                        T.C. Memo. 1999-74



                      UNITED STATES TAX COURT



             AL ZUNI OF ARIZONA, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

                  NASHAT KHALAF, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 18917-96, 18918-96.      Filed March 10, 1999.



     Henry W. Tom and Rick Kilfoy, for petitioners.

     Rachael J. Zepeda, for respondent.


             MEMORANDUM FINDINGS OF FACT AND OPINION


     SWIFT, Judge:   In these consolidated cases, respondent

determined deficiencies in petitioners' Federal income taxes,

additions to tax, and penalties, as follows:
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Al Zuni of Arizona, Inc.

                       Addition to Tax    Accuracy-Related Penalty
Year      Deficiency    Sec. 6651(a)(1)          Sec. 6662(a)
1989       $274,514        $68,628                $54,903
1990        194,163         48,541                   --
1991        142,726         35,682                 28,545
1992        290,668         72,667                 58,134


Nashat Khalaf

                       Addition to Tax    Accuracy-Related Penalty
Year      Deficiency    Sec. 6651(a)(1)          Sec. 6662(a)
1989       $127,674        $32,041                $25,535
1990         51,682         13,204                 10,336
1991         44,038         11,977                  8,807
1992        245,164           --                   49,033


       After settlement of many issues, the issues for decision

involve the amount of income that is to be charged to petitioner

Al Zuni of Arizona, Inc. (Al Zuni), on transfer of its inventory

of Native American jewelry to Nashat Khalaf (Khalaf), its 100-

percent shareholder, and the amount of capital gain that is to be

charged to Khalaf with regard to receipt from Al Zuni of the

jewelry inventory.

       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.
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                         FINDINGS OF FACT

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

At the time the petitions were filed, Khalaf’s residence was

located in New Mexico.

     Al Zuni was incorporated in 1976 as an Arizona corporation

engaged in the business of buying and selling Native American

jewelry.

     Since the early 1980's, Khalaf was the sole shareholder of

Al Zuni.   From 1976 and through the years in issue, Khalaf

traveled throughout the Southwestern United States purchasing and

reselling on behalf of Al Zuni Native American jewelry.

     Native Americans who live on reservations and who make and

sell jewelry often do not have easy access to banks and typically

would sell jewelry to Khalaf only for cash.   Thus, over the

years, Khalaf purchased for cash the items of jewelry that were

added to Al Zuni’s jewelry inventory.

     In September of 1992, on Al Zuni’s books and records there

was recorded a debt obligation of Al Zuni to Khalaf in the amount

of $196,510.

     In mid-September of 1992, a transaction was entered into

between Al Zuni and Khalaf in which Al Zuni transferred to Khalaf

all of its then extant jewelry inventory.

     In minutes of a special meeting of Al Zuni's board of

directors that was held on September 15, 1992, the transfer of a

portion of Al Zuni's jewelry inventory to Khalaf is described as
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a transfer in payment of Al Zuni's above-mentioned $196,510 debt

obligation to Khalaf.   In those same minutes, the transfer of the

balance of Al Zuni’s jewelry inventory to Khalaf is described as

a sale by Al Zuni and as a purchase by Khalaf of the balance of

the jewelry inventory for a total price of $671,413.

     A resolution reflected in the September 15, 1992, minutes of

Al Zuni's board of directors’ meeting indicates that Al Zuni’s

purported sale of jewelry to Khalaf for $671,413 was contingent

upon payment by Khalaf to Al Zuni of the $671,413 stated purchase

price.

     The evidence establishes that Khalaf did not pay to Al Zuni

any portion of the $671,413 stated purchase price for the

jewelry.    The parties herein, however, have stipulated, and we so

find that on September 15, 1992, Al Zuni’s jewelry inventory was

transferred and that Al Zuni’s total cost basis in the jewelry

inventory transferred to Khalaf on September 15, 1992, was

$538,000.

     After the transfer to Khalaf of its jewelry inventory, Al

Zuni had no remaining assets and conducted no further business

activity.

     On September 24, 1992, 9 days after the above transfer,

Khalaf transferred apparently the same jewelry inventory to

American Silver Jewelry Outlet, Inc. (American Silver), a related

corporation of which Khalaf was president and in which Khalaf’s

daughter was the sole shareholder.      The nature and specific terms
                                - 5 -

of the transfer of jewelry from Khalaf to American Silver are not

disclosed in the record.    In a special September 24, 1992,

meeting of the board of directors of American Silver, the

transfer of the jewelry from Khalaf to American Silver is

referred to as a transfer “for sale by consignment” of jewelry

with “a value of $671,413”.

     The trial record does not reflect any further sales or other

disposition by American Silver of the jewelry inventory it

received from Khalaf, nor does it reflect that Khalaf received

any payment from American Silver for the jewelry American Silver

received from Khalaf.   The record herein does not contain any

written inventory, documentation, cost records, or other

description or list of the specific items of jewelry that during

the years in issue were bought and sold by Al Zuni, by Khalaf,

and by American Silver, nor of the items of jewelry that were

transferred on September 15 and 24, 1992, respectively, from Al

Zuni to Khalaf and from Khalaf to American Silver.

     Twice a year, Khalaf would take a physical inventory of Al

Zuni’s jewelry on hand.    Khalaf would provide to Murray Peck

(Peck), the certified public accountant who prepared Al Zuni’s

corporate Federal income tax returns and Khalaf’s individual

Federal income tax returns, information regarding the physical

inventory of Al Zuni’s jewelry that Khalaf had taken and of the

cost of jewelry that each year he had purchased with cash on
                                   - 6 -

   behalf of Al Zuni.   Each year, Peck would use that information to

   compute Al Zuni’s cost of goods sold.

        Since 1980, Peck has been the preparer of Al Zuni’s

   corporate Federal income tax returns and of Khalaf’s individual

   Federal income tax returns.

        Al Zuni’s corporate Federal income tax returns for 1989,

   1991, and 1992 were untimely filed.     Al Zuni has not filed a

   signed Federal income tax return for 1990.

        On Al Zuni’s 1989, 1990 (unsigned), 1991, and 1992 corporate

   Federal income tax returns, there were reported each year the

   following total costs for jewelry inventory purchased, sold, and

   yearend jewelry inventory:


           As Reported on Al Zuni's Federal Income Tax Returns
     Cost of              1989         1990          1991            1992
Jewelry purchased       $696,795    $1,242,051    $1,634,220     $1,845,156
Jewelry sold             560,426       985,030     1,536,380      1,908,386*
Ending inventory         246,369       503,390       601,230         - 0 -

           * After subtraction of jewelry with a reported
             cost of $538,000 to reflect transfer of the
             jewelry inventory to Khalaf.


        On Al Zuni’s 1992 corporate Federal income tax return, which

   was prepared using the accrual method of accounting, the transfer

   of jewelry to Khalaf was reflected as a “transfer”.      The transfer

   is not expressly reflected as either a sale or as a distribution

   to Khalaf.   On Al Zuni's 1992 corporate Federal income tax
                               - 7 -

return, no gain or loss was reported with respect to the

September 15, 1992, transfer of Al Zuni’s jewelry inventory to

Khalaf.

     There was reflected on Al Zuni’s 1992 corporate Federal

income tax return a loan to Khalaf in the amount of $460,600.

This $460,600 purported loan apparently related to the $671,413

stated total purchase price for the jewelry transferred to

Khalaf, less the $196,510 loan that Al Zuni owed to Khalaf and

that was treated by Al Zuni and Khalaf as paid off upon transfer

to Khalaf of the jewelry inventory.

     The purported $460,600 loan from Al Zuni to Khalaf in

connection with the transfer of jewelry inventory to Khalaf was

not reflected by a promissory note or by any other loan

documentation.   No payments of principal or interest were ever

made by Khalaf on the $460,600 purported loan owed to Al Zuni.

     On Al Zuni’s corporate Federal income tax returns for 1983

and subsequent years, the amount of Khalaf’s capital investment

in his shares of stock in Al Zuni was reflected as $486,000.

     On his 1992 Federal income tax return, Khalaf did not report

income or gain with respect to his receipt of jewelry from Al

Zuni.

     On American Silver’s corporate Federal income tax return for

its taxable year ending September 30, 1993, a loan payable to

Khalaf in the total amount of $671,412 was reflected relating to
                              - 8 -

American Silver’s receipt on September 24, 1992, of the jewelry

inventory from Khalaf.

     On audit of Al Zuni, respondent determined that on

September 15, 1992, Al Zuni distributed, rather than sold, all of

its extant jewelry inventory to Khalaf, that the September 15,

1992, transaction between Al Zuni and Khalaf constituted a

distribution to Khalaf in complete liquidation of Al Zuni, that

the jewelry inventory Al Zuni transferred to Khalaf had a cost

basis to Al Zuni of $538,000, a total fair market value upon

distribution of $671,413, and that Al Zuni therefore realized on

the distribution business income of $133,413.

     On audit of Khalaf, respondent determined that Khalaf had a

cost basis of zero in his shares of stock in Al Zuni, that the

value of the jewelry inventory Khalaf received from Al Zuni on

September 15, 1992, was $671,413, that a portion of the jewelry

inventory Khalaf received represented a repayment to Khalaf of

the $196,510 purported loan obligation Al Zuni owed to Khalaf,

and that the balance of the jewelry inventory Khalaf received

with a value of $474,903 represented taxable capital gain income

to Khalaf received in exchange for his shares of stock in Al

Zuni.

                             OPINION

Nature of Transaction

     Respondent treats the September 15, 1992, transfer of

jewelry inventory from Al Zuni to Khalaf as a distribution under
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section 331 in complete liquidation of Al Zuni, which treatment

petitioners do not seriously challenge.   Rather, primarily

petitioners challenge respondent’s determination of the fair

market value of the jewelry inventory transferred to Khalaf, of

Al Zuni’s cost basis in the jewelry inventory, and of Khalaf’s

cost basis in his shares of stock in Al Zuni.

     Generally, in analyzing the factual issue of whether a

transfer of property to shareholders constitutes a distribution

under section 331 in complete liquidation of a closely held

corporation, it is the intent to shut down and liquidate the

corporation that is controlling, not whether a plan of

liquidation was formally adopted.   See Genecov v. United States,

412 F.2d 556, 561-562 (5th Cir. 1969); Kennemer v. Commissioner,

96 F.2d 177, 178 (5th Cir. 1938), affg. 35 B.T.A. 415 (1937).

     The transfer on September 15, 1992, to Khalaf of all of

Al Zuni’s extant jewelry inventory, the termination of any

further business activity of Al Zuni, and the failure of Khalaf

to make any payments on the $460,600 loan purportedly owed to

Al Zuni relating to the transfer constitute strong evidence that

the transfer of Al Zuni’s jewelry inventory to Khalaf constituted

a liquidation of Al Zuni and a distribution to Khalaf, not a

sale.   We so hold.
                              - 10 -

Income of $133,413 Charged to Al Zuni

     Section 336(a) provides generally that gain or loss is to be

recognized by a corporation on distribution of its property in

complete liquidation.   The gain is to be computed based on the

fair market value of the property distributed over the

corporation’s cost basis in the property.

     Fair market value is defined as the price at which property

would change hands between willing buyers and sellers, neither

being under any compulsion to buy or to sell and both having

reasonable knowledge of relevant facts.   See United States v.

Cartwright, 411 U.S. 546, 551 (1973); Collins v. Commissioner,

3 F.3d 625, 633 (2d Cir. 1993), affg. T.C. Memo. 1992-478; Estate

of Hall v. Commissioner, 92 T.C. 312, 335 (1989).

     On the evidence before us in these cases, the best

indication of the fair market value of the jewelry inventory

transferred to Khalaf is found in the representations of value

set forth in Al Zuni's and in American Silver’s documentation

relating to the transaction at issue in these cases, particularly

the minutes of Al Zuni’s September 15, 1992, board of directors’

meeting which reflect a value for the jewelry inventory

transferred to Khalaf of $671,413.

     At trial, Khalaf opined generally as to the decline during

the 1980's in the value of Native American jewelry to the effect

that such jewelry purchased in the early to mid-1980's would, in

1998 (at the time of the trial), be worth only 10 to 30 percent
                              - 11 -

of what it had cost.   Khalaf did not opine as to the general

value of such jewelry in 1992.

     We note that at trial neither party provided timely

independent expert witnesses as to the value of the jewelry

transferred to Khalaf.   Even if experts had been called, due to

Al Zuni’s and Khalaf’s failure to have available a written

inventory, books and records, or other documentation describing

the specific items of jewelry transferred to Khalaf, such experts

would not have had sufficient information to make professional

valuations of the jewelry inventory transferred to Khalaf, and

their testimony would not have been helpful.

     On the limited evidence before us (including petitioners'

and American Silver's written contemporaneous representations as

to the value of the jewelry, the evidence reflected on Al Zuni's

tax returns as to the cost of the jewelry inventory that Khalaf

purchased for Al Zuni in 1990, 1991, and 1992 in the $1 million

plus range and regarding the cost of the jewelry inventory Al

Zuni had on hand at yearend 1990 and 1991 in the one-half million

dollar range), we conclude that the value of the jewelry

inventory transferred to Khalaf on September 15, 1992, was

$671,413.

     With regard to Al Zuni’s cost basis in the jewelry inventory

transferred to Khalaf on September 15, 1992, the parties

stipulated that the jewelry inventory had a cost basis to Al Zuni

of $538,000.   Subtracting the $538,000 cost from the $671,413
                              - 12 -

value of the jewelry inventory transferred from Al Zuni to Khalaf

produces income to Al Zuni of $133,413.

     Petitioners contend that certain checks totaling $133,000

written during 1992 by Khalaf on Al Zuni’s bank account in favor

of Khalaf, Khalaf’s daughter and son, and cash should be treated

as additional purchases of jewelry on behalf of Al Zuni, and

should be treated as increasing Al Zuni’s cost basis in the

jewelry inventory by at least $133,000 and as eliminating

essentially all gain on the transfer of the jewelry inventory to

Khalaf.   No credible evidence indicates that these checks

constitute purchases of jewelry inventory.   Petitioners' attempt

to violate the stipulation of facts as to Al Zuni’s cost basis in

the jewelry inventory is rejected.

     We sustain respondent’s adjustment charging Al Zuni with

income in the amount of $133,413 with regard to the September 15,

1992, transfer of jewelry inventory from Al Zuni to Khalaf.


Capital Gain Income of $474,903 Charged to Khalaf

     Section 331 provides that amounts received by shareholders

in liquidation of a corporation shall be treated as full payment

in exchange for the shareholders' shares of stock in the

corporation.   Under section 1001, a gain or loss realized by

shareholders upon receipt of property in complete liquidation of

a corporation is determined by comparing the value of the
                                - 13 -

property distributed with the cost basis the shareholders had in

their shares of stock.

     We have concluded that the jewelry inventory Khalaf received

from Al Zuni in September of 1992 had a value of $671,413.

Respondent reduced this amount by the $196,510 principal amount

of the loan that Al Zuni apparently owed to Khalaf.    As

explained, respondent treated Khalaf as having a zero basis in

his stock in Al Zuni, and respondent calculated that Khalaf

realized $474,903 in capital gain income on receipt from Al Zuni

of the jewelry inventory.   The only issue remaining with regard

to this income adjustment is the amount of Khalaf’s cost basis in

his shares of stock in Al Zuni.

     Respondent contends that Khalaf has not established that he

had any cost basis in his shares of stock in Al Zuni and that the

full $474,903 constitutes taxable capital gain income to Khalaf.

Petitioners contend that Khalaf’s cost basis in his shares of

stock in Al Zuni was at least $486,000.

     At trial, Khalaf and Peck testified that Al Zuni was

incorporated in 1976 with a capital contribution of property of

$360,000 and that in 1983 Khalaf made an additional cash

contribution to Al Zuni of $126,000.     Khalaf thus contends that

his total cost basis in his stock in Al Zuni was $486,000, an

amount that fully offsets the $474,903 capital gain income that

respondent charges to Khalaf.
                               - 14 -

     The trial record is not complete with regard to Khalaf’s

capital investment in Al Zuni.    No stock record book or canceled

checks were offered into evidence that provide verification of

Khalaf’s basis in his shares of stock in Al Zuni.    In evidence,

however, are copies of Al Zuni’s corporate Federal income tax

returns for 1983 and later years in which Khalaf’s capital

investment in his shares of stock in Al Zuni is consistently

reflected as $486,000.

     Based on the limited evidence before us on this issue and in

light of Khalaf’s testimony and the invested capital reflected on

Al Zuni’s corporate Federal income tax returns, we conclude that

on September 15, 1992, Khalaf’s cost basis in his shares of stock

in Al Zuni was $486,000, and we conclude that Khalaf realized no

capital gain income on the distribution from Al Zuni to him of

Al Zuni's jewelry inventory.

                                      Decisions will be entered

                                 under Rule 155.
