                       T.C. Memo. 2004-140



                     UNITED STATES TAX COURT



          KENNETH W. AND FAYETTA GRAVES, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 7687-02.              Filed June 15, 2004.



     Kenneth W. and Fayetta Graves, pro sese.

     Jack H. Klinghoffer, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GERBER, Chief Judge:   Respondent determined a $24,921

deficiency in petitioners’ 1996 Federal income tax, a $5,818.25

addition to tax under section 6651(a)(1),1 and a $4,865.20


     1
       Unless otherwise stated, all section references are to the
Internal Revenue Code in effect for the taxable year in issue.
All Rule references are to the Tax Court Rules of Practice and
Procedure.
                                - 2 -

accuracy-related penalty under section 6662.    After concessions,

the issues remaining for our consideration are:    (1) Whether

Kenneth W. Graves’s (petitioner) bad debt, which arose in the

course of his business as an employee, is deductible in computing

adjusted gross income or an itemized deduction in computing

taxable income; (2) whether the bad debt is $85,009 as determined

by respondent or $86,040 as now claimed by petitioners; and (3)

whether petitioners are liable for the addition to tax and

penalty under sections 6651(a)(1) and 6662, respectively.

                         FINDINGS OF FACT2

     Petitioners resided in San Dimas, California, on the date

their petition was filed.    They filed a joint Federal income tax

return for their 1996 taxable year.     With respect to their 1996

return, petitioners sought a filing extension to August 15, 1997.

No further extensions were sought after the expiration of the

extension.   Twenty months later, on April 16, 1999, petitioners

filed their 1996 Federal income tax return.    During 1996,

petitioners received interest income.    Petitioner received

pension income and unemployment compensation as well as a salary.

Mrs. Graves3 received salary and miscellaneous income as an

employee of two companies.


     2
       The parties’ stipulation of facts is incorporated by this
reference.
     3
       Mrs. Graves is a party in this case because petitioners
filed a joint return for 1996.
                                - 3 -

     Petitioner was the sole shareholder of KPS Trucking Co.,

Inc. (KPS), a corporation with 26 employees.    He also was a

salaried employee of KPS, managing its daily operations.    Before

1996, KPS began experiencing financial difficulties.    As a

result, petitioner lent capital to KPS in an attempt to continue

business operations and to pay salaries.    Petitioner made six

loans totaling $86,040.

     KPS voluntarily filed for bankruptcy under chapter 7 of the

Bankruptcy Code during July 1996, and the bankruptcy proceeding

concluded on December 11, 1996.   Petitioner’s loans to KPS were

the lowest in priority amongst the debts for payment, and there

were insufficient assets in the estate to satisfy KPS’s

creditors.   Upon the final discharge of KPS’s debts, petitioner’s

loans remained unpaid and were worthless.

     Petitioners reported an $84,7344 loss attributable to the

debt due from KPS on Schedule D, Capital Gains and Losses, of

their 1996 return.    Schedule D concerns the reporting of capital

asset transactions.   Petitioners also deducted the worthless debt

on page 1, line 14 of their 1996 return.    Line 14 is denominated

“Other gains or (losses)”.   The parties disagree as to the

treatment of the loss for tax purposes.    Petitioners now contend

that they should have claimed the bad debt as a deduction on



     4
       Petitioners deducted $84,734 as a loss on their 1996
return but were able to substantiate $86,040 of loans at trial.
                                 - 4 -

Schedule C, Profit or Loss From Business, to arrive at their

adjusted gross income.

     The loans were made in petitioner’s trade or business of

being an employee and were made to enable him to maintain his

employment with KPS.   Although petitioner claimed $84,734 as a

business bad debt on his return, at trial he substantiated loans

to KPS of $86,040.

     Petitioners failed to report the following items of income

on their 1996 income tax return:

            Income Item                           Amount

          Interest                                $3,475
          State tax refund                           105
          Taxable pensions                        29,835
          Computational error                     10,000

     On their January 9, 2002, notice of deficiency, respondent

allowed $85,009 as a business bad debt deduction and treated it

as an itemized deduction on Schedule A, Itemized Deductions.       The

amount respondent allowed is $275 greater than the amount

petitioners claimed on their 1996 return.

                                OPINION

     The issues we consider arise from circumstances under which

petitioner lent his solely owned corporation capital so that it

could continue its operations, including the payment of salaries.

Petitioner was a salaried employee of the corporation and was in

the business of being an employee.       The loans became worthless

during the 1996 tax year, and petitioner claimed the loss in
                                - 5 -

connection with the computation of adjusted gross income.

Respondent, on the other hand, allowed the loss as an itemized

deduction in arriving at taxable income.    There is also a dispute

about whether the loss is $85,009 or $86,040.    Finally, we must

decide whether petitioners are liable for an addition to tax

under section 6651(a)(1) and/or an accuracy-related penalty under

section 6662.

Treatment of the Bad Debt

     Section 166 provides that a business bad debt is deductible

as an ordinary deduction for the year in which the debt becomes

worthless.    Specifically, section 166(a)(1) provides:   “There

shall be allowed as a deduction any debt which becomes worthless

within the taxable year.”    Section 166(d)(1)(A) further provides

that in the case of a taxpayer other than a corporation

“subsection (a) shall not apply to any nonbusiness debt”.

Section 166(d)(2)(A) and (B) defines a nonbusiness debt as a debt

other than:

          (A) a debt created or acquired * * * in connection
     with a trade or business of the taxpayer; or

          (B) a debt the loss from the worthlessness of
     which is incurred in the taxpayer’s trade or business.

Therefore, subsection (a) allows an ordinary loss deduction only

for business bad debts.
                                - 6 -

     Taxpayers bear the burden of showing entitlement to

deductions and must show that a bona fide debt existed and that

the debt became worthless in the year claimed.5    See sec. 166;

Rule 142(a); Dixie Dairies Corp. v. Commissioner, 74 T.C. 476,

493 (1980).   The existence of a bona fide debt can be shown by

proof of a “debtor-creditor relationship based upon a valid and

enforceable obligation to pay a fixed or determinable sum of

money.”   Sec. 1.166-1(c), Income Tax Regs.; see Dixie Dairies

Corp. v. Commissioner, supra.    Whether a bona fide debtor-

creditor relationship exists is a question of fact to be

determined upon a consideration of the relevant facts and

circumstances.   See Fisher v. Commissioner, 54 T.C. 905, 909

(1970).

     It is established that being an employee may be a trade or

business for purposes of section 166.     Trent v. Commissioner, 291

F.2d 669 (2d Cir. 1961), revg. 34 T.C. 910 (1960).     It may be

necessary for an employee to lend money to an employer to

maintain the employee’s employment.     In this case, maintaining

his employment was petitioner’s dominant motivation.

Accordingly, petitioner made the loans in his trade or business

of being an employee for purposes of section 166.     Cf. id.




     5
       No question has been raised with respect to the burden of
proof or production under sec. 7491(a).
                               - 7 -

     Respondent concedes that petitioner’s loans were bona fide

debts that arose in the course of his trade or business of being

an employee of KPS.   The parties stipulated that petitioner made

the loans to maintain his employment with KPS.   The loans became

worthless during 1996 because of the bankruptcy of KPS.     Finally,

petitioner was not in the trade or business of lending money;

rather, he was in the trade or business of operating a trucking

company.

     In the notice of deficiency, respondent allowed $85,009 as a

bad debt deduction.   However, petitioner is now claiming $86,040

for the bad debt deduction.6   The remaining question is whether

the bad debt should be allowed as a deduction from gross income

to arrive at petitioners’ adjusted gross income, or is to be

treated as an itemized deduction in computing their taxable

income.7




     6
      The discrepancy between $85,009 and $86,040 will be
addressed later in the opinion.
     7
       The significance of the parties’ dispute lies in the fact
that itemized deductions are limited by certain thresholds and
restrictions, whereas deductions used to arrive at adjusted gross
income are not. In particular, an itemized deduction in the
setting of this case would be subject to the 2-percent floor
under sec. 67.
                                 - 8 -

     Respondent relies on section 62 and the related regulations

in contending that bad debt deductions in connection with the

trade or business of being an employee are treated as itemized

deductions.   Section 62 provides in part:

          SEC. 62(a). General Rule.--For purposes of this
     subtitle, the term “adjusted gross income” means, in the
     case of an individual, gross income minus the following
     deductions:

               (1) Trade and business deductions.--The
          deductions allowed by this chapter (other than by
          part VII of this subchapter) which are
          attributable to a trade or business carried on by
          the taxpayer, if such trade or business does not
          consist of the performance of services by the
          taxpayer as an employee. [Emphasis added.]

The statute provides, with exceptions none of which are

applicable here, that a taxpayer may not deduct as a trade or

business deduction items connected with the performance of

services as an employee.   The parties stipulated that

petitioner’s trade or business of operating KPS consisted of his

performance of services as an employee.      Under the statute, items

connected with the performance of those services are not

deductible in arriving at adjusted gross income.

     Section 1.62-1T(d), Temporary Income Tax Regs., 53 Fed. Reg.

9874 (Mar. 28, 1988), further amplifies this point as follows:

“For the purpose of the deductions specified in section 62, the

performance of personal services as an employee does not

constitute the carrying on of a trade or business, except as

otherwise expressly provided.”    Because petitioner’s trade or
                                 - 9 -

business consists of the performance of services as an employee,

he may not deduct the business bad debt to arrive at adjusted

gross income under section 62.    Accordingly, petitioner’s

business bad debt must be treated as an itemized deduction under

section 63(d).

     Because the business bad debt is deductible as an itemized

deduction, it is subject to the 2-percent floor under section 67.

Section 67(a) provides in pertinent part:    “In the case of an

individual, the miscellaneous itemized deductions for any taxable

year shall be allowed only to the extent that the aggregate of

such deductions exceeds 2 percent of adjusted gross income.”

Section 67(b) defines miscellaneous itemized deductions as

itemized deductions that are not listed therein.    Section 166

business bad debts are not listed under section 67(b).

Therefore, we hold that petitioner’s business bad debt deduction

is a miscellaneous itemized deduction and is subject to the 2-

percent floor under section 67.

Amount of Business Bad Debt

     We next consider the amount of petitioner’s business bad

debt deduction.8   The parties disagree on the amount to be

deducted.   Petitioners initially deducted $84,734 on their

Federal income tax return.    After examination, respondent allowed



     8
       As previously noted, no question has been raised with
respect to the burden of proof or production under sec. 7491(a).
                              - 10 -

$85,009.   Petitioners are now claiming $86,040 for the business

bad debt deduction.

     Petitioners contend that an amended return was sent to the

Internal Revenue Service claiming $86,040 for the business bad

debt on Schedule C and correcting the pension income.   Respondent

has no record of receiving the amended return.    Irrespective of

whether an amended return was filed, petitioners bear the burden

of showing the amounts of deductions.    Specifically, petitioners

bear the burden of proving they are entitled to the deductions

claimed.   See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); Higbee v. Commissioner, 116 T.C. 438, 440 (2001).

     Respondent allowed an $85,009 business bad debt deduction in

the notice of deficiency.   That allowance was $275 more than the

$84,734 petitioners claimed on their original return.   At trial,

petitioner, by means of testimony and documents, substantiated

that the loans to KPS totaled $86,040.   On the basis of this

evidence, we hold petitioners are entitled to a deduction for the

business bad debt in the amount of $86,040.

Addition to Tax and Accuracy-Related Penalty

     Respondent determined an addition to tax under section

6651(a)(1) and an accuracy-related penalty under section 6662(a).

Section 7491(c) requires the Commissioner to carry the burden of

production in any court proceeding with respect to the liability

of any individual for any penalty, addition to tax, or additional
                               - 11 -

amount.    To meet this burden, the Commissioner must come forward

with sufficient evidence indicating that it is appropriate to

impose the relevant penalty.    See Higbee v. Commissioner, supra.

If the Commissioner carries this burden, taxpayers then bear the

burden of showing that the addition or penalty does not apply;

i.e., that there was reasonable cause, substantial authority,

etc.    Id.

       Petitioners failed to timely file their 1996 return.    In

order to be relieved of the addition to tax, petitioners must

establish that their failure was due to reasonable cause and not

willful neglect.    Id.; see sec. 6651(a)(1).   Reasonable cause is

shown when “the taxpayer exercised ordinary business care and

prudence and was nevertheless unable to file the return within

the prescribed time”.    Sec. 301.6651-1(c)(1), Proced. & Admin.

Regs.

       Petitioners’ 1996 return was due on August 15, 1997, upon

expiration of their filing extension.    Petitioners did not

request a second extension.    Instead, petitioners contend they

were not able to file their return until April 16, 1999, because

they were waiting for the final loss figure from the KPS

bankruptcy proceeding.    Petitioners’ argument falls short,

however, because they knew the amount of the loans made to KPS.

In addition, petitioners could have filed a timely return and

later amended it if the information changed for any reason,
                               - 12 -

including some event in the bankruptcy proceeding.      Petitioners

have not shown reasonable cause for their failure to timely file.

Respondent has met his burden of production with regard to this

addition to tax.    Accordingly, we hold petitioners are liable for

the addition to tax under section 6651(a)(1).

       Respondent also determined petitioners are subject to a

penalty under section 6662(a).      This penalty is imposed on any

portion of an underpayment of tax required to be shown on a

return when the underpayment is due to negligence or disregard of

rules or regulations, or a substantial understatement of income

tax.    See sec. 6662(a) and (b).

       A substantial understatement of tax is defined as an

understatement of tax that exceeds the greater of 10 percent of

the tax required to be shown on the tax return or $5,000.        See

sec. 6662(d)(1)(A)(i) and (ii).      The understatement may be

reduced by an amount attributable to any item for which there was

adequate disclosure and a reasonable basis for which there was

substantial authority.    See sec. 6662(d)(2)(B).    Section 6662(c)

defines negligence as “any failure to make a reasonable attempt

to comply with the provisions of this title”, and disregard means

any “careless, reckless, or intentional disregard.”

       Respondent relies on the record, which reflects that there

was a substantial understatement in this case.      That satisfies

respondent’s burden of production as to the substantial
                                - 13 -

understatement penalty.    Accordingly, petitioners must show that

the accuracy-related penalty should not be imposed with respect

to any portion of the understatement for which they acted with

reasonable cause and in good faith.      See sec. 6664(c)(1); Higbee

v. Commissioner, supra at 448.     The decision as to whether

petitioners acted with reasonable cause and in good faith is one

that depends on all the facts and circumstances.     See sec.

1.6664-4(b)(1), Income Tax Regs.    An honest misunderstanding of

fact or law that is reasonable in light of the experience,

knowledge, and education of the taxpayer may indicate reasonable

cause and good faith.     See Higbee v. Commissioner, supra at 449

(citing Remy v. Commissioner, T.C. Memo. 1997-72).

     Petitioner was a truck driver who was able to gradually

purchase more equipment and hire employees to drive the trucks.

Petitioner’s skills are in the trucking business.     Petitioner

attempted to complete his own tax return for 1996.     His confusion

as to how to properly complete the form is evidenced by his use

of Schedule D, which is used for reporting capital gains and

losses.    Under section 1211(b), which applies to capital gains

and losses, petitioner would have been limited to a $3,000

deduction.   Petitioner intended to claim a bad debt deduction of

$86,040.

     Petitioner was forthright and fully disclosed the amount of

the business bad debt.     Petitioner made an honest and good faith
                              - 14 -

attempt at accurately reporting the bad debt.   The fact that

petitioner mistakenly placed the $86,040 deduction on the wrong

line on the first page of the 1996 return corresponds with his

confusion in using Schedule D.   On the basis of petitioners’

position and their reporting on page 1 of their 1996 return, they

should have reported the loss on Schedule C.    Even if petitioners

had used a Schedule C, respondent contends that they would have

been negligent because the loss should have been shown on a

Schedule A as an itemized deduction.

     In light of petitioner’s educational background, the

circumstances of this case, and the multiplicity of possibilities

for claiming business bad debts, petitioner has shown good faith

and reasonable cause for the way he reported the bad debt

deduction.   We hold that the accuracy-related penalty does not

apply to the portion of the understatement attributable to the

adjustment concerning the bad debt.

     Petitioners concede that they failed to report income from

interest, a State tax refund, and pensions in the total amount of

$33,415, resulting in a substantial underreporting of income.

Petitioners further concede that they “missed” or overlooked

Forms 1099 with the result that they underreported income.

     The unreported income was substantial in amount because the

understatement of income tax exceeds the greater of 10 percent of

the tax required to be shown on the tax return or $5,000.    The
                               - 15 -

tax shown on the 1996 return was $1,174.     The tax required to be

shown on the return was $26,095.    Ten percent of $26,095 is

$2,609.50.    The amount of the understatement of tax on

petitioners’ return is $24,921.    Respondent has therefore

demonstrated that petitioners have substantially understated

their income tax for 1996.

     Further, according to the regulations, negligence includes

“any failure by the taxpayer to keep adequate books and records”.

Sec. 1.6662-3(b), Income Tax Regs.      In this instance petitioners

were negligent by failing to keep adequate books or records and

report the income items.    Therefore, on the basis of substantial

understatement of income tax and petitioners’ failure to keep

adequate records, the accuracy-related penalty applies to the tax

on $33,415 of underreported income.

     Petitioners concede that they made a $10,000 computational

error on their original return which resulted in an

underreporting of income.    This computational error resulted in a

32.88-percent understatement of the income petitioners reported.

Petitioners have not provided a reasonable explanation for the

resulting portion of the understatement of income tax or shown

that they exercised reasonable care in the preparation of their

tax return.    See sec. 1.6662-3(b)(1), Income Tax Regs.

Accordingly, petitioners are liable for the accuracy-related

penalty with regard to the $10,000 error.
                              - 16 -

     Petitioners also concede that they erroneously deducted

self-employment tax.   The regulations provide that negligence is

shown when “A taxpayer fails to make a reasonable attempt to

ascertain the correctness of a deduction * * * on a return which

would seem to a reasonable and prudent person to be ‘too good to

be true’ under the circumstances”.     See sec. 1.6662-3(b)(1)(ii),

Income Tax Regs.   In these circumstances, petitioners did not

report any self-employment tax on their return, nor did they

attach the requisite schedule for such tax.

     Petitioners have not provided a foundation or predicate for

claiming a self-employment tax deduction.    It was not reasonable

for them to claim a deduction for self-employment tax.

Accordingly, petitioners are liable for the section 6662

accuracy-related penalty with respect to the amount of the

understatement of income tax attributable to the self-employment

tax deduction.

     We have considered all of petitioners’ arguments, and to the

extent that they are not mentioned herein, we find them to be

moot or without merit.

     To reflect the foregoing,


                                      Decision will be entered

                                 under Rule 155.
