                          T.C. Memo. 2000-96



                       UNITED STATES TAX COURT



                  TED AND TAMMY ESTES, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 10493-98.                      Filed March 21, 2000.



     Bruce A. Moates, for petitioners.

     Bruce K. Meneely, for respondent.



                          MEMORANDUM OPINION

     DAWSON, Judge:    This case was assigned to Special Trial

Judge Daniel J. Dinan pursuant to Rules 180, 181, and 183.

Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for the years in issue, and all

Rule references are to the Tax Court Rules of Practice and

Procedure.
                               - 2 -

     The Court agrees with and adopts the opinion of the Special

Trial Judge, which is set forth below.

               OPINION OF THE SPECIAL TRIAL JUDGE

     DINAN, Special Trial Judge:   This case is before the Court

on petitioners’ motion, and supplemental motion, for award of

litigation and administrative costs pursuant to the provisions of

Rule 231 and of section 7430 of the Internal Revenue Code in

effect at the time the petition in this case was filed.

     Although respondent requested a hearing on this motion, we

find that a hearing is not necessary.     See Rule 232(a).

Accordingly, we rule on petitioners’ motion on the basis of the

parties’ submissions and the existing record.     Petitioners

resided in Oklahoma City, Oklahoma, at the time the petition was

filed in this case.

                             Background

     The overriding issue in this case was the substantiation of

expenses and costs of goods sold claimed by petitioners to have

been incurred in connection with petitioner husband’s

(petitioner) business.   While the question of whether petitioners

initially maintained adequate business records remains disputed

by the parties, the poor condition of the records at the time of

respondent’s examination is not disputed.     Petitioner contends

that a fire partially destroyed his records, making them

unavailable to respondent.   The parties agree that for one reason
                                - 3 -

or another complete records did not exist at the time of the

audit and that reconstructions of petitioners’ income and

expenses had to be made.    The reconstructions to a large extent

were based upon petitioners’ checks and deposit tickets from the

years in issue.   The examining agent also relied upon bank

records and summary documents prepared by petitioners’

accountant.

     The primary issues discussed by the parties prior to the

issuance of the notice of deficiency were cost of goods sold,

gross receipts, and the sale of oil royalties.    The third issue,

sale of oil royalties, was resolved in petitioners’ favor prior

to the issuance of the notice of deficiency.     Because petitioners

believed they would owe no taxes if the first issue, cost of

goods sold, were decided in their favor, petitioners in

settlement negotiations agreed to concede all other issues if

respondent made a favorable determination regarding the cost of

goods sold amounts.

     Respondent issued a statutory notice of deficiency to

petitioners dated May 19, 1998.   The notice set forth the

following adjustments:

                                          1992      1993      1994

     Advertising expense                ($14,725)    -0-       -0-
     Aircraft expense                      -0-       -0-   ($14,186)
     Commission expense                    -0-    $31,000      -0-
     Cost of goods sold                 219,038    (2,204) 289,491
     Depreciation expense                  (471)     (902)     (832)
     Gross receipts                     (16,808)    5,113 (200,250)
                               - 4 -

                                           1992        1993        1994

     Insurance expense                      -0-       $7,820      $8,763
     Interest income                        $228         524        -0-
     Misc/other expense                    2,624       2,704       3,444
     Net operating loss deduction         25,800      18,775      28,789
     Reclassification items               (4,553)    (17,062)     (9,588)
     Sale of oil royalties                  -0-        3,048        -0-
     Taxes/licenses expense                2,228      (1,299)      3,463
     Travel expense                        3,875       9,764       3,625
     Truck expense                         6,960        -0-         -0-
     Utilities/phone expense               4,778       4,587       5,012
     Self-employment tax deduction        (4,641)       (223)     (4,865)
     Capital gains and losses               -0-        2,460      (3,000)
     Taxable Social Security                -0-          826       4,730
     Deduction for exemptions              2,208        -0-         -0-
     Total adjustments                   226,541      64,931     114,596
     Taxable income on return1           (18,756)    (39,689)    (44,427)
     Taxable income as adjusted          207,785      25,242      70,169
1
   The taxable income amounts are those which the notice of
deficiency indicates were on the original returns filed by
petitioners.

These adjustments resulted in the determination that petitioners

were liable for the following deficiencies, section 6662(a)

accuracy-related penalties, and section 6651(a)(1) additions to

tax in the total amount of $114,514:

                                 1992         1993        1994

           Deficiencies        $66,446       $4,231     $24,438
           Penalties            13,289         -0-        4,888
           Additions to tax       -0-          -0-        1,222
              Total             79,735        4,231      30,548

     Petitioners filed a petition with the Court on June 10,

1998, seeking a redetermination of the deficiencies stated in the

notice.   Respondent filed an answer on July 9, 1998.         In the

answer, respondent took the same position as reflected in the

notice of deficiency.   Petitioners’ counsel first met with a
                                - 5 -

representative and counsel for respondent on January 11, 1999.

At this meeting, several issues were discussed.    Among them were

various details relating to the proper cost of goods sold

amounts, including the contested issue of the amount of beginning

inventory for 1992.    In addition, petitioners presented documents

regarding insurance premiums which respondent accepted as

substantiation of properly deductible expenses.

     At a meeting on January 26, 1999, petitioners presented

additional material regarding the beginning inventory issue.     At

another meeting held on February 17, 1999, several topics were

again discussed, including travel and entertainment expenses, for

which respondent allowed a partial deduction.    At this meeting,

respondent made a settlement offer which proposed to make some

concessions favorable to petitioners in exchange for reciprocal

concessions.   Respondent contends that petitioners provided new

information with regard to the costs of goods sold issue at this

meeting, but petitioners dispute this contention.    After the

meeting, respondent made final calculations regarding the

settlement offer, and forwarded the offer to petitioners on

February 23, 1999.    The offer consisted of the following

liabilities in the total amount of $24,540:
                               - 6 -

                                  1992      1993        1994

          Deficiencies         $18,647     $2,164        -0-
          Penalties              3,729       -0-         -0-
          Additions to tax        -0-        -0-         -0-
          Total                 22,376      2,164        -0-

Petitioners rejected this settlement offer.

     Counsel for both parties, along with respondent’s Appeals

officer, met on March 23, 1999.   Counsel again met on April 2,

1999, this time with petitioner present.   Respondent and

petitioners dispute whether and to what extent new evidence was

given in these later stages of negotiation to substantiate the

amounts claimed as cost of goods sold.   The parties also dispute

whether petitioners’ personal conversations with respondent’s

counsel yielded information previously not available to

respondent.   After this meeting, however, respondent made the

decision to concede the case in whole to petitioners.

     A stipulated decision was entered on May 11, 1999.        The

decision document stated that petitioners were not liable for any

deficiencies, penalties, or additions to tax.1      The Statement of

Income Tax Changes–-prepared by respondent and filed with the




     1
        The Statement of Income Tax Changes lists an
overassessment for taxable year 1992 in the amount of $1,376.
The decision document, however, states that there were no
overpayments in the years at issue.
                              - 7 -

Court by petitioners with their motion for costs–-lists the

following basis for settlement of the case:2

                                        1992        1993        1994

     Advertising expense              $14,725        -0-         -0-
     Aircraft expense                    -0-         -0-     ($14,186)
     Commission expense                  -0-     ($31,000)       -0-
     Cost of goods sold                  -0-       (2,204)       -0-
     Depreciation expense                (471)       (902)      (832)
     Gross receipts                   (16,808)      5,113    (200,250)
     Insurance expense                   -0-       (2,497)     (1,868)
     Interest income                      228       524          -0-
     Misc/other expense                (2,624)     (2,704)     (3,444)
     Net operating loss deduction        -0-       18,775      28,789
     Reclassification items            (4,553)    (17,062)     (9,588)
     Sale of oil royalties               -0-        3,048        -0-
     Taxes/licenses expense            (2,228)     (1,299)     (3,463)
     Travel expense                    (1,938)     (4,882)     (1,813)
     Truck expense                     (6,960)       -0-         -0-
     Utilities/phone expense           (4,778)     (4,587)     (5,012)
     Self-employment tax deduction        688        -0-         -0-
     Capital gains and losses            -0-        2,460      (3,000)
     Taxable Social Security             -0-         -0-         -0-
     Deduction for exemptions            -0-         -0-         -0-
     Total adjustments                (24,719)    (37,217)   (214,667)
     Taxable income on return         (18,756)    (39,689)    (44,427)
     Taxable income as adjusted       (43,475)    (76,906)   (259,094)

A motion by petitioners to vacate the decision was filed on June

14, 1999, and was subsequently granted.    A motion by petitioners

for litigation and administrative costs was filed on June 17,

1999.




     2
        The settlement adjustments seemingly do not accurately
reflect the adjustments agreed to by the parties, as reflected
elsewhere in the record. The reasons for these discrepancies are
unclear. The sole issue before the Court, however, is the
appropriate ruling on petitioners’ motion for litigation and
administrative costs.
                                - 8 -

                              Discussion

     Section 7430 provides for the award of reasonable

administrative and litigation costs to a taxpayer in an

administrative or court proceeding brought against the United

States involving the determination of any tax, interest, or

penalty pursuant to the Internal Revenue Code.     An award of

administrative or litigation costs may be made where the

taxpayer:   (1) Is the “prevailing party”; (2) exhausted available

administrative remedies;3 and (3) did not unreasonably protract

the administrative or judicial proceeding.     See sec. 7430(a),

(b)(1), (3).   The costs claimed must also be reasonable in

amount.   See sec. 7430(c).   These requirements are conjunctive,

and failure to satisfy any one will preclude an award of costs to

petitioners.   See Minahan v. Commissioner, 88 T.C. 492, 497

(1987).

     To be a “prevailing party”, the taxpayer must show that (1)

the taxpayer substantially prevailed with respect to the amount

in controversy or with respect to the most significant issue(s)

presented, and (2) the taxpayer satisfied the net worth

requirement.   See sec. 7430(c)(4)(A).     If respondent establishes

that the position of the United States in the proceeding was




     3
        This requirement does not apply to an award for
reasonable administrative costs. See sec. 7430(b)(1).
                               - 9 -

substantially justified, however, a taxpayer is not a “prevailing

party” for purposes of section 7430.    See sec. 7430(c)(4)(B).4

     After concessions by respondent, the remaining issues are:

(1) Whether the position of the United States in the proceeding

was substantially justified, and (2) whether the amounts of

administrative and litigation costs claimed by petitioners are

reasonable.   Because we hold that respondent’s position was

substantially justified, we need not consider respondent’s

alternative argument that the administrative and litigation costs

requested by petitioners are not reasonable.

     The substantially justified standard under section 7430 is

applied as of the separate dates respondent took positions in the

administrative and judicial proceedings.    See sec. 7430(c)(7).

For purposes of administrative costs, the position of the United

States is that taken in an administrative proceeding as of the

earlier of the date of the receipt by the taxpayer of the notice

of decision by the Internal Revenue Service Office of Appeals or

the date of the notice of deficiency.    See sec. 7430(c)(7)(B).

The position of the United States for purposes of litigation

costs refers to the position of the United States in a judicial



     4
        Because the petition in this case was filed after July
30, 1996, under sec. 7430 the burden is on respondent to show
that the Government’s position was substantially justified. See
Taxpayer Bill of Rights 2, Pub. L. 104-168, sec. 701(d), 110
Stat. 1452, 1464 (1996); Maggie Management Co. v. Commissioner,
108 T.C. 430, 438 (1997).
                               - 10 -

proceeding.   See sec. 7430(c)(7)(A).   A judicial proceeding in

this Court is commenced with the filing of a petition.    See Rule

20(a).   Generally, respondent initially takes a position in the

litigation on the date he files the answer in response to the

petition.    See, e.g., Han v. Commissioner, T.C. Memo. 1993-386.

     The Commissioner’s position is substantially justified if

that position could satisfy a reasonable person and if it has a

reasonable basis in both fact and law.    See Pierce v. Underwood,

487 U.S. 552, 565 (1988).   Determining the reasonableness of the

Commissioner’s position and conduct requires considering what the

Commissioner knew at the time.   See DeVenney v. Commissioner, 85

T.C. 927, 930 (1985).   The Commissioner’s position can be

justified even if the Commissioner eventually concedes the case.

See Sokol v. Commissioner, 92 T.C. 760, 767 (1989).

     Petitioners’ records were at best in a disordered state when

respondent sought to review them.   Only incomplete information

was available to respondent, and respondent was forced to rely

upon reconstructed records to determine petitioners’ tax

liability.    It is well established that taxpayers are required to

keep adequate books and records, and in the absence of such,

respondent may determine a taxpayer’s tax liability by any method

which respondent finds to clearly reflect income.    See sec. 6001;

sec. 446(b); sec. 1.6001-1(a), Income Tax Regs.; sec. 1.446-

1(a)(4), (b)(1), Income Tax Regs.   This is true even where the
                              - 11 -

taxpayer’s records are destroyed by fire, and the taxpayer’s

reconstructions are inadequate.   See, e.g., Jernigan v.

Commissioner, T.C. Memo. 1978-13.   The record in this case

indicates that respondent adopted a reasonable, and therefore

substantially justified, position in light of the inadequacy of

petitioners’ books and records and the information accessible to

respondent throughout the administrative proceedings and in

respondent’s filing of the answer in this case on July 9, 1998.5

     Petitioners argue that respondent was not substantially

justified in his position because respondent’s counsel ultimately

offered to concede the entire tax liability for all years in

issue based upon essentially the same information that was

available to respondent prior to the issuance of the notice of

deficiency.   We find, however, that respondent’s position was

substantially justified in this case because of the lack of

adequate books and records available to respondent.   The fact

that respondent’s counsel ultimately decided to concede the case

may reflect a consideration of a variety of factors–-including

litigation risks–-which earlier were not considered or which were



     5
        Petitioners contend that respondent’s position is that
taken in a notice of decision which was sent to petitioners on
Jan. 15, 1998, several months before the notice of deficiency.
It is unclear from the record whether this notice was in fact a
final decision by the Appeals Office. This is not determinative
in this case, however, because we find that respondent was
substantially justified at all times during the administrative
proceeding.
                              - 12 -

not weighed as heavily by respondent.    Furthermore, the record

shows that the parties were actively engaged in negotiations

throughout the administrative and litigation process, and that

respondent did not unreasonably delay acting upon any information

which he received from petitioners.

     In view of the foregoing, we find that the position of the

United States was substantially justified.    Accordingly, we hold

that petitioners are not entitled to administrative and

litigation costs under section 7430.    Based on this holding, we

need not consider respondent’s alternative argument that the

administrative and litigation costs requested by petitioners are

not reasonable.   Petitioners’ motion will therefore be denied.

                                      An appropriate order and

                               decision will be entered.
