                        T.C. Memo. 2000-379



                      UNITED STATES TAX COURT



    PHILLIP A. O'BRYON AND CYNDIE W. O'BRYON, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 15704-98.                  Filed December 18, 2000.


     Frederick N. Widen and Randall S. Newman, for petitioners.

     Christopher A. Fisher, for respondent.



                        MEMORANDUM OPINION


     PARR, Judge:   This case is before the Court on petitioners'

motion for recovery of attorney's fees and costs pursuant to

section 74301 and Rules 230 through 232.


     1
      References to sec. 7430 are to sec. 7430 of the Internal
Revenue Code in effect for proceedings commenced after July 30,
1996. Unless otherwise indicated, other section references are
                                                   (continued...)
                                - 2 -

     We must decide whether petitioners are the prevailing party

in the underlying tax case within the meaning of section

7430(c)(4), and, if so, whether the litigation and administrative

costs claimed by petitioners are reasonable within the meaning of

section 7430(c)(1) and (2).

     Neither party has requested an evidentiary hearing on

petitioners' motion, and the Court concludes that such a hearing

is not necessary for the proper disposition of petitioners'

motion.   See Rule 232(a)(2).   Accordingly, we decide petitioners'

motion for recovery of attorney's fees and costs on the record of

the case, including respondent's response, petitioners' reply to

respondent's response, and the parties' affidavits and exhibits,

which are incorporated herein by this reference.

Background

     At the time the petition in this case was filed, petitioners

Phillip A. O'Bryon (Phillip) and Cyndie W. O'Bryon (Cyndie)

resided in Shaker Heights, Ohio.   On June 24, 1998, respondent

issued petitioners a notice of deficiency for the taxable years

1991 through 1994.   Respondent determined deficiencies, additions

to tax, and penalties for those years as follows:




     1
      (...continued)
to the Internal Revenue Code in effect for the taxable years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
                                   - 3 -

                        Addition to Tax            Penalties
    Year   Deficiency   Sec. 6651(a)(1)    Sec. 6662(a)     Sec. 6663
    1991     $3,759           -–             $751.80          --
    1992    162,222       $23,343.45        5,393.40      $101,441.25
    1993    112,951        26,206.25        4,181.00        69,034.50
    1994     26,337         2,082.50        2,505.00        10,359.00

     The adjustments contained in the notice of deficiency

resulted primarily from respondent's determination that:

     (1) Petitioners were not entitled to deduct losses claimed

in 1991, 1992, 1993, and 1994 from Diplomat Associates, an Ohio

general partnership (the Diplomat issue).

     (2) Petitioners failed to report in 1992, 1993, and 1994

substantial amounts of income from "illegal means" (the omitted

income issue).

     (3) Petitioners were not entitled to deduct a net operating

loss from the O'Bryon Co. reported on Schedules E, Supplemental

Income and Loss, of their 1992, 1993, and 1994 returns (the

Schedule E issue).

     (4) Petitioners were not entitled to deduct certain expenses

reported on Schedules C, Profit or Loss From Business, of their

1991 and 1992 returns (the Schedule C issue).

     (5) Petitioners' itemized deductions should be reduced each

year because of the increase in their adjusted gross income each

year.

     In the notice of deficiency, respondent determined that

Phillip (but not Cyndie) was liable for the civil fraud penalty
                               - 4 -

for the deficiency attributable to Phillip's omitted income, and

that both petitioners were liable for the accuracy-related

penalty for the balance of the deficiency, as well as delinquency

penalties.

     On September 22, 1998, petitioners timely filed a petition.

In addition to asserting that respondent erred in the

determinations set forth in the notice of deficiency, petitioners

claimed that Cyndie was entitled to relief under section 6015

with respect to deficiencies (including interest, penalties, and

other amounts) attributable to understatements of income by

Phillip.

     Respondent filed the answer on November 20, 1998, denying

any error in the notice of deficiency and denying that Cyndie is

entitled to relief under section 6015.   Petitioners filed their

reply on January 7, 1999.

     On December 1, 1998, respondent transferred the case to

respondent's Appeals Office.   Shortly thereafter, Appeals officer

Allan Fried was assigned the case.

     On February 1, 1999, with the trial scheduled on April 26,

1999, the parties filed a joint motion requesting a continuance.

We granted the joint motion on February 12, 1999.   After several

meetings and communications, the parties reached a full

settlement without trial, and the settlement was executed by the

parties on March 20, 2000.   Pursuant to the agreement, Phillip
                                      - 5 -

(but not Cyndie) was liable for deficiencies, additions to tax,

and penalties as set forth below:

                          Addition to Tax              Penalties
    Year     Deficiency    Sec. 6651(a)(1)    Sec. 6662(a)     Sec. 6663
    1991      $3,759             --               --              --
    1992      53,289          $6,996.75           --          $18,889.13
    1993      38,509           7,595.75           --           14,440.88
    1994      21,809           1,629.70           --            3,481.50


Discussion

     Section 7430(a) provides that the prevailing party may be

awarded reasonable administrative costs incurred in connection

with an administrative proceeding within the Internal Revenue

Service (IRS) and reasonable litigation costs incurred in

connection with a court proceeding.           For this Court to award

reasonable administrative and litigation costs under section

7430, the moving party must satisfy several conjunctive

requirements.    Specifically, the record must show, inter alia,

that:

     (1) The moving party exhausted any administrative remedies

available to him or her within the IRS.           See sec. 7430(b)(1).

     (2) The moving party did not unreasonably protract the

administrative proceeding or the proceeding in this Court.                 See

sec. 7430(b)(3).

     (3) The moving party is the prevailing party.            See sec.

7430(a).

     Respondent concedes that petitioners have met the first two
                                - 6 -

of these requirements.   Thus, we must decide whether petitioners

are the prevailing party.

     To qualify as a "prevailing party", a taxpayer must

establish the following:

     (1) The taxpayer substantially prevailed with respect to the

amount in controversy or with respect to the most significant

issue or set of issues presented.   See sec. 7430(c)(4)(A)(i).

     (2) The taxpayer is either an individual whose net worth

does not exceed $2 million, or an owner of any unincorporated

business, or any partnership, corporation, etc., the net worth of

which does not exceed $7 million at the time the petition is

filed.    See sec. 7430(c)(4)(A)(ii); 28 U.S.C. sec. 2412(d)(2)(B)

(1988).

     A party, however, will not be treated as the prevailing

party if the United States establishes that its position in the

proceeding was substantially justified.   See sec.

7430(c)(4)(B)(i).

     In this case, while respondent determined a total of

$550,567.15 in deficiencies, additions to tax, and penalties for

the years in issue, the March 20, 2000, settlement called for a

total of $170,399.71 in deficiencies, additions to tax, and

penalties.   Respondent agrees that petitioners substantially

prevailed as to the amount in controversy and that they meet the

net worth requirement.   Respondent contends, however, that his
                               - 7 -

position in each proceeding was substantially justified.

     The position of the United States is substantially justified

if it is justified to a degree that could satisfy a reasonable

person and has a reasonable basis both in law and fact.    See

Pierce v. Underwood, 487 U.S. 552, 563-565 (1988) (interpreting

similar language in the Equal Access to Justice Act, 28 U.S.C.

sec. 2412 (1988)); see also Ekman v. Commissioner, 184 F.3d 522,

526 (6th Cir. 1999); Maggie Management Co. v. Commissioner, 108

T.C. 430, 443 (1997).   A position has a reasonable basis in fact

if there is such relevant evidence as a reasonable mind might

accept as adequate to support a conclusion.   See Pierce v.

Underwood, supra at 564-565.   The reasonableness of respondent's

position and conduct necessarily requires considering what he

knew or should have known at the time.   See Rutana v.

Commissioner, 88 T.C. 1329, 1334 (1987); DeVenney v.

Commissioner, 85 T.C. 927, 930 (1985).   In determining whether

respondent acted reasonably, this Court must "consider the basis

for respondent's legal position and the manner in which the

position was maintained."   Wasie v. Commissioner, 86 T.C. 962,

969 (1986).   Respondent's position may be incorrect but

substantially justified if a reasonable person could think it

correct.   See Pierce v. Underwood, supra at 566 n.2.

     "The fact that the Commissioner eventually loses or concedes

a case does not by itself establish that the position taken is
                                - 8 -

unreasonable."    Maggie Management Co. v. Commissioner, supra at

443; see also Broad Ave. Laundry & Tailoring v. United States,

693 F.2d 1387, 1391-1392 (Fed. Cir. 1982); Sokol v. Commissioner

92 T.C. 760, 767 (1989).   However, it remains a relevant factor

in determining the degree of the Commissioner's justification.

See Maggie Management Co. v. Commissioner, supra.

     In deciding this issue, we must identify the point in time

at which the United States is first considered to have taken its

position, and then decide whether the position from that point

forward was substantially justified.    The "substantially

justified" standard applies to a position that the United States

took in an administrative proceeding and a judicial proceeding

respectively.    See sec. 7430(c)(7)(A) and (B).

     The position of the United States in an administrative

proceeding means the position taken as of the earlier of the date

of the receipt by the taxpayer of the Appeals decision or the

date of the notice of deficiency.    See sec. 7430(c)(7)(B).   In

the present case, respondent took a position in the

administrative proceeding as of June 24, 1998, the date of the

notice of deficiency.

     The position of the United States in a judicial proceeding,

for purpose of considering litigation costs, generally refers to

the position taken as of the date when the Commissioner files an

answer to a taxpayer's petition.    See Maggie Management Co. v.
                               - 9 -

Commissioner, supra at 442.   Respondent's position in the

proceeding before this Court was established on November 20,

1998, the date respondent filed the answer.     In the present case,

it is not necessary to analyze respondent’s position separately,

because respondent took the same position on each issue in both

the notice of deficiency and the answer.     See Swanson v.

Commissioner, 106 T.C. 76, 87 (1996).

     We now consider whether respondent's position was

substantially justified.   We analyze respondent's position in the

context of the circumstances that caused respondent to take that

position and the manner in which respondent maintained that

position.   See Wasie v. Commissioner, supra at 969; Kahn-Langer

v. Commissioner, T.C. Memo. 1995-527; Amann v. Commissioner, T.C.

Memo. 1993-542, affd. without published opinion 40 F.3d 1235 (1st

Cir. 1994).   We may also consider:    (1) Whether the Government

used the costs and expenses of litigation against its position to

extract concessions from the taxpayer that were not justified

under the circumstances of the case; (2) whether the Government

pursued the litigation against the taxpayer for purposes of

harassment or embarrassment, or out of political motivation; and

(3) such other factors as the Court finds relevant.     See Sher v.

Commissioner, 89 T.C. 79, 85 (1987), affd. 861 F.2d 131 (5th Cir.

1988).

     Our analysis of what caused respondent to take a position
                                - 10 -

may include events preceding the date the notice of deficiency

was issued.    See Williford v. Commissioner, T.C. Memo. 1994-135.

The reasonableness of respondent's position and conduct

necessarily requires considering what respondent knew at the

time.   See Rutana v. Commissioner, supra at 1334; DeVenney v.

Commissioner, supra at 930; Triplett v. Commissioner, T.C. Memo.

1998-313.     We ask whether respondent knew or should have known

that his position was invalid at the onset.     See Nalle v.

Commissioner, 55 F.3d 189, 191 (5th Cir. 1995), affg. T.C. Memo.

1994-182; Estate of Williamson v. Commissioner, T.C. Memo. 1997-

77.

      For a position to be substantially justified, there must be

substantial evidence to support it.      See Maggie Management Co. v.

Commissioner, 108 T.C. at 443.     It does not require a large or

considerable amount of evidence, but rather such relevant

evidence as a reasonable mind might accept as adequate to support

a conclusion.     See Pierce v. Underwood, supra at 564-565 (citing

Consolidated Edison Co. v. NLRB, 305 U.S. 197, 229 (1938)).

      We have previously adopted an issue-by-issue approach to the

awarding of costs under section 7430, apportioning the requested

awards between those issues for which respondent was

substantially justified and those issues for which respondent was

not substantially justified.     See Swanson v. Commissioner, supra

at 102; Austin v. Commissioner, T.C. Memo. 1997-157.     We follow
                             - 11 -

that approach here and separately discuss whether respondent's

position on each issue was substantially justified.

     From the time the notice of deficiency was issued to the

March 20, 2000, settlement, the parties disagreed as to the

following substantive matters:   (1) Whether amounts that Phillip

received by illegal means and failed to report on the returns for

tax years 1992 through 1994 should be reduced by the amounts that

he claimed to have repaid to his victims; (2) whether Phillip was

subject to section 6663 civil fraud penalties for the unreported

income for tax years 1992 through 1994; (3) whether Cyndie

qualified for relief under section 6015 on deficiencies,

additions to tax, and penalties resulting from Phillip's

embezzlement income; (4) whether petitioners were entitled to

claim deductions for Schedule E losses for tax years 1992 through

1994 in connection with Phillip's S corporation used in his

illegal activities; (5) whether Phillip was entitled to claim a

deduction for section 1231 loss for tax year 1991 with respect to

his interest in an unsuccessful partnership, and to carry over

that loss to subsequent tax years as net operating losses; and

(6) whether petitioners were entitled to claim certain Schedule C

deductions for tax years 1991 and 1992.

Omitted Income From Phillip's Fraudulent Ponzi Scheme

      From 1990 to 1991 or 1992, Phillip operated a Ponzi scheme

through joint business ventures with another individual.
                               - 12 -

Thereafter, he operated the scheme through his wholly owned S

corporation, the O'Bryon Co.   As part of the scheme, Phillip sold

nonexistent certificates of deposit (CD's) to various

individuals.   Phillip used the funds he received in the scheme to

pay individuals who thought they owned CD's that had matured, to

finance his other businesses, and to pay for his personal

expenses.

     On March 30, 1995, Phillip was charged with grand theft

under Ohio law.   The prosecution alleged that Phillip had

operated a fraudulent Ponzi scheme involving fictitious CD's.

Phillip pleaded guilty to the charges.    On April 28, 1995, the

State court judge sentenced Phillip to 2 years in prison and

ordered him to pay $468,834 in restitution to the individuals he

had defrauded.

     In the notice of deficiency, respondent determined that

petitioners failed to report embezzlement income of $423,850 for

1992, $289,578 for 1993, and $46,700 for 1994.

     In the petition, petitioners asserted that respondent erred

in determining that Phillip received funds by illegal means in

the amounts set forth in the notice of deficiency.    Petitioners

asserted that the money Phillip received in the Ponzi scheme was

not includable in his gross income.     Petitioners asserted in the

alternative that, if the money did constitute gross income, then

petitioners should be allowed a deduction under section 162 in
                              - 13 -

the year of repayment for amounts repaid to Phillip's victims.

Petitioners further asserted in the petition that Phillip

believed that during the calendar years 1992, 1993, and 1994, the

amounts of the repayments exceeded the amounts of funds he

wrongfully used in such years.

     Respondent timely filed an answer, and the case was

scheduled for the trial session commencing April 26, 1999.     On

February 1, 1999, the parties requested and were granted a

continuance because there was not enough time (1) to allow

petitioners to assemble and present all the documentation and

information needed to support their position with respect to

various issues, and (2) for respondent to properly review,

consider, and make a determination with respect to various issues

based upon the documentation and information expected to be

presented by petitioners.

     On January 28, 1999, petitioners' counsel met with Mr.

Fried, the Appeals officer, to discuss the case.   Petitioner's

counsel argued that the embezzlement income should be reduced by

the amounts that Phillip had repaid to the individuals he had

defrauded.   Petitioners' counsel told Mr. Fried that petitioners

would provide evidence of the repayments.   Despite repeated

inquiries and requests from Mr. Fried, petitioners did not

deliver all the promised documents showing the repayments until

November 9, 1999.   Patricia Tyers, a revenue agent, assisted Mr.
                               - 14 -

Fried in reviewing the voluminous documents and information

supplied by petitioners.

     After Mr. Fried and Ms. Tyers reviewed the documents and met

with petitioners' counsel several more times, respondent agreed

to offset the embezzlement income by the amounts repaid to some

of Phillip's victims.   The resulting embezzlement income

adjustments, as reflected in the March 20, 2000, settlement, were

$248,842 for 1992, $147,445 for 1993, and $32,450 for 1994.

     On the issue of the omitted income from Phillip's fraudulent

Ponzi scheme, we conclude that respondent's position was

substantially justified.

     Deductions are a matter of legislative grace, and a taxpayer

bears the burden of proving entitlement to any deduction claimed.

See Deputy v. du Pont, 308 U.S. 488, 493 (1940); Hradesky v.

Commissioner, 540 F.2d 821 (5th Cir. 1976), affg. 65 T.C. 87

(1975).   It is well settled that a taxpayer is required to keep

permanent books of account and records to substantiate the income

and expenses reported on his income tax return.      See sec. 6001;

sec. 1.6001-1(a), Income Tax Regs.      Generally, when a taxpayer

does not produce substantiation of claimed deductions,

disallowance is proper.    See Roberts v. Commissioner, 62 T.C.

834, 836-837 (1974); Amann v. Commissioner, T.C. Memo. 1993-542;

Schnelten v. Commissioner, T.C. Memo. 1993-264.      It is reasonable

for respondent not to concede the adjustments until he has
                               - 15 -

received and verified adequate substantiation for the items in

question.   See Simpson Fin. Servs., Inc. v. Commissioner, T.C.

Memo. 1996-317.    Respondent is given a reasonable period of time

in which to resolve a factual issue after receiving all relevant

information.    See Sokol v. Commissioner, 92 T.C. 760, 765-766

n.10 (1989).

     Respondent's position was that petitioners failed to report

income from Phillip's illegal Ponzi scheme.    That position was

based in fact.    Petitioners did not include the income on their

returns.    The adjustment to income was reduced not because

Phillip received less money than the amounts determined by

respondent, but solely because petitioners finally substantiated

the repayments made by Phillip during the years at issue.      Even

in the petition, petitioners failed to specify the amount of the

repayments made each year and merely asserted that Phillip

believed the repayments equaled the amounts received.    It took

several requests from and meetings with Mr. Fried before all the

voluminous documentation required to substantiate the claimed

deductions was supplied to respondent.    This documentation was

not produced during the examination.

     Petitioners did not supply evidence substantiating their

claim as to the alleged repayments until November 9, 1999, nearly

1 year after respondent filed the answer and over 9 months after

petitioners promised to provide such evidence.    See Harrison v.
                              - 16 -

Commissioner, 854 F.2d 263 (7th Cir. 1988) (concession some 6

months after the answer was filed, after the Government had an

opportunity to verify information, held reasonable), affg. T.C.

Memo. 1987-52; Sliwa v. Commissioner, 839 F.2d 602, 609 (9th Cir.

1988) (reasonable for concession not to have been made until the

IRS had opportunity to review records obtained some 6 months

prior), affg. an unreported opinion of this Court; Ashburn v.

United States, 740 F.2d 843 (11th Cir. 1984) (11-month delay in

conceding case not unreasonable); White v. United States, 740

F.2d 836, 842 (11th Cir. 1984) (Government's concession of issue

3 months after issue raised was reasonable).

     Petitioners suggest that respondent was aware of the

restitution ordered by the State court after Phillip pleaded

guilty to grand theft, and assert, therefore, that respondent

knew that Phillip had made the repayments.   Petitioners'

contention is wanting in logic.   The State court issued the order

in 1995.   Any repayments made as a result of the order were

necessarily made after the years at issue in this case and,

therefore, would not be deductible in the years at issue.   Based

on the facts available to respondent, we find it reasonable for

respondent not to offset the embezzlement income with the alleged

payments until the repayments were substantiated.
                              - 17 -

Fraud Penalty

     Section 6663(a) provides that "If any part of any

underpayment of tax required to be shown on a return is due to

fraud, there shall be added to the tax an amount equal to 75

percent of the portion of the underpayment which is attributable

to fraud."   In the notice of deficiency, respondent determined

section 6663 civil fraud penalties against Phillip, at the

statutory rate of 75 percent of the deficiency attributable to

the 1992, 1993, and 1994 embezzlement income.   In entering the

March 20, 2000, settlement, the parties agreed that Phillip was

liable for the civil fraud penalty under section 6663 at a rate

of 37.5 percent, rather than the statutory 75 percent.

     Respondent asserts that Phillip conceded the fraud penalty.

Petitioners contend that Phillip agreed to permit the assessment

of an amount equal to one-half of the amount of the fraud penalty

but never conceded that the returns were fraudulent.   We think

that by agreeing that Phillip was liable for the fraud penalty,

even at the reduced rate, petitioners have conceded that the

returns were fraudulent.

     Furthermore, a review of the record of this case reveals

that respondent was reasonable in determining that petitioners'

omission of income from the Ponzi scheme was attributable to

fraud.
                              - 18 -

     To establish fraud, respondent had to prove by clear and

convincing evidence that Phillip intended to evade the payment of

taxes.   See sec. 7454(a); Rule 142(a); Traficant v. Commissioner,

884 F.2d 258, 264 (6th Cir. 1989), affg. 89 T.C. 501 (1987).      The

existence of fraud is a factual question to be resolved upon

consideration of the entire record.    See Rowlee v. Commissioner,

80 T.C. 1111, 1123 (1983); Stone v. Commissioner, 56 T.C. 213,

224 (1971).   A taxpayer’s entire course of conduct may establish

the requisite fraudulent intent.    See Rowlee v. Commissioner,

supra; Stone v. Commissioner, supra.     Because fraud can rarely be

established by direct proof of a taxpayer’s intent, fraud may be

proven by circumstantial evidence.     See Rowlee v. Commissioner,

supra.

     Fraud may be inferred from any conduct, the likely effect of

which would be to mislead or conceal.     See Spies v. United

States, 317 U.S. 492, 499 (1943).     The courts have relied on

numerous indicia of fraud in deciding cases under section 6663

and its predecessor section 6653(b) including:     (1) Failure to

report income over an extended period of time; (2) failure to

file a tax return; (3) failure to furnish the Government with

access to records; (4) failure to keep adequate books and

records; (5) engaging in illegal activity; (6) concealment of

bank accounts from an Internal Revenue agent; (7) giving

implausible explanations of conduct; (8) willingness to defraud
                               - 19 -

another in a business transaction; and (9) the taxpayer's

experience and knowledge.   See Solomon v. Commissioner, 732 F.2d

1459, 1461-1462 (6th Cir. 1984), affg. per curiam T.C. Memo.

1982-603; see also Kalo v. Commissioner, T.C. Memo. 1996-482,

affd. without published opinion 149 F.3d 1183 (6th Cir. 1998);

Conti v. Commissioner, T.C. Memo. 1992-616, affd. 39 F.3d 658

(6th Cir. 1994); Zack v. Commissioner, T.C. Memo. 1981-700, affd.

692 F.2d 28 (6th Cir. 1982).

     Respondent should not pursue litigation of a civil fraud

penalty unless he has a reasonable basis for believing that he

could prove fraud by clear and convincing evidence.   See Rutana

v. Commissioner, 88 T.C. 329, 1337-1338 (1987); Don Casey Co. v.

Commissioner, 87 T.C. 847, 862 (1986).   In this case, however, we

think it is highly likely that respondent would have successfully

proved Phillip's fraud by clear and convincing evidence.    Phillip

engaged in the fraudulent Ponzi scheme, defrauded his clients,

failed to report on his tax returns for multiple years the

substantial income received from that illegal activity, and

failed to keep accurate records.   Thus, respondent's position was

substantially justified.

Relief From Joint Liability

     In the petition, Cyndie claimed that she was entitled to

relief under section 6015 and should be relieved of liability for

tax attributable to understatements of taxable income by Phillip.
                              - 20 -

In support of her claim, Cyndie alleged that, at the time of

signing the joint income tax returns for the years in issue, she

did not know and had no reason to know of Phillip's

understatement of tax and that it would be inequitable to hold

her liable for deficiencies attributable to such understatements.

In the answer, respondent denied or denied for lack of sufficient

information Cyndie's factual allegations with respect to her

claim for relief under section 6015.

     On March 15, 2000, respondent's counsel, the Associate

District Counsel, and the Appeals officer interviewed Cyndie for

the first time and evaluated her credibility concerning her

claim.   Prior to this meeting, the parties had devoted most of

their discussions to the issue of the embezzlement income offset.

Cyndie did not supply any evidence to establish her qualification

for section 6015 relief until the meeting on March 15, 2000.

After the 2-hour interview, respondent concluded that Cyndie

qualified for section 6015 relief on all issues (not merely on

that of the embezzlement income) for all years in issue.   The

parties' settlement, signed 5 days later, reflects respondent's

concession on the issue of section 6015 relief.   Petitioners

assert that respondent belatedly conceded the merits of Cyndie's

position.

     Section 6015(a) permits an individual who has filed a joint

return to elect to seek relief from joint and several liability
                                - 21 -

provided the taxpayer meets the requirements of section 6015(b).

The requirements of section 6015(b) that must be met are as

follows:

             (A) a joint return has been made for a taxable
     year;

          (B) on such return there is an understatement of
     tax attributable to erroneous items of 1 individual
     filing the joint return;

          (C) the other individual filing the joint return
     establishes that in signing the return he or she did
     not know, and had no reason to know, that there was
     such understatement;

          (D) taking into account all the facts and
     circumstances, it is inequitable to hold the other
     individual liable for the deficiency in tax for such
     taxable year attributable to such understatement; and

          (E) the other individual elects (in such form as
     the Secretary may prescribe) the benefits of this
     subsection not later than the date which is 2 years
     after the date the Secretary has begun collection
     activities with respect to the individual making the
     election, * * *

     Thus, as pertinent here, Cyndie would not be relieved from

joint and several liability under section 6015(b) to the extent

she had actual knowledge, or reason to know, that there was

income from Phillip's Ponzi scheme that was omitted from the

1992, 1993, and 1994 joint returns.      Where relief is requested

with respect to the omission of income (the situation involved

herein), this Court has concluded that, where a spouse seeking

relief has actual knowledge of the underlying transaction that

produced the omitted income, section 6015 relief is denied.      See
                              - 22 -

Cheshire v. Commissioner, 115 T.C. 183 (2000).

     It was Cyndie's burden to prove that she was entitled to

relief under section 6015.   The determination of the

applicability of section 6015 can only be made through an

examination of all the facts and circumstances of the case,

including an assessment of the credibility of the spouse claiming

relief under section 6015.   We think that respondent was

reasonable in requiring more evidence than Cyndie's mere

assertions of eligibility for section 6015 relief or at least

some independent corroboration of those assertions.     See Sliwa v.

Commissioner, 839 F.2d at 608.   Respondent was not required to

concede this case before receiving the documentation necessary to

prove Cyndie's contentions, particularly when there were

credibility issues to be resolved.     See Brice v. Commissioner,

T.C. Memo. 1990-355, affd. without published opinion 940 F.2d 667

(9th Cir. 1991).

     We find nothing in the record that indicates that Cyndie

produced anything other than an assertion of her eligibility.

During the years in issue, Cyndie and Phillip maintained at least

three joint checking accounts into which Phillip deposited some

of the funds received from his fraudulent scheme.    He deposited

$101,800 into the joint accounts in 1992, $359,378 in 1993, and

$33,700 in 1994.
                              - 23 -

     Furthermore, the notice of deficiency asserts a delinquency

penalty for the tax years 1992, 1993, and 1994.   The explanation

indicates that the 1992 return, due October 15, 1993, was not

filed until January 7, 1994; the 1993 return, due October 15,

1994, was not filed until October 19, 1995; and the 1994 return,

due October 15, 1995, was not filed until November 27, 1995.

Phillip was charged on March 30, 1995, with grand theft from the

operation of his Ponzi scheme.   On April 28, 1995, having entered

a guilty plea to the charges, the State court sentenced Phillip

to 2 years in prison and ordered him to pay $468,834 in

restitution.   Absent more than Cyndie's mere assertion of

eligibility for relief under section 6015, it seems highly

unlikely that Cyndie did not know about Phillip's Ponzi scheme

when she signed the returns for the tax years 1993 and 1994 after

Phillip was sentenced by the State court.

     Given the information available to respondent, including the

fact that Phillip deposited funds received from his criminal

activity into petitioners' joint checking accounts throughout the

years in issue, and the joint returns for 1993 and 1994 were

filed after Phillip was convicted on the State theft charges, we

find respondent's position reasonable and substantially

justified.   It is inappropriate to award petitioners litigation

costs attributable to Cyndie's section 6015 claim for relief

under these circumstances.   See Krafsky v. Commissioner, T.C.
                               - 24 -

Memo. 1991-579; Creske v. Commissioner, T.C. Memo. 1990-318,

affd. 946 F.2d 43 (7th Cir. 1991).

Schedule E Losses

     In the notice of deficiency, respondent disallowed

deductions for Schedule E losses in the amounts of $39,002 for

1992, $72,886 for 1993, and $93,116 for 1994 that primarily were

attributable to the O'Bryon Co.    Respondent based the

determination on the fact that petitioners had failed to

establish that the losses were sustained or that, if such losses

were sustained, they were deductible losses under any provision

of the Code.    In particular, petitioners failed to establish that

Phillip had sufficient basis in the S corporation stock to allow

the losses claimed.

     During the audit, petitioners provided respondent with a

copy of the O'Bryon Co.'s filed tax return for 1992.      Respondent

refused to accept the return as sufficient evidence of Phillip's

basis in the stock.    During their settlement negotiations, in

order to establish Phillip's basis in the stock, petitioners

provided Mr. Fried with a copy of the O'Bryon Co.'s unfiled 1993

tax return.    Although no evidence was produced to show how

Phillip's basis in the corporation was calculated, Mr. Fried

accepted both tax returns for the purpose of establishing

Phillip's basis in the company.    Petitioners, however, failed to

provide any evidence to establish that they had sufficient basis
                              - 25 -

for 1994.   In the parties' settlement, respondent conceded the

1992 and 1993 Schedule E loss deductions but disallowed a

deduction for the 1994 Schedule E loss.

     Although Mr. Fried agreed to accept the 1992 and 1993 tax

returns for the O'Bryon Co. for the purpose of establishing

Phillip's basis, we hardly think those returns, by themselves,

were sufficient for that purpose.   A reasonable person would

doubt the credibility of the tax returns supplied, considering

that Phillip, as its sole shareholder, used the O'Bryon Co. as a

vehicle to engage in fraudulent activities.

     In addition, petitioners failed to provide any evidence

establishing Phillip's 1994 basis in the company.   Petitioners

contend that they produced documentation establishing the 1994

basis on March 16, 2000, but that a failure in communication

between respondent's Appeals officer and counsel resulted in

petitioners' reluctant concession of the Schedule E deductions

for that year.   Petitioners' argument is unpersuasive, especially

in light of the tardiness of the alleged production.

     No evidence was produced to support the particular items

claimed on the corporation's return or to show how Phillip's

basis in the corporation was calculated.   Whenever there is a

factual determination with respect to a tax return, respondent is

not obliged to concede the case until the necessary documentation

is received to prove the taxpayer's contentions and claims.     See
                               - 26 -

Sokol v. Commissioner, 92 T.C. 760, 765-766 n.10 (1989); Sher v.

Commissioner, 89 T.C. 79, 87 (1989); DeVenney v. Commissioner, 85

T.C. 927 (1985); see also Johnson v. Commissioner, T.C. Memo.

1991-447; Spirtis v. Commissioner, T.C. Memo. 1985-44.

     The fact that respondent's counsel ultimately decided to

concede the case may reflect a consideration of a variety of

factors--including litigation risks--which earlier were not

considered or which were not weighed as heavily by respondent.

Furthermore, the record shows that the parties were actively

engaged in negotiations throughout the litigation process, and

that respondent did not unreasonably delay acting upon any

information which he received from petitioners.

     Accordingly, we find respondent's position denying Schedule

E loss deductions for the tax years 1992 through 1994 reasonable

and substantially justified.

Deductions for Losses Arising From Diplomat Associates

     The parties disagreed as to whether petitioners were

entitled to claim a deduction for section 1231 loss resulting

from an unsuccessful operation of Diplomat Associates, an

accrual-method partnership that Phillip and his associates formed

in 1986 in order to engage in an apartment rental business.

Diplomat Associates purchased an apartment building for

approximately $1.4 million, the cost of which was financed in

large part by a mortgage made to the partnership.
                              - 27 -

     In 1990, Diplomat Associates, then a two-person partnership,

defaulted on its mortgage notes.   The creditor, a mortgage lender

unrelated to either partner, foreclosed upon the apartment

building.   On May 30, 1991, the building was sold at auction for

$544,000.   Subsequently, the creditor obtained a deficiency

judgment of approximately $870,000 against Diplomat Associates

and its two partners on the outstanding balance of the notes.     By

the end of 1991, Diplomat Associates had no assets and only a

liability for the unpaid balance of the notes.

     Diplomat Associates filed a return for 1991, purporting to

be a final return.   On that return, Diplomat Associates reported

a section 1231 loss of $352,061, the difference between the

partnership's remaining tax basis in the property ($896,061) and

the foreclosure sale price.   On his 1991 tax return, Phillip

claimed a deduction for $176,031, one-half of the loss.

     In the notice of deficiency, respondent disallowed the

entire section 1231 loss deduction on the ground that Phillip had

not disposed of his entire interest in Diplomat Associates within

the meaning of section 469(g).   Additionally, in the notice of

deficiency, respondent disallowed net operating loss (NOL)

deductions of $32,322 for 1992, $70,982 for 1993, and $89,466 for

1994.   The NOL deductions were attributed to suspended passive

activity losses from Diplomat Associates carried over from years

prior to 1991.   Respondent disallowed each NOL deduction on the
                              - 28 -

ground that Phillip's partnership interest had not been fully

disposed of at the end of each year in issue.

     Petitioners' representative submitted a protest dated

January 2, 1996, claiming that the partnership had ceased to

exist at the end of 1991, and that Phillip had disposed of his

entire interest in the partnership.    Respondent dismissed the

argument and maintained the position that Phillip had not

completely disposed of his partnership interest.    Respondent

conceded this issue, however, after petitioners' counsel

presented the same argument and resubmitted the January 2, 1996,

protest.   The parties' settlement of March 20, 2000, reflects

this concession by respondent.

     Section 469 limits a taxpayer's ability to deduct losses

from passive activities.   Generally, a taxpayer may deduct losses

from passive activities from income from passive activities only

and may not use such losses to offset income from nonpassive

activities.   See sec. 469(a), (d).    Passive activity includes any

rental activity.   See sec. 469(c)(2).

     Section 469(g)(1) provides for an exception to this passive

activity loss disallowance rule:   If the taxpayer disposes of his

or her entire interest in any passive activity in a fully taxable

transaction between unrelated parties, any loss from that

activity is not treated as from a passive activity.
                               - 29 -

     Diplomat Associates engaged in an apartment rental activity,

and its partners were subject to the section 469 disallowance

rule.    Phillip could not deduct any loss incurred by Diplomat

Associates unless he disposed of his entire interest in the

partnership in a fully taxable transaction.

     Petitioners assert that respondent was not substantially

justified, because respondent conceded the issue on the basis of

the same argument petitioners submitted in the audit.

     Respondent took the position that Phillip did not dispose of

his entire interest in the partnership because the outstanding

balance of the loan remained unpaid.    Respondent asserts that the

partnership did not report any income from the discharge of

indebtedness.    Respondent, however, did not determine in the

notice of deficiency that the partnership had cancellation of

indebtedness.    Nor did respondent raise that issue in the answer

to the petition.    Respondent has not provided the Court with

petitioners' legal argument that was first rejected and then

accepted.    Respondent has not provided any legal argument or

authority supporting his position that Phillip had not disposed

of his entire interest in the partnership.

        We find that respondent has not established that he was

substantially justified in taking the position that Phillip had

not disposed of his entire interest in the partnership.

Therefore, we shall allow attorney's fees related to this issue.
                               - 30 -

Miscellaneous Schedule C Deductions

     In the notice of deficiency, respondent disallowed a number

of Schedule C deductions that petitioners claimed on their 1991

and 1992 tax returns.    They include investment losses, interest

expenses, travel expenses, commission expenses, and dues.     In the

March 20, 2000, settlement, petitioners conceded these deductions

in full.    We conclude that respondent's position was

substantially justified.

Amount of Reasonable Attorney's Fees and Costs

     We now consider the amount of costs that petitioners may

recover.    Petitioners were the prevailing party with respect to

issues involving the deductibility of losses from Diplomat

Associates.    They were not, however, the prevailing party with

respect to any other issues.

     Administrative costs are those incurred in connection with

an administrative proceeding within the IRS.     Sec. 7430(a)(1),

(c)(2).    Reasonable administrative costs consist of any fees or

expenses imposed by the IRS, the reasonable expenses of necessary

expert witnesses, the reasonable cost of any necessary study,

analysis or report and reasonable fees paid or incurred for the

services of attorneys.    See sec. 7430(c)(2).   Attorney's fees are

those "for the services of an individual (whether or not an

attorney) who is authorized to practice before the Tax Court or

before the [IRS]".    Sec. 7430(c)(3).
                              - 31 -

     For costs incurred on or before January 18, 1999, reasonable

administrative costs include only those costs incurred on or

after the earlier of (1) the date of the receipt by taxpayer of

the notice of decision of the IRS Office of Appeals, or (2) the

date of the notice of deficiency.   See sec. 7430(c)(2).

     Litigation costs are those incurred in connection with a

judicial proceeding.   See sec. 7430(a)(2), (c)(1).   Reasonable

litigation costs consist of reasonable court costs, the

reasonable expenses of necessary expert witnesses, the reasonable

cost of any necessary study, analysis or report, and reasonable

fees paid or incurred for the services of attorneys.    See sec.

7430(c)(1).

     Rule 232(d)(1) requires that, if the parties disagree as to

the reasonable amount of attorney's fees, counsel for the party

moving for such fees and costs submit, among others, a detailed

summary of the time expended by each individual for whom fees are

sought, including a description of the nature of the services

performed during each period of time summarized.

     The billing statements, in large part, do not indicate on

which of the issues each of the attorneys and the paralegal

worked in each time period.   Accordingly, we approximate

petitioners' costs incurred in connection with the Diplomat

Associates losses, bearing heavily against petitioners whose

inexactitude is of their own making.   See Cohan v. Commissioner,
                               - 32 -

39 F.2d 540, 544 (2d Cir. 1930); see also Malamed v.

Commissioner, T.C. Memo. 1993-1 (quoting Cohan in the section

7430 context).

     First, petitioners may not recover for attorney's fees and

costs incurred before June 24, 1998, the date of the notice of

deficiency.    See sec. 7420(c)(2).   Second, petitioners may

recover reasonable fees and reasonable costs specifically and

clearly incurred in connection with the Diplomat Associates

issues.   Third, petitioners may not recover fees and costs

clearly unrelated to the Diplomat Associates issues.     Fourth,

petitioners may recover only a portion of the remaining fees and

costs for which specific issues were not identified.

Attorney's Fees

     Petitioners' counsel submitted a billing statement showing

the amount of time each of attorneys Frederic N. Widen, Caleb J.

McArthur, Randy S. Newman, and M. Collette Gibbons expended in

representing petitioners in both the administrative and the court

proceedings.

     The billing statement indicates that Mr. Widen's hourly rate

was $275 from 1998 to January 28, 1999, $280 from March 17, 1999,

through January 28, 2000, and $290 from February 4, 2000, through

March 20, 2000; that Mr. McArthur's rate was $110 throughout

1998; that Mr. Newman's rate was $120 from March 31, 1999,

through September 13, 1999 and $130 from February 4, through
                               - 33 -

March 17, 2000; and that Ms. Gibbons' rate was $265 on March 7,

2000.

     Absent special factors, an award relating to attorney’s fees

incurred in 1998 is limited to $120 per hour; for calendar year

1999, the attorney fee award limitation under section

7430(c)(1)(B)(iii) is $120 per hour for fees incurred on or

before January 18, 1999 and $130 per hour for fees incurred after

January 18, 1999; and for fees incurred in the calendar year

2000, the attorney fee award limitation is $140 per hour.     See

sec. 7430(c); Rev. Proc. 97-57, 1997-2 C.B. 584; Rev. Proc. 98-

61, 1998-2 C.B. 811; Rev. Proc. 99-42, 1999-46 I.R.B. 568.

     We find that no special factor justifies awarding fees for

attorneys' services at an hourly rate greater than the statutory

limit.   Accordingly, we limit Mr. Widen's and Ms. Gibbons' hourly

rate to the $120, $130, and $140 for pertinent periods.   We note

that Mr. McArthur's and Mr. Newman's hourly rates were under the

statutory caps and find them reasonable.

     Mr. Widen billed 1.8 hours for services provided prior to

the date of notice of deficiency, June 24, 1998.   Those fees are

not recoverable.    See sec. 7430(c)(2).

     In late January 2000, respondent notified petitioners'

counsel that he anticipated that he would concede the Diplomat

Associates issue.   By early March 2000 a final settlement had not

been reached.   Respondent and petitioners included a discussion
                               - 34 -

of the Diplomat Associates issue in their trial memoranda.   Time

billed after January 2000 until early March (25.3 hours) when the

attorneys began preparing the trial memoranda is unrelated to the

Diplomat Associates issue, and attorney's fees for that period

will not be awarded.    Some fees billed for time after early March

are related to general matters that include in part the Diplomat

Associates issue.   Such time is related to the preparation of the

trial memorandum, meetings with respondent's counsel to discuss

the final settlement, and attendance at the call of the calendar

at the trial session.   Time related to the attorneys' effort to

secure petitioners' payment of the attorney's fees, however, is

not related to the Diplomat Associates issue.

     Petitioners' attorneys billed the following hours

aggregating 52.9 hours for work unrelated to the Diplomat

Associates issue:
                             - 35 -

        Date         Hours              Description
     12/03/1997 to
       3/05/1998      1.8     Prior to notice of deficiency
      8/28/1998       0.8     No description
      8/31/1998       0.9     Research embezzlement income used
                              to repay prior embezzled funds
      3/17/1999       0.5     Review IRS letter re: 1998, 1989
      3/23/1999       0.1     Intra office conference regarding
                              protest
      8/20/1999       0.6     Review spreadsheet
     10/11/1999       0.1     Telephone call requesting data
     10/19/1999       0.8     Review data submitted by client
     11/08/1999       0.2     No description
     11/30/1999       1       Meeting with Tyers regarding
                              examination of books
     12/02/1999       1       Meeting with IRS agent
     12/03/1999       1       Meeting with IRS agent
      1/12/2000       0.4     Telephone conference re: cash flow
                              issues
      2/04/2000 to
       3/01/2000     25.3     After respondent conceded issue
      3/02/2000       1       Research trade or business
      3/07/2000       0.3     Conference regarding pledge of
                              account receivable to secure fees
      3/08/2000       3.5     Fee and security agreement
      3/11/2000       0.3     Security agreement and financing
                              statements
      3/13/2000       2.5     Research fraud penalty
      3/14/2000       1.2     Telephone conference with Cyndie
      3/14/2000       2       Research fraud
      3/15/2000       4       Meeting with Cyndie, IRS
      3/15/2000       2       Meeting with IRS re: section 6015
      3/17/2000       1.5     Research collateral estoppel
      3/20/2000       0.1     Telephone call to State of Ohio
      Total hours    52.9

     We do not award fees for these 52.9 hours.

     Petitioners' attorneys billed 116.8 hours on general

matters, such as reviewing the notice of deficiency, drafting the

petition, preparing the trial memorandum, meeting with

respondent's counsel to discuss the final settlement, and

reviewing the final settlement, that do not identify the amount
                             - 36 -

time specifically related to the Diplomat Associates issue.   Of

the hours specifically identified as relating to a specific issue

(either specifically related to Diplomat Associates or

specifically not related to Diplomat Associates) approximately 20

percent of the time was related to the Diplomat Associates issue.

Therefore, we shall allow petitioners 20 percent of the

attorney's fees related to general matters.

     The hours provided by each attorney by category are as

follows:
                                           - 37 -


Category/          Prior to      6/24/1998 to           1/19/1999 to                1/1/2000 to
Attorney          6/24/1998        1/18/1999              12/31/1999                 3/20/2000
Disallowed (0%)
Widen                1.8      -0-    120    -0-      5.3    $130    -0-      23.5    $140    -0-
McArthur             –-       1.7    110    -0-      –-      –-     --        –-      –-      –-
Newman               –-       –-     –-      --      -0-     120    -0-      20.3     130    -0-
Gibbons              –-       –-     –-      –-      –-      –-     –-        0.3     140    -0-
Total                1.8      1.7    –-     -0-      5.3     –-     -0-      44.1     –-     -0-
Diplomat(100%)
Widen                --       -0-    120     -0-     1.8    130     $234      1       140   $140
McArthur             --       1.4    110    $154     –-     –-       –-       –-      –-      –-
Newman               --       –-     –-       –-     8      120      960     -0-      130    -0-
Total                --       1.4    –-      154     9.8    –-     1,194      1       –-     140
General (20%)
Widen                --       25.8   120    619.20   29.8   130     774.80   34.4     140     963.20
McArthur             --       17.1   110    376.20    –-    –-      –-        –-      –-       –-
Newman               --        –-    –-      –-       1.5   120      36       8.2     130     213.20
Total                --       42.9   –-     995.40   31.3   –-      810.80   42.6     –-    1,176.40
                                - 38 -


     Dates                            Hours     Fees Allowed

 Disallowed
   Prior to 6/24/1998                  1.8           -0-
   6/24/1998 to 1/18/1999              1.7
   1/19/1999 to 12/31/1999             5.3
   1/1/2000 to 3/20/2000              44.1
 Diplomat(100%)
   6/24/1998 to 1/18/1999                1.4         $154
   1/19/1999 to 12/31/1999               9.8        1,194
   1/1/2000 to 3/20/2000                 1            140
 General
   6/24/1998 to 1/18/1999             42.9            995.40
   1/19/1999 to 12/31/1999            31.3            810.80
   1/1/2000 to 3/20/2000              42.6          1,176.40
  Total attorney fees allowed                       4,470.60

Costs

     Petitioners provided a billing statement for costs of

$716.63.     A charge of $1.88 is attributable to a long distance

telephone call made February 25, 1998, prior to the issuance of

the notice of deficiency.     That cost is disallowed.

     The costs include $6.25 for "Copy of judgment liens" filed

with the county recorder and common pleas court dated March 17,

2000, and $426.86 for "Lexis/Westlaw" dated March 31, 2000.       The

judgment liens are to protect the attorneys' ability to collect

their fees and are unrelated to the issues in this case.

Additionally, the time sheets indicate that all of the legal

research conducted during the year 2000 was unrelated to the

Diplomat issue.     Therefore, we allow petitioners none of the

costs for judgment liens or "Lexis/Westlaw".
                               - 39 -

     The remaining costs of $281.64 are not clearly related to

the Diplomat issue.    Therefore, we shall allow petitioners 20

percent ($56.33) of those costs.

     Petitioners incurred costs $1,053 for 7.8 hours of paralegal

services billed at the rate of $135 per hour from October 8 to

December 3, 1998.    This Court has awarded fees for paralegals and

law clerks.2   See Powers v. Commissioner, 100 T.C. 457, 493

(1993), revd. on other grounds 43 F.3d 172 (5th Cir. 1995);

Malamed v. Commissioner, T.C. Memo. 1993-1.      Nevertheless, we

find the $135 hourly rate, which is higher than those for some of

the attorneys, unreasonable.    Considering that most of the

paralegal work consisted of filing and document organization, we

reduce the hourly billing rate to $60, one-half of the attorney

rate.    See, e.g., Powers v. Commissioner, supra; Pietro v.

Commissioner, T.C. Memo. 1999-383.      Additionally, since the only

documents petitioners provided respondent to support the

deductions related to the Diplomat issue was a copy of their

legal argument, the paralegal work was related primarily to other

issues.    Therefore, we shall allocate only 10 percent of the

paralegal time ($46.80) to the Diplomat issue.



     2
      Counsel for petitioners included hourly fees for services
provided by a paralegal in the statement for attorney's fees. We
award attorney's fees only to attorneys as defined in sec.
7430(c)(3). See also Rules 200, 230(b)(7). We consider
paralegal fees as part of the costs or expenses but not as
attorney's fees.
                              - 40 -

     Thus, we allow petitioners the following reasonable costs:

          Item                        Cost          Cost Allowed

     2/25/98 telephone call           $1.88             -0-
     Lexis/Westlaw                   426.86             -0-
     Liens                             6.25             -0-
     General costs                   281.64            $56.33
     Paralegal                     1,053.00             46.80
        Total                                          103.13

     Accordingly, we award petitioners $4,470.60 for attorney's

fees and $103.13 for expenses and costs.

     To reflect the foregoing,

                                             An appropriate order and

                                 decision will be entered.
