                    123 T.C. No. 8



                UNITED STATES TAX COURT



          LAWRENCE G. WILLIAMS, Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket Nos. 10314-02, 3262-03.       Filed July 22, 2004.



      P filed for bankruptcy on Dec. 3, 1990, at which
time he owned all of the shares of two S corporations.
Both S corporations sustained operating losses for
1990. P reported the pro rata portion of the 1990
losses attributable to the prebankruptcy period on his
individual tax return for 1990, resulting in a net
operating loss, which he carried forward through 2000.
P was discharged in bankruptcy in 1997. R disallowed
the losses and issued notices of deficiency for 1996-
2000.

     1. Held: Where P, an individual S corporation
shareholder, filed for bankruptcy before the
corporation’s yearend, operating losses sustained by
the corporation during the year in which he filed for
bankruptcy are reported by the bankruptcy estate, not
P, because income or loss of an S corporation is
determined as of the last day of the corporation’s
taxable year.
                                 - 2 -

          2. Held, further, net operating losses to which P
     succeeded upon discharge in bankruptcy must be reduced
     by the amount of discharge of indebtedness income that,
     pursuant to sec. 108(b)(2), I.R.C., was excluded from
     his gross income as a result of his bankruptcy
     discharge.

          3. Held, further, P is not liable for the
     accuracy-related penalty under sec. 6662(a), I.R.C.,
     for any year at issue.



     Lawrence G. Williams, pro se.

     Lydia A. Branche, for respondent.



     KROUPA, Judge:   Respondent determined deficiencies in
petitioner’s income taxes for the years 1996 through 2000
resulting from operating losses sustained by two S corporations
in 1990 that petitioner reported on his individual tax return in
1990, the year in which petitioner filed for bankruptcy, and
carried forward through 2000.1    Respondent also determined that
petitioner is liable for the accuracy-related penalty under
section 6662(a) for each year at issue.
     The three issues for decision are:
     (1) Whether petitioner or his individual bankruptcy estate
(Estate) is entitled to report operating losses sustained during
1990 by two S corporations in which petitioner owned all of the
shares as of the date of filing bankruptcy.    We hold that the
Estate, not petitioner, is entitled to report the losses.


     1
      Petitioner originally filed a ch. 7 bankruptcy petition on
Dec. 3, 1990, then converted it to a ch. 11 bankruptcy in 1991.
The conversion is irrelevant for purposes of our analysis because
secs. 108 and 1398 apply to both chapters if the debtor is an
individual.
                                - 3 -

       (2) Whether petitioner is entitled to report carryforward
losses to which he succeeded upon termination of the Estate after
his debts were discharged in bankruptcy.      We hold that he is not.
       (3) Whether petitioner is liable for each year at issue for
the accuracy-related penalty under section 6662(a)2 for
substantial understatement of income tax.     We hold that he is
not.
                           FINDINGS OF FACT
       These cases were submitted to the Court fully stipulated
under Rule 122.    The stipulation of facts and the accompanying
exhibits are incorporated by this reference, and the facts are so
found.3    Petitioner resided in New York, New York, when he filed
the petitions with this Court.4
       Petitioner was a self-employed investment adviser for each
year at issue.    Petitioner owned all of the shares of two S
corporations, Davidge & Co. (Davidge) and Kuma Securities (Kuma),
until December 3, 1990, the date he filed for bankruptcy.     The


       2
      All section and subchapter references are to the Internal
Revenue Code in effect for the years at issue, unless otherwise
indicated, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
       3
      Sec. 7491 is effective with respect to court proceedings
arising in connection with examinations by the Commissioner
commencing after July 22, 1998, the date the Internal Revenue
Service Restructuring and Reform Act of 1998, Pub. L. 105-206,
sec. 3001, 112 Stat. 726, was enacted. Although the examinations
for these cases began on Aug. 5, 1999, for 1996 through 1998 and
on Apr. 4, 2002, for 1999 through 2000, these cases were
submitted fully stipulated. Therefore, no facts are in dispute,
and we decide these cases without regard to the burden-shifting
rule of sec. 7491(a)(1).
       4
      These two cases were consolidated for trial, briefing, and
opinion in an order from this Court dated May 15, 2003.
                                 - 4 -

shares of both corporations became property of his Estate at that
time.5    Both corporations are calendar year corporations.
     Petitioner used a $4 million loan from Citibank to finance
the operation of Davidge.6    Davidge sustained an operating loss
of $3,385,592 during 1990.    The Schedule K-1, Shareholder’s Share
of Income, Credits, Deductions, etc. (Schedule K-1), that Davidge
issued to petitioner for 1990 showed that $3,125,875 (or 92.33
percent) of the loss for 1990 was allocated to petitioner.    This
amount represents the pro rata portion7 of Davidge’s loss
attributable to the period January 1 through December 3, 1990,
the date petitioner filed for bankruptcy.     The remaining $259,717
(or 7.67 percent) of the loss for 1990 was allocated to the
Estate.
     Kuma sustained an operating loss of $155,593 during 1990.
Similarly, the Schedule K-1 Kuma issued to petitioner for 1990
showed that $143,898 (or 92.33 percent) of the loss for 1990 was
allocated to petitioner.     This amount represents the pro rata
portion of Kuma’s loss attributable to the period January 1
through December 3, 1990, the date petitioner filed for
bankruptcy.    The remaining $11,955 (or 7.67 percent) of the loss
was allocated to the Estate.


     5
      A debtor’s assets, with exceptions not applicable here,
become property of the bankruptcy estate when the debtor files
the bankruptcy petition. 11 U.S.C. sec. 541 (2000).
     6
      The record does not reflect financing information for Kuma.
We assume that petitioner used portions of the Citibank loan to
finance the operation of Kuma as well.
     7
      The pro rata portion is computed by assigning to each day
an equal share of the loss for the year. Sec. 1377(a)(1).
                                  - 5 -

     Petitioner reported on his Federal income tax return for
1990 the pro rata share of the losses sustained by Davidge and
Kuma.    The amounts that petitioner reported were attributable to
the period January 1 through December 3, 1990, the date he filed
for bankruptcy.    Petitioner carried forward losses from 1991
through 2000.8
     Respondent determined that petitioner was not entitled to
the losses sustained by Davidge or Kuma from January 1 through
December 3, 1990, the date petitioner filed for bankruptcy.
Accordingly, respondent disallowed the losses and carryforwards
and issued two notices of deficiency covering the years 1996
through 2000.9    The deficiencies and accuracy-related penalties
for the years at issue are as follows:

                                          Accuracy-Related Penalty
    Year             Deficiency                 Sec. 6662(a)

    1996              $59,597                    $11,919
    1997               63,679                     12,736
    1998               30,524                      6,105
    1999               27,166                      5,433
    2000               12,681                      2,536




     8
      The parties stipulated that petitioner made the election
under sec. 172(b)(3) to forgo the carryback period and carry
forward the losses. The years 1990 through 1995 are not before
us.
     9
      The notice of deficiency for 1996, 1997, and 1998 was
issued on Mar. 20, 2002, and the notice of deficiency for 1999
and 2000 was issued on Nov. 22, 2002.
                                - 6 -

Petitioner timely filed petitions with this Court contesting
respondent’s disallowance of the losses and liability for the
accuracy-related penalty for each year at issue.
     Petitioner received a discharge in bankruptcy on November
26, 1997.    The $4 million Citibank loan was discharged.
                               OPINION
I.   Whether Petitioner or the Bankruptcy Estate Is Entitled to
     the 1990 Losses
     The Bankruptcy Tax Act of 1980, Pub. L. 96-589, sec. 3, 94
Stat. 3397, added section 1398 to eliminate uncertainty and
litigation by detailing how Federal income tax attributes and
liabilities are to be allocated between the bankruptcy estate and
the individual debtor.    See sec. 1398; see also S. Rept. 96-1035,
at 8-13 (1980), 1980-2 C.B. 620, 623-626.    Filing a bankruptcy
petition creates a new taxable entity for Federal tax purposes,
the bankruptcy estate, which is a separate and distinct taxpayer
from the individual debtor.    See 11 U.S.C. sec. 541(a) (2000);
sec. 1398.    The debtor continues as a separate taxable entity
during the pendency of the bankruptcy proceeding.    Sec. 1398.
Section 1398 dictates whether the bankruptcy estate or the
individual debtor reports income, deductions, and credits and
when either taxpayer succeeds to the tax attributes of the other.
     This is a case of first impression in which we must decide
whether filing individual bankruptcy alters the rules that
otherwise apply under subchapter S regarding the allocation and
deductibility by an individual shareholder of losses of S
corporations incurred in the calendar year in which the
individual shareholder files for bankruptcy.
                                 - 7 -

     Respondent claims that the Estate is entitled to the entire
loss generated by each of Davidge and Kuma for 1990 even though
it did not own any shares of either corporation until December 3,
1990, the date petitioner filed for bankruptcy.   Respondent
contends that the Estate is entitled to the entire loss generated
during 1990 because the Estate owned all the shares of Davidge
and Kuma as of December 31, 1990, the corporations’ yearend.
     Petitioner counters that he is entitled to approximately 11
months’ worth of the losses generated during 1990.    Relying on
section 1377(a)(1), which allocates each item of corporate income
or loss pro rata on a per share per day of ownership basis,
petitioner argues that he should be allocated that portion of the
loss generated by each corporation during the time in 1990 that
he owned all the shares of Davidge and Kuma; i.e., the portion
attributable to the period from January 1 through December 3,
1990.   Petitioner essentially argues that bankruptcy proceedings
do not alter the rules for allocating income and loss to S
corporation shareholders under section 1377.   He reasons that the
transfer of his shares in Davidge and Kuma to his Estate should
be treated like any other disposition under section 1377
entitling him to receive a pro rata share of each loss.
     We agree with respondent.    Section 1398 specifically applies
to individuals in bankruptcy and must be considered before
applying the rules of section 1377 to S corporation shareholders
in bankruptcy.   Under section 1398(f)(1), a transfer of an asset
from the debtor to the bankruptcy estate when the debtor files
for bankruptcy is not a disposition triggering tax consequences,
                                 - 8 -

and the estate is treated as the debtor would be treated with
respect to that asset.   Therefore, the Estate is treated as if it
had owned all the shares of Davidge and Kuma for the entire year
and, accordingly, is entitled to the entire loss that each of
Davidge and Kuma generated during 1990, including the loss
attributable to each corporation for the period January 1 through
December 3, 1990.
     Section 1398(e)(1) specifically addresses how income or loss
should be allocated between the individual debtor and the
bankruptcy estate.   The bankruptcy estate is entitled to the
individual debtor’s items of income or loss from the bankruptcy
commencement date under section 1398(e)(1) while any items of
income or loss that the individual debtor received or accrued
before filing for bankruptcy remain with the debtor.10
     We find that petitioner did not receive or accrue any items
of income or loss from Davidge or Kuma in 1990 before he filed
for bankruptcy.   Income or loss of an S corporation is determined
as of the last day of the corporation’s taxable year.      We find
that, because petitioner filed for bankruptcy before the last day
of the S corporations’ tax year, losses of the corporations for
that year flow through in their entirety to the bankruptcy
estate, and in no part to him.
     We held similarly in the partnership context in Gulley v.
Commissioner, T.C. Memo. 2000-190.       In Gulley, we interpreted
section 1398 as it pertained to a partnership interest of an


     10
      The parties stipulated that petitioner did not elect to
bifurcate the 1990 tax year into short, prepetition and
postpetition, years pursuant to sec. 1398(d)(2).
                                 - 9 -

individual partner who filed for bankruptcy.       At issue in Gulley
was whether a partnership loss incurred during the year in which
the individual partner filed for bankruptcy flowed through to the
partner or his bankruptcy estate.        We held that the bankruptcy
petition did not cause the partnership taxable year to close and
that the prepetition losses flowed through to the bankruptcy
estate, not the individual partner.
     Our rationale in Gulley applies to these cases.       Although
there are distinctions between partnerships and S corporations,
none mandate a different result here from our opinion in Gulley.
Both S corporations and partnerships determine income or loss as
of the last day of the entity’s tax year.       See secs. 706(a),
1366(a).   The transfer of shares of an S corporation or a
partnership interest to an individual bankruptcy estate when the
debtor files for bankruptcy does not trigger tax consequences
under section 1398(f)(1) and therefore does not require
calculating items of income or loss as between the individual
debtor and the estate.
     In Gulley and in these cases, the bankruptcy estate held the
entire interest in each respective entity as of the entity’s tax
yearend.   Neither the transfer by the taxpayer in Gulley, nor the
transfer by petitioner, to his respective bankruptcy estate is a
taxable disposition under section 1398(f)(1).       See also Smith v.
Commissioner, T.C. Memo. 1995-406.       Accordingly, as in Gulley,
the bankruptcy estate, not petitioner, is entitled to the income
or loss of the S corporations.
                              - 10 -

     In these cases, by operation of bankruptcy law, the shares
of Davidge and Kuma became property of the Estate when petitioner
filed his bankruptcy petition on December 3, 1990.   Before that
date, none of the loss generated by Davidge or Kuma during 1990
was distributable to petitioner.   The Estate held the shares on
December 31, 1990, the taxable yearend for both corporations.
There was no taxable disposition, and the Estate is treated as
petitioner would have been treated with respect to the shares of
Davidge and Kuma under section 1398(f)(1).   Thus, the
corporations’ losses flowed through to the Estate rather than to
petitioner.
     We next address petitioner’s argument that, because
subsection (g)(1) is the only subsection of section 1398 that
deals specifically with losses, section 1398(g)(1) controls to
entitle petitioner to the losses generated during the year in
which he filed for bankruptcy.   Petitioner reasons that the
Estate succeeds solely to the debtor’s net operating loss
carryovers under section 172 “determined as of the first day of
the debtor’s taxable year in which the case commences”.    Sec.
1398(g).   By focusing on the language “determined as of the first
day of the debtor’s taxable year in which the case commences” in
section 1398(g)(1), petitioner argues that the Estate does not
succeed to any loss Davidge or Kuma generated during the year in
which petitioner filed bankruptcy.
     Petitioner misconstrues section 1398(g)(1).   While section
1398(g)(1) deals with losses, it deals only with carryover losses
(i.e., losses generated before the year in which the individual
                               - 11 -

files for bankruptcy, not losses generated during the year in
which the individual files for bankruptcy).    The losses at issue
here are losses generated during the year in which petitioner
filed for bankruptcy.
      For all the foregoing reasons, we hold that the Estate is
entitled to report the losses Davidge and Kuma generated during
the year in which petitioner filed for bankruptcy.    Accordingly,
we sustain respondent’s determination in the notices of
deficiency disallowing petitioner’s losses from Davidge and Kuma
in 1990.
II.   The Loss Carryforward After Discharge
      We turn next to the issue whether petitioner is entitled to
report carryforward losses.    We begin with some fundamental
principles.    First, a bankruptcy estate can offset income it
generates during bankruptcy with any of the debtor’s operating
losses to which it succeeds.    See secs. 1398(e)(1) and (f)(1),
172(b)(2).    Second, any loss the bankruptcy estate does not use
in one year can be carried forward to offset income the
bankruptcy estate generates in future years until termination of
the estate or until the entire loss is expended or expires.      Sec.
172(b)(2).    Third, if a loss carryforward remains after the
termination of the bankruptcy estate, the discharged debtor
succeeds to the assets and tax attributes of the bankruptcy
estate, including loss carryforwards.    Sec. 1398(i).
      While normally discharge of indebtedness income is taxable
under section 61(a)(12), cancellation of indebtedness (COD)
income realized as a result of a bankruptcy discharge is excluded
                              - 12 -

from gross income in the year of discharge under section 108(a).
In exchange for this exclusion, certain tax attributes that pass
to the debtor from the bankruptcy estate must be reduced by the
amount of debt discharged.   Sec. 108(b)(2).   One such tax
attribute is any remaining loss carryforward.     Id.
     Petitioner was discharged in bankruptcy in 1997.    Instead of
petitioner succeeding to any loss carryforward from the Estate in
1997, respondent argues that any loss carryforward must be
reduced dollar for dollar by the amount of debt discharged.    We
agree.
     The net operating loss that each of Davidge and Kuma
sustained in 1990 flowed through on December 31, 1990, to the
Estate, the sole shareholder at both S corporations’ yearend.
The Estate carried forward these losses through 1997, the year in
which the bankruptcy proceedings terminated.    When petitioner was
discharged in bankruptcy, any remaining losses in the Estate
would have passed to him under section 1398(i).    However, the
discharged $4 million Citibank loan created COD income that was
excluded from petitioner’s gross income under section 108(a).
Thus, any loss carryforward--in this case, the loss approximating
$3,500,000--otherwise available to petitioner upon the
termination of the Estate is reduced dollar for dollar for the
excluded COD income under section 108(b)(2).    Therefore, any loss
carryforward of the Estate to which petitioner succeeded was
reduced to zero under section 108(b)(2)(A).    Petitioner had no
loss in 1997 to recognize in that year or to carry forward to
subsequent years.
                                - 13 -

     On the basis of the foregoing, we sustain respondent’s
determination in the notices of deficiency disallowing
petitioner’s loss carryforwards.
III. Accuracy-Related Penalty
     We turn now to respondent’s determination in the notices of
deficiency that petitioner is liable for the accuracy-related
penalty under section 6662(a) for each year at issue.    Respondent
has the burden of production under section 7491(c) and must come
forward with sufficient evidence that it is appropriate to impose
the penalty.   See Higbee v. Commissioner, 116 T.C. 438, 446-447
(2001).
     Respondent determined that petitioner is liable for the
accuracy-related penalty for a substantial understatement of
income tax under section 6662(b)(2) for each year at issue.
There is a substantial understatement of income tax if the amount
of the understatement exceeds the greater of either 10 percent of
the tax required to be shown on the return, or $5,000.   Sec.
6662(d)(1)(A); sec. 1.6662-4(a), Income Tax Regs.
     Respondent has met his burden of production with respect to
petitioner’s substantial understatement of income tax.   The
following table demonstrates that petitioner understated his
income tax for each year at issue in an amount greater than
$5,000 or 10 percent of the tax required to be shown on his
return.
                                - 14 -

Year          Tax Reported       Required Tax       Understatement

1996              $700             $60,297             $59,597
1997               536              64,215              63,679
1998             4,463              34,987              30,524
1999            11,846              39,012              27,166
2000             9,673              22,534              12,681

       The accuracy-related penalty under section 6662(a) does not
apply to any portion of an underpayment, however, if it is shown
that there was reasonable cause for the taxpayer’s position and
that the taxpayer acted in good faith with respect to that
portion.    Sec. 6664(c)(1); sec. 1.6664-4(b), Income Tax Regs.
The determination of whether a taxpayer acted with reasonable
cause and in good faith is made on a case-by-case basis, taking
into account all the pertinent facts and circumstances, the most
important of which is the extent of the taxpayer’s effort to
assess his proper tax liability for the year.     Sec. 1.6664-
4(b)(1), Income Tax Regs.     Circumstances that may indicate
reasonable cause and good faith include an honest
misunderstanding of law that is reasonable in light of all of the
facts and circumstances.     Sec. 1.6664-4(b), Income Tax Regs.
       While the Commissioner bears the burden of production under
section 7491(c), the taxpayer bears the burden of proof with
respect to reasonable cause.     Higbee v. Commissioner, supra at
446.    The mere fact that we have held against petitioner on the
substantive issue does not, in and of itself, require holding for
respondent on the penalty.     See Hitchins v. Commissioner, 103
T.C. 711, 719-720 (1994) (“Indeed, we have specifically refused
to impose * * * [a penalty] where it appeared that the issue was
                              - 15 -

one not previously considered by the Court and the statutory
language was not entirely clear.”).
     We agree with petitioner that he made a reasonable attempt
to comply with the Internal Revenue Code.    Because this is a case
of first impression, there was no clear authority to guide
petitioner as to the complex and overlapping issues of tax and
bankruptcy law.   We note that respondent has not referred us to
nor have we found any cases that have previously answered the
questions before us.   Petitioner had an honest misunderstanding
of the law, and the position petitioner took was reasonably
debatable.   Accordingly, in light of all the facts and
circumstances, we find petitioner acted reasonably and in good
faith with respect to the underpayment for the years at issue and
is not liable for the accuracy-related penalties under section
6662(a).
     We have considered the other arguments of the parties and,
to the extent not discussed above, we conclude that the arguments
are irrelevant, moot, or meritless.
     To reflect the foregoing,

                                           Decisions will be entered
                                      for respondent with respect to
                                      the deficiencies and for
                                      petitioner with respect to the
                                      penalty under section 6662(a).
