, 47

(2d Cir. 1962) remanding 35 T.C. 268 (1960).     Evidence that the
                                - 14 -

taxpayer could not obtain loans from independent sources weighs

toward equity.    Calumet Indus., Inc. v. Commissioner, 95 T.C. at

287.    We look to whether the terms of the purported debt were a

"patent distortion of what would normally have been available" to

the debtor in an arms-length transaction.    See Litton Business

Sys., Inc. v. Commissioner, 61 T.C. 367, 379 (1973).

       Petitioner presented no evidence on whether it could have

obtained financing from an unrelated party at the time of the

transfer.    Given the facts, however, that the purported debts

were completely unsecured and that Adult Fun did not have a

profitable history at the time of the advances, we are left

unpersuaded that an unrelated third party would have entered into

financing with Adult Fun under the terms that petitioner alleges

were entered into between it and Adult Fun.    Indeed, we read the

record to indicate that it would have been unreasonable for

petitioner to have expected repayment of the advances at the time

they were made.    Petitioner made no attempt to evaluate Adult

Fun's prospects for success.    It did not request any financial

statements or tax returns in order to evaluate Adult Fun's

financial condition.    It did not ask to examine Adult Fun's books

and, if it had, it would have seen that Adult Fun's tax returns

reported a pattern of losses.    The advances were placed at the

risk of Adult Fun’s business, and the terms of the advances were

a patent distortion of what would normally have been available in

an arm’s-length transaction.
                               - 15 -

     This factor weighs toward equity.

     ix.    Subordination

     Subordination of purported debt to the claims of other

creditors weighs towards equity.    Roth Steel Tube Co. v.

Commissioner, supra at 631-632; Stinnett's Pontiac Serv. Inc. v.

Commissioner, 730 F.2d at 639; Raymond v. United States, 511 F.2d

at 191; Austin Village v. Commissioner, supra at 745.

     Petitioner presented no evidence on the order of priority of

Adult Fun’s debts.    Given the fact, however, that the advances

were unsecured, petitioner's right to repayment would have been

subordinate to the interests of the secured creditors, if any.

At best, petitioner and the other unsecured creditors could have

shared in the proceeds that remained after the secured creditors

were satisfied.

     This factor weighs toward equity.

     x.    Use of Funds

     The transfer of funds from a shareholder to a corporation in

order to meet the corporation’s daily business needs weighs

toward debt.    The transfer of funds from a shareholder to a

corporation in order to purchase capital assets weighs toward

equity.    Roth Steel Tube Co. v. Commissioner, 800 F.2d at 632;

Stinnett's Pontiac Serv. Inc. v. Commissioner, supra at 640;

Raymond v. United States, supra at 191.

     The purported notes represented a long term commitment that

was payable mainly from future income.    While some of the
                                 - 16 -

advances were presumably intended to meet Adult Fun's daily

needs, the majority of the funds were used for remodeling

expenses.

       This factor weighs toward equity.

       xi.    Presence or Absence of a Sinking Fund

       The failure to establish a sinking fund for repayment weighs

toward equity.      Roth Steel Tube Co. v. Commissioner, supra at

632; Lane v. United States, 742 F.2d at 1317; Raymond v. United

States, supra at 191; Austin Village v. Commissioner, 432 F.2d at

745.

       The record does not indicate that Adult Fun established a

sinking fund for the repayment of the purported notes.      To the

contrary, repayment was to come solely from Adult Fun's earnings.

       This factor weighs toward equity.

       xii.    Conclusion

       The advances were contributions to Adult Fun's equity.

Accordingly, petitioner may not deduct any loss on the advances

under section 166(a).

3.   Section 6651

       Respondent determined an addition to tax under section

6651(a)(1), asserting that petitioner failed to file a timely

Federal income tax return for the 1989 taxable year.      In order to

avoid this addition to tax, petitioner must prove that its

failure to file timely was:      (1) Due to reasonable cause and

(2) not due to willful neglect.      Sec. 6651(a); Rule 142(a);
                              - 17 -

United States v. Boyle, 469 U.S. 241, 245 (1985); Catalano v.

Commissioner, 81 T.C. 8 (1983).   A failure to file timely is due

to reasonable cause if the taxpayer exercised ordinary business

care and prudence, and, nevertheless, was unable to file the

return within the prescribed time.     Sec. 301.6651-1(c)(1),

Proced. & Admin. Regs.   Willful neglect means a conscious,

intentional failure or reckless indifference.     United States v.

Boyle, supra at 245.

     Petitioner filed its return for its 1989 taxable year almost

8 months past the due dates prescribed in sections 6072(b) and

6081(b).   Petitioner has provided no evidence to overcome

respondent's determination that it is liable for the addition to

tax for failure to file timely.   We sustain respondent on this

issue.

4.   Section 6662

     Respondent also determined accuracy-related penalties under

section 6662 for petitioner’s 1989, 1990, and 1991 taxable years.

Section 6662(a) imposes an accuracy-related penalty equal to

20 percent of the portion of the underpayment that is

attributable to negligence.   Sec. 6662(b)(1).    For purposes of

section 6662(a), “negligence” includes a “failure to make a

reasonable attempt to comply with the Internal Revenue Code”, and

"disregard" includes careless, reckless, or intentional

disregard.   Sec. 6662(c); sec. 1.6662-3(b)(1), Income Tax Regs.
                                - 18 -

Section 6664(c)(1) of the Internal Revenue Code provides a

reasonable cause exception to the accuracy-related penalty.

     Petitioner argues that it is within the exception under

section 6664.    Petitioner argues that it held an honest and good

faith belief about the deductibility of its unrecovered advances

based on its reasonable reliance on MBS to ensure tax compliance.

Petitioner also argues that it was unsophisticated in tax laws

and that it relied on MBS to provide Mr. Shindel with enough

information to ensure proper compliance with those laws.

Although MBS failed to do its job properly, petitioner concludes,

petitioner’s reliance on them to do a proper job was consistent

with ordinary business care and prudence under the circumstances.

     We do not agree.   Reasonable reliance on a tax adviser is

consistent with ordinary business care and prudence only in

certain cases.   In those cases, the taxpayer must establish that:

(1) The adviser had sufficient expertise to justify reliance,

(2) the taxpayer provided necessary and accurate information to

the adviser, and (3) the taxpayer actually relied in good faith

on the adviser’s judgment.   See, e.g., Ellwest Stereo Theatres of

Memphis, Inc. v. Commissioner, T.C. Memo. 1995-610.     Mr. Shindel

prepared and signed petitioner’s tax returns for the years in

issue.   His experience and qualifications were sufficient to

warrant reliance upon his judgement.     Although we find that

petitioner has met the first prong, we find that it has failed to

satisfy the remaining prongs.    Petitioner did not exercise due
                              - 19 -

care, and it failed to do what a reasonable and ordinarily

prudent person would have done under the circumstances.

Petitioner knew it was required to file timely a Federal income

tax return for each year in issue, but it neglected to do so for

its 1989 taxable year.   Given the fact that taxpayers have a

statutory duty to file timely income tax returns, we believe that

a reasonable and ordinarily prudent person would have complied

with the statutory duty to file timely such a return.    We also

believe that breach of this duty is evidence of negligence.

Condor Intl., Inc. v. Commissioner, 98 T.C. 203, 225 (1992),

affd. in part, revd. in part 78 F.3d 1355 (9th Cir. 1996);

Emmons v. Commissioner, 92 T.C. 342, 349 (1989), affd. 898 F.2d

50 (5th Cir. 1990).   The fact that petitioner was negligent in

the instant case is also supported by the fact that petitioner

erroneously claimed deductions for the interest expenses and its

shareholder’s legal fees.   See Condor Intl., Inc., v.

Commissioner, supra at 225; Emmons v. Commissioner, supra at 349.

We sustain respondent on this issue.

     We have considered all of petitioner's arguments for

contrary holdings and, to the extent not addressed above, find

them to be without merit.

     To reflect concessions by respondent,

                                         Decision will be entered

                                    under Rule 155.
