                        T.C. Memo. 1997-135



                      UNITED STATES TAX COURT



     REGINALD MAURICE WISE AND SHANNON RAE WISE, Petitioners
         v. COMMISSIONER OF INTERNAL REVENUE, Respondent

               HENRY VICTOR EICHER, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 12079-94, 12080-94.    Filed March 17, 1997.



     Reginald Maurice Wise and Shannon Rae Wise, pro se.

     Henry Victor Eicher, pro se.

     Michael A. Pesavento, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:   Respondent determined deficiencies in and

additions to petitioners' 1988 Federal income tax as follows:
                                   - 2 -

                                               Additions to Tax
     Petitioners      Deficiency           Sec. 6653(a)   Sec. 6661

     Reginald and    $33,380                $1,669          $8,345
       Shannon Wise1

     Henry Eicher2       9,909                 495           2,477

     On December 14, 1995, petitioner Henry Victor Eicher

(Eicher) filed a Notice of Agreement to be Bound by the decision

in the Wises' case.    Most, but not all, of the issues in Eicher's

case are the same as the issues in the Wises' case.         We accepted

Eicher's agreement to be bound, but, because Eicher has the

burden of proof on all issues in dispute, Rule 142(a), and

because Eicher did not produce evidence, see Rule 149, we deemed

Eicher to have conceded all issues in his case that are not in

common with issues in the Wises' case.3

     At all relevant times, Reginald Maurice Wise (Wise) and

Eicher controlled four pass-through entities, Wesco and Hersco,

which were partnerships, and Wesco Realty, Inc. (WRI) and Intent,

Inc. (Intent), which were S corporations.         Several of the issues



     1
      Respondent determined that the Wises are allowed a general
business credit of $2,675 on their 1988 joint tax return.
     2
      Respondent allowed credits in the following amounts on
Henry Eicher's 1988 tax return: (a) General business credit,
$4,394; (b) credit for prior year minimum tax, $1,375; and (c)
foreign tax credit, $19,515.
     3
      We deem Eicher to have conceded the passive activity loss
limitation issue and the addition to tax for negligence.
Respondent argues that the guaranteed payment issue only relates
to Eicher and is conceded. However, the guaranteed payment also
affects Wise, and we do not deem it to be conceded.
                                 - 3 -

for decision relate to the tax treatment of payments which were

not made and income items which were not received, but which were

shown in the books and records of petitioners and these various

entities.     The specific issues for decision are:

     1.    Whether Hersco may include in gross income for 1984

$189,014 of capital gain related to the sale of land to WRI, and

$100,115 of interest income from WRI related to a mortgage note.

We hold that it may not.

     2.    Whether WRI may deduct, for 1988, $100,138 of interest

related to a mortgage note it gave to Hersco and $173,174 for

professional services performed by Wise's sole proprietorship,

Pro-Ser.     We hold that it may not.

     3.    Whether Wise may include in gross income $231,746 for

services Pro-Ser rendered to WRI.       We hold that he may not.

     4.    Whether WRI may deduct $88,825 for services performed by

Wise.     We hold that it may.

     5.    Whether WRI's payment of $38,500 to Wise was a non-

taxable repayment of a loan.     We hold that it was not.

     6.    Whether $17,197 of expenses reported by Wise on Schedule

C of his tax return should be reported on Schedule A.       We hold

that they should not.

     7.    Whether Hersco may deduct $73,122 of interest expense

related to loans Eicher made to Hersco.       We hold that it may not.
                                  - 4 -

       8.    Whether Eicher may include in gross income $73,122 of

interest related to loans he made to Hersco.       We hold that he may

not.

       9.    Whether Wise and Eicher had enough basis in WRI on July

31, 1988, to deduct their shares of WRI's net operating loss.          We

hold that they did not.

       10.   Whether the Wises are liable for the addition to tax

for negligence under section 6653(a).      We hold that they are.

       11.   Whether the Wises are liable for the addition to tax

for substantial understatement of tax under section 6661.         We

hold that they are if they substantially underpaid tax for 1988.

       12.   Whether Eicher is liable for the addition to tax for

substantial understatement of tax under section 6661.       We hold

that he is if he substantially underpaid tax for 1988.

       Section references are to the Internal Revenue Code in

effect for the year in issue.      Rule references are to the Tax

Court Rules of Practice and Procedure.

                            FINDINGS OF FACT

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

A.     Petitioners

       The Wises lived in Florida and Eicher lived in Brazil when

they filed the petitions in these cases.       Eicher is a U.S.

citizen, but has lived in Brazil since the early 1950's.       He

worked for the Unisys Corporation until 1992.       Eicher used the

address, "c/o 938 Wald Road, Orlando, Florida", on his petition.
                                 - 5 -

     Wise has a bachelor's degree in Business Administration from

Cleveland State University.    He is a licensed Certified Public

Accountant (C.P.A.) in Ohio and Florida.    Wise worked at Price

Waterhouse for 12 or 13 years.    He was an audit partner for four

of those years.

     Wise held a power of attorney from Eicher.    At times the

power was unlimited and at times the power was specific.

     The Wises and Eicher were calendar-year, cash basis

taxpayers.

B.   The Pass-through Entities

     1.      Wesco

     Wesco was a cash basis partnership formed in 1973, with a

fiscal year ending April 30.    Wise and Eicher used Wesco

extensively as a depository or "bank" throughout most of its

existence.     During Wesco's fiscal years 1988 and 1989, Wise held

40 percent and Eicher held 60 percent of Wesco's income, credits,

and deductions.

     2.      Hersco

     Hersco was a calendar-year, cash basis partnership formed in

1973.     During 1987 and 1988, Hersco did not have a bank account

or any recurring sources of liquid funds.     During 1988, Wise held

37.5 percent and Eicher held 62.5 percent of Hersco's income,

credits, and deductions.
                               - 6 -

     3.   Intent Corporation

     Intent, an S corporation on the accrual basis with a fiscal

year ending March 31, was formed in 1972.   During fiscal years

1988 and 1989, Wise held 31.25 percent and Eicher held 68.75

percent of Intent's income, credits, and deductions.

     4.   WRI Corporation

     WRI, an S corporation on the accrual basis with a fiscal

year ending July 31, was formed in 1973.    Wise was president of

WRI at all times relevant here.   WRI initially engaged in real

estate brokerage activities, but was essentially inactive from

1978 to 1985.   WRI owned and operated a resort near Kissimmee,

Florida, during its fiscal year 1988.   Wise and Eicher each were

entitled to 50 percent of WRI's income, credits, and deductions

during WRI's fiscal years 1988 and 1989.

C.   Mortgages and Loans

     1.   The Hersco Mortgage and HMC's Loan to WRI

          a.    WRI's Purchase of Land From Hersco

     Hersco owned 35 acres of unimproved land in Osceola County,

Florida, which it bought for about $134,000 in 1973.    In 1984, an

independent appraiser valued the land at $1,468,000.    On August

14, 1984, Hersco sold the land to WRI for $1,468,000.    At the

closing, WRI paid Hersco $88,000 in cash and gave Hersco a

$1,380,000 mortgage on the land (the Hersco mortgage).    Hersco

sold the land to WRI so Wise and Eicher could develop it in

corporate form and thereby limit their personal liability.
                                - 7 -

          b.    Huntington Mortgage Co. Loan to WRI

     On August 21, 1984, WRI obtained a $2.5 million construction

loan from Huntington Mortgage Co. (HMC).      The loan was secured by

a mortgage (the HMC mortgage) on the improved land.      Wise and

Eicher personally guaranteed the HMC loan.      WRI made payments on

the HMC loan to HMC.   WRI did not default on the HMC loan from

1984 to 1990.   The loan was renewed five times and remained

payable to HMC by WRI.

          c.    The Hersco Mortgage

     The Hersco mortgage was subordinated to the HMC mortgage.

WRI made no payments in cash or property on the Hersco mortgage

from 1984 to 1990.   At all times relevant, WRI did not have

enough funds to make principal and interest payments on the

Hersco mortgage.   Journal entries were made in the books and

records of WRI and Hersco, stating that there had been payment

and simultaneous “loan backs” to WRI.      No evidence regarding the

terms of "loan backs" was offered.      WRI claimed a $100,138

interest deduction relating to the Hersco mortgage for its fiscal

year 1988.   Hersco never sued WRI to collect mortgage payments.

     2.   The Westfield Mortgage

     On December 12, 1986, Westfield Financial Corp. (Westfield)

lent $1.1 million to Intent.    The loan was secured by a mortgage

on land owned by Intent in Pasco County, Florida.     Wise and

Eicher guaranteed the loan.    On December 16, 1986, Intent

disbursed $797,344 of the Westfield loan to WRI in exchange for a
                                  - 8 -

note (the WRI note) in which WRI promised to pay Intent $1.5

million or so much thereof as might be advanced and outstanding

from time to time, plus interest.     The WRI note states that it is

secured by a mortgage on real estate; however, no mortgage was

recorded in Osceola or Orange County record books.

     Intent did not default on the Westfield mortgage from 1986

to 1990.

     3.    Wesco's Loans to WRI

     Wesco lent some operating capital to WRI.    WRI recorded its

receipt of those funds by increasing its loans payable account.

Wesco correspondingly increased its loans receivable account.

WRI made no repayments in cash or property to Wesco during WRI's

fiscal year 1988.   As of July 31, 1987, WRI's books stated that

it had a $980,690 loan payable to Wesco.

D.   Wise's Management and Accounting Fees

     Wise, as president of WRI, was responsible for WRI's daily

operations including planning, accounting, and financing.    On its

fiscal year 1988 tax return, WRI deducted professional management

and accounting fees in the amount of $173,974 for services Wise

rendered to WRI through Wise’s sole proprietorship, Pro-Ser.    WRI

accrued expenses for management and accounting fees even though

WRI generally did not pay the fees to Wise in cash or property.

Wise recorded that he immediately made "loan backs" to WRI and

reported the income on his tax return in the year WRI took the

deduction.   Yearend adjusting journal entries on the books and
                                - 9 -

records of WRI stated that these transactions had occurred.      No

evidence was offered regarding the terms of these "loan backs".

E.   Wise's and Eicher's Claimed Basis in WRI

     Wise and Eicher claimed additional basis in WRI of (1)

$340,277 and $567,130 in 1984, respectively, as a result of WRI's

purchase of land from Hersco in 1984, and (2) $1.25 million each

as of July 31, 1987, as a result of their personal guarantees of

the HMC loan.   In 1986, Wise and Eicher claimed increases in

their basis in WRI of $229,834 and $505,635, respectively, as a

result of the advances from Intent, which Intent made from the

$1.1 million it received from Westfield.      As of July 31, 1987,

Wise and Eicher claimed a basis in WRI of $392,276 and $588,413,

respectively, relating to the Wesco loans.      As of July 31, 1987,

Wise and Eicher claimed increases in their basis in WRI by $3,185

and $5,308, respectively, as a result of accrued interest on the

Hersco mortgage and Wise claimed additional basis in WRI of

$522,484 as a result of his "loan backs" to WRI.      As of July 31,

1987, Wise and Eicher claimed a total basis in WRI of $2,236,140

and $2,813,047, respectively.

     Wise received checks from WRI totaling $88,825 during WRI's

fiscal year 1988.   WRI treated the $88,825 as a loan repayment on

its books and records and did not deduct that amount on its

fiscal year 1988 tax return.    The Wises did not include those

payments on their 1988 tax return.      Eicher received cash

distributions from WRI of $19,000 during WRI's fiscal year 1988.
                                  - 10 -

Also during WRI's fiscal year 1988, Wise and Eicher made cash

advances to WRI of $9,909 and $32,701, respectively.

F.   WRI Losses

     WRI sustained losses from its operations during 1986, 1987,

1988, and 1989.     Wise and Eicher had each claimed that they had

$840,617 of cumulative losses from WRI as of July 31, 1987.         WRI

reported a loss of $784,160 for its fiscal year 1988.

G.   Tax Returns

     1.      Hersco's 1988 Tax Return

     Hersco reported a net long-term capital gain of $189,014 on

its 1988 partnership tax return.      Also on that return, Hersco

reported the following amount of ordinary income:

                  Item                             Amount

           Other income                           $100,115
     Less
           Guaranteed payment to Eicher             73,122
           Taxes                                       828
           Other deductions                          1,789

                   Ordinary income                 $24,376

             a.    Capital Gain

     Hersco reported net long-term capital gain from the 1984

sale of property from Hersco to WRI.       Yearend entries in the

books and records of WRI and Hersco stated that there had been

payments of principal and interest from WRI to Hersco and

simultaneous “loan backs” from Hersco to WRI.       No payments were

made.     No evidence was offered regarding the terms of these "loan

backs".
                                   - 11 -

            b.     Other Income

     Generally, WRI did not make any payments of cash or property

on the principal or interest it owed to Hersco.          Yearend journal

entries in the books of WRI and corresponding journal entries in

the books and records of Hersco stated that WRI had paid

principal and interest and that there were simultaneous “loan

backs” from Hersco to WRI.        No evidence was offered regarding the

terms of those "loan backs".

            c.     Guaranteed Payment

     The guaranteed payment reported on Hersco's 1988 partnership

return was for accrued interest payable to Eicher on Hersco's

indebtedness to him.     The amount was not paid in cash or

property.    The "payment" was made only by increasing Hersco's

indebtedness to Eicher.

     2.     Eicher's 1988 Tax Return, Investment Income, and
            Expenses

     Eicher claimed a deduction for investment interest expense

of $76,466 on his 1988 tax return.          He also reported the

following amounts of net investment income and expenses:

                 Item                                Amount

          Interest income                            $77,808
          Dividend income                              2,919
          Investment expenses                        (34,452)

     Net investment income                           $46,275

Interest income included the $73,122 guaranteed payment from

Hersco to Eicher.
                                - 12 -

     3.   Wises' 1988 Tax Return

          a.      Pro-Ser's Accounting Fees

     The Wises reported on their Schedule C for their 1988 tax

return, gross receipts of $320,838 from Pro-Ser, Wise's sole

proprietorship.    Pro-Ser provided services largely to Wesco,

Hersco, WRI, Intent, and Eicher.    Pro-Ser did not offer services

to the general public.    Included in Wise's gross receipts of

$320,838 was $231,746, which had been billed to WRI but was never

paid in cash or property.    Also included was $89,092 that

originated from Wesco, Hersco, Intent, and Eicher.    Yearend

journal entries were made in the books and records of WRI which

showed that WRI had paid Wise.    Simultaneous journal entries in

WRI's books and records stated that there had been an immediate

“loan back” from Wise to WRI.    No evidence was offered regarding

the terms of the "loan backs".

     b.   Pro-Ser's Expenses

     The Wises claimed $56,992 of expenses relating to Pro-Ser on

Schedule C of their 1988 tax return.

     c.   Investment Income and Expenses

     The Wises deducted $55,885 for investment interest expense

on their 1988 joint tax return.    They also reported net

investment income as follows:
                               - 13 -

              Item                          Amount

         Interest income                   $22,129
         Dividend income                     1,176
         Long-term capital gain             70,8864
         Real estate taxes                  (2,135)
         Personal property tax                 (38)
         Miscellaneous                        (462)

     Net investment income                 $91,556

H.   The $38,500 Wise Received From WRI

     During 1988, Wise received $38,500 in checks from WRI.         WRI

treated the $38,500 as loan repayments to Wise.       WRI did not

deduct the $38,500, and Wise did not include the $38,500 in gross

income in 1988.   WRI has never deducted officers' compensation.

                               OPINION

     Respondent's determinations regarding petitioners' 1988 tax

returns primarily relate to three events:    (1) The 1984 land sale

from Hersco to WRI and subsequent transactions, (2) Wise's

management of WRI, and (3) WRI's pass-through losses.

Petitioners dispute all of respondent's determinations.

Respondent's determinations are presumed correct, and petitioners

bear the burden of proof.    Rule 142(a); Welch v. Helvering, 290

U.S. 111, 115 (1933).

A.   1984 Land Sale From Hersco to WRI and Subsequent
     Transactions

     On August 14, 1984, Hersco sold unimproved land with a basis

of about $134,000 to WRI for $1,468,000.    At the closing, WRI

     4
      Wise’s flow-through portion of Hersco's long-term capital
gain is $70,886 (37.5 percent of $189,014).
                                - 14 -

paid $88,000 in cash and gave Hersco a $1,380,000 mortgage (the

Hersco mortgage) on the land.    Respondent contends that, for

1988, Hersco may not include in gross income interest from the

Hersco mortgage or capital gain from the sale, and WRI may not

deduct interest expense related to the Hersco mortgage because

WRI generally made no principal and interest payments on the

Hersco mortgage.5   Respondent also argues that the 1984 sale was

a sham.   Petitioners disagree and argue that:   (1) The Wise-

Eicher group had enough funds to pay principal and interest, (2)

Hersco constructively received the principal and interest

payments, and (3) the sale was bona fide.

           1.   Hersco's Capital Gain and Interest Income

     Respondent contends that Hersco may not include in gross

income $189,014 of capital gain or $100,115 of interest income.

The capital gain represents the amount of installment sale gain

petitioners contend Hersco should report from the 1984 sale.     The

interest represents the income and liability accounts shown on

the books of Hersco and WRI, respectively.

     Petitioners contend that, because Wise and Eicher controlled

four entities, including WRI and Hersco, they had the power to

compel payment of principal and interest, and therefore Hersco

constructively received the capital gain and interest income.


     5
      The $23 difference in the amount of interest Hersco
included and the amount WRI deducted is due to WRI's under
accrual for 1987.
                                - 15 -

Respondent argues that WRI lacked the funds to make the principal

and interest payments, and therefore there was no constructive

receipt by Hersco.    We agree with respondent.

     A cash basis taxpayer such as Hersco must include in its

income amounts which it actually or constructively received. Sec.

1.451-1(a), Income Tax Regs.; see Corliss v. Bowers, 281 U.S. 376

(1930).   Whether a taxpayer constructively received income is a

question of fact.     Avery v. Commissioner, 292 U.S. 210 (1934);

Willits v. Commissioner, 50 T.C. 602, 612-613 (1968).    There is

no constructive receipt if the payor lacks the funds to make the

payments.   Estate of Noel v. Commissioner, 50 T.C. 702, 706-707

(1968); Jacobs v. Commissioner, 22 B.T.A. 1166, 1169 (1931).

     In the instant case, Hersco did not receive payments of

principal or interest in cash or property.    The payments existed

only as yearend journal entries in the books and records of WRI

and Hersco.   Petitioners did not show that WRI had enough funds

to make the payments.    WRI reported a $784,160 loss in 1988.    The

mere showing of a payment on the books of WRI and Hersco does not

constitute receipt.    See sec. 1.451-2(a), Income Tax Regs.   We

conclude that Hersco did not constructively receive the capital

gain and interest income, and that they are not includable in

Hersco's 1988 gross income.    We agree with respondent on this

issue.
                                  - 16 -

     2.   WRI's Interest Expense

     Respondent contends that WRI may not deduct $100,138 of

interest expense.    An accrual basis taxpayer may only deduct

expenses or interest owed to a related cash basis taxpayer when

the amount involved is includable in the gross income of the cash

basis payee.    Sec. 267(a)(2).    WRI and Hersco are related

taxpayers.    Sec. 267(b)(10); see sec. 267(e)(1).       WRI uses the

accrual method of accounting; Hersco uses the cash method of

accounting.    As we concluded at par. A-1, above, the interest

payments on the Hersco mortgage are not includable in Hersco's

gross income.    Thus, the interest expense is not deductible on

WRI's fiscal year 1988 tax return.         Sec. 267(a)(2).   We agree

with respondent on this issue.

     3.   Bona Fide Sale

     We need not decide whether the sale was bona fide.          For

reasons discussed above at pars. A-1 and A-2, Hersco may not

include the payments in income, and WRI cannot deduct the

interest expense whether or not the sale was bona fide.

B.   Wise's Management of WRI

     1.   Management Fees

     Respondent contends that (a) WRI may not deduct management

and accounting fees of $173,974 for services performed by Pro-

Ser, and (b) Wise may not include $231,746 in gross income as

payment for those services.    Based on application of the factors

that we considered in deciding Hersco did not constructively
                                  - 17 -

receive income (see par. A-1, above), we conclude that WRI may

not deduct $173,174 for services rendered to WRI by Pro-Ser, and

Wise may not include in gross income $231,746 related to those

services.     We agree with respondent on these issues.

       2.    Officers' Compensation and Reallocation of Expenses

       Respondent contends that (a) WRI should deduct $88,825 for

officer compensation, (b) Wise should include $38,500 as

compensation, and (c) $17,197 of Wise's expenses reported on

Schedule C of his 1988 tax return should be reallocated to

Schedule A.      Petitioners contend that the payments were loan

repayments and therefore should neither be deducted by WRI nor

included by Wise.

       Respondent contends that the payments were officers'

compensation.      We disagree because WRI did not pay any officers'

compensation.      Petitioners contend that the payments were loan

repayments.      We disagree.   Wise's "loan backs" to WRI lacked

economic effect because the payments were neither received nor

lent back.      Sec. 1.451-2(a), Income Tax Regs.   See par. B-1,

above.      Instead, we conclude that the amounts were paid to Wise

for management and accounting fees performed by Wise through Pro-

Ser.    Thus, (a) WRI may deduct the $88,825 it paid to Wise, (b)

Wise must include in gross income $38,500 of the amount he

received, and (c) the Wises correctly reported expenses on

Schedule C of their tax return.
                              - 18 -

C.   Guaranteed Payment

     Respondent contends that (1) Hersco may not deduct a $73,122

payment to Eicher, and (2) Eicher may not include the payment in

gross income.   Petitioners contend that (1) the payment was

incorrectly reported as a guaranteed payment on Hersco's 1988 tax

return because, in actuality, it was a payment of interest on

Eicher's loans to Hersco; (2) Hersco can deduct the interest

payment; and (3) Eicher constructively received the payment, and

thus Eicher must include the interest payment in gross income.

Respondent agrees with petitioners that on Hersco's 1988

partnership return the payment was reported incorrectly as a

guaranteed payment.   However, respondent contends that (1) Hersco

may not deduct the payment because it uses the cash method of

accounting, and (2) Eicher conceded that the payment is

includable in his gross income.   We do not believe that Eicher

conceded the issue; the treatment of the payment on Eicher's tax

return relates to the treatment of the payment on Hersco's tax

return.   We do, however, agree with respondent that Hersco may

not deduct the payment.

     1.    Hersco

     Hersco is a cash basis taxpayer.   A cash basis taxpayer may

not deduct an expense unless it was paid to its creditors during

the tax year.   B & L Farms Co. v. United States, 238 F. Supp.

407, 415 (S.D. Fla. 1964), affd. 368 F.2d 571 (5th Cir. 1966);

Oklahoma Gas & Elec. Co. v. United States, 333 F. Supp 1178, 1181
                                - 19 -

(W.D. Okla. 1971), affd. 464 F.2d 1188 (10th Cir. 1972); see sec.

1.446-1(c)(1)(I), Income Tax Regs.       A cash basis taxpayer cannot

accrue an expense.    See B & L Farms Co. v. United States, supra

at 415-416.     Therefore, Hersco may not deduct the expense unless

it paid it.

     The payment was not made in cash or property.      Journal

entries nominally increased Hersco's indebtedness to Eicher, but

journal entries do not establish that a payment was made.         Finoli

v. Commissioner, 86 T.C. 697, 743 (1986).       The debit from

interest payable to loans payable to Eicher was simply a shift

from one account to another.     See Baird v. Commissioner, 25 T.C.

387, 394 (1955).

     Petitioners have failed to prove that the interest payment

was actually made.     Thus, we hold that Hersco may not deduct the

$77,122 interest payment it reported as a guaranteed payment.

     2.      Eicher

     Eicher is a cash basis taxpayer.      As discussed at par. A-1,

above, a cash basis taxpayer is taxable on income when it is

actually or constructively received.      Sec. 1.451-1(a), Income Tax

Regs.     Eicher never received the interest payment in cash or

property.     The payment was made only in the sense that it was

described by journal entries in the books and records of Hersco,

reflecting payment and a simultaneous "loan back" of the funds.

Hersco did not have enough funds to make the payment.      During

1988, Hersco did not have a bank account or any recurring sources
                               - 20 -

of liquid funds with which to make the payment.     There is no

constructive receipt if the payor lacks the funds to make the

payments.   See par. A-1, above.   Estate of Noel v. Commissioner,

50 T.C. at 706-707; Jacobs v. Commissioner, 22 B.T.A. at 1169.

The mere recording of a payment on the books of Hersco is not

receipt.    See sec. 1.451-2(a), Income Tax Regs.   There was no

constructive receipt by Eicher.    Thus, the $77,122 is not

includable in Eicher's 1988 gross income.    We agree with

petitioners on this issue.

D.   Wise's and Eicher's Basis in WRI

     Respondent contends that petitioners may not deduct pass-

through losses from WRI for 1988 because Wise and Eicher each had

a zero basis in WRI as of July 31, 1987, and each made net

contributions to WRI of only $9,909 and $13,701, respectively.

Petitioners contend that Wise and Eicher each had enough basis in

WRI in 1988 to deduct their respective pass-through losses.       We

agree with respondent.

     The amount of pass-through losses that an S corporation

shareholder can deduct is limited to the sum of the shareholder's

adjusted basis in his stock and the shareholder's adjusted basis

of any indebtedness of the S corporation to the shareholder.

Sec. 1366(d)(1).    WRI had operating losses in 1986 and 1987.     As

of July 31, 1987, Wise and Eicher each claimed $840,617 of
                               - 21 -

cumulative losses from WRI.6   WRI reported a loss of $784,160 for

its fiscal year 1988.   Respondent determined that WRI's 1988 loss

was $598,873, and that the Wises and Eicher could each carry

forward $299,437 of that loss.

     As of July 31, 1987, Wise and Eicher claimed a basis in WRI

of $2,236,140 and $2,813,047, respectively, which they calculated

as follows:

               Claimed Basis in WRI as of 7/31/87

                                    Eicher           Wise
Capital stock                    $      750     $      750
Guarantee of the HMC loan         1,250,000      1,250,000
Loan backs of payments on           567,130        340,277
     the Hersco mortgage
1987 interest on the                    5,308          3,185
     Hersco mortgage
1986 Intent advances to WRI         505,635          229,834
Wesco's loans to WRI                588,413          392,276
     as of 7/31/87
Loan backs to WRI                   204,675          522,484

Total basis before losses        $3,121,911     $2,738,806
     as of 7/31/87
WRI losses claimed                 (840,617)        (840,617)
     as of 7/31/87
Unexplained basis                   531,753          337,951

Total basis claimed              $2,813,047     $2,236,140
     as of 7/31/87

     Respondent determined that the Wises and Eicher had the

following basis as of July 31, 1987:




     6
      In the notice of deficiency, respondent determined that
Wise's and Eicher's share of WRI's cumulative losses was $848,424
on July 31, 1987.
                               - 22 -

                                   Eicher            Wise
Basis claimed                    $2,813,047       $2,236,140
     as of 7/31/87
Adjustments
Guarantee of the HMC loan        (1,250,000)      (1,250,000)
Loan backs related to the          (567,130)       ( 340,277)
     Hersco mortgage
1987 interest on the                    (5,308)         (3,185)
     Hersco mortgage
1986 Intent advances to WRI           (505,635)       (229,834)
Wesco's loans to WRI                  (588,413)       (392,276)
     as of 7/31/87
Loan backs related to                                 (522,484)
     management fees

Total adjustments                 (2,916,486)     (2,738,056)

Total basis as of 7/31/87         $          0    $          0

     A shareholder taxpayer may not increase his or her adjusted

basis unless the taxpayer made an economic outlay.       See Underwood

v. Commissioner, 535 F.2d 309 (5th Cir. 1976), affg. 63 T.C. 468

(1975) (exchange of notes relating to funds lent by a C

corporation to an S corporation is insufficient to establish an

economic outlay which increases the shareholder's adjusted

basis); Hitchins v. Commissioner, 103 T.C. 711, 715 (1994); Perry

v. Commissioner, 54 T.C. 1293, 1296 (1970), affd. 27 AFTR 2d 71-

1464, 71-2 USTC par. 9502 (8th Cir. 1971) (exchange of notes

between a shareholder and an S corporation is insufficient to

establish an economic outlay which increases the shareholder's

adjusted basis).    The S corporation must be directly indebted to

a shareholder for the shareholder to increase his or her basis in

stock to decide the amount of the S corporation's net operating

loss the shareholder may deduct; an indebtedness to a pass-
                               - 23 -

through entity which advanced the funds and is closely related to

the taxpayer does not increase the shareholder's adjusted basis

in stock.    Hitchins v. Commissioner, supra; Frankel v.

Commissioner, 61 T.C. 343, 347-348 (1973), affd. 506 F.2d 1051

(3d Cir. 1974) (partnership); Prashker v. Commissioner, 59 T.C.

172 (1972) (estate); Burnstein v. Commissioner, T.C. Memo. 1984-

74 (S corporation); Robertson v. United States, 32 AFTR 2d 73-

5556, 73-2 USTC par. 9645 (D. Nev. 1973) (trust).7

     1.     Guarantee of the HMC Loan

     On August 21, 1984, WRI obtained a $2.5 million construction

loan from HMC.    It was secured by a mortgage on the land WRI

bought from Hersco plus any improvements made on the land.    Wise

and Eicher each personally guaranteed the HMC loan.    Petitioners

contend that Wise and Eicher can each increase their basis in WRI

by $1.25 million as a result of their personal guarantees.

Respondent contends that Wise and Eicher may not increase their

basis in WRI as a result of their personal guarantees because

they did not make an economic outlay.    We agree with respondent.

     A shareholder's guarantee of a debt of an S corporation,

without an economic outlay, does not make the corporation


     7
      Most of the cases interpreting "indebtedness of the S
corporation to the shareholder" apply former section 1374(c)(2).
That section was repealed by the Subchapter S Revision Act of
1982, Pub. L. 97-354, sec. 2, 96 Stat. 1669, 1677-1683 effective
for taxable years beginning after December 31, 1982. There are
no differences between former section 1374(c)(2) and the current
section 1366(d)(1)(B), that affect this analysis.
                                - 24 -

indebted to the shareholder.     Harris v. United States, 902 F.2d

439, 441-446 (5th Cir. 1990); Estate of Leavitt v. Commissioner,

875 F.2d 420, 422-426 (4th Cir. 1989), affg. 90 T.C. 206, 211-218

(1988); Brown v. Commissioner, 706 F.2d 755, 756 (6th Cir. 1983),

affg. T.C. Memo. 1981-608; Underwood v. Commissioner, 535 F.2d

309, 312 (5th Cir. 1976), affg. 63 T.C. 468 (1975); Hitchins v.

Commissioner, 103 T.C. 711, 715 (1994); Perry v. Commissioner, 47

T.C. 159, 163-164 (1966), affd. 392 F.2d 458 (8th Cir. 1968).

     Petitioners contend that this case is controlled by Selfe v.

United States, 778 F.2d 769 (11th Cir. 1985).      In Selfe, the U.S.

Court of Appeals for the Eleventh Circuit indicated that the

shareholder's guarantee of an S corporation loan could increase

the shareholder's basis even though the shareholder had not

satisfied any of the obligation.     Id. at 774.   The court remanded

the case to the District Court for it to decide whether the loan

in question was in substance a loan to the shareholder rather

than to the corporation.     Id. at 775.   In Selfe, the taxpayer

started a business and obtained a loan which was secured by her

own property.   The taxpayer later incorporated the business under

subchapter S and converted the loan into a corporate obligation,

which she guaranteed and which continued to be secured by her

property.   Id. at 770.    This case is distinguishable on its facts

from Selfe because HMC made the original loan to WRI, not to Wise

or Eicher, and neither Wise nor Eicher pledged their own property

as security for the loan.
                               - 25 -

     Petitioners argue that we should decide this issue based on

what they contend is the substance of this transaction; i.e., a

loan from HMC to Wise and Eicher, which they closed through WRI,

and that a $2.5 million outlay occurred which increased their

stock bases.

     Ordinarily, taxpayers are bound by the form of the

transaction they have chosen; taxpayers may not in hindsight

recast the transaction to obtain tax advantages.    Don E. Williams

Co. v. Commissioner, 429 U.S. 569, 579-580 (1977); Commissioner

v. National Alfalfa Dehydrating & Milling Co., 417 U.S. 134, 148-

149 (1974).

     The substance of this loan is not different from its form.

The HMC loan to WRI did not lack substance.   Petitioners never

made an economic outlay justifying the basis they claimed.

Apparently, HMC and WRI intended that the HMC loan be to the

corporation.    The loan has been renewed five times and remained

in the same form, namely payable to HMC by WRI.    There was no

default on the loan from 1984 to 1990.   WRI made repayments

directly to HMC.   There is no evidence that WRI was indebted to

Wise and Eicher for this loan.

     Wise's and Eicher's guarantees do not alter the fact that

WRI is the borrower.   It is not surprising that a lender to a

small, closely held corporation such as WRI would seek personal

guarantees from its shareholders.   See Harris v. United States,

supra at 445.   The wholly unperformed guarantees do not meet the
                               - 26 -

requirement that an economic outlay be made before a

corresponding increase in basis can occur.     Harris v. United

States, supra; see Underwood v. Commissioner, supra at 312.

Thus, Wise and Eicher may not increase their respective bases in

WRI with respect to the HMC loan.    We agree with respondent on

this issue.

     2.     "Loan Backs"

            a.   Hersco Mortgage

     Petitioners contend that Wise's and Eicher's bases in WRI

increased by their share of the "loan backs" related to the

Hersco mortgage.    Respondent contends that the "loan backs" may

not be included in Wise's and Eicher's bases because the "loan

backs" are not real debt, and the "loan backs" were between WRI

and Hersco, not between WRI and Wise or Eicher.    Petitioners

contend that the "loan backs" are bona fide debt and that Hersco

was an agent or conduit for Wise and Eicher.    We agree with

respondent.

     As discussed at par. B-1, above, WRI did not pay the Hersco

mortgage.    Wise recorded the purported payments with yearend

journal entries in WRI's books and records.    WRI did not make an

economic outlay with respect to the Hersco mortgage.    The claimed

"loan backs" existed only as journal entries in Hersco's books;

they are not bona fide debts or economic outlays because Hersco

did not receive anything it could lend to WRI.     Underwood v.

Commissioner, supra at 311-312.
                                - 27 -

     Even if the loans were bona fide WRI debts to Hersco, Wise

and Eicher may not increase their respective bases in WRI.    For

indebtedness to be considered as part of a shareholder's adjusted

basis in S corporation stock, the indebtedness must run directly

to the S corporation's shareholders; loans from an entity in

which the shareholders of the S corporation have substantial or

even identical ownership interests do not qualify.     Hitchins v.

Commissioner, 103 T.C. at 715; Frankel v. Commissioner, 61 T.C.

at 347-350; Prashker v. Commissioner, 59 T.C. 172 (1972).

     Petitioners rely on Burnstein v. Commissioner, T.C. Memo.

1984-74, to support their argument that Hersco was a conduit for

Wise and Eicher, and that the indebtedness runs to them as

shareholders of WRI.   However, we rejected an argument to that

effect in Burnstein v. Commissioner, supra.     Thus, neither Wise

nor Eicher may increase their bases in WRI as a result of

Hersco's "loan backs" to WRI.     We agree with respondent on this

issue.

          b.    Management Fees

     Petitioners contend that Wise may increase his basis in WRI

by $522,484 as a result of "loan backs" of the management fees

WRI owed him.   Respondent contends that the "loan backs" are not

included in his basis because the "loan backs" are not real

indebtedness.   We agree with respondent.

     Wise created the management fee "loan backs" in the same way

that he created the Hersco mortgage payment "loan backs".    See
                                - 28 -

pars. B-1, C-1, and E-2-a, above.     Wise made journal entries in

WRI's books and records stating that there had been payment and

simultaneous "loan backs".     However, in reality, WRI never parted

with or received back any fees.    No notes were issued for the

"loan backs", the "loan backs" were not secured by any

collateral, there was no repayment schedule, and no collection

activity was ever attempted.     Thus, for the reasons discussed at

par. E-2-a, above, regarding the Hersco mortgage payment "loan

backs", there was no economic outlay by Wise to WRI, and Wise

cannot increase his basis as a result of his management fee "loan

backs".     We agree with respondent on this issue.

       3.   Intent Loan and Wesco's Loan

       In December 1996, Westfield lent $1.1 million to Intent (the

Westfield loan), secured by land Intent owned.        Shortly

thereafter, Intent lent to WRI about $797,344 of the proceeds

from the Westfield loan, in exchange for a note from WRI.       Wise

and Eicher claimed that their bases in WRI increased by $229,834

and $505,635, respectively, as a result of Intent's loan to WRI.

They also claimed that their bases in WRI increased by $392,276

and $588,413, respectively, as a result of loans Wesco made to

WRI.    Respondent contends that neither Wise nor Eicher may

increase his basis in WRI as a result of either Intent's or

Wesco's loans to WRI because none of those loans was a debt of

the S corporation that ran to Wise or Eicher as required by

section 1366(d)(1)(B).     Petitioners disagree and argue that both
                              - 29 -

Intent and Wesco were acting as agents for Wise and Eicher with

respect to the Westfield, Intent, and Wesco loans, and therefore

the funds lent to WRI came directly from Wise and Eicher.    We

agree with respondent.

     For the reasons discussed at par. E-1, above, relating to

the HMC loan, we will not recharacterize the form of these

transactions.   From 1986 to 1990, there was no default on the

Westfield loan, the loan repayments were made directly from WRI

to Westfield, and neither Wise nor Eicher had to make any

payments on the Westfield note.   In addition, WRI made no

repayments on its loans from Intent or Wesco.

     Intent, like WRI, was an S corporation, and Wesco, like

Hersco, was a partnership.   As discussed at par. E-2-a, above,

relating to the Hersco loan, borrowing from an entity in which

the shareholders of an S corporation have substantial or even

identical ownership interests does not qualify as indebtedness

which runs directly to the S corporation's shareholders.

Hitchins v. Commissioner, supra at 715; Frankel v. Commissioner,

supra at 347-350; Prashker v. Commissioner, supra at 172.    Thus,

Wise and Eicher may not increase their respective bases in WRI as

a result of either Intent's loan of a majority of the proceeds

from the Westfield loan or Wesco's loans.   We agree with

respondent on this issue.
                                - 30 -

E.     Additions to Tax

       1.   Negligence8

       Negligence is a lack of due care or failure to do what a

reasonable and ordinarily prudent person would do under the

circumstances.    Zmuda v. Commissioner, 731 F.2d 1417, 1422 (9th

Cir. 1984), affg. 79 T.C. 714 (1982); Neely v. Commissioner, 85

T.C. 934, 947 (1985).     Respondent contends that the Wises were

negligent in reporting the items of income, losses, and expenses,

that they claimed on their 1988 tax return.     To avoid liability

for negligence, the Wises must show that they acted reasonably

and prudently and exercised due care in reporting the above items

on their 1988 tax return in light of their experience and

business sophistication.     Avellini v. Commissioner, T.C. Memo.

1995-489; Lucas v. Commissioner, T.C. Memo. 1995-341; Poplar v.

Commissioner, T.C. Memo. 1995-337; see Henry Schwartz Corp. v.

Commissioner, 60 T.C. 728, 740 (1973).

       Most of the adjustments that respondent made to the Wises’

1988 tax return relate to the timing of reporting income and

expenses.    Those income items and expenses relate to journal

entries that were meant to increase the Wises’ and Eicher's debt

basis in WRI so that petitioners could claim pass-through losses



       8
        We deem Eicher to have conceded the negligence additions to
tax.    See note 4, above.
                                - 31 -

from WRI.    Wise, a sophisticated taxpayer, made or supervised

making those journal entries and preparing the tax returns for

all the entities and parties involved in this case.    We held that

the Wises and Eicher may not increase their respective bases in

WRI because, among other reasons, they did not follow the rules

and regulations concerning the proper timing of including income

and deducting expenses.    Wise was negligent in not following

those rules.    We conclude that the Wises are liable for the

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

     2.     Substantial Understatement

     Section 6661(a) imposes an addition to tax of 25 percent of

the amount of any underpayment attributable to a substantial

understatement of tax.     Pallottini v. Commissioner, 90 T.C. 498

(1988).     An understatement is the amount by which the correct tax

exceeds the tax reported on the return.    Sec. 6661(b)(2)(A).    An

understatement is substantial if it exceeds the greater of 10

percent of the correct tax or $5,000.    Sec. 6661(b)(1)(A).

     If a taxpayer has substantial authority for the tax

treatment of any item on the return, the understatement is

reduced by the amount attributable to it.    Sec. 6661(b)(2)(B)(i).

Similarly, the amount of the understatement is reduced for any

item adequately disclosed either on the tax return or in a

statement attached to the return.    Sec. 6661(b)(2)(B)(ii).
                              - 32 -

Respondent has authority to waive this addition to tax, if the

taxpayer shows there was reasonable cause for the understatement

and the taxpayer acted in good faith.   Sec. 6661(c).

     Petitioners bear the burden of proving that imposition of

the addition to tax under section 6661 is erroneous.    Rule

142(a); Tweeddale v. Commissioner, 92 T.C. 501, 506 (1989).

           a.   The Wises

     The Wises substantially understated their income tax for

1988.   Although distinguishable on its facts, Selfe v. United

States, 778 F.2d 769 (11th Cir. 1985), is substantial authority

for petitioners' claim to increase their bases because Wise and

Eicher guaranteed the HMC loan.   However, they have not shown

that they (1) had other substantial authority for the other

positions taken on their tax return, (2) adequately disclosed

their position on the tax return or in a statement attached to

the tax return, (3) had reasonable cause for the understatement,

or (4) acted in good faith.   The Wises have failed to carry their

burden of proof.   We agree with respondent on this issue except

for petitioners' increased basis for the HMC loan.

          b.    Eicher

     Eicher may reduce the amount of the understatement because

of his reliance on Selfe v. United States, supra.    To the extent

Eicher has otherwise substantially understated his income tax for
                             - 33 -

1988, we hold that he is liable for the addition to tax under

section 6661.

     To reflect the foregoing,



                                             Decisions will be

                                        entered under Rule 155.
