                       T.C. Memo. 1998-405



                     UNITED STATES TAX COURT



    DONALD C. RICHARDSON AND RITA M. ALLAIRE, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

  PAIGE COMMUNICATIONS CORPORATION OF LOUISIANA, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 12252-97, 12253-97.    Filed November 12, 1998.



     William A. Neilson and Joseph J. Ecuyer III, for

petitioners.

     Joseph Ineich, for respondent.



                       MEMORANDUM OPINION


     PANUTHOS, Chief Special Trial Judge:    This matter is before

the Court on petitioners' motions for award of reasonable
                                  - 2 -


litigation and administrative costs under section 74301 and Rules

230, 231, and 232.   These related cases have been consolidated

for the purpose of considering these motions.

     On March 13, 1997, respondent issued statutory notices of

deficiency to petitioner Paige Communications Corporation of

Louisiana (PCCL) and to petitioners Donald C. Richardson and Rita

M. Allaire2, husband and wife, for the taxable year ended 1993.

Deficiencies in income tax and penalties were determined as

follows:

                                                    Penalties
     Taxpayer        Deficiency           Sec. 6663(a)   Sec. 6662(a)1

Richardson/Allaire    $12,781                   $9,586        -0-
PCCL                  104,002                   78,002        -0-
     1
        The negligence penalty was imposed as an alternative to
the fraud penalty.

     Respondent determined that petitioners received income in

the form of constructive dividends from PCCL in the amount of

$47,086.   Respondent determined that the constructive dividends

consisted of (1) PCCL corporate income in the amount of $14,443

diverted for petitioners' personal use; (2) improvements to

petitioners' residence paid for by PCCL in the amount of $8,549;

     1
          Unless otherwise indicated, section references are to
the Internal Revenue Code as amended, and all Rule references are
to the Tax Court Rules of Practice and Procedure.
     2
          "Petitioners" will collectively refer to petitioners
Richardson and Allaire. "Petitioner" will refer to petitioner
Donald C. Richardson individually.
                                - 3 -


and (3) petitioners' personal expenses charged to American

Express and paid by PCCL in the amount of $24,094.

     Respondent also determined a deficiency against PCCL.      The

adjustments to PCCL were (1) unreported corporate income in the

amount of $14,443; (2) disallowed "Other Deductions" in the

amount of $263,956; (3) a disallowed interest deduction in the

amount of $37,777; and (4) an upward adjustment to "Cost of Goods

Sold" in the amount of $13,770 due to an error on the return.

     Petitions were timely filed with this Court by petitioners

and PCCL on June 11, 1997.   At that time, petitioners were

residents of Kenner, Louisiana.   PCCL, a Louisiana corporation,

had its principal office at Metairie, Louisiana.

     In the timely filed answer in each case respondent included

specific allegations in support of the determination that

petitioners and PCCL were liable for a penalty due to fraud.

Respondent alternatively alleged in the answer in each case that

petitioners and PCCL, respectively, were liable for an accuracy-

related penalty for 1993.    Additionally, on August 8, 1997, the

cases were sent to the Appeals Division of the Internal Revenue

Service in New Orleans, Louisiana, for consideration.

     The cases were calendared for trial at a trial session

commencing March 9, 1998, in New Orleans, Louisiana.      Prior to

trial, and after several meetings between the Appeals Office and

petitioners, the cases were settled.      Stipulations of settlement

were filed for each docketed case.      The stipulations reflected
                                - 4 -


(1) a deficiency in income tax due from petitioners in the amount

of $2,358; (2) a penalty due from petitioners in the amount of

$472 as provided under section 6662(a); (3) a deficiency in

income tax due from PCCL in the amount of $698 (without taking

into consideration a tentative net operating loss carryback

allowance of $1,214 from 1996); and (4) a penalty due from PCCL

in the amount of $140 as provided under section 6662(a).     No

penalty was due from petitioners or PCCL for fraud as provided

under section 6663.

     Petitioners and PCCL each filed a motion for an award of

reasonable litigation and administrative costs.    Respondent filed

an objection to each motion.    Petitioners and PCCL filed a reply

to respondent's objections.    Each party submitted memoranda in

support of their respective positions.    None of the parties have

requested a hearing in this matter.     We conclude that a hearing

is not necessary to decide this motion.    Rule 232(a)(2).

     The issues for decision are:    (1) Whether respondent's

position in the underlying proceedings was substantially

justified; and (2) whether the amount of costs claimed by

petitioners and PCCL with regard to the litigation and

administration costs is reasonable.

Background

     The following facts are based on the entire record,

including the affidavits and exhibits submitted by the parties

and the parties' pleadings.
                                - 5 -


     1.    Events Leading to Examination by Internal Revenue
           Service

     Petitioner had become friends with Edward Paige (hereinafter

Paige) in 1974.    In 1982, Paige formed Paige Communications

Corporation, a California entity (Paige-Cal)3.   In 1983 a joint

venture was entered into between Paige-Cal and petitioners to

form PCCL.

     At PCCL's inception, petitioner Allaire owned 375 shares of

the company, and Paige-Cal, through Paige, its president, owned

the remaining 125 shares.    During 1988, Paige-Cal's shares were

transferred to petitioner Allaire, who then became the sole

shareholder of PCCL.    Petitioner was PCCL's president.

     In November 1992, petitioner hired Paige as a consultant to

PCCL.    However, by way of a letter dated October 1, 1993,

petitioner Allaire advised Paige that his position at PCCL was

abolished effective October 29, 1993, and that his employment

with the company would cease on that date.

     Subsequent to his termination from PCCL, Paige wrote a

letter to the Internal Revenue Service (IRS) dated March 22,

1994.    This letter enumerated specific allegations against

petitioners and PCCL.    Paige's allegations were premised upon

information he allegedly obtained while employed by PCCL.      Paige

     3
          The record does not reflect whether Paige-Cal was an
incorporated business as provided by California law. For this
reason, we are referring to it as a California entity.
                               - 6 -


alleged, inter alia: (1) Information provided to the IRS

regarding PCCL was improperly reported; (2) petitioner sold items

from PCCL's inventory and payments for such items were made to

petitioner and not reported by petitioner or PCCL; (3) some of

petitioners' personal expenses were paid by PCCL, including

payments for improvements to their home; (4) PCCL's books were

"being fixed" so as to report little or no tax liability; and (5)

petitioners formed a shell company, Dorrial, Inc., to divert

funds from PCCL.

     In support of his allegations in the letter Paige included

summaries of (1) equipment removed by petitioner from PCCL's

inventory; (2) petitioners' personal expenses paid by company

checks and company credit cards; and (3) company equipment

installed at petitioners' home. In addition, Paige attached

schedules, PCCL's balance sheets, and PCCL's financial statements

to support the above summaries.   Paige also provided the IRS with

names of witnesses to support his allegations and with names of

individuals and businesses to whom Paige believed petitioner was

selling the inventory items for personal gain.

     2.   IRS Examination and Investigation

     Beginning in October 1994, the income tax returns for

petitioners, PCCL, and Dorrial, Inc. (a related entity) were

examined.   The exam included the 1993 tax year as well as prior

years.    The revenue agent conducting the examination interviewed
                               - 7 -


individuals that either purchased equipment from PCCL or provided

goods and/or services to petitioners and PCCL.   The revenue agent

also interviewed petitioners and former employees of PCCL.    The

revenue agent also requested and obtained documents relevant to

the examination.

     At some point the revenue agent made a referral to the

Criminal Investigation Division of the IRS (CID).    Special agents

from CID interviewed petitioners on June 7 and June 15, 1995.

During the course of the interviews, petitioners discussed Paige

and his involvement with PCCL, as well as the improvements made

to their home, the unreported sales of PCCL equipment, and

Dorrial, Inc.

     Throughout the examination and investigation, petitioners

maintained they were unaware PCCL paid for the improvements to

their home.   They alleged that Paige made all arrangements for

the work to be completed.   Notwithstanding the above, it was

discovered that petitioner Allaire had signed PCCL's checks in

order to pay for the home improvements.   She claimed to have no

knowledge of the purpose of the checks.   Additionally, respondent

was provided with specific invoices, memoranda, and a proposal

from Wayne Catalano and Al Horn, third-party contractors that

completed the improvements to petitioners' home.    These

documents, in total, reflected that PCCL was billed in the amount

of $8,549 for work completed at petitioners' home.
                                 - 8 -


     Also as part of the examination, the revenue agent conducted

a telephone interview with Wayne Catalano.   Catalano informed the

revenue agent that petitioner was present at the first

consultation pertaining to the work to be done at the home.     He

also informed the revenue agent that petitioner was aware of the

circumstances surrounding the work and that petitioner delegated

the authority to proceed with the work to Paige.   The revenue

agent had also interviewed a former employee of PCCL.    This

former employee specifically informed the revenue agent that

petitioners were aware of the payment arrangement for the home

improvements.

     During the interviews with the special agents, petitioner

admitted: (1) Making two sales of PCCL's inventory; (2) having

the checks made out in his name; (3) not reporting the income;

(4) using the funds for personal expenses; and (5) having made

these types of sales in the years 1990 through 1993, although

petitioner claimed to have split the income with Paige during

1993.   During the course of the investigation, respondent

received evidence of a minimum of eight unreported sales made

payable to petitioner in 1993.

     On August 19, 1996, petitioners' attorney, William Neilson

(Neilson), wrote a letter to a special agent involved with the

criminal investigation.   In the letter, Neilson questioned

Paige's credibility and motives in contacting the IRS with these

allegations against petitioners and PCCL.    In addition, Neilson
                               - 9 -


discussed the subject of the home improvements.     Specifically,

the special agent was informed "the Richardsons were aware that

Mr. Paige used corporate funds to improve their property,

although they were not privy to the exact amounts or how those

funds were disbursed".   Also, Neilson attempted to categorize the

unreported funds received by petitioner from the sale of PCCL

equipment as either business or investment expenses.

     Sometime in the beginning of March 1997, respondent

requested petitioners to extend the period of limitations with

respect to the examination of the individual and corporate income

tax returns.   Petitioners did not agree to the extension.    On

February 28, 1997, respondent scheduled an appointment with

petitioners for March 17, 1997, to conclude the examination of

petitioners' return.   On March 4, 1997, respondent contacted

petitioners' attorney to cancel the March 17, 1997, appointment

based on the belief the statute of limitations was set to expire.

     On March 5, 1997, respondent sent petitioners proposed

changes to their 1993 tax return.4     On March 11, 1997, respondent

issued a letter to petitioner notifying him that he was no longer

the subject of a criminal investigation.     On March 13, 1997,

respondent issued the respective notices of deficiency.     After

petitions and answers were filed, petitioners met with

respondent's appeals officer on several occasions.     During these

     4
          We assume proposed changes were also sent with respect
to PCCL; however, the record does not so indicate.
                              - 10 -


meetings, pertinent documentation pertaining to the issues in

dispute was provided to respondent.    Subsequently, respective

settlements were reached.

Discussion

     1.   General

     Section 7430(a) provides that the prevailing party in any

administrative or court proceeding may be awarded a judgment for

(1) reasonable administrative costs incurred in connection with

such administrative proceedings within the IRS, and (2)

reasonable litigation costs incurred in connection with such

court proceedings.   Sec. 7430(a), (c).5   However, there is an

exception to the "prevailing party" rule if the United States

establishes that its position was substantially justified.     Sec.

     5
          Sec. 7430(c)(1), as applicable to these cases, provides
that reasonable litigation costs include reasonable fees paid or
incurred for the services of attorneys in connection with the
court proceeding, except that such fees shall not be in excess of
$110 per hour. Sec. 7430(c)(2), as applicable in these cases,
provides that the term "reasonable administrative costs" only
includes "costs incurred on or after the earlier of (i) the date
of the receipt by the taxpayer of the notice of the decision of
the Internal Revenue Service Office of Appeals, or (ii) the date
of the notice of deficiency."

     The Internal Revenue Service Restructuring & Reform Act of
1998 (RRA 1998), enacted July 22, 1998, amended the above-noted
sections. Pub. L. 105-206, secs. 3101(a)(1), (g), 112 Stat. 685,
727-729. The amendments apply to services performed or costs
incurred more than 180 days after the date of the enactment of
this Act (180 days after July 22, 1998). RRA 1998 sec. 3101(g),
112 Stat. 729. Accordingly, RRA 1998 is not applicable to the
instant cases.
                              - 11 -


7430(c)(4)(B).6   The parties dispute (1) whether the

Commissioner's position was substantially justified, and (2)

whether the amounts of costs and attorney's fees claimed by

petitioners and PCCL are reasonable.7

     To decide whether respondent's position was substantially

justified, the Court must first identify the point in time at

which respondent is considered to have taken a position and then

decide whether the position taken from that date forward was

substantially justified.   In general, we look separately at the

dates that respondent took a position in the administrative

proceeding and in the proceeding in this Court.   Sec.

7430(c)(7)(A) and (B); Huffman v. Commissioner, 978 F.2d 1139,

     6
          Sec. 7430, as amended by the Taxpayer Bill of Rights 2
(TBOR 2), Pub. L. 104-168, secs. 701-704, 110 Stat. 1452, 1463-
1464 (1996), requires the Commissioner to establish that the
Commissioner's position in such proceedings was substantially
justified. TBOR 2 sec. 701(a) and (b), 110 Stat. 1463. The
amendments to sec. 7430 are effective with respect to
"proceedings commenced after * * * [July 30, 1996]". TBOR 2
secs. 701(d), 702(b), 703(b), and 704(b), 110 Stat. 1464. As the
petition in each of these cases was filed in June 1997, section
7430 as amended by TBOR 2 applies. Maggie Management Co. v.
Commissioner, 108 T.C. 430, 441 (1997). As such, the burden is
on the Commissioner to establish that the Commissioner's position
was substantially justified.
     7
          Respondent concedes that petitioners and PCCL have:
(1) Substantially prevailed in the proceeding within the meaning
of sec. 7430(c)(4)(A)(i); (2) exhausted their administrative
remedies within the meaning of sec. 7430(b)(1); (3) not
unreasonably protracted the Court or administrative proceedings
within the meaning of sec. 7430(b)(3); and (4) satisfied the net
worth requirements of sec. 7430(c)(4)(A)(ii).
                                - 12 -


1148 (9th Cir. 1992), affg. in part, revg. in part and remanding

T.C. Memo. 1991-144.

     Respondent takes a position in an administrative proceeding

as of the earlier of the date the taxpayer receives an IRS

Appeals decision or the Commissioner sends the notice of

deficiency.   Sec. 7430(c)(7)(B).   Respondent's position in the

administrative proceeding was established on March 13, 1997, when

the statutory notices of deficiency were mailed.    Respondent took

a position in the judicial proceeding in these cases on August

12, 1997, when respondent's answers were filed.    Sec.

7430(c)(7)(A); California Marine Cleaning, Inc. v. Commissioner,

T.C. Memo. 1998-311; Kahn-Langer v. Commissioner, T.C. Memo.

1995-527; Lockett v. Commissioner, T.C. Memo. 1994-144 (citing

Huffman v. Commissioner, supra at 1148); Amann v. Commissioner,

T.C. Memo. 1993-542, affd. per curiam without published opinion

40 F.3d 1235 (1st Cir. 1994).    In this instance it is not

necessary to analyze respondent's position separately on each of

these dates as respondent's position was the same at both times.

Swanson v. Commissioner, 106 T.C. 76, 87 (1996).

     We now consider whether respondent's position in the

administrative and judicial proceedings was substantially

justified.    We analyze respondent's position in the context of

what caused respondent to take that position.     Lennox v.

Commissioner, 998 F.2d 244, 247-249 (5th Cir. 1993), revg. in
                              - 13 -


part and remanding T.C. Memo. 1992-382.8    Additionally, we look

at the manner in which respondent maintained that position.

Wasie v. Commissioner, 86 T.C. 962, 969 (1986); Kahn-Langer v.

Commissioner, supra; Amann v. Commissioner, supra.      Factors which

may be considered include:

     (1) whether the government used the costs and expenses
     of litigation against its position to extract
     concessions from the taxpayer that were not justified
     under the circumstances of the case, (2) whether the
     government pursued the litigation against the taxpayer
     for purposes of harassment or embarrassment, or out of
     political motivation, and (3) such other factors as the
     Court finds relevant. [citing H. Rept. 97-404, at 12
     (1981), Sher v. Commissioner, 89 T.C. 79, 85 (1987),
     affd. 861 F.2d 131 (5th Cir. 1988).]

     Our analysis of what caused respondent to take that position

may include events preceding the date the notices of deficiency

were issued.   Lennox v. Commissioner, supra; Uddo v.

Commissioner, T.C. Memo. 1998-276; Williford v. Commissioner,

T.C. Memo. 1994-135.   The reasonableness of respondent's position

and conduct necessarily requires considering what respondent knew

at the time.   Rutana v. Commissioner, 88 T.C. 1329, 1334 (1987);

DeVenney v. Commissioner, 85 T.C. 927, 930 (1985); Triplett v.

Commissioner, T.C. Memo. 1998-313.     We ask ourselves "whether

* * * [the Commissioner] knew or should have known that [the

Commissioner's] position was invalid at the onset."      Estate of

     8
          Venue for appeal in these cases lies to the Court of
Appeals for the Fifth Circuit. Accordingly, precedent from that
jurisdiction controls our analysis of the issues. Golsen v.
Commissioner, 54 T.C. 742, 757 (1970), affd. 445 F.2d 985 (10th
Cir. 1971).
                               - 14 -


Williamson v. Commissioner, T.C. Memo. 1997-77 (quoting Nalle v.

Commissioner, 55 F.3d 189, 191 (5th Cir. 1995), affg. T.C. Memo.

1994-182).

     Whether respondent's position was substantially justified

turns on a finding of reasonableness, based upon all the facts

and circumstances, as well as the legal precedents relating to

the case.    Pierce v. Underwood, 487 U.S. 552 (1988); Nalle v.

Commissioner, supra; Coastal Petroleum Refiners, Inc. v.

Commissioner, 94 T.C. 685, 688-696 (1990).   A position is

substantially justified if that position could satisfy a

reasonable person.    Pierce v. Underwood, supra at 565; Powers v.

Commissioner, 100 T.C. 457, 473 (1993), affd. on this issue,

revd. in part, and remanded on other issues 43 F.3d 172 (5th Cir.

1995).   Respondent's position may be incorrect but substantially

justified "if a reasonable person could think it correct".

Pierce v. Underwood, supra at 566 n.2.

     The reasonableness standard applies to motions for

litigation and administrative costs under section 7430.

Nicholson v. Commissioner, 60 F.3d 1020, 1025-1026 (3d Cir.

1995), revg. T.C. Memo. 1994-280.   For a position to be

substantially justified, there must be "substantial evidence" to

support it.    Pierce v. Underwood, supra at 564-565; Maggie

Management Co. v. Commissioner, 108 T.C. 430, 443 (1997); Powers

v. Commissioner, supra.    "That phrase does not mean a large or

considerable amount of evidence, but rather 'such relevant
                                 - 15 -


evidence as a reasonable mind might accept as adequate to support

a conclusion'."     Pierce v. Underwood, supra at 564-565 (quoting

Consolidated Edison Co. v. NLRB, 305 U.S. 197, 229 (1938)).

     Respondent argues that respondent's position was

substantially justified as to each issue raised in the notices of

deficiency.    We have previously adopted an issue-by-issue

approach to the awarding of costs under section 7430.     Swanson v.

Commissioner, supra at 102; see Powers v. Commissioner, 51 F.3d

34, 35 (5th Cir. 1995).

          A.    Adjustment to Petitioners' 1993 Tax Return

     The statutory notice of deficiency issued to petitioners

included an adjustment in the amount of $47,086 based on payments

made by PCCL either to petitioners or for their benefit.

Respondent determined that petitioners received constructive

dividends from three separate transactions.

     Based on the information set forth below, which was known to

respondent at the time the statutory notice of deficiency was

issued, and which information remained unchanged at the time of

the answer to their petition, we are satisfied that respondent

had a basis in fact for the position that petitioners had

unreported income in the amount of $47,086.

                  (1).   Constructive Dividend: Unreported Income
                         Received for Sales of PCCL Equipment

     Petitioner admitted to special agents during interviews with

CID that he made two sales of PCCL equipment, had the proceeds of
                                - 16 -


the sales made payable to himself, used the funds for personal

expenses, and did not report the proceeds as income.     Respondent

obtained from third-party sources copies of eight canceled checks

for 1993 listing petitioner as the payee for sales of equipment.

These canceled checks totaled $14,443.

                (2).    Constructive Dividend:   Improvements to
                        Petitioners' Home

     Respondent received invoices and other documentation from

contractors who performed work on petitioners' home.     The

invoices were made out to and paid by PCCL in the amount of

$8,549.   Petitioner Allaire signed the checks as an agent of PCCL

in payment of the invoices.    Respondent also received information

from third-party sources that petitioners were aware of the

payment arrangements.

                (3).    Constructive Dividend: Petitioners'
                        Personal Expenses Charged to PCCL's
                        American Express Account

     Respondent's revenue agent had reviewed PCCL's American

Express statements.    The revenue agent concluded that $24,094

contained in these statements was attributable to personal

expenses of petitioners.

          B.   Adjustments to PCCL's 1993 Tax Return

     The statutory notice of deficiency issued to PCCL included

adjustments in the total amount of $316,176.9     Based on the

     9
          Less the $13,770 upward adjustment to "Cost of Goods
Sold" due to an error on the return.
                               - 17 -


information set forth below, which was known to respondent at the

time the statutory notice of deficiency was issued, and which

information remained unchanged at the time of respondent's answer

to the petition, we are satisfied that respondent had a basis in

fact for the position that PCCL had (1) received unreported

income in the amount of $14,443; (2) erred in claiming "Other

Deductions" to the extent of $263,956; and (3) erred in claiming

an interest expense deduction in the amount of $37,777.

               (1).    Unreported Income

     The notice of deficiency issued to PCCL included an

adjustment in the amount of $14,443 due to unreported income from

the sale of PCCL's equipment by petitioner.      Respondent received

copies of eight canceled checks made out to petitioner.     Also, as

described in A.(1) above, petitioner admitted to sales by PCCL.

               (2).    Other Deductions (PCCL)

     On its 1993 tax return, PCCL had claimed a total of $376,431

in "Other Deductions".10   The notice stated that "it has not been

verified that any amount in excess of $109,875 constitutes an

ordinary and necessary business expense or was expended for the

purpose designated."

     10
          We note that petitioners contend in their pleadings
that respondent arbitrarily denied all of PCCL's business
expenses. The notice of deficiency is clear that only a portion
of the expenses were disallowed.
                                - 18 -


     Respondent had interviewed a third-party former employee of

PCCL.     This interview provided respondent with information that

PCCL was "fixing its books".     In addition, respondent had

received documentation from Paige, which was supported by the

interview with the employee.

     In Simpson Fin. Servs., Inc. v. Commissioner, T.C. Memo.

1996-317, the Commissioner disallowed a portion of the taxpayer's

claimed expenses because of lack of substantiation.

Documentation was eventually provided to the Commissioner's

appeals officer, and subsequently to District Counsel.     Based on

the documentation provided to the Commissioner, the parties

settled all issues raised in the notice of deficiency.     We denied

the taxpayer's request for an award of attorney's fees.

Specifically, we said:

        In the notices of deficiency, respondent premised the
        adjustments primarily on petitioners' failure to
        substantiate items on their returns. Deductions are a
        matter of legislative grace, and petitioners bore the
        burden of establishing their entitlement thereto. * * *
        In addition, section 6001 imposed on petitioners an
        affirmative duty to maintain books and records
        sufficient to establish items reported on their
        returns. It was reasonable for respondent not to
        concede the adjustments until she had received and
        verified adequate substantiation for the items in
        question. Harrison v. Commissioner, 854 F.2d 263, 265
        (7th Cir. 1988), affg. T.C. Memo. 1987-52; Sokol v.
        Commissioner, 92 T.C. 760, 765 (1989). [Citation
        omitted.]
                                 - 19 -


     Petitioners substantiated a large part of the expenses

during their meetings with respondent's Appeals officer by

providing the requisite documentation at that time.

                  (3).   Interest Expense Deduction (PCCL)

     The notice of deficiency to PCCL adjusted a claimed interest

expense deduction in the amount of $37,777.     Respondent

disallowed the interest expense deduction because "it has not

been established that any amount constitutes an ordinary and

necessary business expense or was expended for the purpose

designated nor that a bona fide debt existed".     For the reasons

stated in the "Other Deductions" analysis, respondent had a basis

in fact at the time of the notice of deficiency for his position

of disallowing the interest deduction.     PCCL did not substantiate

this claimed deduction until it provided the requisite documents

to respondent's Appeals Office subsequent to the filing of the

petition.

     In addition, during the course of respondent's examination,

respondent had interviewed a former employee of PCCL with regard

to this matter.    Respondent was provided with pertinent

information that a related entity, Dorrial, Inc., was set up as a

"shell corporation", with the purpose of diverting PCCL funds.

Also, Paige had provided respondent with information regarding

the loan and related company in issue.
                               - 20 -


     Based on the foregoing analysis, we also conclude that

respondent had a basis in law for all of the adjustments in the

notices of deficiency and the answer to the petition, as provided

under the Internal Revenue Code.

           C.   Fraud (PCCL and Petitioners)

     Respondent determined that PCCL and petitioners were liable

for penalties for fraud as provided under section 6663.

Respondent's agents conducted an examination and investigation of

these cases from October 1994 through March 1997.    This

investigation included interviewing third parties that had

relevant information and/or documentation pertinent to the issues

at hand.   In addition, respondent's revenue agent and special

agents interviewed petitioners, sent document requests to

petitioners, and examined PCCL's financial statements.

Respondent's revenue agent thoroughly reviewed PCCL's American

Express statements and drafted a report based on her conclusions

of the examination.

     With regard to the unreported income, petitioner admitted to

receiving income from selling PCCL's inventory.    He admitted

these sales did not go through PCCL's normal sales channels.     He

also admitted that such income was not reported.    Respondent was

aware that petitioners were in control of PCCL.

     With regard to the home improvements, respondent discovered

petitioner Allaire signed PCCL's checks to pay for the work being
                                 - 21 -


done.     Wayne Catalano, a contractor who completed some of the

improvements to the home, informed respondent that petitioner was

present at the home when the first meeting was conducted

regarding the improvements.      He informed respondent that

petitioner was aware of what was going on.      Petitioner had

delegated the authority to Paige to handle the transaction.

     Petitioners contended throughout the investigation that they

were unaware PCCL had paid the expenses for the improvements to

the home.     However, petitioners were aware they had not paid the

home improvement expenses themselves.      In addition, petitioners'

and PCCL's attorney informed respondent by letter that

petitioners were aware of PCCL's having paid the home improvement

expenses but they were not privy to the amounts.

     Based on this information, the information provided to

respondent regarding Dorrial, Inc., and the information provided

to respondent regarding PCCL, we conclude respondent had a basis

in fact and law for determining petitioners and PCCL were liable

for penalties for fraud under section 6663.      See Whitesell v.

Commissioner, 90 T.C. 702 (1988); Reinhardt v. Commissioner, T.C.

Memo. 1995-82.

        2.   Petitioners' Arguments

        Petitioners argue that the resulting settlement of the

deficiencies to amounts that were minimal in comparison to the

amounts contained in the notices of deficiency, and the
                               - 22 -


settlement of the penalties for negligence, instead of fraud,

indicate that respondent was not substantially justified.    We

disagree.   The fact that the Commissioner eventually loses or

concedes a case does not establish that a taxpayer is entitled to

an award of reasonable litigation and administrative costs.

Wilfong v. United States, 991 F.2d 359, 364 (7th Cir. 1993);

Hanson v. Commissioner, 975 F.2d 1150, 1153 (5th Cir. 1992);

Sokol v. Commissioner, 92 T.C. 760, 767 (1989).   However, it is a

factor to be considered.   Estate of Perry v. Commissioner, 931

F.2d 1044, 1046 (5th Cir. 1991); California Marine Cleaning, Inc.

v. Commissioner, T.C. Memo. 1998-311.

     In their motions, petitioners and PCCL claimed that

respondent had access to all records throughout the course of the

investigation.   It is well settled that a taxpayer is required to

keep permanent books of account and records to substantiate the

income and expenses reported on his income tax return.    Sec.

6001; sec. 1.6001-1(a), Income Tax Regs.   Generally, when a

taxpayer does not produce substantiation of claimed deductions,

disallowance is proper.    Amann v. Commissioner, T.C. Memo. 1993-

542, affd. 40 F.3d 1235 (1st Cir. 1994); see Roberts v.

Commissioner, 62 T.C. 834, 836-837 (1974); Schnelten v.

Commissioner, T.C. Memo. 1993-264.

     There is nothing in the record that suggests petitioners'

and PCCL's records and books were available to respondent.     It
                                - 23 -


took several meetings with respondent's Appeals officer before

all the voluminous documentation required to substantiate the

claimed deductions were supplied to respondent.      This

documentation was not produced during the examination.      The issue

is not whether petitioners and PCCL had documentation supporting

their position.   Rather, the issue is whether respondent had a

basis in fact for the position in the notices of deficiency.      As

stated above, we conclude that respondent did.

     Petitioners and PCCL also contend that respondent's position

was not substantially justified because petitioners and PCCL

refused to extend the statute of limitations.      They contend

"respondent issued this notice * * * simply because the statute

of limitations was set to expire".       Even if it were shown to be

true that respondent issued the notices to toll the running of

the statute of limitations, that is not an unreasonable action

for respondent to take.

     In Chaum v. Commissioner, 69 T.C. 156 (1977), the IRS issued

a notice of deficiency to toll the running of the statute of

limitations after the taxpayers refused to consent to an

extension.   We rejected the taxpayers' arguments that the IRS

action was arbitrary.     Id. at 160-164.    In Wasie v. Commissioner,

86 T.C. 962, 969 (1986), we found that the IRS had acted

reasonably in issuing a notice of deficiency where the taxpayer

had refused to extend the statute of limitations.      See also
                               - 24 -


Harrison v. Commissioner, 854 F.2d 263 (7th Cir. 1988), affg.

T.C. Memo. 1987-52.

     Petitioners and PCCL also contend that the notices of

deficiency were based on respondent's sole reliance on a "bad

whistle blower", and, therefore, respondent was not substantially

justified in issuing the notices.   Petitioners contend that they

notified respondent of Paige's lack of credibility and

questionable motives for making allegations against petitioners

and PCCL in August 1995.   Petitioners claim that respondent was

therefore notified at an early stage of the investigation and,

essentially, should not have continued the investigation.

     Petitioners' letter was dated August 19, 1996, not 1995 as

petitioners contend.   Respondent was provided information which

asserted that Paige lacked credibility a year and 10 months after

the investigation had begun.   Respondent's determinations were

not based solely on Paige's allegations.   Paige also submitted

substantial documentation to respondent, along with a list of

witnesses.    Paige's allegations may have triggered an examination

of the 1993 and previous years tax returns; however, it was the

subsequent examination and criminal investigation that provided

information that caused respondent to issue the notices of

deficiency.

     There is no indication in the record that respondent

undertook a position that was not substantially justified.   For
                                - 25 -


example, there appears to be no instance of respondent's failing

to consider a claim made by PCCL for entitlement to a deduction

that had been supported by sufficient proof.     In the context of

what respondent knew at the time the notices of deficiency were

issued and the petitions were answered, there was substantial

evidence to support respondent's position.

       3.   Conclusion

       We conclude that respondent had a reasonable basis in fact

and law for all issues raised in the notices of deficiency based

on the investigation of these cases conducted by respondent

before trial.     See Reinhardt v. Commissioner, T.C. Memo. 1995-82.

We also conclude that respondent's position that petitioners and

PCCL were liable for the penalties for fraud, or alternatively,

for negligence for 1993 had a reasonable basis in both fact and

law.    We hold that respondent has established that respondent's

position was substantially justified and that neither petitioners

nor PCCL are entitled to an award for administrative and

litigation costs under section 7430.     Petitioners' and PCCL's

motions will therefore be denied.11

       To reflect the foregoing,

                                           Appropriate orders and

                                      decisions will be entered.

       11
          As a result of our conclusions herein, we need not
decide whether the amounts of petitioners' claimed administrative
and litigation costs are reasonable.
