                       T.C. Memo. 1997-511



                     UNITED STATES TAX COURT



                 KAREN ANN KEEGAN, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 26696-96.            Filed November 13, 1997.



     Karen Ann Keegan, pro se.

     Robert W. Dillard, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     PANUTHOS, Chief Special Trial Judge:    This case was heard

pursuant to the provisions of section 7443A(b)(3) and Rules 180,
                                   - 2 -


             181, and 182.1    Respondent determined deficiencies in

petitioner's Federal income taxes and accuracy-related penalties

under section 6662(a) as follows:

                                           Accuracy-Related Penalty
Year               Deficiency                   Sec. 6662(a)

1994                $5,204.00                     $1,040.80
1995                 4,909.37                        981.87

       After concessions,2 the issues for decision are:       (1)

Whether petitioner underreported gross income on her return for

the taxable year 1994; (2) whether petitioner is entitled to cost

of goods sold claimed on Schedules C of her returns for the

taxable years 1994 and 1995; (3) whether petitioner is entitled

to dependency exemptions for the taxable years 1994 and 1995; (4)

whether petitioner is entitled to head-of-household filing status

for the taxable years 1994 and 1995; and (5) whether petitioner

is liable for the accuracy-related penalty under section 6662(a)

for the taxable years 1994 and 1995.

                              FINDINGS OF FACT

       Some of the facts have been stipulated, and they are so

found.     The stipulation of facts and the attached exhibits are


       1
        All section references are to the Internal Revenue Code
in effect for the years in issue, unless otherwise indicated.
All Rule references are to the Tax Court Rules of Practice and
Procedure.
       2
        Petitioner concedes that she is not entitled to car and
truck expenses claimed on Schedule C of her 1994 tax return in
the amount of $3,132.
                                   - 3 -


incorporated herein by this reference.       At the time of filing the

petition, petitioner resided at Clearwater, Florida.

1.   Petitioner's Schedules C

        In 1988, petitioner began operating a sole proprietorship

which offered drafting services under the name Keegan &

Associates (K & A).       Petitioner managed K & A and performed any

necessary bookkeeping.       Petitioner's cousin, Robert Gorges, and

their daughter, Windi Keegan (Windi), worked for K & A during the

taxable years in issue.3      Since petitioner had no drafting

experience, Mr. Gorges performed any required drafting services.

In addition, Mr. Gorges operated the business when petitioner was

away.       Windi answered telephones and performed other

administrative duties.

     Although petitioner did not pay Windi or Mr. Gorges a fixed

salary or weekly wage, they would from time to time take cash

from K & A.       In addition, many of Mr. Gorges' and Windi's living

expenses were paid out of K & A's funds.       Petitioner kept no

records of the amount of cash which K & A paid for services

rendered during the taxable years in issue.

     On Schedules C of her returns for the taxable years 1994 and

1995, petitioner reported gross receipts, cost of goods sold, and

expenses related to K & A as follows:

                                  1994                 1995

        3
            Petitioner and Mr. Gorges have never been married.
                                - 4 -


Income:
  Gross receipts              $8,010               $18,285
  Cost of goods sold:
    Cost of labor              6,200                10,275
    Materials and supplies     1,383                 2,065
    Other costs                  ---                   826
  Gross income                   427                 5,119

Expenses:
  Advertising                    480                    566
  Car and truck                3,132                    ---
  Taxes and licences             ---                     70
  Utilities                      ---                    175
Total expenses                 3,612                    811

Net profit or (loss)          (3,185)                 4,308

2.   Dependency Exemption and Filing Status for 1994 and 1995

      During the fall of 1994 and throughout 1995, petitioner was

a full-time student at Eckerd College, located in St. Petersburg,

Florida.    Petitioner lived in a dormitory located on Eckerd

College's campus.    Petitioner's expenses for tuition, room, and

board were paid through either scholarship proceeds or student

loans.    When petitioner was not living at college, petitioner

stayed at a house owned by her aunt, Helen Gorges.4    Mr. Gorges

and Windi also lived in Ms. Gorges' house throughout the years

1994 and 1995.    Although there was an agreement that petitioner

and/or Mr. Gorges would pay rent in the amount of $55 per week to

Ms. Gorges, neither petitioner, Mr. Gorges, nor Windi paid rent

to Ms. Gorges during the years in issue.




      4
          Helen Gorges is Mr. Gorges' mother.
                               - 5 -


      Windi, in addition to working for K & A, also worked at an

IGA grocery store from January 1995 to November 1995, earning

between $120 and $130 per week.   Windi used her earnings for

personal expenses.

      Petitioner received assistance from Federal and State

agencies during the taxable years in issue.   The assistance

included food stamps for the entire taxable year 1994 and for 3

to 4 months during the taxable year 1995.   Petitioner received

monthly food stamp benefits in the amount of $212 ($2,544 per

year).   Petitioner, Mr. Gorges, and Windi were also covered under

Medicaid during the taxable years in issue.

      Petitioner claimed Mr. Gorges and Windi as dependents on her

returns for the years 1994 and 1995, and claimed head-of-

household filing status for each of those taxable years.

3.   Respondent's Adjustments for the Taxable Years 1994 and 1995
     and Reconstruction of Petitioner's Income for the Taxable
     Year 1994

      Upon examination, respondent disallowed the cost of goods

sold claimed by petitioner on Schedules C of her 1994 and 1995

returns.   Respondent also disallowed the claimed dependency

exemptions for each of the taxable years in issue and determined

that petitioner was not entitled to claim head-of-household

filing status.

      In addition to these adjustments, respondent reconstructed

petitioner's income for the taxable year 1994 by using the source
                                 - 6 -


and application of funds method.    As a result, respondent

determined that petitioner failed to report gross income in the

amount of $4,578.   This amount was calculated as follows:

Income:
  Gross wages1                            $8,707
  Gross receipts (Schedule C)              8,010
  1993 tax refund                            198
Total known sources of income                              $16,915

Expenses:2
  Federal taxes withheld                                      1,668
  Schedule C expenses (as verified)                             480
  Personal living expenses--
    Bureau of Labor Statistics3                             19,345
Total expenses                                             (21,493)

Unreported income                                             4,578
     1
        In addition to her Schedule C activities, petitioner
worked for Office Depot during the taxable year 1994 and reported
wages earned in the amount of $8,707.
     2
       On Schedule C of her 1994 return, petitioner claimed cost
of goods sold in the amount of $7,583. Respondent disallowed
petitioner's claimed cost of goods sold, and, accordingly,
respondent's reconstruction of petitioner's income does not
reflect cost of goods sold.
     3
       Respondent utilized the average annual expenditures for
1994 for one person, U.S. Department of Labor, Bureau of Labor
Statistics. One component of these living expenses is the cost
of shelter in the amount of $4,089.


                                OPINION

     We begin by noting that petitioner bears the burden of

proving that respondent's determination is erroneous.    Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).     Moreover,

deductions are a matter of legislative grace, and petitioner

bears the burden of proving that she is entitled to any
                                 - 7 -


deductions claimed.    INDOPCO, Inc. v. Commissioner, 503 U.S. 79,

84 (1992).

1.   Respondent's Reconstruction of Petitioner's Income

       Pursuant to a reconstruction of petitioner's income for the

taxable year 1994, respondent determined that petitioner had

failed to report gross income in the amount of $4,578.

       Taxpayers are required to maintain adequate records of

taxable income.    Sec. 6001.   Where a taxpayer fails to produce or

maintain adequate records from which actual income may be

ascertained, the Commissioner may reconstruct a taxpayer's income

by any method that clearly reflects income.     Sec. 446(b); Goodmon

v. Commissioner, 761 F.2d 1522, 1524 (11th Cir. 1985); Petzoldt

v. Commissioner, 92 T.C. 661, 687, 693 (1989).     The method of

reconstructing income need only be reasonable in light of all

surrounding circumstances.      Petzoldt v. Commissioner, supra at

687.

       The source and application of funds method has been regarded

as a reasonable method of determining income.     United States v.

Johnson, 319 U.S. 503, 517-518 (1943); Meier v. Commissioner, 91

T.C. 273, 295-296 (1988).    As explained by this Court in DeVenney

v. Commissioner, 85 T.C. 927, 930 (1985):

            The * * * [source and application of funds] method
       is based upon the assumption that the amount by which a
       taxpayer's cash expenditures during a taxable period
       exceed * * * [the taxpayer's] known sources of income
       for that period is taxable income, unless the taxpayer
                               - 8 -


     can show his expenditures were made from some
     nontaxable source of funds. * * *

A deficiency based upon the source and application of funds

method is presumptively correct, and the burden of proof is on

the taxpayer to prove otherwise.   Rule 142(a).   A taxpayer may

meet this burden by proving that assets were on hand at the

beginning of the taxable period with which to make the

expenditures, that amounts received during the year were

nontaxable, or that someone else made the expenditures.      Id. at

930-931.

     In this instance, respondent used the average living

expenses of one person, as provided by the Bureau of Labor

Statistics (BLS), as a basis for determining that petitioner's

income for the taxable year 1994 included the cost of supporting

herself.   See Denson v. Commissioner, T.C. Memo. 1982-360

(discussing the Commissioner's reliance on BLS tables).    We have

previously approved the Commissioner's use of BLS data when

reconstructing a taxpayer's income.    See Giddio v. Commissioner,

54 T.C. 1530, 1533 (1970).   Nevertheless, if evidence exists

which indicates that a taxpayer's living expenses for the taxable

year in question were less than the average living expenses

provided in the BLS tables, we may modify the Commissioner's

reconstruction under the source and application of funds method

to account for that difference.    Denson v. Commissioner, supra.
                               - 9 -


     Petitioner admitted at trial that she refused to provide

respondent with any of K & A's bank statements for each of the

taxable years in issue.   Petitioner also refused to provide

respondent with any billing statements issued by K & A to its

customers during the taxable year 1994.   This documentation could

have permitted respondent to ascertain the correctness of the

reported income.   Given the absence of any documentation in the

record, we find that respondent was reasonable in reconstructing

petitioner's income under the source and application of funds

method.

     Despite our conclusion that respondent was reasonable in the

determination to reconstruct petitioner's income, the record

indicates that petitioner's living expenses were less than the

average living expenses provided in the BLS tables.   The average

living expenses provided in the BLS tables includes costs for

shelter in the amount of $4,089.5   During the taxable year 1994,

however, petitioner did not incur any rent or mortgage expense.

Accordingly, we reduce petitioner's living expenses, as reflected

in respondent's reconstruction, by the amount of $4,089.

Consequently, we conclude that petitioner failed to report income



     5
        Respondent did not include any funds expended for
dormitory lodging. Since the record reflects that such lodging
was paid out of loans or scholarship funds, such payments would
be properly excluded from a source and application of funds
analysis.
                              - 10 -


during the taxable year 1994 in the amount of $489 ($4,578 less

$4,089).

2.   Cost of Goods Sold

      Respondent disallowed the cost of goods sold which

petitioner claimed on Schedules C of her returns for the taxable

years 19946 and 1995.

      In disallowing the cost of goods sold claimed by petitioner

for 1995, respondent did not contest petitioner's

characterization of the items in question as costs of goods sold

rather than as claims for deductible expenses under section 162.

The cost of goods sold is subtracted from gross receipts for

purposes of determining gross income, whereas business expenses

are deducted from gross income.   Hahn v. Commissioner, 30 T.C.

195, 197 (1958), affd. per curiam 271 F.2d 739 (5th Cir. 1959).

In effect, cost of goods sold, unlike business expenses, is

excluded from gross income.   Section 1.61-3(a), Income Tax Regs.,

provides that "In a manufacturing, merchandising, or mining

business, 'gross income' means the total sales, less the cost of

goods sold".


      6
        We do not consider respondent's adjustment to cost of
goods sold for 1994. Any allowance by the Court would result in
an increase in petitioner's expenditures, which would have the
effect of increasing income under the source and application of
funds analysis. Since we have fully addressed respondent's
reconstruction of petitioner's income for 1994, we see no reason
to address separately respondent's adjustment with respect to
costs of goods sold for 1994.
                                - 11 -


     Petitioner's business provided drafting services, and

nothing in the record indicates that K & A was engaged in

manufacturing or merchandising.    Therefore, we consider the cost

of goods sold in question to be claims for business expense

deductions under section 162.

     Section 162(a) provides that there shall be allowed as a

deduction all the ordinary and necessary expenses paid or

incurred during the taxable year in carrying on any trade or

business.   Section 6001 requires that a taxpayer liable for any

tax shall maintain such records, render such statements, make

such returns, and comply with such regulations as the Secretary

may from time to time prescribe.    To be entitled to a deduction

under section 162(a), therefore, a taxpayer is required to

substantiate the deduction through the maintenance of books and

records.

     In the event that a taxpayer establishes that he or she has

incurred a deductible expense, but is unable to substantiate the

precise amount of the expense, we may estimate the amount of the

deductible expense.   Cohan v. Commissioner, 39 F.2d 540, 543-544

(2d Cir. 1930).   We cannot estimate deductible expenses, however,

unless the taxpayer presents evidence sufficient to provide some

rational basis upon which estimates may be made.    Vanicek v.

Commissioner, 85 T.C. 731, 743 (1985).
                              - 12 -


     Petitioner's claimed expenses for the taxable year 1995

relate to the cost of labor, the cost of materials and supplies,

and "other costs".   We first address petitioner's claims for

expenses relating to labor costs.   Although petitioner kept no

documentation concerning amounts paid by K & A for services

rendered and testified that the amounts reflected on the returns

were estimates, we are convinced that Mr. Gorges and Windi

performed services for K & A and were compensated.   Particularly,

petitioner's lack of drafting experience serves as strong

indication that she relied upon Mr. Gorges to perform necessary

drafting services.   Moreover, given petitioner's status as a

full-time student during the fall of 1994, we are convinced that

petitioner relied upon Windi to perform various administrative

duties while petitioner was not available.   In return, K & A

provided for a portion of Mr. Gorges' and Windi's living

expenses.   Employing the rule of Cohan v. Commissioner, supra, we

conclude that petitioner is entitled to a deduction for

compensation paid to Mr. Gorges and Windi in the amount of $5,000

for 1995.

     We now address petitioner's claims for expenses relating to

materials and supplies and "other costs" with respect to the

taxable year 1995.   Petitioner testified that, in similar fashion

to the claimed labor expenses, the amounts reflected on her

return as expenses for materials and supplies and for "other
                                - 13 -


costs" were estimated.    Petitioner failed to provide any detailed

testimony concerning these claimed expenses and offered no

written substantiation.    We, therefore, have no basis to make an

estimate.    Petitioner has failed to meet her burden of proving

entitlement to these claimed expenses.     Rule 142(a).

Accordingly, we sustain respondent's determination to that

extent.

3.   Dependency Exemption and Filing Status for 1994 and 1995

     (a)    Dependency

      Section 151(c) allows an exemption amount for each

dependent:     (1) Whose gross income for the taxable year is less

than the exemption amount, or (2) who is a child of the taxpayer

and is a student who has not attained the age of 24 at the close

of such calendar year.     Sec. 151(c)(1)(A) and (B)(ii).

Dependents are generally defined as individuals who receive over

half of their support from a taxpayer in the calendar year in

which that taxpayer's taxable year begins.     Sec. 152(a).

      For purposes of determining whether or not an individual

received over one-half of his or her support from the taxpayer

during a given calendar year, there shall be taken into account

the amount of support received from the taxpayer as compared to

the entire amount of support which the individual received from

all sources.     Sec. 1.152-1(a)(2)(i), Income Tax Regs.    Support

includes amounts which an individual has contributed to his or
                                - 14 -


her own support.     Sec. 1.152-1(a)(2)(ii), Income Tax Regs.     To

determine whether a taxpayer has furnished over half of an

individual's support, there must be included the cost of food,

shelter, clothing, medical and dental care, education, and the

like.     Sec. 1.152-1(a)(2)(i), Income Tax Regs.   Although the

amount of an item of support is usually its cost, where lodging

is furnished to an individual, the amount of support is the fair

market value of such lodging.     Id.    Welfare payments or similar

public assistance received directly by a claimed dependent, or

received by the taxpayer for the benefit of a claimed dependent,

are not considered support furnished by the taxpayer.         Gulvin v.

Commissioner, 644 F.2d 2 (5th Cir. 1981), affg. T.C. Memo. 1980-

111; Williams v. Commissioner, T.C. Memo. 1996-126, affd. without

published opinion 119 F.3d 10 (11th Cir. 1997).

        In cases where two or more persons contribute to the support

of an individual, section 152(c) provides that a taxpayer is

treated as contributing over one-half of the support of an

individual for the calendar year if:      (1) No one person

contributed over half of the individual's support; (2) over half

of such support was received from persons each of whom, but for

the fact that he or she did not contribute over half of such

support, would have been entitled to claim such individual as a

dependent for the taxable year beginning in such calendar year;

(3) the taxpayer contributed over 10 percent of such support; and
                                - 15 -


(4) each person described in (2) (other than the taxpayer) who

contributed over 10 percent of such support files a written

declaration that he or she will not claim such individual as a

dependent for any taxable year beginning in such calendar year.

     Respondent argues that petitioner is not entitled to the

claimed dependency exemptions because she did not provide over

one-half of the support for Windi and Mr. Gorges during the

taxable years in issue.     Petitioner bears the burden of proof on

this issue.    Rule 142(a); Seraydar v. Commissioner, 50 T.C. 756,

760 (1968).

     Petitioner offered little evidence concerning the amount of

support she provided to Mr. Gorges or Windi.     Furthermore, Mr.

Gorges and Windi resided rent-free in a home owned by Ms. Gorges,

and they received Government benefits during each of the years in

issue.     In this regard, Ms. Gorges did not file a written

declaration that she would not claim either Mr. Gorges or Windi

as dependents on her return.     Sec. 152(c).   Moreover, Mr. Gorges

and Windi worked, received income, and provided for their own

personal living expenses during each of the years in issue.

Accordingly, petitioner has failed to establish that she is

entitled to the claimed exemptions for either Mr. Gorges or Windi

during each of the taxable years in issue.      Therefore, respondent

is sustained on this issue.

     (b)    Filing Status
                               - 16 -


      Petitioner claimed head-of-household filing status on her

returns for the taxable years 1994 and 1995.    Under section

2(b)(1), a taxpayer who is unmarried may file a return as "head

of household" if that taxpayer maintains as his or her home a

household which constitutes for more than one-half of such

taxable year the principal place of abode of certain described

individuals.

      In this case, petitioner has failed to establish that she

maintained a household within the meaning of section 2(b).

Petitioner neither owned nor paid rent for the house where Windi

or Mr. Gorges resided during the taxable years in question.

Moreover, Mr. Gorges is not a person who comes within the

provisions of section 2(b)(1) and section 151.    Accordingly, we

sustain respondent on this issue.

4.   Accuracy-Related Penalty Under Section 6662(a)

      Respondent determined that petitioner was liable for the

accuracy-related penalty under section 6662(a) for the taxable

years 1994 and 1995.   The accuracy-related penalty is equal to 20

percent of any portion of an underpayment attributable to a

taxpayer's negligence or disregard of rules or regulations.      Sec.

6662(a) and (b)(1).    The term "negligence" includes any failure

to make a reasonable attempt to comply with the provisions of the

Internal Revenue Code, and the term "disregard" includes any

careless, reckless, or intentional disregard.    Sec. 6662(c).   The
                                - 17 -


penalty does not apply to any portion of an underpayment for

which there was reasonable cause and with respect to which the

taxpayer acted in good faith.    Sec. 6664(c).   Generally,

taxpayers bear the burden of proving that they are not liable for

the accuracy-related penalty imposed by section 6662(a).      Rule

142(a); Tweeddale v. Commissioner, 92 T.C. 501, 505 (1989).

     Petitioner has failed to offer any evidence to suggest that

she acted with reasonable cause and good faith with respect to

the issues discussed herein.     Petitioner has failed in her burden

of proving that she is not liable for the accuracy-related

penalty.   We, therefore, sustain respondent's determination that

petitioner is liable for the accuracy-related penalty under

section 6662(a) for the taxable years 1994 and 1995.

     To reflect the foregoing,

                                           Decision will be entered

                                      under Rule 155.
