                          T.C. Memo. 2004-201



                     UNITED STATES TAX COURT



              JAMES C. BLANNING, JR., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 16309-98.               Filed September 1, 2004.



     James C. Blanning, Jr., pro se.

     Michael W. Lloyd, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GERBER, Chief Judge:     Respondent determined Federal income

tax deficiencies of $24,664 and $6,801 for petitioner’s 1992 and

1993 tax years, respectively.    Included in the deficiencies are

self-employment tax determinations of $8,907 and $3,880 for 1992

and 1993, respectively.    Finally, respondent determined that

petitioner was liable for additions to taxes for 1992 and 1993
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under section 6651(a).1   The issues remaining for our

consideration are:   (1) Whether petitioner failed to report

income in the amounts of $75,614 and $27,462 for 1992 and 1993,

respectively; (2) whether petitioner has shown entitlement to

business deductions in excess of those allowed by respondent; and

(3) whether petitioner is liable for self-employment taxes.

                          FINDINGS OF FACT

     At the time his petition was filed, petitioner’s legal

residence was in the State of Colorado.      Brenda Benz was

petitioner’s intimate and confidant, and she followed

petitioner’s direction in business matters and was remunerated

for her efforts.   Gary Krubsack was a friend of petitioner’s and

participated in petitioner’s business activities. During 1992 and

1993, petitioner identified corporations that were not current

with their obligations to the State of Colorado and that held

title to real estate or other property.      When petitioner

discovered that a corporation was not properly registered and

therefore in a delinquent inactive status with the State of

Colorado, he organized a new corporation with the same name as

the delinquent corporation and caused the transfer of the title

of properties held by the delinquent corporation to a third


     1
       Section references are to the Internal Revenue Code in
effect for the period under consideration. Rule references are
to the Tax Court’s Rules of Practice and Procedure. Respondent
conceded that petitioner is not liable for the addition to tax
under sec. 6651(a) for either taxable year.
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corporation over which petitioner had control or in which he had

some involvement.    Although petitioner contends that the

delinquent corporations had become dissolved under the law of the

State of Colorado, his actions were improper and violated the

criminal laws of the State of Colorado.    Petitioner incurred

expenses in conducting this activity.

     As a result of this illegal business activity, petitioner

directly or indirectly received money from the sale of the

transferred properties or from investors who advanced capital to

develop these properties.    One such transaction involved real

property that had been held by a delinquent corporation and a new

corporation created by petitioner which obtained $280,000 in net

proceeds from a $380,000 loan using the property as collateral.

     Ultimately, petitioner became the subject of civil and

criminal proceedings resulting in judgments against petitioner

and his incarceration.    In particular, petitioner was convicted

of racketeering, theft, criminal attempt, securities fraud,

forgery, and first degree offer of false instrument for

recording.

     Petitioner caused the organization of and controlled the

following corporate entities, each of which maintained bank

accounts:    Aspen Western Development Corp. (Aspen); Youwonder

Corp. (Youwonder); Aspen-Western Mining Corp. (Western);

Riverbank Corp., Inc. (Riverbank); Riverbank West Corp., Inc.
                               - 4 -

(Riverbank West); Benz-Niva Corp. (Benz); R.F. Riverbend, Inc.

(Riverbend); and High Western Development Corp. (High Western).

No Federal corporate tax returns were filed for High Western,

Benz, or Youwonder.

     Petitioner did not maintain adequate records of his business

activity.   Respondent reconstructed petitioner’s income from this

activity by means of the specific items method, which involved

tracking checking account transactions to petitioner or his

related entities.   Petitioner received income for personal

services in real estate activity from some of the above-named

corporations, as follows:

                                       Amount and Year
     Corporation                1992                     1993

     High Western           $10,500.00              $3,800.00
     Benz                    63,426.50              12,000.00
     Youwonder                1,688.00              11,662.00

       Total                 75,614.50              27,462.00

     In performing the reconstruction of petitioner’s income for

1992 and 1993, respondent utilized checks that had been

negotiated by petitioner and his related entities and backed out

or removed certain items and transfers between accounts to avoid

the possibility of double counting.    Respondent’s audit was

commenced after receipt of incomplete records of petitioner’s

business activity from the State of Colorado.    The State of

Colorado had conducted a criminal examination and reviewed

petitioner’s and his related corporations’ records to determine
                               - 5 -

whether petitioner had received income from criminal activity and

whether the amount of that income reached the threshold for the

filing of a Colorado income tax return.    The State of Colorado

provided respondent with records that, in the State’s judgment,

reflected income to petitioner.

     Respondent asked petitioner, who was then incarcerated, for

records of his business activities, and petitioner was unable to

produce any records other than those respondent received from the

State of Colorado.   Petitioner advised that his records had been

discarded while he was incarcerated.    Respondent did not allow

any deductions in connection with respondent’s determination of

petitioner’s business activity.

     Petitioner failed to file Federal income tax returns for

1992 and 1993 as of the time respondent began the audit of

petitioner’s income activities.   Petitioner did not provide

records of income or expenses to respondent in connection with

the examination of his 1992 and 1993 tax years.    In the notice of

deficiency, respondent allowed petitioner standard deductions of

$3,600 and $3,700 for 1992 and 1993, respectively.

                              OPINION

     During 1992 and 1993, petitioner was engaged in illicit

property transactions.   The transactions generally involved real

property of corporations, unrelated in any way to petitioner,

that were delinquent in their obligations to the State of
                               - 6 -

Colorado.   Petitioner sought out these corporations and organized

new corporations with the same name as the delinquent

corporations and, then, transferred the delinquent corporations'

real property to a third corporation that petitioner directly or

indirectly controlled.   Thereafter, petitioner would benefit from

transactions in the acquired real property.

     The State of Colorado conducted a criminal investigation

regarding petitioner’s illicit activity resulting in the

prosecution and incarceration of petitioner.   Thereafter, the

State of Colorado provided respondent with limited records of

petitioner and his related corporate entities that had been used

in support of the criminal investigation.   Respondent used those

records to reconstruct petitioner’s 1992 and 1993 income for

Federal income tax purposes.   Petitioner has not filed Federal

income tax returns or maintained any records of his income-

producing activity.

Reconstruction of Petitioner’s Income for 1992 and 1993

     Respondent, based on a form of a specific items

reconstruction method, determined that petitioner had unreported

income from real estate transactions of $75,614 and $27,462 for

1992 and 1993, respectively.   In general, the Commissioner’s

determination enjoys a presumption of correctness and the

taxpayer bears the burden of showing that the Commissioner’s

income determinations are in error.    Rule 142(a); Helvering v.
                                - 7 -

Taylor, 293 U.S. 507 (1935); Welch v. Helvering, 290 U.S. 111

(1933).2   Where, however, the Commissioner’s determination

concerns unreported illegal income, the Commissioner must offer

some substantive evidence connecting the taxpayer to the income-

producing activity before the Commissioner’s determination is

afforded a presumption of correctness.    Erickson v. Commissioner,

937 F.2d 1548, 1551 (10th Cir. 1991), affg. T.C. Memo. 1989-552;

MacCracken v. Commissioner, T.C. Memo. 1993-376.

     In this case, respondent has amply demonstrated that

petitioner possessed liquid assets, expended funds, and/or made

substantial deposits in various bank accounts.   This was shown by

means of checks, issued in petitioner’s name or to cash, that

were negotiated by petitioner and by corporate checks used to pay

petitioner’s living expenses.   In addition, petitioner stipulated

that he was engaged in an income-producing activity.

     The Commissioner is entitled to reconstruct a taxpayer’s

income by a reasonable method where the taxpayer fails to

maintain adequate books and records.    Sec. 446(b); Erickson v.

Commissioner, supra at 1553; Parks v. Commissioner, 94 T.C. 654,

658 (1990). Petitioner has not shown or adequately argued that

respondent’s method of reconstruction was unreasonable or in any


     2
       The audit of petitioner’s 1992 and 1993 income taxes
commenced prior to July 22, 1998, the effective date of the
Internal Revenue Service Restructuring and Reform Act of 1998,
Pub. L. 105-206, 112 Stat. 685. Therefore, sec. 7491 is
inapplicable to this proceeding.
                                 - 8 -

way flawed.     Likewise, petitioner has not shown that respondent’s

determination of unreported income was in error.      Accordingly, we

sustain respondent’s determination and hold that petitioner

failed to report gross income from his real estate activity of

$75,614 and $27,462 for 1992 and 1993, respectively.

Whether Petitioner Is Entitled to Deductions in Connection With
His Real Estate Business Activity

        Generally, a taxpayer must show that he is entitled to

deductions with respect to his business activity.       Rule 142(a);

Welch v. Helvering, supra.     Under section 162(a), ordinary and

necessary expenses incurred in carrying on a trade or business

may be deductible.     The fact that a deduction was incurred in an

illegal activity is not sufficient to deny a deduction that is

otherwise allowable.     Commissioner v. Tellier, 383 U.S. 687

(1966); Commissioner v. Sullivan, 356 U.S. 27 (1958); Brizell v.

Commissioner, 93 T.C. 151 (1989); cf. sec. 162(c), (f).

Taxpayers are required to maintain books and records in support

of the items reported on a return.       Sec. 1.6001-1(a), Income Tax

Regs.     More stringent record keeping requirements apply to

certain travel and entertainment expenses.      Sec. 274(d).

     In this case, petitioner has attempted to meet his burden by

reconstructing his expenditures through secondary and incomplete

documentation.     In particular, petitioner offered credit card

statements and some invoices.     Respondent reviewed petitioner’s

documents and after performing a perfunctory analysis, contends
                                 - 9 -

that the vast majority of them were either for nondeductible

personal items or for transportation and entertainment and did

not meet the more stringent requirements of section 274(d).

Petitioner, on the other hand, contends that most of the

expenditures represented by these documents were in connection

with his real estate business activity.

     The credit card records, which are admittedly incomplete,

totaled $11,179.74 for the 2-year period (1992-93).     Of the

$11,179.74:    $9,234.43 was for 1992; $1,679.02 was for 1993; and

$266.29 was not differentiated as to the year.    The Court found

respondent’s review of these items to be hypercritical.     Other

than items that are clearly for travel and entertainment,

respondent did not give petitioner the benefit of the doubt.       For

example, on a charge for the changing of a lock, respondent in

denying a deduction commented:    “Why did lock(s) need to be

changed”?    In situations where the payment of the credit card by

one of petitioner’s related corporate entities had been

determined to be income, respondent in denying a deduction,

commented:    “Bus purpose--already acctd above??”3   On several

purchases of hardware, respondent in denying a deduction

commented:    “Bus purpose--vague”.




     3
       We assume that respondent concluded that these
expenditures that were used to reconstruct petitioner’s income
were personal in nature and not deductible as a business expense.
                               - 10 -

     Under Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930),

inadequately substantiated expenses may be estimated by a court

where it is shown that a taxpayer is unquestionably entitled to

some deductions.   In this case there are certain obvious expenses

that would have been incurred by petitioner in his activity.     For

example, the costs of forming “duplicate” corporate entities,

filing deeds for transfer of real estate, telephone, etc.

Petitioner testified that the cost of filing a deed could range

from several dollars to thousands of dollars.

     We have taken into consideration:   (1) The fact that

petitioner’s records are incomplete; (2) some of petitioner’s

expenditures appear to be personal or nondeductible under section

274; (3) petitioner’s records; and (4) petitioner’s testimony,

and hold that petitioner is entitled to business deductions of

$15,123 and $5,492 for 1992 and 1993, respectively.   Cohan v.

Commissioner, supra.

Whether Petitioner’s Income Is Subject to Self-Employment Tax

     In the setting of this case, petitioner’s income was derived

through corporate entities, but, in effect, was earned in his

individual capacity.   Section 1401 imposes a tax on an

individual’s net earnings from self-employment.   “Net earnings

from self-employment” are defined as the gross income derived by

an individual from any trade or business carried on by such

individual, less deductions.   There is no question about the fact
                                 - 11 -

that petitioner carried on his real estate activity for a period

of no less than 2 years.      In addition, illegal business

activities have been found to be subject to the self-employment

tax.    See, e.g., Basada v. Commissioner, T.C. Memo. 1998-144.

       Petitioner bears the burden of showing that the income

derived from his real estate activity was not from self-

employment.    Rule 142(a).    Petitioner has not refuted the ample

record in this case reflecting that petitioner was self-employed.

Therefore, it is held that petitioner is subject to self-

employment taxes to be computed under Rule 155.

       To reflect the foregoing,


                                        Decision will be entered

                                   under Rule 155.
