                        T.C. Memo. 1997-27



                      UNITED STATES TAX COURT



         STUART AND BETSY BOBRY, ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos.   5007-94, 5008-94,      Filed January 15, 1997.
                   5009-94.



     Sherman F. Levey, for petitioners.

     Raymond M. Boulanger and Kevin M. Murphy, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     SWIFT, Judge:   Respondent determined deficiencies in

petitioners’ joint Federal income taxes and accuracy-related

penalties for 1989 through 1992 as follows:

1
      Cases of the following petitioners are consolidated
herewith: Harold and Terri Bobry, docket No. 5008-94; and
Michael and Doris Bobry, docket No. 5009-94.
                                       - 2 -

Stuart and Betsy Bobry
Docket No. 5007-94

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

           1989           $991,916                    $198,383
           1990            563,956                     112,791
           1991            508,406                     101,681
           1992            444,764                      88,953


Harold and Terri Bobry
Docket No. 5008-94

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

           1989           $160,505                     $32,101
           1990            260,288                      52,058
           1991            239,272                      47,854
           1992            203,619                      40,724


Michael and Doris Bobry
Docket No. 5009-94

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

           1989           $160,505                     $32,101
           1990            260,288                      52,058
           1991            238,686                      47,737
           1992            203,621                      40,724


     Unless otherwise indicated, all 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.

     After settlement, the issues for decision are:                 (1) The

amount of Lyell Metal Co., Inc.’s (Lyell Metal’s) cost-of-goods

sold; and (2) whether petitioners are liable for the accuracy-

related penalties.
                               - 3 -

                         FINDINGS OF FACT

     Some facts have been stipulated and are so found.

Petitioners resided in Pittsford, New York, when their petitions

were filed.

     During the years in issue, petitioners Stuart Bobry, Harold

Bobry, and Michael Bobry (Harold and Michael are sons of Stuart

Bobry) owned all of the stock in Lyell Metal, an S corporation,

as follows:


                          Percentage of Stock Ownership
           Year            Stuart    Harold    Michael

           1989             75.50      12.25    12.25
           1990             52         24       24
           1991             52         24       24
           1992             52         24       24


     During 1989 through 1992, Lyell Metal was engaged in the

scrap metal recycling business in the vicinity of Rochester, New

York.   Lyell Metal purchased scrap metal from large, industrial

users of scrap metal, from small businesses, and from

individuals.

     In the Rochester, New York, metropolitan area, much of the

trade in scrap metal occurs by way of cash transactions.

Industrial companies from which large quantities of scrap metal

are purchased will often accept payment by check, while most

small businesses and individuals from whom scrap metal is

purchased accept payment only by cash.
                              - 4 -

     During 1989 through 1992, Lyell Metal maintained certain

books and records relating to its purchase of scrap metal by

check and by cash.

     With regard to Lyell Metal's purchase of scrap metal by

check, Lyell Metal's books and records reflect the amount and

date of the checks, the payee, the nature and quantity of scrap

metal purchased, and other information regarding each

transaction.

     With regard to Lyell Metal’s purchase of scrap metal by

cash, Lyell Metal's records are not as complete as they are for

the purchase of scrap metal by check.   With regard to the

purchase of scrap metal by cash, upon receipt in Lyell Metal’s

yard of scrap metal from customers, Lyell Metal’s yard employees

would prepare receipts in triplicate showing unit cost, total

cost, metal type, and weight of scrap metal received.   The

customers would then present the receipts to the cashier in Lyell

Metal’s front office, and the cashier would pay customers in cash

the amount indicated on the receipts.   For each transaction, the

cashier would verify the information on the receipt for accuracy,

would give one of the copies of the receipt to the customer, and

would retain two copies of the receipt.

     During 1989 through 1992, at the end of each business day,

one of Lyell Metal’s office clerks would compare and verify

conformity of the records of the total amount of cash that Lyell
                                 - 5 -

Metal had paid out that day to purchase scrap metal (as per the

retained copies of the receipts) with the cash register tape.

     On the next business day, an office clerk would prepare a

Lyell Metal check made payable to "cash" in the total amount of

the cash that Lyell Metal had paid out on the prior business day

to purchase scrap metal, would cash this check at the bank, and

would place the cash received in Lyell Metal’s front office cash

register to replenish the cash that had been used the prior day

to purchase scrap metal.

     The canceled checks made payable each day to "cash" (along

with Lyell Metal’s other canceled checks) were returned by the

bank and were retained for each year by Lyell Metal.    The

retained canceled checks made payable to cash represented the

primary record that Lyell Metal used to keep track of its cost of

scrap metal purchased by cash (along with its more complete

records relating to its cost of scrap metal purchased by check).

For example, Lyell Metal used the total amount of the canceled

checks made payable to cash during a week as the total amount for

cash purchases of scrap metal for that week.    Lyell Metal's

records do not reflect names, addresses, or other identifying

information regarding the customers from whom Lyell Metal

purchased scrap metal by cash.

     During 1989 through 1992, Lyell Metal retained all of the

canceled checks made payable to cash.    During 1989, 1990, and

through October of 1991, however, Lyell Metal retained for only 8
                              - 6 -

to 12 weeks the daily cash register tapes and the copies of the

receipts reflecting Lyell Metal’s purchases of scrap metal.

Before the cash register tapes and the copies of the receipts

were disposed of, Lyell Metal's accountant occasionally would

spot check the accuracy of the receipts with the inventory

records that were maintained by Lyell Metal.

     Since October of 1991, Lyell Metal has retained the daily

cash register tapes and copies of the receipts reflecting its

purchases of scrap metal by cash.   Such receipts, however, do not

reflect the identity of the customers from whom Lyell Metal

purchased scrap metal.

     During 1989 through 1992, certain inventory records were

maintained by Lyell Metal and apparently reflect only the type

and quantity of scrap metal that was purchased by check and by

cash and the scrap metal that was part of Lyell Metal’s inventory

at any one point in time.

     For 1989, 1990, and 1991, Lyell Metal’s cost-of-goods sold

was computed based on the canceled checks (i.e., those checks

made payable to specific payees to take into account scrap metal

purchased by check and also the checks made payable each day to

cash to take into account scrap metal purchased by cash).

     For 1992, Lyell Metal's cost-of-goods sold was computed

based on the copies of the receipts of scrap metal purchased that

were retained for that year, and also on the canceled checks.
                               - 7 -

The receipts and canceled checks reflected the same total cash

purchases of scrap metal for the year.

     On some occasions, Lyell Metal paid cash for expenses

unrelated to the purchase of scrap metal.   For example, Lyell

Metal paid cash for the services of an electrician.

     On February 21, 1992, respondent requested of Lyell Metal in

writing that Lyell Metal obtain, record, and retain for

respondent detailed information (namely, names, addresses, Social

Security numbers, and employee identification numbers)

identifying the customers from whom Lyell Metal purchased scrap

metal by cash.   As of the date of trial, Lyell Metal has not

complied with respondent’s request.


Lyell Metal’s Reported Gross Profit Margins, Federal Income Tax
Returns, and Respondent’s Audits

     Based on the evidence before us, from 1989, 1990, and 1991,

Lyell Metal’s gross profit margins (as reflected by gross revenue

and cost-of-goods sold as reported on Lyell Metal’s tax returns)

exceeded the average gross profit margins of similarly sized

scrap metal companies.   For 1992, the record does not reflect an

average gross profit margin for scrap metal companies.

     For 1989 through 1991, the following schedule reflects Lyell

Metal’s gross revenue and total cost-of-goods sold as reported on

its Federal income tax returns, Lyell Metal’s gross profit

margins based on the tax returns as filed, and the average gross
                                   - 8 -

profit margins of similarly sized companies within the scrap

metal industry:


             Lyell Metal’s Reported           Reported Gross Profit Margins
Year   Gross Revenue    Cost-of-Goods Sold   Lyell Metal    Industry Average

1989     $20,548,908      $14,434,001         29.75%             22.3%
1990      17,489,213       13,137,949         24.87%             20.3%
1991      13,222,367       10,094,291         23.66%             21.4%


       For 1989 through 1992, Lyell Metal filed Federal income tax

returns as an S corporation.       For each year in issue, Lyell Metal

included in its claimed cost-of-goods sold calculation purchases

of scrap metal by check and by cash.

       In preparing Lyell Metal’s Federal income tax returns for

the years in issue and in calculating Lyell Metal’s cost-of-goods

sold as claimed on Lyell Metal’s tax returns with respect to

scrap metal purchased by cash, Lyell Metal’s accountant relied

primarily on and used the total dollar amount of the canceled

checks made payable to cash and the inventory records.           For the

portion of 1991 and for 1992 during which copies of the customer

receipts and cash register tapes were retained, the accountant

also used the retained copies of the receipts and cash register

tapes that reflected purchases of scrap metal by cash.

       The following schedule reflects, for 1989 through 1992,

Lyell Metal's calculation of its total purchases of scrap metal

by check and by cash and Lyell Metal's total cost-of-goods sold

as reported on Lyell Metal's Federal income tax returns.
                                     - 9 -

                      Lyell Metal’s
           Calculation of Purchases of Scrap Metal     Lyell Metal's Reported
 Year      By Check       By Cash    Total Purchases     Cost-of-Goods Sold

1989     $8,813,624     $5,637,214     $14,450,838          $14,434,001
1990      8,492,978      4,662,030      13,155,008           13,137,949
1991      6,722,992      3,745,733      10,468,725           10,094,291
1992      6,410,910      3,330,418       9,741,328            9,610,215


        For 1989 through 1992, petitioners timely filed their joint

Federal income tax returns reflecting the pass-through tax

consequences of Lyell Metal’s S corporation status.

        On audit, respondent disallowed for each year for lack of

substantiation approximately 83 percent of Lyell Metal’s reported

purchases of scrap metal by cash, and respondent determined the

tax deficiencies in dispute herein based on this disallowance.

The 17 percent of alleged purchases of scrap metal by cash that

respondent allowed apparently reflects respondent’s estimate of

Lyell Metal’s total cash purchases of scrap metal for amounts

under $200 per transaction.

        For 1992, respondent disallowed 83 percent of Lyell Metal’s

reported purchases of scrap metal by cash even though Lyell

Metal's reported amount therefor was based not only on the

canceled checks made payable to cash but also on the copies of

the receipts and cash register tapes that were retained by Lyell

Metal for 1992 that reflected cash purchases.           Respondent's

disallowance for 1992 apparently was based on the fact that the

canceled checks and copies of the receipts did not contain all of
                                 - 10 -

the information that respondent had requested about the identity

of Lyell Metal’s customers.

     During the audit, respondent found no corroborating evidence

of unreported income on the part of petitioners.

     The following schedule reflects, for 1989 through 1992,

Lyell Metal’s claimed purchases of scrap metal by cash that were

disallowed by respondent, and Lyell Metal’s total cost-of-goods

sold as redetermined by respondent.


            Cash Purchases Disallowed
                  by Respondent                  Cost-of-Goods Sold
     Year   for Lack of Substantiation     as Redetermined by Respondent

     1989          $4,641,192                      $9,792,809
     1990           3,869,186                       9,268,763
     1991           3,108,958                       6,985,333
     1992           2,764,247                       6,845,968


     Respondent’s adjustments to Lyell Metal’s claimed cost-of-

goods sold increased Lyell Metal’s alleged gross income for the

years in issue, and this alleged additional income was charged to

petitioners’ joint Federal income tax returns.

     For 1989 through 1992, respondent also determined accuracy-

related penalties against petitioners for negligence relating to

the adjustments to Lyell Metal's cost-of-goods sold.


                                OPINION

     In calculating gross income, taxpayers may offset gross

revenue with cost-of-goods sold.         Metra Chem Corp. v.

Commissioner, 88 T.C. 654, 661 (1987); B.C. Cook & Sons, Inc. v.
                              - 11 -

Commissioner, 65 T.C. 422, 428 (1975), affd. per curiam 584 F.2d

53 (5th Cir. 1978).   Taxpayers, generally, bear the burden of

proof regarding the proper amount of their cost-of-goods sold.

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

v. Commissioner, 371 F.2d 684, 687 n.5 (1st Cir. 1967), affg.

T.C. Memo. 1966-99; Goldsmith v. Commissioner, 31 T.C. 56, 62

(1958).

     Taxpayers are expected to maintain adequate records to

substantiate claimed cost-of-goods sold.   Sec. 6001; sec. 1.6001-

1(a), Income Tax Regs.   Where taxpayers do not have adequate

records, but where the record suggests that they clearly incurred

an offset to gross income, courts may estimate the offset based

on the evidence.   Cohan v. Commissioner, 39 F.2d 540, 544 (2d

Cir. 1930).

     Respondent argues that Lyell Metal failed to substantiate

adequately its purchases of scrap metal by cash because Lyell

Metal did not maintain records of specific purchases of scrap

metal by cash nor records that identified the specific customers

from whom Lyell Metal purchased scrap metal by cash.

     Petitioners argue that Lyell Metal’s records (namely, for

1989, 1990, and 1991, the canceled checks made payable to cash

that were used daily to replenish Lyell Metal’s front office with

the amount of cash paid out the prior day to purchase scrap

metal, and for 1992, copies of the retained receipts, cash

register tapes, and the canceled checks made payable to cash)
                              - 12 -

adequately establish and substantiate its purchases of scrap

metal by cash.   Petitioners also argue that the accuracy of Lyell

Metal’s reported cost-of-goods sold is supported by the average

gross profit margins within the scrap metal industry.

     The evidence in this case supports the basic accuracy of

Lyell Metal's reported scrap metal purchases and reported cost-

of-goods sold.   For all the years in issue, Lyell Metal retained

its canceled checks made payable to cash and its general

inventory records.   For 1992, Lyell Metal also retained copies of

its receipts and its cash register tapes reflecting cash

purchases of scrap metal, which records corroborate the basic

accuracy of using, in this case, Lyell Metal's canceled checks

made payable to cash to compute the total cash purchases of scrap

metal for 1992 and thereby for the earlier years as well.

     For 1989 through 1991, Lyell Metal’s reported gross profit

margins exceeded the average gross profit margins of similarly

sized companies within the scrap metal industry.

     If respondent’s determinations for 1989 through 1991 were

sustained, Lyell Metal would be taxed on the basis of gross

profit margins that would be twice the industry average.

Although the evidence indicates that Lyell Metal was a profitable

company, it does not indicate that Lyell Metal was that much more

profitable than other scrap metal companies, and it does not

indicate that petitioners realized anywhere near the income

charged to them by respondent.
                              - 13 -

     Although the evidence largely supports the accuracy of Lyell

Metal’s reported cost-of-goods sold, the evidence does indicate

that Lyell Metal did improperly include in its cost-of-goods-

sold computation some expenses for non-cost-of-goods-sold items

(i.e., Lyell Metal paid for some expenses by cash that were not

related to the purchase of scrap metal and to that extent Lyell

Metal’s purchases and its cost-of-goods-sold computation was

overstated), and Lyell Metal’s records relating to cash purchases

of scrap metal are not as complete as they should be.   We do not

condone Lyell Metal’s failure to maintain more complete and

accurate records with regard to individual purchases of scrap

metal, particularly those where Lyell Metal made payment therefor

by cash.

     Based on the evidence before us, we hold that Lyell Metal is

entitled to include 95 percent of its calculation of its

purchases of scrap metal by cash as part of its cost-of-goods-

sold computation for the years in issue.   Cohan v. Commissioner,

supra.   The 5-percent reduction that we sustain is supported by

the fact that Lyell Metal did include some non-cost-of-goods-sold

items in its cost-of-goods sold computation for some years and by

Lyell Metal’s incomplete recordkeeping.

     For 1989 through 1992, the following schedule reflects our

computation and estimate of Lyell Metal’s total purchases of

scrap metal by cash, of Lyell Metal’s total cost-of-goods sold,
                                   - 14 -

and of the additional income to be charged to Lyell Metal and to

the shareholders thereof.

               Estimated             Estimated            Estimated
  Year       Cash Purchases      Cost-of-Goods Sold   Additional Income

  1989        $5,355,353           $14,152,140           $281,861
  1990         4,428,929            12,904,848            233,101
  1991         3,558,446             9,907,004            187,287
  1992         3,163,897             9,443,694            166,521


     Under section 6662(a), a 20-percent accuracy-related penalty

applies to underpayments of tax attributable to either negligence

or to a disregard of the rules or regulations.

     Taxpayers are expected to maintain adequate records and

failure to do so may constitute negligence and a disregard of

rules or regulations.      Sec. 6001; see also Schroeder v.

Commissioner, 40 T.C. 30, 34 (1963); Bard v. Commissioner, T.C.

Memo. 1990-431.   Petitioners bear the burden of proof with

respect to this issue.        Rule 142(a).

     As indicated, for the years in issue Lyell Metal failed to

maintain complete records.        Prior to 1991, Lyell Metal retained

copies of receipts reflecting its cash purchases of scrap metal

for only 8 to 12 weeks, and for all of the years in issue Lyell

Metal failed to maintain any identifying information relating to

customers to whom Lyell Metal paid cash for scrap metal.             We

sustain respondent’s determination of the accuracy-related

penalties.

     To reflect the foregoing,
- 15 -


     Decisions will be

entered under Rule 155.
