                        T.C. Memo. 1998-260



                      UNITED STATES TAX COURT



           MARTIN AND BARBARA SCHACHTER, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 2939-96.                        Filed July 15, 1998.



     Martin A. Schainbaum, for petitioners.

     Paul J. Krug, for respondent.


             MEMORANDUM FINDINGS OF FACT AND OPINION


     SWIFT, Judge:   Respondent determined deficiencies in and

additions to tax with regard to petitioners' taxable years as

follows:
                                                        - 2 -
                                                           Additions to Tax
                     Sec.           Sec.          Sec.       Sec.       Sec.        Sec.      Sec.
                     6653           6653          6653       6653       6653        6653      6653     Sec.
Year   Deficiency   (a)(1)       (a)(1)(A)     (a)(1)(B)    (b)(1)   (b)(1)(A)   (b)(1)(B)   (b)(2)    6661

1985    $163,048       --               --         --      $81,524      --           --         **    $40,762
1986     168,368       --          $     336        *         --     $121,229        **         --     42,092
1987     154,962       --              2,220        *         --       82,915        **         --     38,741
1988      21,488      $39               --         --       15,525      --           --         --      5,372


                             *    50 percent of interest due on portion of
                                  underpayment attributable to negligence.

                             ** 50 percent of interest due on portion of
                                underpayment attributable to fraud.


              Unless otherwise indicated, 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.

              The primary issues for decision are whether petitioners are

       to be charged with additional partnership income and whether

       petitioners are liable for the fraud and other additions to tax.


                                               FINDINGS OF FACT

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

              Petitioners are husband and wife and resided in Hayward,

       California, at the time they filed their petition in this case.

       Hereinafter references to petitioner are to Martin Schachter.

              In 1954, petitioner’s father Ben Schachter began operating

       as a sole proprietorship a wholesale soap distribution business

       under the name of Cal Ben Co. (Cal Ben).
                               - 3 -

     By May of 1955, petitioner and a relative by the name of

David Karp were working as partners in the business, and Cal Ben

was conducted as a partnership.

     On September 7, 1959, Ben Schacter, David Karp, and

petitioner entered into a written partnership agreement that

provided that they would share equally as partners in the profits

and losses of Cal Ben.

     On May 1, 1967, Ben Schachter retired and relinquished his

interest in Cal Ben.   Thereafter, petitioner and David Karp

operated Cal Ben as equal partners, and each was entitled to 50

percent of the profits and losses of Cal Ben.

     A checking account and a money market account for Cal Ben

were maintained in Cal Ben's name at Bay Bank of Commerce.     The

address for the accounts at Bay Bank of Commerce apparently

reflected Cal Ben's mailing address, and all bank statements for

these accounts apparently were mailed to Cal Ben's business

mailing address.

     Also, after August 8, 1977, and during the years in issue, a

bank account was maintained at Lloyds Bank California (which in

1986 was acquired by Sanwa Bank California) in the name of "C B

Co., MFG." (the Lloyds/Sanwa account).   Petitioner and David Karp

were authorized signatories on the Lloyds/Sanwa account.   The

address for the Lloyds/Sanwa account reflected petitioners'

residence address, and all bank statements for the Lloyds/Sanwa

account were mailed to petitioners' residence.
                                - 4 -

     Cal Ben's books and records were maintained and Cal Ben's

partnership tax returns were filed using a hybrid method of

accounting under which the accrual method of accounting was used

to account for purchases and sales of Cal Ben's inventory of soap

products, and the cash method of accounting was used to account

for other miscellaneous items of income and for Cal Ben's general

business expenses.   Cal Ben's general business expenses were

recorded on a cash basis in a cash disbursements journal.

     From 1955 through 1987, petitioner Barbara Schachter and

Marcia Karp, David Karp’s wife, maintained on a part-time basis

the books and records of Cal Ben.   In January of 1987, a full-

time bookkeeper was hired and assumed bookkeeping

responsibilities for Cal Ben.

     Purchase orders from Cal Ben’s customers for soap products

generally were received in the offices of Cal Ben over the

telephone.   Whoever received the telephone purchase orders

prepared for each order a sales invoice.   A copy of each sales

invoice was sent to Cal Ben's warehouse to have the order filled.

A copy of each sales invoice was sent to the customers along with

the merchandise, and the original of each sales invoice was given

to petitioner.

     After reviewing sales invoices, petitioner generally would

forward the invoices to Cal Ben's bookkeepers.   Upon receipt of

sales invoices from petitioner, the bookkeepers recorded
                               - 5 -

information relating to the sales reflected by the invoices in

Cal Ben’s sales journal (reported sales).

     During at least 1985, 1986, 1987, and 1988, however,

petitioner did not forward to Cal Ben's bookkeepers all of Cal

Ben's sales invoices.   As a result, sales associated with

invoices not forwarded to Cal Ben's bookkeepers were not

reflected as sales in Cal Ben’s sales journal (unreported sales).

     Cal Ben's sales invoices were not identified by number, and

therefore unreported sales could not be easily detected and

identified.

     Petitioner generally opened mail containing payments

received from Cal Ben's customers.     Payments received relating to

reported sales were deposited into Cal Ben’s bank accounts at Bay

Bank of Commerce.   With regard, however, to payments received

relating to unreported sales, petitioner or David Karp would

prepare bank deposit slips and would deposit the payments into

the Lloyds/Sanwa account.

     Petitioners were aware of the existence of the Lloyds/Sanwa

account, and they were aware that unreported sales were not

recorded in Cal Ben’s sales journal.

     During 1985 through 1988, payments received on sales of Cal

Ben's soap products were deposited into the above three bank

accounts in the following amounts:
                                         - 6 -

          Bank               1985           1986            1987           1988
Bay Bank of Commerce
     Checking acct        $1,525,661      $1,622,475     $1,437,782      $1,711,269
     Money market             -0-             -0-            -0-            204,056

Lloyds/Sanwa acct            683,161         764,642        632,943         145,305

     Total deposits       $2,208,822      $2,387,117     $2,070,725     $2,060,630


              Some funds deposited into the Lloyds/Sanwa account were

       later transferred to Cal Ben’s accounts at Bay Bank of Commerce

       and were used to purchase inventory and other supplies for Cal

       Ben.    Those purchases were recorded in Cal Ben's books and

       records as purchases.

              During the years in issue, petitioners used funds deposited

       into the Lloyds/Sanwa account to purchase tax-exempt bearer bonds

       in their individual names.      During the years in issue,

       petitioners also used funds deposited into the Lloyds/Sanwa

       account to pay expenses relating to a personal yacht, a facelift

       for Barbara Schachter, and carpet and utility expenses for

       petitioners' residence.

              Petitioners knew that funds relating to unreported sales

       deposited into the Lloyds/Sanwa account had been used to purchase

       the bonds, and Barbara Schachter generally cashed interest

       coupons associated with the bearer bonds.

              In December of 1987, petitioner purchased a 1988 BMW 750IL

       automobile with cash totaling $72,451.
                                - 7 -

       Cal Ben’s 1985 through 1988 Forms 1065, U.S. Partnership

Return of Income, were prepared by Burton Propp (Propp), a

certified public accountant.    The gross receipts figures reported

by Propp on Cal Ben's partnership tax returns were taken from

reported sales recorded in Cal Ben's sales journal.

       Propp was given no information relating to Cal Ben's

unreported sales, nor was he given any information relating to

payments received from customers that were deposited into the

Lloyds/Sanwa account.    Propp was not told nor otherwise informed

of the existence of the Lloyds/Sanwa account.    As a result, total

sales receipts of Cal Ben and the taxable income of petitioners

relating to petitioner's 50-percent partnership interest in Cal

Ben were underreported on Cal Ben’s partnership and on

petitioners’ individual Federal income tax returns

       Petitioner understood that he was legally obligated to pay

income taxes on his share of Cal Ben’s net partnership profits.

       The schedule below sets forth Cal Ben's gross sales as

reported on Cal Ben’s partnership tax returns for the years at

issue, unreported sales as stipulated by the parties, and Cal

Ben’s corrected gross sales:


                                 Cal Ben's Gross Sales
Year               Reported          Unreported        Corrected
1985              $1,486,450        $ 667,862          $2,154,312
1986               1,562,228           660,536          2,222,764
1987               1,455,416           507,766          1,963,182
1988               1,679,209           116,784          1,795,993

       Total      $6,183,303        $1,952,948         $8,136,251
                                 - 8 -

     On June 6, 1988, 6 days after respondent’s representative

first contacted petitioner to initiate the audit of petitioners'

Federal income tax returns and of Cal Ben's partnership tax

returns for 1985 through 1988, petitioner closed the Lloyds/Sanwa

account.

     On October 24, 1986, petitioner signed an application for a

credit card on which he represented that Cal Ben had gross sales

for 1985 of $2.1 million.

     On Cal Ben’s 1986, 1987, and 1988 partnership tax returns,

costs for various personal items and for items that, during

respondent’s audit, petitioners could not substantiate were

claimed as deductions.

     On petitioners' 1985 through 1988 joint Federal income tax

returns, petitioners underreported petitioner's share of the net

income of Cal Ben, as follows:


                     Year             Amount
                     1985            $333,931
                     1986             337,606
                     1987             257,871
                     1988              79,799


     On their 1987 joint Federal income tax return, petitioners

underreported gain realized on sale of petitioners' residence

located in Aptos, California.    The gain was underreported as a

result of petitioners’ inclusion of nondeductible repair expenses

and recurring items in the calculation of their adjusted tax

basis in the residence and of petitioners’ failure to adjust the
                               - 9 -

tax basis of the residence by casualty losses sustained and

claimed in prior years.

     During respondent’s audit, when petitioner was asked if he

had made any purchase with cash in excess of $10,000, petitioner

incorrectly stated that he had not done so.

     On August 17, 1988, respondent’s representative requested

petitioner to provide copies of all bank statements for 1985

through 1988 relating to Cal Ben and to petitioner.   In response

to that request, respondent’s representative was provided

documents pertaining only to the two bank accounts at Bay Bank of

Commerce.   Respondent's representative was not informed by

petitioner of the Lloyds/Sanwa account.

     When he discovered deposits into the Lloyds/Sanwa account,

respondent's representative requested of petitioner records

pertaining to that account, but petitioner refused to provide any

further information.

     At the conclusion of respondent’s audit, respondent

determined against petitioners the income tax deficiencies, the

fraud, and the negligence additions to tax set forth above, and

respondent determined that the fraud related only to unreported

sales of Cal Ben and that negligence related to all other

adjustments.

     In determining the income tax deficiencies, respondent

allowed as business expense deductions nearly all of the costs

and expenses that were recorded in Cal Ben’s books and records
                              - 10 -

and that were claimed on Cal Ben’s partnership tax returns.

During and after trial, the parties settled all issues relating

to deductions disallowed in respondent’s notice of deficiency.

     In 1993, a Federal grand jury returned an indictment

charging petitioner and David Karp with tax evasion in violation

of section 7201 and with conspiracy to defraud the United States

by obstructing the lawful ascertainment and collection of income

taxes in violation of 18 U.S.C. section 371.

     On May 30, 1993, after his indictment, David Karp died.

     On September 23, 1993, petitioner pled guilty to one count

of tax evasion with respect to his individual income tax

liability for 1986 in violation of section 7201 and to one count

of conspiracy to defraud the United States in violation of 18

U.S.C. section 371.   In connection with the above plea,

petitioner was sentenced to prison and fined $250,000.


                              OPINION

     Under section 6653(b) the addition to tax for fraud is

applicable if any part of an underpayment of tax is attributable

to fraud.   To establish fraud, respondent is required to prove

that the taxpayer underreported his or her correct tax liability

and that some part of the underreporting was due to fraudulent

intent.   DiLeo v. Commissioner, 96 T.C. 858, 873 (1991), affd.

959 F.2d 16 (2d Cir. 1992).
                              - 11 -

     Respondent has the burden of proving fraud by clear and

convincing evidence.   Sec. 7454(a); Rule 142(b); Bagby v.

Commissioner, 102 T.C. 596, 607 (1994).

     As we have found, the evidence establishes that Cal Ben's

sales were significantly underreported for each year at issue and

that as a result petitioner's share of Cal Ben's sales income was

underreported on petitioners' joint Federal income tax returns.

     Petitioners contend, however, that Cal Ben's unreported

sales for each year should be offset by additional deductible

business expenses of Cal Ben that allegedly were paid out of the

Lloyds/Sanwa account, that were not properly recorded as expenses

in Cal Ben’s cash disbursements journal, and that were not

claimed on Cal Ben's partnership tax returns.   Petitioners

contend that the additional expenses, if allowed, would greatly

reduce the unreported net income of Cal Ben and the unreported

taxable income of Cal Ben chargeable to petitioner.   In support

of the claimed additional business expenses, petitioners offer

evidence of net profit margins of other wholesale businesses.

Petitioners note that without allowance of the claimed additional

business expenses, net profit margins of Cal Ben would far exceed

average net profit margins relating to wholesale businesses, as

set forth in government and business survey data.   Further,

petitioners claim that funds used to purchase bonds, a yacht, and

other expensive items for personal use constituted accumulated
                                - 12 -

savings of capital from prior years, not unreported current-year

sales of Cal Ben.

     Petitioners' arguments are not persuasive.

     We first note that the unreported sales of Cal Ben for each

of the years in issue reflect figures substantially higher than

the claimed additional business expenses of Cal Ben.    Thus, even

if the claimed additional business expenses of Cal Ben were

allowed, the net profits of Cal Ben (and petitioners’

underreported taxable income relating thereto) would still be

substantial.

     Evidence as to average profit margins of other businesses

does not overcome, in this case, the evidence that establishes

Cal Ben’s unreported sales and the lack of any credible evidence

that establishes Cal Ben’s entitlement to additional business

expenses.

     General survey information regarding other businesses does

not, in this case, provide a credible basis for allowing Cal Ben

additional business expenses.    The survey information is general.

It does not purport to represent information on companies

comparable to Cal Ben.   It raises no doubt in our mind as to the

underreporting of significant sales and partnership income that

occurred on Cal Ben’s partnership tax returns and the

underreporting of petitioner's income that occurred on

petitioners’ Federal income tax returns.
                              - 13 -

     Petitioners argue that Cal Ben’s net profit percentages as

reflected on Cal Ben’s filed and audited partnership tax returns

for later years (namely, 1994 and 1995) corroborate their claim

that during the years in issue Cal Ben’s actual profit margins

were much lower than those reflected by respondent’s audit

adjustments and that Cal Ben must have incurred and should now be

allowed significant additional business expenses during the years

in issue.   We disagree.

     During 1994 and 1995, Cal Ben was operated not as a

partnership but as a sole proprietorship owned by petitioner, and

Cal Ben was managed by others while petitioner was incarcerated

in Federal prison on his sentence for tax evasion and conspiracy.

Further, petitioner and Cal Ben incurred extraordinary legal fees

in 1994 relating to petitioner’s legal problems.   Thus, Cal Ben’s

reported sales receipts and income for 1994 and 1995 are not

indicative of Cal Ben’s income in earlier years.

     In light of the evidence in this case regarding, among other

things, Cal Ben's unreported sales, Cal Ben’s inadequate books

and records, the undisclosed Lloyds/Sanwa bank account in which

payments from unreported sales were deposited, the personal

purchases, and petitioner’s lack of cooperation, petitioners’

attempted use of general survey data regarding profit margins of

unrelated companies is of little persuasive value and is

rejected.   Although used in appropriate cases -- particularly by

respondent where taxpayers have not filed income tax returns and
                               - 14 -

have not maintained adequate books and records -- general survey

data may be rejected where taxpayers, as in the instant case,

seek to use such data to overcome clear evidence of unreported

income.    See, e.g., United States v. Marabelles, 724 F.2d 1374,

1381-1382 (9th Cir. 1984); Lollis v. Commissioner, 595 F.2d 1189,

1190-1191 (9th Cir. 1979), affg. T.C. Memo. 1976-15; Cebollero v.

Commissioner, 967 F.2d 986 (4th Cir. 1992), affg. T.C. Memo.

1990-618.    As we have stated --

       Such evidence is * * * of little probative value * * *
       and * * * too speculative to serve as the basis for
       additional reductions in gross income * * * [Farrow v.
       Commissioner, T.C. Memo. 1985-518.]

       We note that once respondent has established unreported

sales, the taxpayer has the burden of proving with credible

evidence expenses that would offset the unreported sales.    See

United States v. Marabelles, supra at 1379; Barragan v.

Commissioner, 69 F.3d 543 (9th Cir. 1995) (citing Elwert v.

United States, 231 F.2d 928, 933 (9th Cir. 1956)), affg. without

published opinion T.C. Memo. 1993-92; Avery v. Commissioner, T.C.

Memo. 1993-344.

       For the first time at trial, petitioners asserted their

entitlement to additional deductible business expenses for Cal

Ben.    The petition filed by petitioners made no allegation with

regard to unclaimed partnership expenses, and general and vague

references in the petition to “additional” facts do not satisfy

the affirmative pleading requirement of Rule 34(b) with regard to
                              - 15 -

such expenses.   Pebley v. Commissioner, T.C. Memo. 1981-701,

affd. without published opinion 703 F.2d 576 (9th Cir. 1983).

Even if petitioners were to conform the pleadings to the proof,

the evidence introduced by petitioners at trial regarding alleged

additional business expenses was so unsubstantial that such a

motion, if made, would be denied.   Goldsmith v. Commissioner, 31

T.C. 56, 63-64 (1958).

     In any event, with exception of two items that the parties

have agreed to, we reject the evidence regarding claimed

additional business expenses of Cal Ben.1   Petitioner’s self-

serving testimony that Cal Ben's payments from unreported sales

deposited into the Lloyds/Sanwa account were used for additional

off-the-book partnership expenses was not credible.   Copies of

checks drawn on the Lloyds/Sanwa account indicate that much of

the sales receipts deposited into the Lloyds/Sanwa account was

used to make personal investments and to pay personal expenses.

Other checks were merely made payable to petitioner Barbara

Schachter or to David Karp personally.   The names of the payees

on many of the checks are illegible.

     Petitioners did not call as trial witnesses any of the

individual payees whose names on the checks are legible to

testify as to the purposes of the payments, nor did petitioners



1
      At trial, respondent did allow petitioner additional
deductible business expenses for consulting payments of
$19,502.59 and for truck depreciation.
                              - 16 -

introduce any invoices or other records to establish a business

purpose for the payments.

     The expert report prepared by petitioners’ expert for

purposes of this litigation is based largely on out-of-court

statements purportedly made by petitioner regarding checks

written on the Lloyds/Sanwa account.   Other than petitioner’s

testimony, no trial testimony or other documentary evidence was

offered or admitted at trial to establish the purpose of the

checks.

     Although we allowed petitioners' expert’s report into

evidence, much of the information relied upon by petitioners’

expert is vague and so speculative as to make his report largely

meaningless.   Soden v. Freightliner Corp., 714 F.2d 498, 500-507

(5th Cir. 1983); United States v. Sims, 514 F.2d 147, 149-150

(9th Cir. 1975); Viterbo v. Dow Chem. Co., 646 F. Supp. 1420,

1424 (E.D. Tex. 1986), affd. 826 F.2d 420 (5th Cir. 1987).

Further, under rule 703 of the Federal Rules of Evidence,

petitioners' expert’s reliance on hearsay in his report does not

elevate the hearsay to the status of evidence that would

establish the truth of the matter asserted (namely, the business

nature and deductibility of alleged expenses mentioned therein).

Paddack v. Dave Christensen, Inc., 745 F.2d 1254, 1261-1262 (9th

Cir. 1984); Greenberg v. United States, 295 F.2d 903, 907-909

(1st Cir. 1961).
                             - 17 -

     Also, because petitioners’ expert’s report was based, in

large part, on hearsay evidence, and not on complete and legible

books and records of Cal Ben or of petitioners, the report is not

entitled to additional weight under rule 1006 of the Federal

Rules of Evidence as a summary of otherwise admissible voluminous

records.

     Petitioner testified that $50,455 in 1985 and $84,078 in

1987 of payments from unreported sales deposited into the

Lloyds/Sanwa account were used to purchase inventory and should

be treated as additional cost of goods sold.    It appears,

however, that these claimed additional inventory purchases were

already taken into account as costs of goods sold in Cal Ben’s

purchase journal and partnership tax returns.

      With regard to illegible checks drawn on the Lloyds/Sanwa

account and expenses allegedly incurred for business travel,

entertainment, and gifts, the canceled checks and petitioner's

unsupported testimony fail the substantiation requirements of

section 274(d).

     The record in this case provides no basis, under Cohan v.

Commissioner, 39 F.2d 540 (2d Cir. 1930), for estimating alleged

additional business expenses of Cal Ben.   Other than expenses the

parties have agreed to, no credible evidence supports

petitioners’ claim that additional business expenses were

incurred by Cal Ben, and no credible evidentiary basis was
                                - 18 -

provided on which estimates of additional business expenses could

be made.

     Petitioners’ claim that the large personal investments and

purchases were made with accumulated, nontaxable capital savings

from earlier years is completely unsubstantiated and incredible.

Petitioners’ investments in the bearer bonds and other large

personal expenses that were incurred during the years in issue

appear clearly to have been paid with payments from unreported

sales of Cal Ben deposited into the Lloyds/Sanwa account.

     Instead of presenting credible evidence (e.g., receipts,

invoices, and testimony of payees identified on checks

representing alleged additional business expenses), petitioners

largely offered only speculative testimony and general survey

data.

     The credible evidence before us establishes that

petitioner's 50-percent share of the cumulative unreported gross

sales of Cal Ben is approximately $960,000.     See chart supra p.

7.   It is established that substantial underpayments of

petitioners' correct Federal income tax liabilities occurred for

each year in issue.

        Because of his criminal conviction for tax evasion,

petitioner's fraudulent intent with regard to his 1986 Federal

income tax liability is established.     DiLeo v. Commissioner, 96

T.C. at 885-886; Amos v. Commissioner, 43 T.C. 50 (1964), affd.

360 F.2d 358 (4th Cir. 1965).
                               - 19 -

     With regard to 1985, 1987, and 1988, petitioner’s conspiracy

conviction constitutes evidence of petitioner's fraudulent

intent.    Mobley v. Commissioner, 33 F.3d 1382 (11th Cir. 1994),

affg. without published opinion T.C. Memo. 1993-60.

     The cumulative evidence in this case is strong and

persuasive to the effect that, during at least the 4 years in

issue, sales of Cal Ben were knowingly underreported, and

petitioners' taxable income relating thereto was knowingly and

willfully underreported on petitioners' Federal income tax

returns.

     Petitioner handled the invoices, payments, and bank deposits

relating to Cal Ben’s unreported sales.   Petitioners used

payments from unreported sales of Cal Ben to make personal

investments and to pay personal expenses.

     The evidence is clear and convincing that during 1985

through 1988 petitioner intentionally diverted approximately $2

million of unreported sales of Cal Ben into the Lloyds/Sanwa

account.    Petitioner intentionally withheld invoices pertaining

to these sales from Cal Ben’s bookkeepers so that the specific

sales would not be recorded in Cal Ben's sales journal and in the

form of partnership income on petitioners' income tax returns.

     Barbara Schachter was a bookkeeper for Cal Ben and knew of

the Lloyds/Sanwa account and knew generally that payments from

unreported sales were deposited into that account were not

recorded in Cal Ben's sales journal.    Barbara Schachter's claim
                               - 20 -

that she understood that many of the checks deposited into the

Lloyds/Sanwa account represented bad checks is not credible.

Bank statements for the Lloyds/Sanwa account were mailed to

petitioners’ residence, and Barbara Schachter was the recipient

of significant funds paid out of that account.

     The evidence is persuasive, and we so find, that petitioners

each fraudulently intended to evade reporting and paying their

correct Federal income tax liabilities for 1985, 1986, 1987, and

1988 relating to unreported sales of Cal Ben.    Petitioners

underreported their distributive share of Cal Ben’s income with

knowledge of the understatements and with intent to commit fraud.

     Further evidence of petitioners’ fraud includes:   (1) The

large discrepancies between the income reported on petitioners’

income tax returns and petitioners' corrected income; (2) the

failure to maintain accurate and complete books and records;

(3) the fact that petitioners provided incorrect and incomplete

information to their tax return preparer; and (4) the fact that

petitioners did not disclose the Lloyds/Sanwa account to

respondent’s representative.

     Lastly, with regard to fraud, petitioners argue that

imposition of the civil fraud addition to tax on top of

petitioner's prison sentence and fine relating to his criminal

conviction would constitute double jeopardy and would violate the

U.S. Constitution.
                                - 21 -

     We disagree.   See Hudson v. United States, 522 U.S. __,

118 S. Ct. 488 (1997); Kennedy v. Mendoza-Martinez, 372 U.S. 144

(1963); Helvering v. Mitchell, 303 U.S. 391 (1938); Grimes v.

Commissioner, 82 F.3d 286 (9th Cir. 1996); and I & O Publg. Co.

v. Commissioner, 131 F.3d 1314 (9th Cir. 1997), affg. Ward v.

Commissioner, T.C. Memo. 1995-286, which are controlling on this

issue in favor of respondent.

     Because a part of petitioners' underpayment of tax for each

year in issue was due to fraud, the assessment of tax

deficiencies for each year is not barred by the statute of

limitations.    Sec. 6501(c)(1); Meier v. Commissioner, 91 T.C.

273, 303 (1988).

     Respondent determined that the negligence addition to tax

under section 6653(a) applies to the portion of the deficiencies

in tax for 1986, 1987, and 1988 that are not subject to the fraud

addition to tax (namely, the entire amount of the deficiencies

other than that portion attributable to petitioner’s share of Cal

Ben's unreported sales).   The portions of the deficiencies

against which the negligence additions to tax were determined

relate primarily to unsubstantiated claimed partnership business

expenses and the inclusion of repairs in petitioners' calculation

of the tax basis on the Aptos residence, issues which the parties

have settled.

     The negligence addition to tax will apply if, among other

things, the taxpayer fails to maintain adequate books and records
                              - 22 -

with regard to the items in question.   Crocker v. Commissioner,

92 T.C. 899, 917 (1989).   Because of petitioners' failure to

maintain such records and because of petitioners' improper

calculation, without adequate explanation, of the tax basis of

the Aptos residence, we conclude that petitioners are liable for

the negligence additions to tax relating to the above items and

to all other adjustments in issue.

     Section 6661(a) provides an addition to tax of 25 percent2

of the amount of any underpayment attributable to a substantial

understatement of tax.   The term "understatement" is defined in

section 6661(b)(2)(A) as being the excess of the amount of tax

required to be shown on the return for a year over and above the

amount shown on the return.   An understatement is substantial if

it exceeds the greater of 10 percent of the tax required to be

shown on the return or $5,000.   The amount of the understatement

can be reduced if substantial authority exists for the taxpayer's

treatment of the item in dispute, or if the item is adequately

disclosed in the return or in a statement attached to the return.

Sec. 6661(b)(2)(B).   For each year involved in this case, the




2
     In their trial memorandum, petitioners state that a 10-
percent rate was in effect for 1985. However, sec. 8002 of the
Omnibus Budget Reconciliation Act of 1986, Pub. L. 99-509, 100
Stat. 1951, increased the rate to 25 percent for penalties
assessed after Oct. 21, 1986. Therefore, the correct rate for
1985 is 25 percent. Licari v. Commissioner, 946 F.2d 690 (9th
Cir. 1991), affg. T.C. Memo. 1990-4.
                              - 23 -

deficiencies exceed both 10 percent of the tax required to be

shown on the return and $5,000.

     Petitioners presented no credible evidence that there

existed substantial authority for the erroneous treatment of any

item on their income tax returns or that any item was adequately

disclosed on their tax returns.   Petitioners are liable for the

substantial understatement additions to tax pursuant to section

6661.   See Slater v. Commissioner, T.C. Memo. 1996-366; Miravalle

v. Commissioner, T.C. Memo. 1994-49.


                                         Decision will be entered

                                    under Rule 155.
