                        T.C. Memo. 2006-32



                      UNITED STATES TAX COURT



SEARCY M. FERGUSON, JR., AND ELIZABETH L. FERGUSON, Petitioners
        v. COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 18229-04.             Filed February 27, 2006.



     Searcy M. Ferguson, pro se.

     Kathryn F. Patterson, for respondent.



                        MEMORANDUM OPINION


     WELLS, Judge:   Respondent determined a deficiency in

petitioners’ 2000 Federal income tax of $91,763, a section

6651(a)(1) addition to tax for failure to file of $9,176.30, and

a section 6662 accuracy-related penalty of $18,352.60.   Unless

otherwise indicated, all section references are to the Internal
                              - 2 -

Revenue Code, as amended, and all Rule references are to the Tax

Court Rules of Practice and Procedure.

     The issues to be decided are as follows:

     (1) Whether petitioners may deduct a loss related to the

alleged abandonment of real property by Searcy M. Ferguson’s

(petitioner) bankruptcy estate;

     (2) whether petitioners may deduct a loss related to the

alleged theft of a diamond ring by petitioner’s former wife;

     (3) whether petitioners may deduct a loss related to the

alleged failure of petitioner’s former wife to assume the

obligation of liens that attached to real property awarded to her

pursuant to an agreement incident to divorce;

     (4) whether petitioners may deduct a loss related to the

alleged failure of petitioner’s former wife to pay taxes on real

property awarded to her pursuant to an agreement incident to

divorce;

     (5) whether petitioners are liable for a section 6651(a)(1)

addition to tax for failure to file timely; and

     (6) whether petitioners are liable for a section 6662

accuracy-related penalty.
                               - 3 -

                            Background

General Background

     Petitioners are husband and wife.    At the time of the filing

of the petition, they resided in Dallas, Texas.

     From January of 1967 until their divorce in January of 1987,

petitioner was married to Elizabeth Robertson Ferguson Smith (Ms.

Smith).   The final judgment and decree of divorce incorporated an

agreement incident to divorce dated November 25, 1986 (the

divorce agreement).   To resolve various controversies subsequent

to the divorce agreement, Ms. Smith and petitioner entered a

settlement agreement in 1988 (the 1988 settlement agreement) and

another settlement agreement in 1989 (the 1989 settlement

agreement).

The Vernon Property

     During 1985, petitioner purchased three tracts of real

property in or near Vernon, Texas (hereinafter collectively

referred to as the Vernon property).1    During 1994, petitioner

secured a loan from Herring National Bank with a lien on the

Vernon property.

     During December of 1999, petitioner filed a bankruptcy

petition under chapter 11 of the Bankruptcy Code with the U.S.

Bankruptcy Court for the Northern District of Texas.    The case


     1
      Before 2001, petitioner conveyed a small portion of the
Vernon property.
                                - 4 -

was converted from a chapter 11 case to a chapter 7 case, and

petitioner subsequently transferred the Vernon property to the

bankruptcy estate.   On August 7, 2001, pursuant to a court order

lifting the automatic stay, Herring National Bank foreclosed on

the Vernon property.   During May of 2003, the court approved an

application filed by the bankruptcy trustee to abandon remaining

property, books, and records of the bankruptcy estate on grounds

that any remaining assets were of de minimis value.    On April 7,

2004, the court discharged petitioner in bankruptcy.

The Diamond Ring

     During 1984, petitioner’s wholly owned S corporation, Searcy

M. Ferguson, Inc. (the corporation), purchased a 16.25-carat

diamond, which subsequently was made into a ring (the diamond

ring), presumably at the expense of the corporation.    At the time

of the purchase, petitioner was married to Ms. Smith.   The

divorce agreement designated the diamond ring as the separate

property of Ms. Smith.

     As plaintiffs in a suit filed against Ms. Smith in Texas

State court on November 8, 1994, petitioner and the corporation

claimed, inter alia, that Ms. Smith was liable for conversion of

the diamond ring.    However, the trial court granted Ms. Smith’s

motion for summary judgment with respect to the conversion
                               - 5 -

claim.2   The court noted that petitioner had agreed pursuant to

the 1989 settlement agreement not to reopen the divorce case or

the divorce agreement.   Consequently, the court held petitioner

and the corporation to be barred by judgment and estopped by

agreement from asserting the conversion claim against Ms. Smith.3

The Southampton Property

     During their marriage, Ms. Smith and petitioner owned real

property located in Southampton, New York (the Southampton

property).   The divorce agreement designated the Southampton

property as the separate property of Ms. Smith.   With respect to

encumbrances on real property subject to the divorce agreement,

the divorce agreement contained the following indemnity provision

(the indemnity provision):

          Assumption of Encumbrances. Each party hereby
     assumes the encumbrances, ad valorem taxes and liens on
     all the property each will hold subsequent to the date
     of this Agreement, unless express provision is made
     herein to the contrary; and each party agrees to
     indemnify and hold harmless the other party and his or
     her property from any claim or liability that the other
     party will suffer or may be required to pay because of
     such encumbrances or liens.


     2
      As discussed below, the trial court also granted summary
judgment with respect to petitioner’s claims that Ms. Smith
breached the divorce agreement by failing to assume the liability
for liens on certain real property and for failing to file a
proper 1986 Federal income tax return.
     3
      Although petitioner and the corporation appealed the
judgment of the trial court, they did not claim on appeal that
the trial court erred in granting summary judgment with respect
to the conversion claim.
                               - 6 -

     From October 23, 1986, to January 30, 1987, petitioner

executed three deeds of trust, encumbering his community property

interest in the Southampton property as security for loans from

Union Bank & Trust of Dallas (Union Bank).   On December 17, 1987,

Union Bank released the three deeds of trust.    In a letter dated

December 18, 1987, Union Bank provided Ms. Smith’s attorney with

the following explanation for the release:

     Pursuant to your letter demanding our release of liens
     on * * *[the Southampton property], we have consulted
     with our attorney and have agreed to release our liens
     on the property. It does appear that the liens were
     granted in violation of an injunction at the time, and
     since * * *[petitioner] has deeded the property to
     * * *[Ms. Smith] as a result of their divorce, our
     unrecorded liens are invalid.

     Petitioner ultimately repaid the underlying liability to

Union Bank and added as a cause of action in his aforementioned

suit against Ms. Smith a claim that Ms. Smith breached the

indemnity provision of the divorce agreement by failing to assume

the obligation for the liens on the Southampton property.    As

with the conversion claim, the trial court granted Ms. Smith’s

motion for summary judgment with respect to the aforementioned

breach claim on grounds that petitioner had agreed pursuant to

the 1989 settlement agreement not to reopen the divorce case or

the divorce agreement.   The court held petitioner to be barred by

judgment and estopped by agreement from asserting the

aforementioned breach claim against Ms. Smith.   On appeal, the

appellate court upheld the trial court’s decision on grounds that
                                - 7 -

the claim was barred by the statute of limitations.   See Smith v.

Ferguson, 160 S.W.3d 115, 124 (Tex. Ct. App. 2005).

1986 Tax Liability

     With respect to the 1986 Federal income tax returns of Ms.

Smith and petitioner, the divorce agreement provided as follows:

          Manner of Preparing U.S. Individual Income Tax
     Return for 1986. Each party shall file a separate U.S.
     Individual Income Tax Return for the year 1986.
     Section 66 of the Internal Revenue Code is useable and
     applicable by spouse in 1986. * * *[Ms. Smith and
     petitioner] each agree that they will file their
     separate returns for 1986 in accordance with said
     section and pay the tax computed under said separate
     returns.

     The Internal Revenue Service examined petitioner’s 1986

Federal income tax return.   In docket No. 5841-92, this Court

entered a stipulated decision with respect to petitioner’s 1986

Federal income tax liability.

     Petitioner added, as a cause of action in his aforementioned

State court suit against Ms. Smith, a claim that Ms. Smith

breached the divorce agreement by failing to file a proper 1986

Federal income tax return and causing petitioner to pay Ms.

Smith’s Federal income tax liability for that year.   As with the

claims discussed above, the trial court granted Ms. Smith’s

motion for summary judgment with respect to the aforementioned

breach claim on grounds that petitioner had agreed pursuant to

the 1989 settlement agreement not to reopen the divorce case or

the divorce agreement.   The trial court held petitioner to be
                               - 8 -

barred by judgment and estopped by agreement from asserting the

aforementioned breach claim against Ms. Smith.    On appeal, the

appellate court upheld the trial court’s decision.    See id.   The

appellate court noted that petitioner indemnified Ms. Smith from

Federal income tax liabilities before 1987 pursuant to the 1988

settlement agreement.4   Id. at 123.   Consequently, the appellate

court held petitioner to be estopped from claiming that Ms. Smith

breached the divorce agreement by failing to file a proper 1986

Federal income tax return.   Id.




     4
      In Smith v. Ferguson, 160 S.W.3d 115, 123 n.5 (Tex. Ct.
App. 2005), the court set forth the tax indemnity provision of
the 1988 settlement agreement as follows:

     “Ferguson does hereby agree to pay out of the proceeds
     of the Closing all amounts due to the United States
     Internal Revenue Service for past due federal income
     taxes which have resulted in placement of federal tax
     liens against any asset in which Smith has a present
     interest, and to further obtain releases for Smith from
     the Internal Revenue Service releasing federal tax
     liens that it now has in any such property in which
     Smith has an interest. Ferguson further agrees to
     indemnify and hold Smith harmless from any and all
     demands, claims, actions and lawsuits, including,
     expenses, costs and attorney’s fees incurred in
     connection with the defense thereof or related to any
     and all taxes, whether income, ad valorem or of any
     other character, plus any penalties and interest
     associated therewith, for tax years prior to 1987.”
                                - 9 -

Petitioners’ 2000 Federal Income Tax Return

     Petitioners filed a 2000 Federal income tax return on

December 12, 2001.5   Respondent timely mailed a statutory notice

of deficiency to petitioners.   Petitioners timely filed a

petition with this Court for a redetermination of the determined

deficiency and filed an amended petition on October 7, 2004.

Petitioners subsequently submitted an amended 2000 Federal income

tax return (amended tax return) in connection with respondent’s

Appeals Office review of the instant case.    With the exception of

certain disputed deductions that are described in detail below,

the parties stipulate that the amended tax return accurately

reflects petitioners’ tax liability for 2000.

                            Discussion

     The parties dispute whether petitioners are entitled to

deductions with respect to (1) the alleged abandonment of the

Vernon property by petitioner’s bankruptcy estate, (2) the

alleged theft of the diamond ring by Ms. Smith, (3) the alleged

failure of Ms. Smith to assume the obligation for the liens on

the Southampton property, and (4) the alleged failure of Ms.

Smith to file a proper 1986 Federal income tax return.

     Deductions are a matter of legislative grace, and

petitioners bear the burden of proving that they are entitled to



     5
      Petitioners had filed a request to extend the filing due
date to Oct. 15, 2001.
                               - 10 -

the claimed deductions.6   See Rule 142(a); New Colonial Ice Co.

v. Helvering, 292 U.S. 435, 440 (1934); Welch v. Helvering, 290

U.S. 111, 115 (1933).    We now turn to our analysis of the

disputed deductions.

Alleged Abandonment of the Vernon Property

     Respondent contends that the Vernon property is treated for

Federal income tax purposes as the property of petitioner’s

bankruptcy estate (the bankruptcy estate) upon the commencement

of the bankruptcy case pursuant to section 1398 and,

consequently, that petitioners did not realize a loss upon any

disposition of the Vernon property by the bankruptcy estate in

2000.    Petitioners contend that the bankruptcy estate abandoned

the Vernon property to Herring National Bank in 2000 and that

petitioners acquired the right to recognize a related loss when

petitioner “purchased all assets and claims of his bankruptcy

estate” in a foreclosure sale on February 1, 2004.

     The record does not support petitioners’ contention that the

bankruptcy estate abandoned the Vernon property in 2000.      Rather,

the parties stipulated that Herring National Bank foreclosed its

lien on the Vernon property on August 7, 2001, and petitioners

have offered no evidence that the bankruptcy estate abandoned the

Vernon property before the foreclosure.    Furthermore, the



     6
      We note that petitioners have made no contentions with
respect to sec. 7491(a).
                             - 11 -

bankruptcy trustee’s final report indicates that the Vernon

property was not abandoned by the bankruptcy estate.   As noted

above, the court approved an application filed by the bankruptcy

trustee to abandon remaining property, books, and records of the

bankruptcy estate in May of 2003.   At that time, however, the

bankruptcy estate did not include the Vernon property, which was

the subject of the foreclosure by Herring National Bank in 2001.

Petitioners have failed to demonstrate that the bankruptcy estate

abandoned the Vernon property in 2000.   Consequently, we hold

that petitioners are not entitled to deduct a loss in 2000 with

respect to the alleged abandonment.7

Alleged Theft or Embezzlement of the Diamond Ring by Ms. Smith

     Respondent contends that petitioners are not entitled to a

theft loss deduction because Ms. Smith lawfully possessed the

diamond ring pursuant to the divorce agreement.   Petitioners

contend that the corporation owned the diamond ring at all

relevant times,8 that the corporation was not a party to the




     7
      Because we hold that petitioners failed to demonstrate that
the bankruptcy estate abandoned the Vernon property in 2000, we
need not decide whether such an abandonment would result in a
loss for Federal income tax purposes. See Benton v.
Commissioner, 122 T.C. 353, 368-369 (2004).
     8
      Petitioners contend that the divorce agreement created a
bailment with respect to the diamond ring, and Ms. Smith held a
mere right to possession as the bailee.
                                    - 12 -

divorce agreement,9 and, consequently, that the divorce

agreement’s designation of the diamond ring as the separate

property of Ms. Smith was ineffective.       Because Ms. Smith refused

to return the diamond ring to the corporation upon demand,

petitioners contend that Ms. Smith embezzled the diamond ring and

that petitioners are entitled to a related section 165 theft loss

deduction in 2000.

     Section 165 generally provides for the deduction of certain

casualty losses, including losses from theft.10       For purposes of


     9
      Petitioners rely on an alleged prior State court decision.
Although petitioners have provided this Court with no evidence as
to the alleged State court decision, we understand petitioners’
position to be that the court rejected a claim by the corporation
that Ms. Smith breached the divorce agreement with respect to
certain oil and gas properties on grounds that the corporation
was not a party to the divorce agreement. Petitioners contend
that the State court decision that the corporation was not a
party to the divorce agreement terminated Ms. Smith’s right of
possession with respect to the ring.
     10
          SEC. 165.   LOSSES.

             (a) General Rule.--There shall be allowed as a
         deduction any loss sustained during the taxable year and
         not compensated for by insurance or otherwise.

                  *     *       *   *    *   *    *

             (c) Limitation on Losses of Individuals.--In the case
         of an individual, the deduction under subsection (a) shall
         be limited to--

                  *     *       *   *    *   *    *

                 (3) except as provided in subsection (h), losses of
             property not connected with a trade or business or a
             transaction entered into for profit, if such losses
                                                      (continued...)
                                 - 13 -

section 165, the term “theft” includes but is not limited to

larceny, embezzlement, and robbery.       Sec. 1.165-8(d), Income Tax

Regs.     The law of the jurisdiction where the alleged loss is

sustained governs the determination of whether a theft or

embezzlement occurred.     Citron v. Commissioner, 97 T.C. 200, 207

(1991).     Tex. Penal Code Ann. sec. 31.03 (Vernon Supp. 2005),

defines theft as follows:

     Section 31.03.     Theft.

          (a) A person commits an offense if he unlawfully
     appropriates property with intent to deprive the owner
     of property.

             (b) Appropriation of property is unlawful if:

             (1) it is without the owner’s effective consent;
             * * *.

Petitioners bear the burden of proving that a theft has occurred

and that the requirements of section 165 have been met.      See

Mendes v. Commissioner, 121 T.C. 308, 314-315 (2003).

     Petitioners have failed to show that Ms. Smith unlawfully

appropriated the diamond ring.     Although the corporation was not

a party to the divorce agreement, petitioner, the sole

shareholder of the corporation, was a party to the divorce

agreement.     The facts and circumstances demonstrate that either

petitioner consented to the designation of the diamond ring as


     10
          (...continued)
              arise from fire, storm, shipwreck, or other casualty,
              or from theft.
                               - 14 -

the separate property of Ms. Smith on behalf of the corporation

or the corporation ratified the designation.11   See Safety Intl.,

Inc. v. Dyer, 775 F.2d 660, 662 (5th Cir. 1985).    Consequently,

we conclude that petitioners have failed to show that Ms. Smith

did not receive the corporation’s effective consent with respect

to the diamond ring and have failed to prove that a theft of the

ring occurred.    Accordingly, we hold that petitioners are not

entitled to deduct a loss in 2000 with respect to the alleged

theft of the diamond ring.

Alleged Failure of Ms. Smith to Assume Obligation for Liens on
the Southampton Property

     Respondent contends that petitioners are not entitled to

deduct a loss related to the alleged failure of Ms. Smith to

assume the obligation for liens on the Southampton property

because no related liability existed between petitioner and Ms.

Smith.    Petitioners contend that Ms. Smith’s failure to assume

the obligation for liens on the Southampton property constituted

a theft and/or a bad debt and that petitioners are entitled to a

deduction.12




     11
      The parties stipulated that petitioner was the sole
shareholder of the corporation.
     12
      Petitioners do not specify whether the claimed deduction
constitutes a sec. 165 theft loss deduction or a sec. 166 bad
debt deduction.
                                    - 15 -

      With respect to the liens on the Southampton property,

petitioners have presented no evidence that Ms. Smith unlawfully

appropriated petitioner’s property intending to deprive him of

it.   Consequently, we hold that petitioners are not entitled to a

section 165 theft loss deduction with respect to the alleged

failure of Ms. Smith to assume the obligation of liens on the

Southampton property.         See Rule 142(a).

      Furthermore, petitioners have failed to demonstrate that

they are entitled to a section 166 bad debt deduction with

respect to the liens on the Southampton property.        Section 166(a)

generally provides that a taxpayer may deduct the amount of

certain debts owed to the taxpayer which become worthless in the

year of the deduction.13        Section 166(d) provides that the loss


      13
           SEC. 166.    BAD DEBTS

              (a)   General Rule.--

                  (1) Wholly worthless debts.--There shall be allowed
              as a deduction any debt which becomes worthless within
              the taxable year.

                  (2) Partially worthless debts.--When satisfied that
              a debt is recoverable only in part, the Secretary may
              allow such debt, in an amount not in excess of the part
              charged off within the taxable year, as a deduction.

                    *     *     *     *    *     *   *

              (d)   Nonbusiness Debts.--

                  (1) General rules.--In the case of a taxpayer other
              than a corporation--

                                                         (continued...)
                                 - 16 -

of a noncorporate taxpayer resulting from the worthlessness of a

nonbusiness debt is treated as a short-term capital loss.      Sec.

166(d)(1).

     Under certain circumstances, a taxpayer’s payment in

discharge of an agreement to act as guarantor, endorser,

indemnitor or other secondary obligor (hereinafter generally

referred to as guarantor) may be either (1) deducted as a

worthless business debt pursuant to section 166(a) or (2)

deducted as a worthless nonbusiness debt pursuant to section

166(d) (subject to treatment as a short-term capital loss).14


     13
          (...continued)
                   (A) subsection (a) shall not apply to any
              nonbusiness debt; and

                  (B) where any nonbusiness debt becomes   worthless
             within the taxable year, the loss resulting   therefrom
             shall be considered a loss from the sale or   exchange,
             during the taxable year, of a capital asset   held for
             not more than 1 year.

          (2) Nonbusiness Debt Defined.--For purposes of
     paragraph (1), the term “nonbusiness debt” means a debt
     other than--

                  (A) a debt created or acquired (as the case may
             be) in connection with a trade or business of the
             taxpayer; or

                  (B) a debt the loss from the worthlessness of
             which is incurred in the taxpayer’s trade or
             business. * * *
     14
      § 1.166-9. Losses of guarantors, endorsers, and
indemnitors incurred, on agreements made after December 31, 1975,
in taxable years beginning after such date.--

                                                      (continued...)
                             - 17 -

However, such a payment may be treated as a worthless debt only

if (1) the taxpayer entered into the agreement to act as

guarantor either in the course of the taxpayer’s trade or

business or in a transaction for profit; (2) the taxpayer had a

legally enforceable duty to make the payment; and (3) the

taxpayer entered into the agreement before the obligation became


     14
      (...continued)
          (a) Payment treated as worthless business debt. This
     paragraph applies to taxpayers who, after December 31, 1975,
     enter into an agreement in the course of their trade or
     business to act as (or in a manner essentially equivalent
     to) a guarantor, endorser, or indemnitor of (or other
     secondary obligor upon) a debt obligation. Subject to the
     provisions of subparagraphs (c), (d), and (e) of this
     section, a payment of principal or interest made during a
     taxable year beginning after December 31, 1975, by the
     taxpayer in discharge of part or all of the taxpayer’s
     obligation as a guarantor, endorser, or indemnitor is
     treated as a business debt becoming worthless in the taxable
     year in which the payment is made or in the taxable year
     described in paragraph (e)(2) of this section. Neither
     section 163 (relating to interest) nor section 165 (relating
     to losses) shall apply with respect to such a payment.

          (b) Payment treated as worthless nonbusiness debt.
     This paragraph applies to taxpayers (other than
     corporations) who, after December 31, 1975, enter into a
     transaction for profit, but not in the course of their trade
     or business, to act as (or in a manner essentially
     equivalent to) a guarantor, endorser, or indemnitor of (or
     other secondary obligor upon) a debt obligation. Subject to
     the provisions of paragraphs (c), (d), and (e) of this
     section, a payment of principal or interest made during a
     taxable year beginning after December 31, 1975, by the
     taxpayer in discharge of part or all of the taxpayer’s
     obligation as a guarantor, endorser, or indemnitor is
     treated as a worthless nonbusiness debt in the taxable year
     in which the payment is made or in the taxable year
     described in paragraph (e)(2) of this section. Neither
     section 163 nor section 165 shall apply with respect to such
     a payment. [Sec. 1.166-9, Income Tax Regs.]
                              - 18 -

worthless.   Sec. 1.166-9(d), Income Tax Regs.   Furthermore, such

a payment may be treated as a worthless debt only if the taxpayer

demonstrates that reasonable consideration was received in return

for the assumption of the secondary liability.

     We understand petitioners’ contention to be that

petitioner’s payment of the underlying liability to Union Bank in

discharge of petitioner’s obligation as a guarantor may be

treated as a worthless debt and that petitioners may deduct the

payment pursuant to section 166(a) or (d).    However, petitioners

have made no contentions and offered no evidence that petitioner

entered into an agreement to act as a guarantor in exchange for

reasonable consideration, that petitioner entered into such an

agreement in the course of his trade or business or a transaction

for profit, that petitioner had an enforceable legal duty to make

the payment, or that petitioner entered into such an agreement

before the obligation became worthless.   Accordingly, we conclude

that petitioners have failed to demonstrate that petitioner’s

payment of the underlying liability to Union Bank constitutes a

worthless debt for purposes of section 166.   Consequently, we

hold that petitioners are not entitled to deduct the payments as

either a worthless business debt pursuant to section 166(a) or as

a worthless nonbusiness debt pursuant to section 166(d).
                              - 19 -

Alleged Failure of Ms. Smith To File a Proper 1986 Federal Income
Tax Return

     Respondent contends that petitioners are not entitled to

deduct a loss with respect to the alleged failure of Ms. Smith to

file a proper 1986 Federal income tax return because no related

liability existed between Ms. Smith and petitioner.   Petitioners

contend that Ms. Smith and petitioner agreed pursuant to the

divorce agreement to file separate 1986 Federal income tax

returns, that Ms. Smith failed to file a proper 1986 Federal

income tax return, that petitioner’s return was audited and he

was required to pay Ms. Smith’s 1986 tax liability of $118,000,15

that Ms. Smith’s failure to file a proper 1986 Federal income tax

return constitutes “theft by swindling and false pretenses”, and

that petitioners are entitled to deduct the $118,000 as a bad

debt loss and/or as a theft loss.16

     Petitioners have failed to demonstrate that they are

entitled to a section 165 theft loss deduction related to the

alleged failure of Ms. Smith to file a proper 1986 Federal income




     15
      Petitioners contend that their accountant determined that
Ms. Smith’s alleged failure to file a proper 1986 Federal income
tax return resulted in expenses to petitioner of $118,000 “after
allowing her all credits for community splitting.”
     16
      Petitioners do not specify whether the claimed deduction
constitutes a sec. 165 theft loss deduction or a sec. 166 bad
debt deduction.
                                - 20 -

tax return.   Petitioners have presented no evidence that Ms.

Smith unlawfully appropriated petitioner’s property intending to

deprive him of it.   On the contrary, the record demonstrates that

petitioner agreed pursuant to the 1988 settlement agreement to

indemnify Ms. Smith with respect to any and all taxes for tax

years prior to 1987.    As discussed above, in Smith v. Ferguson,

160 S.W.3d at 123, the court held that petitioner’s indemnifying

Ms. Smith against Federal income tax liabilities effectively

estopped petitioner from later claiming that Ms. Smith breached

the divorce agreement by failing to file a proper 1986 Federal

income tax return.     We conclude that petitioners have failed to

show that the alleged failure of Ms. Smith to file a proper 1986

Federal income tax return constitutes a theft.    Consequently, we

hold that petitioners are not entitled to a section 165 theft

loss deduction for the failure of Ms. Smith to file a proper 1986

Federal income tax return.

     Furthermore, petitioners have failed to demonstrate that

they are entitled to a section 166 bad debt deduction related to

the alleged failure of Ms. Smith to file a proper 1986 Federal

income tax return.     We understand petitioners’ contention to be

that petitioner’s payment of Ms. Smith’s 1986 tax liability in

discharge of petitioner’s obligation as a guarantor may be

treated as a worthless debt and that petitioners may deduct the

payment pursuant to either section 166(a) or (d).    The record
                                - 21 -

demonstrates that petitioner indemnified Ms. Smith against

Federal income tax liabilities for the 1986 tax year pursuant to

the 1988 settlement agreement.     However, petitioners have made no

contentions and offered no evidence that petitioner entered into

the aforementioned agreement in the course of his trade or

business or a transaction for profit.     Consequently, we conclude

that petitioners failed to demonstrate that petitioner’s payment

of Ms. Smith’s 1986 tax liability constitutes a worthless debt

for purposes of section 166.     See sec. 1.166-9(d)(1), Income Tax

Regs.     Accordingly, we hold that petitioners are not entitled to

deduct the payment as either a worthless business debt pursuant

to section 166(a) or as a worthless nonbusiness debt pursuant to

section 166(d).

Addition to Tax for Failure To File

        Respondent contends that petitioners did not file their 2000

Federal income tax return within the time prescribed by law and,

consequently, that petitioners are liable for an addition to tax

pursuant to section 6651.     Petitioners contend that their bank

and tax records were the subject of a subpoena related to

petitioner’s bankruptcy case, that the records were not returned

to them until November of 2001 despite petitioner’s repeated

demands, that the records were out of order upon their return,

and, consequently, that petitioners were unable to timely file

their 2000 Federal income tax return.
                               - 22 -

     Section 6651(a)(1) provides for an addition to tax of 5

percent of the tax required to be shown on the return for each

month or fraction thereof for which there is a failure to file,

not to exceed 25 percent.   The addition to tax for failure to

file a return timely will be imposed if the return is not filed

timely unless the taxpayer shows that the delay was due to

reasonable cause and not willful neglect.    Sec. 6651(a)(1).    The

Commissioner bears the burden of production with respect to the

addition to tax.   Sec. 7491(c).   The parties stipulated that

petitioners filed their 2000 Federal income tax return on

December 12, 2001, after receiving a 6-month extension.

Consequently, we must determine whether petitioners have shown

that the delay was due to reasonable cause and not willful

neglect.

     A delay is due to reasonable cause if the taxpayer exercised

ordinary business care and prudence and was nevertheless unable

to file the return within the prescribed time.    Sec. 301.6651-

1(c)(1), Proced. & Admin. Regs.    “Willful neglect” is defined as

a “conscious, intentional failure or reckless indifference.”

United States v. Boyle, 469 U.S. 241, 245 (1985).    In the instant

case, the record demonstrates that petitioners requested and were

granted a 6-month extension to file the 2000 Federal income tax

return.    Petitioners contend and respondent does not dispute that

petitioners lacked access to essential financial records as of
                               - 23 -

October 15, 2001.    However, petitioners did not make any attempt

to file a return reporting their income and expenses as

accurately as they could using the best information available.

See Belk v. Commissioner, 93 T.C. 434, 447 (1989).    On the basis

of the instant record, we conclude that petitioners have not

shown that the delay was due to reasonable cause.    Consequently,

petitioners are liable for a section 6651 addition to tax for

failure to file a timely return.

     Petitioners further contend that the Bankruptcy Code

precludes the assessment of a section 6651 addition to tax for

failure to file.17   However, in exercising jurisdiction to

redetermine a deficiency, this Court lacks jurisdiction to decide

whether the deficiency and the related addition to tax were

discharged in a prior bankruptcy proceeding.    Neilson v.

Commissioner, 94 T.C. 1, 9 (1990); Graham v. Commissioner, 75

T.C. 389, 396 (1980); cf. Washington v. Commissioner, 120 T.C.

114, 120 (2003) (Tax Court’s jurisdiction to decide whether

discharge occurred extends to section 6330 proceedings but not to



     17
      Petitioners’ reply brief set forth the aforementioned
contention as follows:

          Further, petitioners, the injured taxpayers,
     assert that any late penalties for a faultless 2000 tax
     year late filing are statutorily and explicitly barred
     by applicable federal bankruptcy statutes. The IRS
     baroque twist sidesteps bankruptcy laws. No further
     discussion of the penalty issue seems appropriate or
     necessary.
                              - 24 -

deficiency suits).   Consequently, we do not decide whether the

discharge in bankruptcy released petitioners from the liability

for the section 6651 addition to tax.18

Accuracy-Related Penalty

     Respondent contends that petitioners’ 2000 Federal income

tax return reflected a substantial understatement, that

there was no reasonable cause for the understatement, and,

consequently, that petitioners are liable for an accuracy-related

penalty pursuant to section 6662(a).

     Section 6662(a) imposes a 20-percent accuracy-related

penalty with respect to the portion of any underpayment of tax

attributable to a substantial understatement of income tax.   An

“understatement” is the excess of the amount of tax required to

be shown on the return over the amount of tax that is actually

shown on the return.   Sec. 6662(d)(2)(A).   A “substantial



     18
      Petitioners’ amended petition contended, inter alia, that
the bankruptcy estate paid the entire tax liability determined by
the bankruptcy court, that the bankruptcy court discharged
petitioner on Apr. 7, 2004, and, consequently, that respondent is
precluded from subsequently asserting any deficiency against
petitioners. Petitioners made no further contention at trial or
on brief that the bankruptcy court discharged the underlying 2000
tax liability at issue, and the parties have presented no
evidence with respect to such a discharge. As discussed above,
this Court lacks jurisdiction to decide whether a deficiency was
discharged in a prior bankruptcy proceeding. Neilson v.
Commissioner, 94 T.C. 1, 9 (1990); Graham v. Commissioner, 75
T.C. 389, 396 (1980). Consequently, we do not decide whether the
bankruptcy court discharged the underlying deficiency, addition
to tax, or accuracy-related penalty for petitioners’ 2000 tax
year.
                                 - 25 -

understatement” of income tax exists if the amount of the

understatement for the taxable year exceeds the greater of (1) 10

percent of the tax required to be shown on the return or (2)

$5,000.    Sec. 6662(d)(1)(A).   However, the amount of an

understatement is reduced by any portion for which (1) there was

substantial authority for the taxpayer’s treatment, (2) or the

relevant facts affecting the item’s tax treatment were adequately

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

and there is a reasonable basis for the tax treatment.       In

addition, no penalty under section 6662 may be imposed with

respect to any portion of an underpayment if it is shown that

there was a reasonable cause for the portion and that the

taxpayer acted in good faith with respect to the portion.         Sec.

6664(c)(1).

     Pursuant to section 7491(c), respondent bears the burden of

production with respect to the determined accuracy-related

penalty.   Consequently, respondent must produce sufficient

evidence to demonstrate that the accuracy-related penalty is

appropriate.   See Higbee v. Commissioner, 116 T.C. 438, 446

(2001).    Once respondent meets his burden of production,

petitioner must produce sufficient evidence to persuade the Court

that respondent’s determination is incorrect.     Id. at 447.

     The evidence demonstrates that the Federal income tax

liability for petitioners’ 2000 tax year is $91,763 but that
                               - 26 -

petitioners reported zero income tax on their 2000 Federal income

tax return.    Because $91,763 exceeds $5,000 and 10 percent of the

amount required to have been shown on petitioners’ return, we

conclude that respondent has produced sufficient evidence to

demonstrate that the underpayment is attributable to a

substantial understatement and that an accuracy-related penalty

is appropriate.   See sec. 6662(d)(1)(A).

     In the petition, petitioners contended that no penalty

should be imposed because (1) “there was absolute full

disclosure”, (2) petitioners acted in good faith, and (3) any

understatement was due to reasonable cause.    However, petitioners

made no contentions and produced no evidence opposing the section

6662(a) accuracy-related penalty at trial or on brief.      See Rules

142(a), 149(b); Burris v. Commissioner, T.C. Memo. 2001-49.

Consequently, petitioners have failed to persuade the Court that

respondent’s determination with respect to the accuracy-related

penalty was incorrect.    Accordingly, we hold that petitioners are

liable for a section 6662(a) accuracy-related penalty for

substantial understatement of tax.

     We have considered all of the contentions that the parties

have raised.    To the extent not addressed herein, those

contentions are without merit or unnecessary to reach.
                        - 27 -

To reflect the foregoing,


                                 Decision will be entered for

                            respondent.
