                        T.C. Memo. 1997-68



                      UNITED STATES TAX COURT


        RELIABLE CREDIT ASSOCIATION, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent


     Docket No. 4283-95.            Filed February 10, 1997.


     Neale E. Creamer, for petitioner.

     Shirley M. Francis, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION



     DAWSON, Judge:   This case was assigned to Special Trial

Judge Carleton D. Powell pursuant to the provisions of section

7443A(b)(4) and Rules 180, 181, and 183.1    The Court agrees with



1
    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 -


and adopts the opinion of the Special Trial Judge that is set

forth below.



                OPINION OF THE SPECIAL TRIAL JUDGE

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

on petitioner's motion, as supplemented, for an award of

reasonable litigation costs,2 pursuant to section 7430.    The only

issues presented are:   (1) Whether respondent's position was

substantially justified, and (2) whether, if not, the claimed

litigation costs are reasonable in amount.3

                         FINDINGS OF FACT

     Reliable Credit Association, Inc. (Reliable or petitioner)

is a corporation engaged in the business of purchasing existing

notes and other contract receivables at a discount, thereby

realizing income over the life of the notes or receivables in the

form of interest and upon maturity or collection equal to the

discount.   At the time the petition was filed, Reliable's

principal office was located in Portland, Oregon.

     Respondent audited petitioner's 1991 and 1992 tax returns

and issued a notice of deficiency to petitioner.     In the notice

of deficiency respondent determined that, for the taxable years

2
    Petitioner does not request an award of reasonable
administrative costs. See sec. 7430(a)(1).
3
    Respondent does not dispute that petitioner satisfies the
remaining elements of a claim for reasonable litigation costs.
                                - 3 -


1991 and 1992, petitioner was liable for deficiencies in the

respective amounts of $1,432,427 and $1,057,707, and accuracy-

related penalties under section 6662(a) in the respective amounts

of $286,485 and $211,541.    Essentially, respondent's

determinations were based on two contentions:    (1) Petitioner's

method of accounting did not clearly reflect income, and, as a

result, various items of interest and discount income were

understated, and (2) petitioner failed to substantiate deductions

for bad debts, rental expenses, and depreciation.    With regard to

the first contention, respondent determined that petitioner's

books and records were inadequate to establish the amount of

petitioner's gross income.

     Petitioner timely filed a petition with this Court.

Subsequently, petitioner hired Milton D. Mittelstedt

(Mittelstedt), a certified public accountant with Deloitte &

Touche LLP, to assist in the litigation.    Mittelstedt apparently

did not attempt to reconcile petitioner's income from its

accounting records.   Rather he prepared net worth analyses.   A

net worth analysis is a reconstruction of a taxpayer's taxable

income based on changes of net worth from the beginning to the

end of a taxable period.    These analyses became the basis of a

settlement that was reached between petitioner and respondent's

appeals officer.   For services rendered between June 1995 and
                               - 4 -


February 1996, totaling 114 hours, Mittelstedt charged petitioner

$34,200.

     This case was calendared for trial on May 20, 1996, and was

reported settled at the calendar call.    The parties entered into

a closing agreement, signed by petitioner on June 6, 1996.   This

agreement provided that the dispute would be resolved by using an

indirect method of determining taxable income because

petitioner's records were "inadequate to determine [the amount

of] unearned discount income from various deferred income

accounts and the [amount of] bad debts from the various bad debt

accounts", and that in subsequent years petitioner would maintain

records sufficient to allow its tax return to be audited on a

"line-by-line" basis "as the appropriate rules and regulations

may require."

     On June 19, 1996, the parties filed a stipulation with this

Court providing that petitioner was liable for deficiencies in

income taxes for the taxable years 1991 and 1992 in the amounts

of $383,874 and $124,325, respectively.   The stipulation further

provided that petitioner was not liable for the section 6662(a)

penalties for either year.   The motion for litigation costs was

subsequently filed.
                               - 5 -


                              OPINION

General Principles--Substantially justified

     Section 7430(a)(2), subject to certain limitations not

relevant here, generally allows a taxpayer that files a petition

in this Court to recover reasonable litigation costs incurred

with respect to the determination of any tax or penalty, provided

the taxpayer is the "prevailing party".   To be considered a

"prevailing party" a taxpayer must establish, inter alia, that

the position of the United States was "not substantially

justified".4   Sec. 7430(c)(4)(A)(i).

     The fact that the Commissioner ultimately concedes all or

part of a case is not sufficient to establish that the

Commissioner's position was unreasonable in an administrative or

civil tax proceeding.   Sokol v. Commissioner, 92 T.C. 760, 765-

767 (1989); Sher v. Commissioner, 89 T.C. 79, 87 (1987), affd.


4
    In 1986, Congress amended sec. 7430 by replacing the term
"unreasonable" with the phrase "not substantially justified".
Tax Reform Act of 1986, Pub. L. 99-514, sec. 1551, 100 Stat.
2752. This change was effected to conform sec. 7430 more closely
with the Equal Access to Justice Act (EAJA), 28 U.S.C. sec. 2412
(1988). H. Conf. Rept. 99-841, at 799, 801 (1986), 1986-3 C.B.
(Vol. 4) 1, 799, 801. In the context of the EAJA, the Supreme
Court has interpreted the phrase "not substantially justified" to
mean "justified to a degree that could satisfy a reasonable
person." Pierce v. Underwood, 487 U.S. 552, 565 (1988). This
Court has consistently held that the "substantially justified"
standard is not a departure from the "reasonableness" standard.
See, e.g., Sher v. Commissioner, 89 T.C. 79, 84 (1987), affd. 861
F.2d 131 (5th Cir. 1988).
                                - 6 -


861 F.2d 131 (5th Cir. 1988).   Furthermore, it is generally

considered "reasonable" for the Commissioner to require a

taxpayer to substantiate income and deductions, and the

Commissioner typically will not be held liable for costs under

section 7430 for taking a position that requires a taxpayer to

show that such requirements have been met.   See Amann v.

Commissioner, T.C. Memo. 1993-542, affd. without published

opinion 40 F.3d 1235 (1st Cir. 1994); Chiaffarano v.

Commissioner, T.C. Memo. 1992-614.



The Parties' Contentions

     Petitioner sets forth various arguments in support of the

contention that respondent's position was not substantially

justified.   The gravamens of petitioner's contention are:   (1)

Respondent conceded the majority of the deficiencies; (2)

respondent failed to employ certain "standard auditing

procedures" that would have enabled respondent to easily

ascertain the correct amount of the taxable income; and (3)

petitioner offered to settle the case prior to the issuance of

the notice of deficiency for roughly the same amount as

ultimately stipulated.

     Respondent's primary contention is that petitioner's books

and records were inadequate, and, as a result, respondent's
                               - 7 -


determination was substantially justified.   Specifically,

respondent contends that the records petitioner maintained were

insufficient to establish the amount of petitioner's gross

income.   Petitioner does not dispute this point.   In reply,

however, petitioner contends that this contention "evidences

[the] Commissioner's continued obsession that each line item of

gross income must be known with certainty rather than

concentrating [her] attention on taxable income (the quantity on

which the tax is actually calculated)."

     We note initially that section 63(a) defines "taxable

income" as gross income minus allowable deductions.    Thus, gross

income is the starting point for the computation of taxable

income.   In addition, our tax system is based on self-assessment.

Flora v. United States, 362 U.S. 145, 176 (1960).     As a result,

the Code and the regulations contain various record keeping

requirements.   Section 6001 requires that

          Every person liable for any tax imposed by this title
     * * * shall keep such records, render such statements, make
     such returns, and comply with such rules and regulations as
     the Secretary may from time to time prescribe. * * *

     Section 1.6001-1(a), Income Tax Regs., provides that

     any person subject to tax under subtitle A of the Code * * *
     shall keep such permanent books of account or records * * *
     as are sufficient to establish the amount of gross income,
     deductions, credits, or other matters required to be shown
     by such person in any return of such tax * * *
                               - 8 -


While the requirements of sec. 1.6001-1, Income Tax Regs., are

connected with the term "or", in this context, we interpret "or"

in the conjunctive rather than disjunctive.    Cf. DeSylva v.

Ballentine, 351 U.S. 570, 573 (1956) (interpreting "or" in the

conjunctive); United States v. One 1973 Rolls Royce, V.I.N. SRH-

16266, 43 F.3d 794, 815 (3d Cir. 1994) (holding that context is

determinative of whether the term "or" is used in the conjunctive

or disjunctive).   It is not open to question that taxpayers must

keep records sufficient to establish the amount of income

received, deductions claimed, as well as the amount of any

credit, rather than records that establish just one of the three.

See, e.g., Lias v. Commissioner, 24 T.C. 280, 308 (1955), affd.

235 F.2d 879 (4th Cir. 1956); Rao v. Commissioner, T.C. Memo.

1996-500; Wynn v. Commissioner, T.C. Memo. 1996-415; Baker v.

Commissioner, T.C. Memo. 1994-283;     Mitchell v. Commissioner,

T.C. Memo. 1968-137, affd. 416 F.2d 101 (7th Cir. 1969).

     In the absence of adequate books and records, the

Commissioner may determine the existence and amount of a

taxpayer's income by any method that clearly reflects income.

Sec. 446(b); Harbin v. Commissioner, 40 T.C. 373, 377 (1963).

The Commissioner may use any reasonable method.     DiLando v.

Commissioner, T.C. Memo. 1975-243.     No particular method is

required since circumstances will vary in individual cases.
                                - 9 -


Harbin v. Commissioner, supra at 377.    Further, the Commissioner

is not required to make estimations or ferret out every possible

itemized deduction.    Conforte v. Commissioner   74 T.C. 1160,

1177-1178 (1980), affd. in part and revd. and remanded in part on

other grounds 692 F.2d 587 (9th Cir. 1982).

     Petitioner does not directly attack the method of accounting

that respondent used in determining its income and deductions,

and we have not been informed as to that methodology.    Rather,

petitioner asserts that a taxpayer is not required to

substantiate its gross income provided taxable income can be

determined with reasonable accuracy.    Given the definition of

taxable income and the recordkeeping requirements, we disagree,

and conclude that petitioner was required to keep records

sufficient to establish the amount of its gross income.     DiLeo v.

Commissioner, 96 T.C. 858, 867 (1991), affd. 959 F.2d 16 (2d Cir.

1992).    Accordingly, we find petitioner's argument that

respondent's position was not substantially justified is fatally

flawed.    See Amann v. Commissioner, T.C. Memo. 1993-542, affd.

without published opinion 40 F.3d 1235 (1st Cir. 1994);

Chiaffarano v. Commissioner, T.C. Memo. 1992-614.

     Petitioner makes other arguments, most of which rely to some

extent on the premise that petitioner was not required to keep

records sufficient to establish the amount of its gross income,
                               - 10 -


and for that reason they lack merit.    A few of these arguments,

however, deserve some further discussion.

     Petitioner asserts that respondent's settlement of the case

largely in petitioner's favor, and for an amount roughly equal to

an offer made by petitioner during audit, establishes that

respondent's position was not substantially justified.    We

disagree.   As stated previously, the settlement of a case in

petitioner's favor is not determinative of whether respondent's

position is substantially justified.    We find this particularly

true in cases where the issue is substantiation of gross income

and deductions.   In reaching this conclusion, we note that this

case does not involve a situation where the Commissioner

continued to litigate the issue long after the taxpayer had

provided the net worth analyses.    Here, despite petitioner's

apparent failure to keep adequate records, respondent settled the

case accepting an indirect method of verifying taxable income

proposed by petitioner on condition that petitioner would change

its method of accounting.    In such circumstances, we believe that

respondent's refusal of petitioner's settlement offers little

weight in determining whether respondent's position was

substantially justified.    In this regard, while petitioner may

have substantially prevailed, the agreed deficiency is hardly de

minimis.
                               - 11 -


     Petitioner also argues that respondent should be estopped

from challenging the adequacy of petitioner's records because

respondent failed to raise the issue in a prior audit.   This

argument is not well taken.   It is well established that the

Commissioner's failure to challenge a taxpayer's treatment of an

item in an earlier year does not preclude an examination of the

correctness of the treatment of that item in a later year.

Automobile Club of Michigan v. Commissioner, 353 U.S. 180, 183

(1957); Alfred I. duPont Testamentary Trust v. Commissioner, 66

T.C. 761, 765 (1976), affd. 574 F.2d 1332 (5th Cir. 1978).

     Lastly, petitioner claims respondent failed to employ

certain "standard auditing procedures" that would have enabled

respondent to easily ascertain the correct amount of the

deficiencies.   While, as mentioned above, petitioner does not

directly attack respondent's method for determining gross income

and deductions, petitioner contends that respondent was required

to make net worth analyses similar to that prepared by

Mittelstedt.    Leaving aside the fact that this supposedly simple

endeavor cost petitioner almost $35,000 in accounting fees,

petitioner has not cited, and we are not aware of, any authority

that requires the Commissioner to employ particular auditing
                              - 12 -


procedures in particular situations.5   In sum, "when the taxpayer

has defaulted in * * * [its] task of supplying adequate records,

* * * [the taxpayer] is not in a position to be hypercritical of

the Commissioner's labor."   Webb v. Commissioner, 394 F.2d 366,

372 (5th Cir. 1968), affg. T.C. Memo. 1966-81.

     Since we have found that respondent's position was

substantially justified, and, therefore, petitioner is not

entitled to recover litigation costs, there is no reason to

determine whether the costs claimed are reasonable.   To reflect

the above and the stipulation of the parties,

                                    An appropriate order and

                              decision will be entered.




5
    Petitioner has cited provisions of the Internal Revenue
Manual; however, such provisions are not mandatory and do not
confer any rights upon taxpayers. United States v. Will, 671
F.2d 963, 967 (6th Cir. 1982).
