                        T.C. Memo. 1996-529


                      UNITED STATES TAX COURT



              EDWARD AND RUTH KELLY, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 28233-91, 7795-94.       Filed December 2, 1996.



     Geoffrey J. O'Connor, for petitioner Edward Kelly,

     Norman Trabulus, for petitioner Ruth Kelly.

     Andrew J. Mandell and Lewis J. Abrahams, for respondent.




              MEMORANDUM FINDINGS OF FACT AND OPINION


     BEGHE, Judge:   Respondent determined deficiencies in

petitioners'1 Federal income tax, additions to tax and penalties

as follows:


     1
      During preparation of this opinion, counsel for petitioner
Ruth Kelly informed the Court of his client's death. A motion to
substitute her estate as petitioner had not been received as of
the date of this opinion.
                                        - 2 -


                                            Additions to Tax              Penalties
                              Sec.                 Sec.           Sec.       Sec.
Year        Deficiency     6653(a)(1)(A)2       6653(a)(1)(B)     6661       6662
                                                      1
1986         $64,061          $3,203                            $16,015      --
                                                      2
1987          48,593           2,430                              9,713      --
1989          26,496            --                   --             --     $5,299
1990          12,425            --                   --             --      2,485
1991          41,064            --                   --             --      8,213
1992          55,580            --                   --             --     11,116
       1
           Fifty percent of the interest due on $64,061
       2
           Fifty percent of the interest due on $38,853.


       After concession by respondent of an issue raised on behalf

of petitioners at trial,3 the issues for decision are:

       (1)     Whether losses sustained by petitioner Edward Kelly

(Mr. Kelly) in trading stock options should be characterized as

ordinary or capital losses.            We hold that they were capital

losses.

       (2)     Whether brokerage commissions earned by Mr. Kelly in

connection with his stock option trades may be treated as an

offset against the amount of his trading losses rather than as

ordinary income, and whether brokerage commissions paid by

Mr. Kelly in connection with his stock option trades are




       2
      Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the years at issue, and all
Rule references are to the Tax Court Rules of Practice and
Procedure.
       3
      Respondent conceded that petitioners were entitled to
deduct gambling losses in an amount equal to their gambling
winnings for 1986, pursuant to sec. 165(d).
                                - 3 -


deductible as ordinary and necessary business expenses.     We hold

that the earned commissions were taxable as ordinary income, and

that the paid commissions are added to the basis of options

purchased and treated as an offset to the price of options sold.

     (3)    Whether petitioners were entitled to deduct certain

unreimbursed employee business expenses.     We hold that the

deductions were properly disallowed.

     (4)    Whether petitioners are liable for additions to tax

under sections 6653(a) and 6661 and accuracy-related penalties

under section 6662(a), (b)(1) and (2).    We hold that petitioners

are so liable.

     (5)    Whether petitioner Ruth Kelly (Mrs. Kelly) is entitled

to relief from liability as an innocent spouse.     We hold that she

is not entitled to innocent spouse relief.4


                          FINDINGS OF FACT

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

The stipulation of facts and attached exhibits are incorporated

herein by this reference.    Petitioners filed joint Federal income

tax returns, as husband and wife, for each of the years at issue.

At the time the petitions were filed, they resided in Brentwood,

New York.



     4
      On most issues petitioners have a conflict of interest.
Mrs. Kelly joined her husband only with respect to issue (2).
                               - 4 -


     Mr. Kelly has been a stockbroker for approximately 45 years.

During the years at issue, he was employed full time by Shearson

Lehman as office manager of its branch in Bay Shore, New York.

Beginning in 1983, he also devoted considerable time to stock

option trading for his own account.    These trading activities and

the market research that informed them would occupy at least 50

percent of a typical workday during this period.   The annual

volume of his option trades appears to have fluctuated between

about 450 and 900 during the years at issue.   Mr. Kelly was not a

floor trader; he purchased options through a Shearson Lehman

broker who had a direct wire to the floor of the exchanges.     The

amount of time he held the options varied from a few hours to a

few weeks.   The parties have stipulated that he did not hold any

property as inventory or primarily for sale to customers in the

ordinary course of his trade or business, did not sell to

customers of his own, and performed no merchandising function

with respect to his options transactions.

     Mr. Kelly paid commission fees to Shearson Lehman in

connection with the purchases and sales of options for his own

account.   As an employee, he received a 30-percent discount

relative to the amount of commissions that a member of the public

would pay.   He also earned and received commissions as an

employee in connection with his option trades.   The commission
                               - 5 -


payments that he received represented compensation for bringing

business to his employer.

     Since 1979 Mr. Kelly has been registered with the Chicago

Board of Options Exchange and the National Association of

Securities Dealers, Inc. (NASD), as an "options principal".    In

this capacity he was authorized to approve customer accounts for

options trading and oversee compliance with the rules of NASD and

other rules concerning options transactions within the brokerage

office.   Mr. Kelly did not need to be a registered options

principal in order to engage in any of his options trades; any

Shearson Lehman customer satisfying certain financial and other

criteria was qualified to trade options.

     On their Forms 1040 for earlier taxable years not in issue,

1983 through 1985, petitioners reported Mr. Kelly's occupation as

"stockbroker-dlr".   The Schedule C filed with their return for

1983 describes his main business activity as "dealer in options".

Nevertheless, for each of these years petitioners treated

Mr. Kelly's net loss from options trading as a capital loss and

reported it on Schedule D.

     In February 1987, before the preparation of his tax return

for 1986, Mr. Kelly read newspaper articles discussing the then

recent decision of the U.S. Supreme Court in Commissioner v.

Groetzinger, 480 U.S. 23 (1987).   On the basis of these articles,

he understood the case to stand for the proposition that where a
                                 - 6 -


taxpayer carries on an activity continually and regularly with

the intent of making a profit, he is engaged in a trade or

business for tax purposes, and losses from the activity are

deductible without limitation.    He wondered whether Groetzinger

affected the deductibility of the losses he incurred in his

voluminous options trading.   Mr. Kelly brought the case to the

attention of Yale Auerbach (Auerbach), a certified public

accountant who had regularly prepared his tax returns since the

early 1950's.   Auerbach read Groetzinger and told Mr. Kelly that

it did not apply to his options trading; in the absence of

authority to operate his own brokerage business, he would

continue to be a trader for tax purposes, and must treat his

losses as capital.   Mr. Kelly informed Auerbach that he was a

registered options principal, which meant that he was "registered

to deal in options".   Auerbach was unfamiliar with the nature of

this position, but on further questioning, Mr. Kelly satisfied

him that as a registered options principal he was qualified to

establish his own office and "deal as any other broker does".

Auerbach advised Mr. Kelly that under those circumstances he

could adopt the position that he was engaged in a business and

that the trading losses were ordinary.   Subsequently, Mr. Kelly

also consulted Carroll Baymiller (Baymiller), the attorney who

had represented the taxpayer in Groetzinger.    The record does not
                                - 7 -


disclose what Mr. Kelly told Baymiller, or what advice, if any,

Baymiller rendered.

     Auerbach prepared and signed petitioners' tax returns for

1986 and 1987.    On Schedules C filed with their returns for these

years, petitioners reported losses from options trading in the

amounts of $108,318 and $100,917, respectively, and described

Mr. Kelly's principal business as "options dealer".    Auerbach's

accounting practice was acquired by Russell T. Glazer (Glazer),

who prepared and signed petitioners' tax returns for 1989 through

1992.   In transferring petitioners' account to Glazer, Auerbach

explained the reasoning behind the ordinary loss treatment of

Mr. Kelly's options trading.    On Schedules C filed with their

returns for those years, petitioners reported ordinary losses

from options trading of $82,253, $24,717, $143,019, and $178,462,

respectively.    Mr. Kelly's principal business is not stated on

the Schedules C for 1989 and 1990, but on the Forms 1040 his

occupation is described as "stckbrkr-trader".    The Schedules C

for 1991 and 1992 describe Mr. Kelly's principal business as

"trader".   A list of all Mr. Kelly's options trades for the year

was attached to each of the returns for the years 1989 through

1992.   The lists are marked "Attachment to Schedule C", and

identify the stock to which the option relates, dates bought and

sold, purchase and sale prices, and gain or loss.
                                - 8 -


       During the years at issue Shearson Lehman had a policy of

reimbursing employee travel and entertainment expenses, subject

to certain documentation and other requirements.     Mr. Kelly

received reimbursements from his employer, and claimed deductions

for unreimbursed entertainment expenses, in the amounts set forth

below:

                                          Amount Deducted for
Year            Amount Reimbursed        Unreimbursed Expenses

1986               $4,415.00                    $25,200
                                                1
1987                3,965.00                      25,299
                                                  2
1989                5,611.81                        2,480
                                                2
1990                2,397.70                      12,440
                                                  2
1991                6,562.81                        1,400
                                                  2
1992                6,426.42                        2,385
       1
        As reduced by 2 percent of adjusted gross income.
       2
        As reduced by 20 percent.

Petitioners have no documents in their possession supporting the

claimed unreimbursed entertainment expenses for taxable years

1986, 1987, 1990, 1991, and 1992.    Mr. Kelly used to have an

expense diary for 1986, which he produced to respondent's agent

in the course of the audit.    The agent informed Mr. Kelly that

the diary was of no value in substantiating the claimed

deductions.    Mr. Kelly subsequently lost the diary in the course

of an office move.    Petitioners did introduce in evidence an

expense diary for 1989 together with receipts.    The diary lists

total expenses of $5,702.41.    There are receipts to confirm

$5,085.76 of the claimed expenses, and for some claimed expenses
                               - 9 -


information on the receipts does not correspond to the

information in the diary.

     Petitioners were married in 1941.   At the time of trial,

they were still living together, and there is no evidence that

they were at any time separated.

     Mrs. Kelly did not complete high school and took no formal

courses in business or finance.    Before her marriage to Mr. Kelly

and the birth of petitioners' son Edward in 1945, she worked as a

telephone operator, dancer, typist, and airline stewardess.

After 1945, she was a full-time homemaker, responsible for the

upkeep of the family home and for paying bills for household

expenses.   Edward was born with Down's Syndrome.   As his health

deteriorated during the 15 years before his death in October

1989, he lived at home under Mrs. Kelly's constant care or in the

hospital, where she attended him.   During this period Mrs. Kelly

was thoroughly preoccupied with Edward's condition and needs for

care and seems to have had no interest in discussing financial or

business matters with Mr. Kelly.

     Mrs. Kelly was aware that her husband was employed by

Shearson Lehman as a stockbroker.   But they did not discuss his

business.   Although Mr. Kelly spent a considerable amount of time

at home doing work related to his options trading and made no

efforts to conceal his activities from her, she remained entirely

ignorant of these activities and of the losses he incurred.    When
                              - 10 -


Mr. Kelly entertained business associates at restaurants,

Mrs. Kelly sometimes accompanied him.    On these occasions she and

other women present would carry on their own conversations.      At

Mr. Kelly's request, Mrs. Kelly sometimes assisted him in

maintaining records of the entertainment expenses for purposes of

reimbursement.

     Mrs. Kelly took no part in the preparation of the joint tax

returns for the years at issue.   Each of the returns was prepared

and signed by the accountant, and then delivered to petitioners

for their review.   Mrs. Kelly signed the returns without review

or inquiry.   Mrs. Kelly made no attempt to inform herself of

their contents because she trusted Mr. Kelly completely, not

because he in any way hindered or discouraged her from doing so.

She endorsed the refund checks they received, but neither asked

nor cared what Mr. Kelly would do with the money.

     In 1989 Mrs. Kelly learned that Mr. Kelly was in a

controversy with the Internal Revenue Service.    She signed a

power of attorney to authorize lawyers to represent them in

administrative proceedings.   Mr. Kelly did not show her any

correspondence with the lawyers regarding the nature of the

controversy, and she remained ignorant of the details until after

the years at issue.

     Petitioners experienced no marked changes in their lifestyle

during or after the years at issue.    Mrs. Kelly received no
                                - 11 -


direct benefit from the income tax refunds they received.

Mr. Kelly deposited the refund checks in his separate bank

account and used the proceeds to finance further options trading.


                                OPINION

       Petitioners bear the burden of proof on all issues.     Rule

142(a).

1.    Character of Trading Losses

       Respondent determined that the stock options sold by

Mr. Kelly during the years at issue were capital assets, and

that the net losses he realized were accordingly capital losses

subject to the limitations of sections 165(f) and 1211(b).       We

sustain respondent's determination.

       Under section 1234, unless an option to buy or sell stock

constitutes property described in section 1221(1), gain or loss

from the sale of the option is treated as gain or loss from the

sale of property having the same character as the stock would

have in the taxpayer's hands.       Sec. 1234(a)(1), (3)(A).   Section

1221(1) creates an exception to the definition of a capital asset

for

            Stock in trade of the taxpayer or other property
       of a kind which would properly be included in the
       inventory of the taxpayer if on hand at the close of
       the taxable year, or property held by the taxpayer
       primarily for sale to customers in the ordinary course
       of his trade or business;
                                - 12 -


     Mr. Kelly contends that his options trading activity was

sufficiently regular, substantial, and time-consuming to

constitute a trade or business for Federal income tax purposes,

so that the losses arising from the activity qualify for ordinary

treatment.   This argument confuses a necessary with a sufficient

condition.   Buying and selling securities on an exchange must

constitute a trade or business in order for the securities to

qualify for the exception to capital asset treatment.    But a

taxpayer who meets this trade or business requirement may be

either a trader or a dealer.    Unless he is a dealer, the

securities he holds in connection with his business are capital

assets.   Laureys v. Commissioner, 92 T.C. 101, 136-137 (1989);

King v. Commissioner, 89 T.C. 445, 457-458 (1987); Polacheck v.

Commissioner, 22 T.C. 858, 862 (1954); Kemon v. Commissioner, 16

T.C. 1026, 1032-1033 (1951).    The distinction between trader and

dealer turns on whether the taxpayer's business activities have

the characteristics specified in section 1221(1).    The parties

have stipulated that Mr. Kelly's options trading lacked these

characteristics:   Mr. Kelly did not hold his options as

inventory; he did not sell to customers; he performed no

merchandising function.   Therefore, if he was engaged in the

business of buying and selling options, it was as a trader rather

than a dealer, and the options would not constitute property

described in section 1221(1).    Kemon v. Commissioner, supra;
                              - 13 -


Tybus v. Commissioner, T.C. Memo. 1989-309; Kobernat v.

Commissioner, T.C. Memo. 1972-132.

      Mr. Kelly attempts to distinguish the many cases denying

ordinary loss treatment under similar circumstances on the ground

that he was a registered options principal.    He argues that his

stock options fall within the literal terms of section 1221(1):

"stock options are a Registered Options Principal's 'stock in

trade'.   Stock options are what a Registered Options Principal is

primarily involved in."   Mr. Kelly's figurative use of the

statutory language finds no support in the case law interpreting

it.   Property does not constitute "stock in trade" within the

meaning of section 1221(1) unless it is held by the taxpayer

primarily for sale to customers.     Van Suetendael v. Commissioner,

152 F.2d 654, 654 (2d Cir. 1945), affg. a Memorandum Opinion of

this Court; Wood v. Commissioner, 16 T.C. 213, 225-226 (1951).

The functional significance of the registered options principal

to the operation of the securities market and his relationship to

a licensed dealer is not entirely clear from the record.    For

purposes of characterizing Mr. Kelly's trading losses, however,

the only question is whether he was acting in the capacity of a

dealer when he engaged in the specific transactions that produced

the losses.   Laureys v. Commissioner, supra; Kemon v.

Commissioner, supra.   Mr. Kelly concedes that he did not engage

in these transactions in his capacity as a registered options
                               - 14 -


principal.   It follows that his status as a registered options

principal, whatever that entails, has no bearing on our

disposition of these cases.

      Because Mr. Kelly was not an options dealer with respect to

the transactions in which his losses arose, the character of the

stock options depends on the character that the underlying stock

would have had in his hands.   Sec. 1234(a).    Mr. Kelly does not

argue that he was a dealer in stock, and the record affords no

basis for that conclusion.    Therefore the options that Mr. Kelly

traded were capital assets, and the net losses he realized in

these transactions were capital losses.

2.   Treatment of Commissions Earned and Paid

      On their tax returns for the years at issue, petitioners

apparently treated commissions paid to Mr. Kelly by his employer

on account of his options trades as ordinary income, and treated

commissions paid by Mr. Kelly to his employer in connection with

these trades either as part of the cost basis of the options or

as an adjustment to the gain or loss realized.    In these

proceedings petitioners take the position that if they are not

entitled to deduct Mr. Kelly's options trading losses in full as

ordinary losses, then an "absurd" inconsistency arises between

the treatment of the commissions Mr. Kelly earned and paid on the

same transactions.   Either the earned commissions should be

treated as a rebate that reduced his costs to acquire and sell
                              - 15 -


the options rather than as ordinary income, or the paid

commissions should be treated as deductible business expenses

that more than offset his commission income.   Petitioners argue

that this integrated approach to taxing the commission

transactions would more accurately reflect their substance and

has parallels in other areas of the Code.

     We have no occasion to consider whether either of

petitioners' proposals for integrating the tax treatment of the

commissions at issue to achieve consistency would be desirable as

a matter of tax policy; the proper tax treatment of such

commissions is well established.   The parties have stipulated

that Mr. Kelly received the commissions as compensation for

providing business for his employer.   There is no evidence that

they were intended specifically as a discount or rebate.   The

definition of gross income expressly covers "compensation for

services, including * * * commissions".   Sec. 61(a)(1).   The fact

that the taxpayer earned the commissions on transactions in which

he acquired property from or through his employer for his own

account does not alter their character as ordinary income.    The

argument that in such cases the commissions should be treated as

discounts from the cost of the property, and accounted for by

adjustments to basis or the sale price rather than included in

gross income, has been repeatedly rejected by this Court and

others.   Ostheimer v. United States, 264 F.2d 789 (3d Cir. 1959)
                              - 16 -


(life insurance agent commissions); Williams v. Commissioner, 64

T.C. 1085 (1975) (real estate agent commissions); Bailey v.

Commissioner, 41 T.C. 663 (1964) (life insurance agent

commissions); Kobernat v. Commissioner, T.C. Memo. 1972-132

(stockbroker commissions).

      Costs incurred in the acquisition and disposition of a

capital asset are nondeductible capital expenditures.     Woodward

v. Commissioner, 397 U.S. 572, 575 (1970).   Thus, for a taxpayer

who is not a dealer, brokerage fees incurred to purchase

securities must be added to the cost basis of the securities, and

brokerage fees incurred to sell securities must be offset against

the sale price.   Sec. 1.263(a)-2(e), Income Tax Regs.

3.   Employee Business Expenses

      Respondent disallowed petitioners' deductions for

unreimbursed entertainment expenses on the grounds, inter alia,

that the deductions were not substantiated in accordance with

section 274(d).   Mr. Kelly argues that he adequately

substantiated his expenses for at least 1 of the years at issue

and that the Court should use its discretion in estimating the

amount of the deductible expenses for the other years.    We agree

with respondent that petitioners are not entitled to any of the

claimed deductions.

      Section 274(d) was intended to preclude discretionary

estimation of certain business expenses by the courts pursuant to
                               - 17 -


the common law rule of Cohan v. Commissioner, 39 F.2d 540 (2d

Cir. 1930).    Sanford v. Commissioner, 50 T.C. 823, 828 (1968),

affd. per curiam 412 F.2d 201 (2d Cir. 1969); sec. 1.274-5(a),

Income Tax Regs.   The section provides that no amount may be

deducted for entertainment expenses unless the taxpayer

substantiates, by adequate records or by sufficient evidence

corroborating his own statement:   (1) The amount of the expense;

(2) the time and place of the entertainment; (3) the business

purpose of the entertainment; and (4) the business relationship

to the taxpayer of the persons entertained.   Substantiated

expenses may be deducted only to the extent that they exceed

amounts for which the taxpayer was reimbursed.    Register v.

Commissioner, T.C. Memo. 1988-390.

     Mr. Kelly presented no testimony or documentation in support

of the claimed deductions for 1986, 1987, 1990, 1991, and 1992.

He submitted an expense diary, together with receipts, for 1989.

The total amount of expenses for which there are receipts is

$5,085.76.    Mr. Kelly was reimbursed by Shearson Lehman for his

1989 expenses in the amount of $5,611.81.   Accordingly,

petitioners have not substantiated any amount of unreimbursed

business expenses for this year.   Sec. 1.274-5(c)(2), Income Tax

Regs.

     Mr. Kelly may have maintained records of his business

entertainment expenses for other years.   During the audit of
                                - 18 -


petitioners' 1986 and 1987 returns, the revenue agent examined an

expense diary for 1986.     This diary and possibly other records as

well were lost by Mr. Kelly in the course of an office move.

The regulations provide an exception to the normal substantiation

requirements where the taxpayer can establish that at one time he

possessed adequate records and that his inability to produce them

is attributable to fire, flood, or other casualty beyond his

control.     In such cases the taxpayer may satisfy his burden of

proof by reasonably reconstructing his records.      Sec. 1.274-

5(c)(5), Income Tax Regs.     It is doubtful that loss of

documentation in transit is a casualty beyond the taxpayer's

control within the meaning of section 1.274-5(c)(5), Income Tax

Regs.    Gizzi v. Commissioner, 65 T.C. 342, 345 (1975); Silver v.

Commissioner, T.C. Memo. 1972-102.       In any event, Mr. Kelly has

not attempted to reconstruct the lost records.

4(a)     Additions to Tax for 1986 and 1987

        Respondent determined that petitioners are liable for

additions to tax for negligence under section 6653(a) for taxable

years 1986 and 1987.     Section 6653(a) provides for an addition

to tax if any part of an underpayment of tax is attributable to

negligence.     The amount of the addition is 5 percent of the

entire underpayment plus 50 percent of the interest payable with

respect to the portion of the underpayment attributable to

negligence.     Sec. 6653(a)(1)(A) and (B).   Negligence is defined
                              - 19 -


as the lack of due care or failure to do what a reasonable and

ordinarily prudent person would do under the circumstances.

Neely v. Commissioner, 85 T.C. 934, 947 (1985).    The treatment of

an item may be attributable to negligence if the taxpayer failed

to maintain adequate records to substantiate it properly.

Crocker v. Commissioner, 92 T.C. 899, 917 (1989); Schroeder v.

Commissioner, 40 T.C. 30, 34 (1963); Robbins v. Commissioner,

T.C. Memo. 1981-449.   Any part of an underpayment attributable to

a position taken by the taxpayer in reasonable, bona fide

reliance upon professional tax advice is not attributable to

negligence.   Ewing v. Commissioner, 91 T.C. 396, 423-424 (1988),

affd. without published opinion 940 F.2d 1534 (9th Cir. 1991);

Jackson v. Commissioner, 86 T.C. 492, 539 (1986), affd. 864 F.2d

1521 (10th Cir. 1989).   In order to prove reasonable reliance the

taxpayer must demonstrate that he supplied his adviser with

complete and accurate information.     Pessin v. Commissioner, 59

T.C. 473, 489 (1972); Enoch v. Commissioner, 57 T.C. 781, 803

(1972); Gill v. Commissioner, T.C. Memo. 1994-92, affd. without

published opinion 76 F.3d 378 (6th Cir. 1996).

     Petitioners have not attempted to contest respondent's

determination of negligence insofar as it applies to their

failure to substantiate the business expense deductions they

claimed.   However, Mr. Kelly argues that he acted reasonably in

characterizing his trading losses as ordinary losses on
                               - 20 -


petitioners' income tax returns:   "petitioner Edward Kelly

justifiably relied upon the expertise of his Certified Public

Accountant and, taking the matter far beyond normal prudence and

care, counsel for the taxpayer in the Groetzinger case."

     The record does not disclose the details of Mr. Kelly's

consultation with Baymiller.   We know from Auerbach's testimony,

however, what information Auerbach elicited from Mr. Kelly, and

how it influenced the accountant's advice.    In concluding that

ordinary loss treatment was warranted, Auerbach apparently

attached decisive importance to Mr. Kelly's statement that

registration as an options principal qualified him to establish

his own business as an options dealer.   The petition in docket

No. 28233-91 contains a similar allegation:    "Kelly is a licensed

options dealer".   Considering the importance of this allegation

to Mr. Kelly's theory of the case, one would have expected him to

present evidence verifying its accuracy.   He did not.   When

Mr. Kelly was asked as a witness to explain what the status of

registered options principal entails, he described

responsibilities for reviewing customer accounts and monitoring

compliance with institutional rules.    On brief Mr. Kelly asserts

only that he was "licensed in the securities business", and in

his account of how Auerbach formed his opinion based on the

information Mr. Kelly supplied, we find a curious qualification:

"Mr. Auerbach decided that, in view of (A) Mr. Kelly's ROP
                              - 21 -


status, (B) his stated ability to open his own office and deal as

any other broker does, * * * Groetzinger did apply to Mr. Kelly's

option trading activities as an ROP". (Emphasis added.)    However,

Mr. Kelly has not shown by his own testimony or otherwise that

his status as a registered options principal in fact entitled him

to open his own office and deal in options.    Thus he has not

satisfied his burden of showing that he provided his accountant

with complete and accurate information on this material point.

We therefore reject Mr. Kelly's claim of reliance on his

accountant.   The additions to tax under section 6653(a) are

accordingly sustained.

      Respondent further determined that petitioners are liable

for the additions to tax under section 6661.    Section 6661

imposes an addition to tax equal to 25 percent of the amount of

any underpayment attributable to a substantial understatement of

income tax.   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.   Sec. 6661(a) and (b)(1).   The amount of the

understatement is reduced by that portion which is attributable

to:   (1) The tax treatment of any item for which there was

substantial authority, or (2) any item with respect to which the

relevant facts affecting the item's tax treatment are adequately

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

Sec. 6661(b)(2)(B).
                              - 22 -


     Mr. Kelly contests respondent's determination on the ground

that petitioners adequately disclosed the facts relevant to their

deduction of Mr. Kelly's trading losses.    For purposes of section

6661, disclosure is adequate if it is made on a properly

completed Form 8275, on a statement attached to the return in a

form prescribed by the regulations, or on the return, provided

that the taxpayer provides sufficient facts to enable the

Internal Revenue Service to identify the potential controversy.

Schirmer v. Commissioner, 89 T.C. 277, 285-286 (1987); S. Rept.

97-494 at 274 (1982); sec. 1.6661-4(b), Income Tax Regs.    The

Schedules C filed with petitioners' tax returns for 1986 and 1987

show the computation of the net loss and identify Mr. Kelly's

principal business as "options dealer".    Petitioners did not

disclose the relevant facts affecting the tax treatment of the

losses.   Although the identification of Mr. Kelly's business as

"options dealer" is highly relevant, it was conclusory, and we

have found it to be inaccurate.   The scant information on the

1986 and 1987 returns is consistent with the position that the

losses are ordinary, and would not have apprised the Internal

Revenue Service of a potential controversy over characterization.

The additions to tax under section 6661 are sustained.5

     5
      Mr. Kelly also contests respondent's method of computing
petitioners' liability for the addition to tax under sec. 6661.
He contends that in computing the amount of the "underpayment"
for purposes of sec. 6661, respondent improperly failed to give
                                                   (continued...)
                                  - 23 -


4(b)       Accuracy-Related Penalties for 1989-92

       Respondent determined that petitioners are liable for the

accuracy-related penalties under section 6662(a) and (b)(1) for

the taxable years 1989 through 1992.6      These sections impose a

penalty equal to 20 percent of the portion of an underpayment of

tax that is attributable to negligence or disregard of rules or

regulations.       "Negligence" includes any failure to make a

reasonable attempt to comply with the provisions of the Code.

Sec. 6662(c).       As under prior law, failure to maintain records to

substantiate an item constitutes negligence.        Sec. 1.6662-

3(b)(1), Income Tax Regs.       The penalty does not apply to any

portion of an underpayment for which the taxpayer had reasonable

cause and acted in good faith.       Sec. 6664(c)(1).   For the taxable

years at issue, the penalty also may be avoided by making

adequate disclosure of relevant information.        Secs. 1.6662-1,

-3(a), (c), Income Tax Regs.




       5
      (...continued)
petitioners credit for the amount of tax withheld. Mr. Kelly is
plainly mistaken. For both 1986 and 1987 respondent properly
computed the underpayment as the excess of the corrected tax
liability over the net payment (amount withheld less amount
refunded). See Woods v. Commissioner, 91 T.C. 88, 95-99 (1988).
Mr. Kelly's challenge to the computation of the "underpayment"
for purposes of the accuracy-related penalties for 1989-92 on the
same ground is similarly without merit. See sec. 6664(a).
       6
      By amendment to answer, respondent also asserted accuracy-
related penalties under sec. 6662(b)(2). We need not consider
the alternative theory.
                              - 24 -


     Mr. Kelly contests petitioners' liability for accuracy-

related penalties using largely the same arguments he used to

challenge the additions to tax for 1986 and 1987.    There is no

dispute that the negligence penalty applies to the portion of the

underpayment attributable to petitioners' unsubstantiated

employee business expense deductions.   Valadez v. Commissioner,

T.C. Memo. 1994-493; sec. 1.6662-3(b)(1), Income Tax Regs.

Reliance on professional tax advice may qualify for the

reasonable cause and good faith exception.    Sec. 1.6664-4(b)(1),

Income Tax Regs.   Yet inasmuch as Mr. Kelly failed to prove the

accuracy of the information on which petitioners' return preparer

based his judgment, he cannot avoid application of the negligence

penalty to the ordinary loss deductions.     Eyefull Inc. v.

Commissioner, T.C. Memo. 1996-238; Saghafi v. Commissioner, T.C.

Memo. 1994-238.

     Mr. Kelly's contention that petitioners adequately disclosed

the relevant facts relating to their treatment of the trading

losses is likewise without merit.   Petitioners' returns for 1989

through 1992 describe Mr. Kelly's business as "trader", and an

attachment to each return lists Mr. Kelly's trades during the

year.   This information does not constitute adequate disclosure.

The adequate disclosure exception to the negligence penalty is

provided for in sections 1.6662-3(c) and -4(f), Income Tax Regs.,

which became effective for returns due after December 31, 1991.
                               - 25 -


Sec. 1.6662-2(d)(1), Income Tax Regs.    Under these regulations,

disclosure is adequate if and only if it is made on Form 8275 (or

Form 8275-R).    Secs. 1.6662-3(c)(2) and -4(f)(1), Income Tax

Regs.    Petitioners did not file Form 8275 for 1991 or 1992.7   For

returns due prior to the effective date of sections 1.6662-3(c),

and -4(f), Income Tax Regs., taxpayers were entitled to rely on

Notice 90-20, 1990-1 C.B. 328, as authority for the adequate

disclosure exception.    Closely tracking the language of the

legislative history that directed the Secretary to provide for

such an exception, Notice 90-20 states that "disclosure must be

full and substantive and be clearly identified as being made to

avoid imposition of the accuracy-related penalty."     Id. at 329;

H. Rept. 101-247 at 1393 (1989).    Disclosure may be made on Form

8275.    Alternatively, it may be made on the return, in which case

the front page of the return must bear the caption "DISCLOSURE

MADE UNDER SECTION 6662."    Id.   Petitioners' returns for 1989 and

1990 did not comply with these requirements and no Forms 8275




     7
      For the first time in his reply brief, Mr. Kelly challenges
the validity of these regulations on the ground that they exceed
the scope of the Secretary's interpretive authority. Mr. Kelly
evidently believes that the conditions in the regulations for
adequate disclosure are too restrictive. The argument was raised
too late for consideration. Aero Rental v. Commissioner, 64 T.C.
331, 338 (1975). We note in passing, however, that as the
statute itself provides no exception to the negligence penalty
for adequate disclosure, we fail to see how invalidating the
regulations would serve petitioners' interest.
                              - 26 -


were filed.   The accuracy-related penalties are sustained for all

years.

5.   Innocent Spouse

      Mrs. Kelly sought to escape liability on the ground that she

was an innocent spouse within the meaning of section 6013(e).

Under section 6013(e)(1), an individual who filed a joint return

with her spouse may obtain relief from joint liability for tax

where all of the following requirements are satisfied:   (1) A

joint return was filed on which; (2) there was a substantial

understatement of tax attributable to grossly erroneous items of

her spouse; (3) in signing the return she neither knew nor had

reason to know of such understatement; and (4) taking into

account all the facts and circumstances, it would be inequitable

to hold her liable for the resulting deficiencies.   It is

undisputed that joint returns were filed for each of the taxable

years at issue, that there was a substantial understatement for

each year, and that the understatements were attributable to

Mr. Kelly.

      "Grossly erroneous items" include any claim of a deduction

"in an amount for which there is no basis in fact or law."     Sec.

6013(e)(2)(B).   The courts have held that a claim "without a

basis in fact or law" is one that is frivolous, fraudulent, or

phony.   Friedman v. Commissioner, 53 F.3d 523, 529 (2d Cir.

1995), affg. in part and revg. in part T.C. Memo. 1993-549; Bokum
                                - 27 -


v. Commissioner, 94 T.C. 126, 142 (1990), affd. 992 F.2d 1132

(11th Cir. 1993); Douglas v. Commissioner, 86 T.C. 758, 763

(1986); Purcell v. Commissioner, 86 T.C. 228, 240 (1986), affd.

826 F.2d 470 (6th Cir. 1987).

     Mrs. Kelly took the position that both the employee business

expense deductions and the ordinary loss deductions were not only

plainly without merit, but "phony".      She argued that in view of

Shearson Lehman's reimbursement policy, "If * * * the claimed

unreimbursed expenses had a factual basis, there is no logical

explanation why they were not reimbursed.     * * *   The logical

inference from the failure to seek reimbursement or, if it was

sought, to obtain it, is that the claimed expenses were never

incurred or were not business-related."     An alternative

explanation, however, is that the expenses were not reimbursed

by Mr. Kelly's employer, or that Mr. Kelly did not seek

reimbursement, for the same reason that the deductions were

disallowed by respondent, a failure to substantiate.8     Failure to

substantiate adequately does not, by itself, prove that the

expenses were fictitious or were nondeductible personal expenses.


     8
      It is not uncommon for employees to refrain from pursuing
claims for reimbursement to which they would be entitled under
the employer's policy, believing it impolitic to do so in view of
the nature or amount of the relevant expenses. There is nothing
in the record that would rule this out as another possible
explanation for why Mr. Kelly might not have obtained
reimbursement in spite of having genuinely incurred business-
related expenses.
                              - 28 -


Douglas v. Commissioner, 86 T.C. at 763; cf. Perry v.

Commissioner, T.C. Memo. 1992-258.

     Mrs. Kelly conceded that the options trading losses reported

on the joint returns were real.   She contended, however, that the

deductions were "phony" because they were based on "outright

deception, followed by obfuscation":   That in support of the

deductions for 1986 and 1987, on Schedule C Mr. Kelly

fraudulently represented that he was an options dealer, and that

in support of the deductions for 1989 and 1990, he deliberately

omitted to report the nature of his business on Schedule C in

order not to jeopardize the deductions.

     There are a number of serious weaknesses in this argument.

First, the argument applies only to the first 4 of the years at

issue.   There is no suggestion of deliberate misrepresentation in

the reporting of Mr. Kelly's losses for 1991 and 1992.

     Second, the argument fails to take account of the fact that

on the joint returns for the 3 years preceding the first year in

which Mr. Kelly adopted ordinary treatment for his options

trading losses, he consistently reported his business as

"dealer".   Yet he did not use this status to claim any tax

benefits for these years.   The inference that for 1986 and 1987

he misrepresented the nature of his business with fraudulent

intent is therefore not compelling.
                                - 29 -


     Third, on brief Mrs. Kelly evidently accepted the accuracy

of Mr. Kelly's representation to Auerbach that registration as an

options principal qualified Mr. Kelly to do business as an option

dealer.    Inasmuch as Auerbach, an experienced tax professional,

also accepted this conclusion, it appears to us that Mr. Kelly's

representation of himself as an options dealer on the returns did

not constitute such a substantial deviation from ordinary

behavior that it cannot be ascribed to an honest misunderstanding

or simple carelessness.

     In this connection, Reid v. Commissioner, T.C. Memo. 1989-

294, cited by respondent, appears to us to have a bearing on the

outcome.    In that case, the husband's losses on commodity futures

transactions were incorrectly treated as ordinary rather than

capital on the joint returns.    It was held that there was a basis

in fact for the losses because they had actually been sustained

and that there may also have been some basis in law for the

argument that the losses were ordinary because the futures

transactions were related to the husband's farm operations (an

argument under Corn Prods. Ref. Co. v. Commissioner, 350 U.S. 46

(1955)).    Similarly here, the fact that Mr. Kelly was in the

securities business and that he and the return preparers had

concluded, in the aftermath of Commissioner v. Groetzinger, 480

U.S. 23 (1987), that he was entitled to be treated as a dealer in
                              - 30 -


options provided an arguably colorable--albeit incorrect--basis

for the position taken on the joint returns.

     There is no evidence that the deductions were frivolous,

fraudulent, phony, or otherwise so groundless as to be grossly

erroneous.   Accordingly, the substantial understatements for the

taxable years at issue were not attributable to grossly erroneous

          items.   We need not consider the other requirements for

innocent spouse relief.9

     In view of the foregoing,


                                         Decision will be entered

                                    under Rule 155 in docket No.

                                    28233-91, and decision will be

                                    entered for respondent in

                                    docket No. 7795-94.




     9
      After the reply briefs in these cases had been filed, the
Court of Appeals for the Seventh Circuit decided Resser v.
Commissioner, 74 F.3d 1528 (7th Cir. 1996), revg. and remanding
T.C. Memo. 1994-241. By letter, counsel for Mrs. Kelly called
the decision to our attention in the belief that the facts were
in some respects similar to those of these cases. Since neither
this Court nor the Court of Appeals for the Seventh Circuit
decided whether the understatement in that case resulted from
grossly erroneous items, and the case has been remanded to this
Court for further findings on that issue, we leave for another
day any discussion of the opinion of the Court of Appeals for the
Seventh Circuit in Resser.
