                                  T.C. Memo. 1996-318



                            UNITED STATES TAX COURT



         CHARLES R. BOWDEN AND SUE I. BOWDEN, Petitioners v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



       Docket No. 14318-93.                                  Filed July 15, 1996.



       Charles R. Bowden and Sue I. Bowden, pro sese.

       Lisa W. Kuo, for respondent.



                    MEMORANDUM FINDINGS OF FACT AND OPINION

       GERBER, Judge:       Respondent determined deficiencies in and

additions to petitioners’ Federal income tax, and an accuracy-

related penalty as follows:

                                    Additions to Tax                         Penalty
                        Sec.           Sec.            Sec.          Sec.      Sec.
Year   Deficiency    6651(a)(1)    6653(a)(1)(A)   6653(a)(1)(B)     6661     6662(a)
                                                        1
1986    $41,891      $10,473        $2,095                         $10,473      ---
1989     42,764       10,691          ---              ---          ---       $8,553
                                       - 2 -

     1
         50 percent of the interest due on $41,891.

     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, unless otherwise

indicated.

     After concessions, the issues remaining for our

consideration are:        (1) Whether petitioners are entitled to

depreciation deductions of $154,986 and $207,060 for their 1986

and 1989 taxable years, respectively; (2) whether petitioners are

entitled to other Schedule C deductions for 1986 and 1989;

(3) whether petitioners failed to include income of $163,001 and

$72,817 received during their 1986 and 1989 tax years,

respectively; (4) whether petitioners are liable for self-

employment tax on any part of the $163,001 and $72,817 amounts;

(5) whether petitioners are liable for an addition to tax for

negligence under section 6653(a)(1)(A) and (B) for 1986 and the

accuracy-related penalty under section 6662(a) for 1989; (6)

whether petitioners are liable for the substantial understatement

addition to tax under section 6661 for 1986, and (7) whether

petitioners are liable for the late filing addition to tax under

section 6651(a)(1) for 1986 and 1989.1


     1
       The notice of deficiency reflects an investment tax credit
carryforward issue involving $98,660 for 1986. Since the time of
the pleadings, the parties have not addressed this issue.
Therefore, for purposes of this case, the investment tax credit
                                                   (continued...)
                               - 3 -


                         FINDINGS OF FACT2

     Petitioners resided in Laguna Hills, California, at the time

their petition was filed.   Petitioners’ 1986 Federal income tax

return was filed on July 29, 1988.     Petitioners' 1989 Federal

income tax return was filed during October 1990.3     Charles R.

Bowden and Sue I. Bowden were the sole officers and shareholders

of approximately 12 corporations.4     Petitioners and their

corporations were primarily engaged in the business of buying,

selling, financing, and operating water vending machines (vending

machines).   These vending machines purified water by reverse

osmosis.

     Mr. Bowden, as president of each corporation (with the

exception of C.B. Crest), managed the salespeople, promoted



     1
      (...continued)
carryforward issue is deemed conceded by petitioners.     See Rule
142.
     2
       The parties’ stipulations of facts and exhibits are
incorporated by this reference.
     3
       The filing date on petitioners’ 1989 return is clear as to
the month and year (Oct.--1990) but the exact day is not clear.
Petitioners signed their 1989 return on Oct. 14, 1990.
     4
       For our purposes, the corporations involved in this case
included but were not limited to: (1) Purified Water Inv. Corp.
(PWIC); (2) Purified Water Manufacturing Corp. (PWMC); (3)
Aqualator Vending Corp. (AVC); (4) Aqualator Intl. Corp. (AIC);
(5) Aqualator Serv. Corp. (ASC); (6) Aqualator Manufacturing
Corp. (AMC); (7) Aqualator R&D Corp. (Aqualator R&D); (8) C.B.
Crest, Inc. (C.B. Crest); (9) Septech, Inc. (Septech); (10) Pac-
Tech Capital Corp. (Pac-Tech); and (11) The Water Doctor, Inc.
(Water Doctor, Inc.).
                                   - 4 -


public relations, and arranged and negotiated various financing

agreements with financial institutions concerning the vending

machines.       Mr. Bowden was named president and secretary of PWIC

on April 10, 1987.

        As a corporate officer, Mrs. Bowden’s primary activity was

to maintain the corporate bank accounts by reviewing the cash

balances on a daily basis.       She also performed such tasks as the

disbursing of funds, signing of checks, and transferring of funds

between corporate accounts.       Mrs. Bowden held the position of

president of C.B. Crest, and she was president, secretary, and

chief financial officer of PWIC from June 11, 1985, until April

10, 1987.

        Mr. Bowden had worked as an accountant, controller, and

management consultant before becoming self-employed.       He received

a bachelor's of business administration in accounting and a

master of sciences in accounting.       However, he had not practiced

as an accountant for many years.       Mrs. Bowden is a bookkeeper.

PWIC and PWMC

        Petitioners incorporated PWIC and PWMC for the purpose of

consolidating the operations of AVC, ASC, AIC, and Aqualator

R&D.5       In connection with the consolidation, the Aqualator

corporations were not dissolved.       PWIC was on a fiscal year

ending April 30.

        5
            Collectively referred to as the Aqualator corporations.
                                - 5 -


     During its 1986 fiscal year, PWIC leased and occasionally

sold vending machines for home, office, and commercial water

purification use.   During 1986, PWIC operated 490 vending

machines and collected the revenues and incurred expenses in

connection with the machines.
                                       - 6 -


        During the years under consideration, PWIC made payments to

petitioners and paid certain of their expenses, as follows:

Payee                    Amount       Stated Reason         Date

Mrs. Bowden               $6,700.00    Auto expenditures         June 1986

Mrs. Bowden                  579.92    Entertainment             July 1986

Transamerica Occidental    1,500.00    Life Ins. policy          July 1986
 Life Ins. Co.                          for Mr. Bowden

Mrs. Bowden                  700.00    Travel                    Oct. 1986

Mrs. Bowden                  500.00    Interco-Aqualator Serv.   Oct. 1986

Transamerica Occidental    1,500.00    Life Ins. policy          Nov. 1986
 Life Ins. Co.                          for Mr. Bowden

Crocker Natl. Bank        11,495.98    For Mrs. Bowden             1986

Pentech Financial Servs. 1,590.00      For Mrs. Bowden             1986

San Bernardino County        353.00    For Mrs. Bowden             1986
 tax collector

Mrs. Bowden               12,346.67    Unidentified                1986

Mr. Bowden                   399.56    Entertainment             Dec. 1986

Mrs. Bowden                  500.00    Consulting fee            Dec. 1986

VISA                       7,314.58    Mr. Bowden’s                1986
                                        credit card bill

American Express             447.63    Mr. Bowden’s                1986
                                        credit card bill

American Express           4,548.81    Mr. Bowden’s                1989
                                        credit card bill

American Express           3,858.61    Mr. Bowden’s                1989
                                        credit card bill

Newport Vending1          44,250.00    Mrs. Bowden                 1989

Mrs. Bowden                4,100.00    Salary                      1989
        1
        Newport Vending is a partnership between Mr. Bowden's brother, Hollis
Bowden, and Cathy M. Smith Handel, Mrs. Bowden's daughter.

        Petitioners provided respondent with PWIC’s general ledgers

for the periods:        (1) May 1 through December 31, 1986;
                                     - 7 -


(2) January 1 through May 21, 1989; and (3) the month of October

1989.   Petitioners did not provide respondent with PWIC’s general

ledgers for the periods:         (1) June 1 through September 30, 1989;

and (2) November 1 through December 31, 1989.

     Petitioners provided respondent with PWIC’s canceled checks

from May 29 through December 31, 1986.          Petitioners did not

provide respondent with PWIC’s canceled checks from January 1

through December 31, 1989.

C.B. Crest

     Petitioners purchased C.B. Crest with the intention of

consolidating or merging the Aqualator corporations into it.          No

consolidation or merger took place.

     During the 1989 fiscal year, C.B. Crest used the assets of

the Aqualator corporations.        C.B. Crest rented out and

occasionally sold vending machines, as well as home, office, and

commercial water purification systems.          In 1989, C.B. Crest

operated (including collecting the revenues and paying the

expenses) 551 water vending machines.

     C.B. Crest paid petitioners the following amounts during the

taxable year 1989:

        Payee        Amount           Reason           Date

    Mrs. Bowden   $16,710.83         Unidentified    Jan.-July 1989

    Mrs. Bowden        105.04        Postage         Jan. 1989

    Mrs. Bowden        127.02        Rent            July 1989

    Mrs. Bowden      51,679.84       Salary          Jan.-July 1989
                                     - 8 -


    Mr. Bowden       17,479.84       Salary         Jan.-July 1989

     Petitioners provided respondent with C.B. Crest’s general

ledgers for the periods:         (1) January 1 through July 31, 1989;

(2) parts of the month of August 1989; and (3) the month of

October 1989.    Petitioners did not provide respondent with C.B.

Crest’s general ledgers for:         (1) Parts of the month of August

1989, and (2) the months of September, November, and December

1989.   Petitioners provided respondent with C.B. Crest’s canceled

checks for January 1 through July 26, 1989.

Aqualator Vending Corp. (AVC)

     Between January 1 and June 31, 1986, Mrs. Bowden received

$1,500 from AVC.   The amount was paid in five checks.

Petitioners provided respondent with AVC’s general ledgers for

January 1 through July 31, 1986.         Petitioners did not provide

respondent with AVC’s general ledgers for the periods:

(1) August 1 through December 31, 1986; and (2) January 1 through

December 31, 1989.

     Petitioners did not provide respondent with AVC's canceled

checks for the periods:     (1) May 17 through December 31, 1986;

and (2) January 1 through December 31, 1989.

Transactions

     During the years under consideration, petitioners and their

various corporations were involved in transactions with Ocean

Leasing (Ocean Leasing), MDFC Equipment Leasing Corp. (MDFC),
                                - 9 -


Bank of Whittier, National Bank of Southern California (NBSC),

Southern Pacific Thrift and Loan (Southern Pacific), and

Concordia Federal Bank for Savings (Concordia Bank).    Each of

these entities lent funds to petitioners and their corporations.

Mr. Bowden was personally involved in the negotiations and

arrangements for the loan transactions.    Petitioners were

involved in about 200 lawsuits involving their corporations,

vending and water purifier activity, and loans.

     1.   Ocean Leasing

     In 1983, petitioners, through their proprietorship, Vista

Vending, entered into an agreement to lease two vending machines

from Ocean Leasing.    Originally, AVC sold the vending machines to

Ocean Leasing.    Petitioners claimed a $6,996 depreciation

deduction for the vending machines on their Schedule C for Vista

Vending on the 1984 and 1985 tax returns.

     2.   MDFC

     On September 12, 1984, AIC and Septech, petitioners’

corporations, entered into a transaction with a company, MDFC.

This transaction involved 10 vending machines.    On the same date,

MDFC paid $167,000 to Septech for the 10 vending machines, and

then leased them to AIC for a 60-month period.    At the end of the

lease, AIC had the option to purchase the machines for fair

market value.    Prior to the MDFC lease, Septech sold the 10
                                - 10 -


vending machines to AIC.    When the MDFC lease occurred, AIC gave

the same 10 vending machines to Septech to sell to MDFC.

     In 1986, MDFC sued petitioners and their corporations for

defaulting on the MDFC lease.    On August 27, 1986, a settlement

favoring MDFC was entered by the California superior court.

Under the settlement, MDFC was to receive:    (1) $199,000, (2)

possession of the 10 vending machines in question, and (3) a

second priority judgment lien on property owned by petitioners in

San Bernardino County.   The $199,000 was payable $10,000 on or

before July 15, 1986, and $3,150 per month for 60 months,

beginning August 1, 1986.    During October 1989, MDFC filed papers

in court reflecting full satisfaction of the settlement in the

California superior court.

     On September 20, 1989, MDFC’s lawyers wrote to Arthur Handel

(Mr. Handel), petitioners’ attorney, indicating that upon the

payment of the personal property taxes escrow amounts, “your

client will be the owner of the Aqualator vending machines

originally leased.”   On October 18, 1994, MDFC informed Mr.

Bowden by letter that he was entitled to possession of the 10

vending machines as part of the satisfaction of judgment between

MDFC and AIC.   MDFC also stated that it did not take possession

of the vending machines.    MDFC by an October 25, 1994, letter

advised respondent’s agents that MDFC’s judgment against AIC and

petitioners had been fully satisfied on September 6, 1989.     As a
                                 - 11 -


result of the satisfaction, petitioners retained possession and

title to the equipment.

     3.     Bank of Whittier

     On August 20, 1985, the Bank of Whittier loaned petitioners

$250,000.     On January 15, 1986, petitioners gave the Bank of

Whittier a security interest in 16 vending machines to secure the

loan.     The Bank of Whittier caused notice of the security

interest to be filed under provisions of the California Uniform

Commercial Code.     According to the security interest documents,

petitioners’ corporations owned the vending machines.     The loan

was guaranteed by the corporations and, ultimately, was

defaulted.

     On February 24, 1986, petitioners and the Bank of Whittier

agreed that the $241,066.01 unpaid principal loan balance would

be satisfied from a new loan to be issued to Mrs. Bowden and

guaranteed by Mr. Bowden.      In turn, the Bank of Whittier released

all corporate guaranties and assigned its security interest in

the 16 vending machines to Mrs. Bowden.     Also pursuant to the

same agreement, Mrs. Bowden assigned her one-third interest in

LBJ Properties to the Bank of Whittier.6     The settlement

agreement is silent as to the ownership of the vending machines.

Payments on this loan were made by petitioners individually and


     6
       The record does not otherwise divulge further information
about LBJ Properties.
                              - 12 -


by their corporations.   As of the time of the commencement of

this case, the new loan to Mrs. Bowden remained outstanding.

     4.   NBSC

     In 1985 and 1986, petitioners’ corporation Pac-Tech obtained

a loan from NBSC.   NBSC took, as security, assignments on a

number of the vending machine leases.7    Funds were disbursed to

Pac-Tech in return for the assignments.    Pac-Tech defaulted on

the notes.

     On February 24, 1986, petitioners agreed with NBSC to pay

the outstanding loan balance of $442,595.29 with a new loan

issued to Mrs. Bowden and guaranteed by Mr. Bowden.    Mrs. Bowden

assigned her interest in the 1 Crestwood Drive, Newport Beach

property (Crestwood property) to NBSC via a deed of trust.     In

return, NBSC agreed to release all corporate guaranties.

Paragraph 6 of the settlement agreement states:

     Bank will release to Hollis Bowden its security
     interest in 41 water vending machines and 3rd party
     leases presently held as collateral for the original
     obligation.

On February 25, 1986, Hollis Bowden, who is the brother of

petitioner Charles R. Bowden, executed an agreement subordinating




     7
       A typical lease submitted for the record states that AVC
is the “supplier of equipment”. Pac-Tech is denominated as
“lessor” and “secured party”. An unrelated third party is
“lessee”. NBSC is the “assignee” of the “secured party”.
                              - 13 -


his lien on the Crestwood property in favor of NBSC.8   On the

same date, NBSC recorded its security interest on the Crestwood

property.   Subsequently, Hollis Bowden transferred the security

interest in the 41 vending machines to petitioners in return for

stock in the Aqualator corporations.

     On October 19, 1994, NBSC notified petitioners that its

records showed payment in full of the $442,595 secured by “a lien

on your home and 41 vending machines”.   On October 20, 1994, NBSC

advised petitioners that the bank’s records indicated that the

“lien” on the 41 vending machines was transferred, along with an

assignment of certain lease proceeds, to Hollis Bowden.

     Clement Smith (Mr. Smith), a senior commercial lending

officer for NBSC, believed that when NBSC took assignments from

Pac-Tech on a number of leases, the financial institution became

the owners of the leases.   It was Mr. Smith’s belief that the

lease documents conveyed ownership to NBSC.   Mr. Smith believed

that by filing a security interest on the vending machines NBSC

acquired a titled interest.   Mr. Smith also believed that NBSC

was entitled to take depreciation on the vending machines in

question.   He also stated that NBSC had the right to sell the

vending machines, absent default on the part of petitioners, to

third parties.

     8
       On Oct. 29, 1985, Hollis Bowden had given Mr. Bowden
special power of attorney over his interest in the Crestwood
property.
                                - 14 -


     5.    Southern Pacific

     On December 28, 1984, Southern Pacific agreed to purchase

vending machine leases between Pac-Tech and various third

parties.     Monthly rentals were to be collected by Pac-Tech, which

would in turn remit them to Southern Pacific.     In early 1985,

Southern Pacific, pursuant to the agreement, purchased

assignments to approximately 40 leases.     Each lease was for a

term of 5 years and provided for $437 monthly rental payments.

Each lease provided that, in the event of default, the entire

balance due under the lease could be accelerated.     Mr. Bowden

guaranteed the payment of the leases.

     On June 30, 1986, Southern Pacific lent $554,417.61 to Pac-

Tech.     The revenue from the vending machines, however, was not

sufficient to make the monthly lease payments.     Consequently, the

deficiency grew each month.     At some point, the leases went into

default.

     Subsequently, Southern Pacific renegotiated the debt,

including the pledge of approximately 100 vending machines as

collateral.     Southern Pacific filed a security interest for each

vending machine.

     Christopher Forman (Mr. Forman), then acting president of

Southern Pacific, believed that it had purchased a stream of

payments on individual leases.     Mr. Forman thought that Southern

Pacific was entitled to collect all or a portion of the payments
                              - 15 -


that were being made by the lessees on the equipment.    It was Mr.

Forman’s understanding that Southern Pacific’s purchase of the

vending machine leases was the same as obtaining a titled lien

interest on a motor vehicle through the certificate of ownership.

In other words, Southern Pacific would be seen as the lienholder

on the equipment.   Any rights Southern Pacific had in the

purchased leases would come into play only if there was a default

by the individual lessee on the lease payments.

     On July 16, 1987, Prudential Bancorp, as an assignee of

Southern Pacific, sued petitioners, alleging that petitioners

were liable for an amount in excess of $550,000 on personal

guaranties furnished to Southern Pacific.   On June 30, 1989,

petitioners offered the Crestwood property to Prudential Bancorp

in exchange for extinguishment of liens, unpaid taxes, and

satisfaction of Prudential Bancorp’s claims.   On September 15,

1989, petitioners conveyed the Crestwood property to Prudential

Bancorp.   Under the settlement stipulation, Prudential Bancorp

was entitled to the proceeds from the sale of the Crestwood

property, which it sold to unrelated third parties for

$2,525,000.   Prudential Bancorp used the proceeds to satisfy the

Southern Pacific loan, the NBSC loan, a $1.4 million loan from

Concordia Bank, the debt owed to Hollis Bowden, and all

mechanic's liens.
                                - 16 -


     On August 21, 1989, petitioners’ attorney, Mr. Handel, wrote

to Prudential Bancorp’s attorney to confirm his understanding

that pursuant to the settlement, Prudential Bancorp would

“immediately release any and all interests” in the vending

machines.

     6.    Crestwood Property

     Petitioners purchased the Crestwood undeveloped land during

1983 for $375,000 and in 1984 borrowed $1.4 million from

Concordia Bank to construct a residence.     Concordia Bank received

a security interest in the Crestwood property.     Petitioners

completed construction of a 12,000-square-foot, three-story,

four-car-garage residence in October 1986.

     The Crestwood property was flooded twice during December

1987.     On or about December 6, 1987, a few days after petitioners

moved in, sewage backed up, contaminating the first floor of the

house.     Within a week, a windstorm caused flooding and wind

damage to the property.     For example, it blew out all the windows

in the house.

     During June 1988, another flooding incident occurred at the

Crestwood property.     The floods destroyed some of petitioners’

personal and corporate records as well as personal property.     The

destroyed records were discarded by workers who were cleaning up

the flood damage.
                              - 17 -


     On or about December 6, 1987, petitioners filed a claim with

their insurance company for damage caused by the sewer backup.

Petitioners received $48,480 in satisfaction of their claim.      On

or about December 16, 1987, petitioners filed a second claim with

their insurance company for flood damage caused by rain.    The

insurance company paid petitioners $75,200 to satisfy their

second claim.   On or about June 15, 1988, petitioners filed the

third claim for alleged vandalism that caused interior damage to

their home.   Petitioners received $135,626 in satisfaction of

that claim.

     Finally, petitioners filed an insurance claim for

loss of corporate papers in connection with the floods.

Petitioners received $25,000 in satisfaction for corporate

records stored in a portion of their residence leased to one of

their corporations.   The loss of the corporate papers was not

covered under petitioners’ homeowner’s policy.

     Petitioners reported on their 1986 Schedule C gross receipts

of $163,001 and deductions for:   Insurance--$100, mortgage

interest--$69,860, taxes--$340, and contract labor expenses--

$69,850.   Petitioners’ reported, on their 1989 Schedule C gross

receipts of $72,817 and deductions for:   Insurance--$7,945,

mortgage interest--$65,639, taxes--$8,050, and repairs--$14,490.

     Petitioners’ attorney, Mr. Handel, believed that the

settlement agreements with the financial institutions provided
                              - 18 -


that title and ownership of the vending machines passed to

petitioners or their various corporations.9   Mr. Handel contended

that it was “always clear” that these financial institutions had

no interest in the machines other than obtaining paybacks of

loans.   Mr. Handel believed that either petitioners or their

corporations would have the right to pursue a stolen vending

machine.

                              OPINION

     The controversies here, to a great extent, focus on the

ownership of numerous water purification machines leased, sold,

and used for business purposes by petitioners’ corporations.     The

questions are substantially factual and have been complicated

because of petitioners’ relationships with their numerous

interrelated corporate entities.   This case is further

complicated by a myriad of transactions, including sales, sales

and lease backs, loans and security interests, and other

interrelated transactions and settlements of controversies and

lawsuits.   The absence of business records (both corporate and

individual) for key periods further exacerbates the situation.

The record in this case is patchy and, in many instances, vague.

     Respondent determined that petitioners were not entitled to

deduct expenses claimed on the Schedules C attached to their 1986

     9
       Mr. Bowden waived the attorney-client privilege so that
Mr. Handel could testify before this Court. Also, it appears
that Mr. Handel is Mr. Bowden’s son-in-law.
                                - 19 -


and 1989 income tax returns.     Respondent challenges the claimed

depreciation with respect to certain vending machines because

petitioners failed to establish their ownership of or basis in

those machines.     In that same vein, respondent also determined

that petitioners are not entitled to certain other deductions

related to the vending machines for the 1986 and 1989 tax years.

Respondent also determined that petitioners failed to report

income paid to them by or on their behalf by their corporations.

Conversely, petitioners contend that they are entitled to

depreciate, as well as to deduct all related expenses with

respect to, the vending machines in question.

A.   Depreciation

      Petitioners contend that the assignments of security

interests in the vending machines gave them title and, therefore,

ownership.   Consequently, petitioners contend that in 1986 they

owned approximately 70 out of the 490 vending machines operated

by their corporations.

      Respondent counters that:    (1) Petitioners have no capital

investment in the vending machines; (2) there are no documents in

the record which prove that petitioners owned the vending

machines; and (3) the vending machines have not been shown to

have a useful life exceeding 1 year.

      Deductions are a matter of legislative grace, and the

taxpayer bears the burden of proving that he or she is entitled
                              - 20 -


to any claimed deductions.   Rule 142(a); New Colonial Ice Co. v.

Helvering, 292 U.S. 435, 440 (1934); Welch v. Helvering, 290 U.S.

111, 115 (1933).   This includes the burden of substantiating the

amount and purpose of the item claimed.     Hradesky v.

Commissioner, 65 T.C. 87, 90 (1975), affd. per curiam 540 F.2d

821 (5th Cir. 1976); sec. 1.6011-1(a), Income Tax Regs.

     Section 167 provides, in part, for a depreciation deduction

with respect to property used in a trade or business.

Depreciation allows the taxpayer to recover the cost of the

property used in a trade or business or for the production of

income.   United States v. Ludey, 274 U.S. 295, 300-301 (1927);

Durkin v. Commissioner, 872 F.2d 1271, 1276 (7th Cir. 1989),

affg. 87 T.C. 1329 (1986).

     "'[D]epreciation is not predicated upon ownership of

property but rather upon an investment in property.'"     Estate of

Franklin v. Commissioner, 544 F.2d 1045, 1049 (9th Cir. 1976)

(quoting Mayerson v. Commissioner, 47 T.C. 340, 350 (1966)

(emphasis added)), affg. 64 T.C. 752 (1975); see also Helvering

v. F. & R. Lazarus & Co., 308 U.S. 252 (1939).    The taxpayer who

is entitled to the depreciation deduction is the one who suffers

the economic loss of his investment by virtue of the wear and

tear or exhaustion of the property--the one who has the economic

benefits and burdens of ownership.     Frank Lyon Co. v. United

States, 435 U.S. 561 (1978); Leahy v. Commissioner, 87 T.C. 56
                              - 21 -


(1986).   Consequently, a stockholder normally is not entitled to

depreciate property of his corporation because he lacks a direct

economic interest or investment in the property itself.    See

Hunter v. Commissioner, 46 T.C. 477, 489-490 (1966).

     Generally, a taxpayer’s capital investment in the property

is the cost of acquiring the depreciable property.    See Durkin v.

Commissioner, supra; secs. 167(c), 1011, 1012; sec. 1.1012-1(a),

Income Tax. Regs.   Petitioners contend that their depreciable

basis is derived from the lenders' assignments to them of

security interests in the property.    This presents a question of

whether, under State law, a security interest affords petitioners

an ownership interest sufficient to entitle them to claim

depreciation.

     State law is determinative of the parties' rights and

interests, and Federal law is determinative of the Federal income

tax consequences of those rights or interests.    Morgan v.

Commissioner, 309 U.S. 78, 80 (1940); Lucas v. Earl, 281 U.S. 111

(1930); Sampson v. Commissioner, 81 T.C. 614, 618 (1983), affd.

without published opinion 829 F.2d 39 (6th Cir. 1987).

     Generally, California law provides that a security interest

in personal property is given to secure a payment or performance

of an obligation and not to acquire personal property.    See Cal.

Com. Code sec. 1201(37)(a) (West Supp. 1996).    The holder of a

security interest is denominated a secured party.    The priority
                              - 22 -


of a secured party’s security interest in collateral is dependent

on the time of filing a financing statement in relation to the

filing of other secured interests.     See generally Cal. Com. Code

secs. 9302, 9312, 9105(m), 9401 (West 1990).10    The purpose of a

financing statement is to inform existing or prospective

creditors of the extent to which an existing or prospective

debtor has encumbered   assets.   Borg-Warner Acceptance Corp. v.

Bank of Marin, 111 Cal. Rptr. 361 (Ct. App. 1973).

     Petitioners and their corporations have engaged in a series

of transactions prior to defaulting on several loans.     The

vending machines owned by petitioners’ corporations were the

security for the loans.   Petitioners and the financial

institutions entered into settlement agreements in which the

security interests were assigned from the lenders to

petitioners.11

     10
       California law provides that a financing statement is a
document which satisfies the requirements of Cal. Com. Code sec.
9402(1) (West 1990). This section provides:

     A financing statement is sufficient if it gives the
     names of the debtor and the secured party, is signed by
     the debtor, gives an address of the secured party from
     which information concerning the security interest may
     be obtained, gives a mailing address of the debtor, and
     contains a statement indicating the types, or
     describing the items, of collateral. * * *

     11
       In the settlement with NBSC and petitioners, the security
interests were assigned from NBSC to Hollis Bowden, who in turn
assigned them to Mrs. Bowden. In some of the settlement
                                                   (continued...)
                                - 23 -


     Petitioners argue that those security interests provide them

with an ownership interest in the vending machines.     Generally, a

security interest is not equivalent to a capital investment.

Helvering v. F. & R. Lazarus & Co., supra; see Cal. Com. Code

sec. 1201(37)(a).    The security interests provided petitioners

with an interest in property designed to secure the payment or

performance of an obligation.    A security interest does not,

without further action, transfer title or an ownership interest

in property.    Moreover, the assignment or release of a security

interest eliminates the secured party's ability (in this case the

financial institutions) to take possession of the property in the

event of default.    Additionally, a security interest is not the

equivalent of “cash or other property” used to acquire the

property.12    See sec. 1.1012-1(a), Income Tax Regs.

     The transfer of the Crestwood property to Prudential Bancorp

pursuant to the settlement agreement did not create a capital

investment in the vending machines.      Instead, it resulted in an

exchange or sale of that property, as discussed infra pp. 30-33.

Prudential Bancorp received the Crestwood property in exchange


     11
      (...continued)
agreements, petitioners provided property or funds in exchange
for the assignment of security interests in the vending machines.
     12
       This would be so even though, as part of the settlement
agreements in which petitioners received assignment of the
security interests, they did give cash or property to the
financial institutions.
                              - 24 -


for the release of petitioners’ obligations to the financial

institutions.   No vending machines were transferred to

petitioners in exchange for the Crestwood property.

     It is significant that petitioners have failed to

substantiate their ownership of the vending machines.     They have

not been able to demonstrate that through their proprietorship,

Vista Vending, they owned the vending machines leased from Ocean

Leasing and, thus, were entitled to claim depreciation.

Petitioners also argue that there were corporate agreements that

transferred ownership of the vending machines from their

corporations to them in the event that petitioners were required

to pay on their guaranties of corporate debt.   Petitioners

contend that the records lost in connection with the floods

provided that petitioners would be entitled to the vending

machines if they paid corporate debts pursuant to individual

guaranties.   Alternatively, petitioners allege the existence of

oral agreements that would have accomplished the same result.

Petitioners have also argued that their corporations did not

depreciate the vending machines as proof of the existence of the

oral agreements.   In this regard, some of petitioners’

corporations’ returns are in the record.   A review of those

returns reflects an inconsistent pattern where depreciation on

vending machines was claimed in some years and not in others.

This evidence is inconclusive.
                                - 25 -


     In the absence of direct evidence, we could consider

credible, secondary evidence.    Malinowski v. Commissioner, 71

T.C. 1120, 1125 (1979).   The only evidence offered by petitioners

to carry their burden is their own testimony.   We found

Mr. Bowden’s testimony on this subject to be vague, conclusory,

uncorroborated, and in many respects, contradictory.13

     Petitioners’ attorney, Mr. Handel, did not know who owned

the machines after the Prudential Bancorp transaction.14

Mr. Handel disclaimed any personal knowledge of the agreements or

their purported contents.

     Petitioners also relied on a September 20, 1989, letter from

the law firm of Glass, Alper, Goldberg & Cohn, which contains a

statement that ownership of the vending machines will vest in

Mr. Handel’s client.   This letter, by itself, is inconclusive

     13
       In an effort to establish their ownership of the
machines, petitioners attempted to introduce into evidence “re-
creations” of these purportedly lost documents. At trial, we
held that those documents were not admissible because they were
hearsay.
     14
       The following exchange between respondent’s counsel and
Mr. Handel is instructive:

     Q: Okay. And are there any documents showing that the
     ownership went to the * * * [petitioners] -- clearly
     stating ownership went to the * * * [petitioners]?

     A: No. I don’t think so. I think they only alluded
     to. There is a release of the UCC interest in the
     machines by MDFC.

Respondent followed the same line of questioning with various
financial institutions with consistent responses by Mr. Handel.
                              - 26 -


because Mr. Handel’s clients consisted of petitioners and their

corporations.   Our conclusion is also supported by the October

25, 1994, letter written by MDFC to respondent’s agents that

contains the statement that the judgment against AIC and

petitioners was satisfied on September 6, 1989.   We believe that

the essence of these letters is that the financial institutions

regarded petitioners as the officers and shareholders of their

wholly owned corporations.

     We found Mr. Forman’s (the acting president of Southern

Pacific) testimony to be both credible and consistent with

California law and the record.   He characterized Southern

Pacific’s rights or interest in the vending machines as those of

the holder of a security interest that could develop into a

possessory or other property interest upon default on the lease

payments.   See generally Cal. Com. Code sec. 1201(37)(a).   On the

other hand, Mr. Smith (a senior commercial lending officer for

NBSC) testified that NBSC became the owner of certain leases that

were assigned to it through transactions with petitioners’

corporations.   Mr. Smith misconstrued the effect and character of

the transactions between NBSC and petitioners’ corporation.    NBSC

possessed nothing more than any other security holder involved as

a lender with petitioners’ corporations.   The assignment of the

leases was to provide a source of repayment of outstanding loans.
                                - 27 -


     Finally, petitioners submitted a confused jumble of

corporate records that have not been properly organized,

reconciled, or explained.    For example, PWIC’s records for 1989

extend only from January through May 21 and for the month of

October.    The record reflects that petitioners were paid $25,000

by the insurance company for missing corporate documents in a

room leased to one of their corporations at the Crestwood

property.15    However, in this instance, we are confronted with a

multiplicity of missing documents from three different

corporations owned by petitioners.

     Under these circumstances, petitioners’ testimony, without

further corroboration, is insufficient to carry petitioners’

burden.    See Geiger v. Commissioner, 440 F.2d 688, 689 (9th Cir.

1971), affg. per curiam T.C. Memo. 1969-159; Mills v.

Commissioner, 399 F.2d 744, 749 (4th Cir. 1968), affg. T.C. Memo.

1967-67; Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

     We hold that petitioners have failed to prove their

ownership of and/or depreciable basis in the vending machines and

that respondent’s determination regarding the depreciation is

sustained.16


     15
       The record is silent about which corporation leased the
room in the Crestwood property.
     16
        Our holding negates the need to reach respondent’s
argument that petitioners have not shown that the vending
machines have a useful life exceeding 1 year.
                               - 28 -


B.   Failure To Substantiate Other Schedule C Deductions

      Petitioners contend that in 1986 and 1989, they owned

certain vending machines from which their corporations collected

the revenue.   In connection with those vending machines,

petitioners claimed the operating and related expenses.

Respondent determined that petitioners are not entitled to

deductions.

      Section 162(a) allows a deduction for “all ordinary and

necessary expenses paid or incurred during the taxable year in

carrying on any trade or business”.     See also sec. 1.162-1(a),

Income Tax Regs.

      Taxpayers are required to maintain records that are

sufficient to enable the Commissioner to determine their correct

tax liability.   See Meneguzzo v. Commissioner, 43 T.C. 824, 831-

832 (1965); sec. 6001; sec. 1.6011-1(a), Income Tax Regs.     Also,

the taxpayer bears the burden of substantiating the amount and

purpose of the item claimed.   Hradesky v. Commissioner, 65 T.C.

at 90; sec. 1.6001-1(a), Income Tax Regs.     Under certain

circumstances, if a taxpayer establishes the entitlement to a

deduction but does not establish the amount of the deduction, we

may estimate the amount allowable.      Cohan v. Commissioner, 39

F.2d 540 (2d Cir. 1930).

      Finally, “the trade or business of the corporation must be

considered separately from the trade or business of the
                                - 29 -


shareholders.”     Markwardt v. Commissioner, 64 T.C. 989, 995

(1975).

     Petitioners on their 1986 Schedule C claimed deductions for:

Insurance--$100, mortgage interest--$69,860, taxes--$340, and

contract labor--$69,850.    Petitioners, on their 1989 Schedule C

claimed deductions for:    Insurance--$7,945, mortgage interest--

$65,639, taxes--$8,050, and repairs--$14,490.

     Petitioners have not demonstrated that the expenses were

incurred for the vending machines that petitioners have claimed

they owned.   The record does not reflect that the expenses were

paid or incurred during the tax years 1986 and 1989.    In

addition, petitioners have not shown that any such items were

ordinary and necessary business expenses.    Sec. 1.162-1(a),

Income Tax Regs.

     Petitioners contend that, in 1986, they owned 70 vending

machines out of the total of 490 and that they prorated all

corporate operating expenses between the vending machines alleged

to be theirs and the total.    However, petitioners presented no

evidence demonstrating the proration or allocation between the

vending machines claimed by petitioners and the corporate vending

machines.

     It should also be noted that PWIC, PWMC, and C.B. Crest, in

addition to commercial water purification, leased systems for

home use.   Petitioners conceded on brief that they failed to
                              - 30 -


identify and prorate those expenses of home use water

purification systems.   They explained that the home use aspect

was “overlooked” in their Federal income tax returns because it

was no more than 2 percent of the total revenue.

     Because petitioners have not been able to substantiate the

amounts of expenses or establish their ownership and operation of

the approximately 70 vending machines, we hold that they are not

entitled to deduct the claimed expenses.

C. Petitioners’ Obligation To Report Gross Income From the
Vending Machines

     Petitioners contend, in the alternative, if they are not

entitled to deduct vending machine depreciation and deductions

claimed on their Schedules C for 1986 and 1989, then they

incorrectly reported the gross receipts from those same vending

machines.   Petitioners reported gross receipts from the vending

machines of $163,001 and $72,817 on their 1986 and 1989 Schedules

C, respectively.   Respondent contends that petitioners

constructively received income from their corporations.

     The notice of deficiency makes no determination concerning

the income or its source reported on petitioners’ Schedules C.

Respondent’s determination regarding the Schedules C simply

involved the disallowance of the claimed deductions.    For

purposes of trial and briefing, respondent argues that

petitioners did not establish their entitlement to the

depreciation or other deductions in connection with the vending
                              - 31 -


machines, in part, because they did not own or show their

ownership of the machines.

     Respondent proposed several arguments in response to

petitioners’ argument that they are not required to report the

income if we find, as we did, that they did not own the vending

machines.   Respondent argued that payments made to third parties

on behalf of a corporation’s sole shareholder are income to the

shareholder.   That argument is inapposite with respect to the

amounts petitioners reported on their 1986 and 1989 returns as

income from the vending machines that they believed they owned.

In another part of this opinion we address the question of

whether payments made to or on behalf of petitioners are income

to them and should have been reported by them.

     Respondent also argued that petitioners constructively

received the income from the vending machines and income from the

sale of the Crestwood property.   As to the constructive receipt,

respondent does not contend that petitioners specifically

received the $163,001 or $72,817 amounts from the corporations or

that those amounts are constructive dividends.   Although the

record reflects that petitioners are required to report certain

income they received as compensation or because the

corporation(s) paid petitioners’ obligations, that matter is also

addressed in another portion of this opinion.    Attribution of the

amounts reported as vending machine receipts to the amounts
                              - 32 -


specifically received by petitioners or paid on their behalf

would result in duplication of the items.

     Respondent also argued that a series of bookkeeping entries

on October 31, 1989, constituted a set-aside of income, which

support respondent's argument that petitioners should have

reported the $163,001 and $72,817 amounts of income for 1986 and

1989, respectively.   The bookkeeping entries involved the

$150,316 reduction to an account entitled "Loans Payable-S.

Bowden" and a equal increase to an account "Salaries-

Supervision".   Respondent contends that the $150,316 could have

constituted a constructive receipt of funds.   From the record,

the nature of these bookkeeping entries is not apparent, and it

is not evident that petitioners had an unrestricted right to

withdraw money or that it was available to be withdrawn.

     Finally, respondent apparently argues that petitioners built

a large and luxurious house and that the two tax returns under

consideration do not support their ability to build such a house.

We cannot agree with respondent’s conclusion without further

evidence and analysis.   In particular, respondent has not

performed a reconstruction of petitioners’ income for the 1986 or

the 1989 tax year in order to provide a starting point from which

a comparison of income and/or worth could be made.

     Accordingly, we hold that petitioners were not required to

report the income from the vending machines on their 1986 and
                               - 33 -


1989 Schedules C, based on our findings and holdings that

petitioners did not own certain of the vending machines and that

they were not entitled to depreciation and other deductions.

D.   Transfer of Crestwood Property to Prudential Bancorp

      On September 15, 1989, petitioners transferred the Crestwood

property to Prudential Bancorp.   In exchange, petitioners were

released from their obligations to Southern Pacific and NBSC, the

debt owed Hollis Bowden, and the $1.4 million loan obligation to

Concordia Bank.   In addition, all debt giving rise to mechanic's

liens on the property was satisfied.    The obligations to Southern

Pacific and NBSC were in connection with petitioners’

corporations' debts and petitioners’ personal guaranties.

Prudential Bancorp, after obtaining the Crestwood property from

petitioners, sold it to unrelated third parties for $2,525,000,

its fair market value.

      Petitioners reported, on their 1989 income tax return, that

the sale price of the Crestwood property was $1,786,000, with a

cost basis of $1,872,776.17   It appears that petitioners derived

the “sale price” from their computation or estimate of the amount

of debt canceled by means of the settlement.   Petitioners

therefore reported a loss of $86,776 on their 1989 tax return.

On brief, petitioners contend that the sale price should be


      17
       On brief, petitioners erroneously state a “total cost of
$1,786,000" and “a sales price * * * of $1,872,776".
                                - 34 -


derived from the total of all claims paid by Prudential Bancorp

in the settlement agreement, rather than the ultimate sale price

to third parties.18

     Generally, a transfer of property by a debtor to a creditor

in satisfaction, in whole or in part, of an indebtedness

constitutes a “sale or exchange” under section 1001, and the

excess of the fair market value over the basis of the property

applied against the indebtedness constitutes taxable gain.     Gehl

v. Commissioner, 102 T.C. 784, 786 (1994), affd. without

published opinion 50 F.3d 12 (8th Cir. 1995); Allan v.

Commissioner, 86 T.C. 655, 659-660 (1986), affd. 856 F.2d 1169,

1172 (8th Cir. 1988); Freeland v. Commissioner, 74 T.C. 970

(1980).   The sale price represents the fair market value of the

property at the time of sale.    Sec. 1.1001-1(a), Income Tax Regs.

     Petitioners, on brief, argue that they understated the cost

basis reported on their return because they calculated the

Concordia Bank loan as $1 million instead of $1,400,000.

Petitioners contend that the addition of the omitted amount

brings the cost basis to $2,186,000.     Petitioners also contend


     18
       It is not likely that the total of all debts settled with
Prudential Bancorp approximated $1.8 million. That is so because
the minimum amount of debt on the Crestwood property, as
contended by respondent, is $1.75 million. In addition to the
debt outstanding on the Crestwood property, petitioners settled
their obligations relating to the corporate debt. It is likely
that the total or overall amount of debt settled exceeded the
eventual sale price of the Crestwood property, or $2,525,000.
                                - 35 -


that the sale price was properly $2,272,776.       Based on these

amended figures, petitioners argue they would be entitled to

claim a loss.19

     Respondent contends that petitioners should recognize gain

from the transfer of the Crestwood property computed as the

difference between the fair market value of the Crestwood

property and petitioners’ cost basis.       Specifically, respondent

contends that the deemed gain is $750,000, which is the

difference between $2,525,000, the fair market value of the

property (the gross sale proceeds of the property received by

Prudential Bancorp) and petitioners’ basis in the property.

Respondent determined petitioners’ basis in the Crestwood

property to be $1,775,000, comprising two amounts--$375,000 and

$1.4 million.     These amounts represent the loan from Concordia

Bank, the proceeds of which were used by petitioners to construct

a residence on the property, and the cost of the land.

     Based on the documentary evidence and petitioners’s

testimony, it is apparent that petitioners’ basis in the

Crestwood property exceeded the outstanding balance of the

mortgage and the cost of the land.       The additional amount is

attributable to the outstanding mechanic's liens.       In these

circumstances, petitioners’ testimony, along with other related

     19
       Assuming petitioners' amended figures to be correct, the
transaction would have resulted in a gain of $86,776. See sec.
1.1001-2(a), Income Tax Regs.
                                 - 36 -


evidence, reflects that their basis in the property would have

originally been more than $1.75 million.      Therefore, we hold that

petitioners’ basis, as determined by respondent, was understated.

Accordingly, we hold that petitioners’ basis in the Crestwood

property was $2 million.      Cohan v. Commissioner, 39 F.2d 540 (2d

Cir. 1930).    Accordingly, petitioners must recognize $525,000 of

gain on the transfer of the property to Prudential Bancorp.

E.   Unreported Income

      1.   Salaries

      Petitioners have stipulated that they failed to report

salaries and self-employment income in varying amounts for 1986

and 1989.    Those amounts will be considered in the Rule 155

computation.

      Petitioners reported $42,000 of income subject to Social

Security on Schedule SE of their 1986 Federal income tax return.

Respondent contends that Mrs. Bowden omitted $18,000 in

compensation from PWIC in the 8-month period ending December 31,

1986.   Petitioners contend that the $18,000 was, in fact,

included in the $42,000 already reported on the aforementioned

Schedule SE.    From the record in this case, we have no reason to

doubt petitioners’ testimony that the $18,000 amount was already

included in the total of $42,000 that respondent determined

should be reported.      Accordingly, the $18,000 is deemed to be

part of the $42,000 already reported by petitioners.
                               - 37 -


     2. Reimbursements and Other Items

     During 1986, Mrs. Bowden received $21,626.59 from PWIC and

AVC for auto expenses, entertainment, consulting, and other

unidentified items.    Also, in the same year, petitioners’

corporations paid $14,138.48 on behalf of Mrs. Bowden to a travel

agency, Crocker National Bank, Pentech Financial Services, and

the San Bernardino County tax assessor.     Petitioners’

corporations also made payments on loans still outstanding to

both the Bank of Whittier and NBSC, respectively.     In 1986,

petitioners’ corporations paid $10,762.21 for Mr. Bowden’s life

insurance and credit card charges.      In the same year, Mr. Bowden

received $399.56 from PWIC as reimbursement of entertainment

expenses.

      In 1989, Mrs. Bowden received $16,942.89 from C.B. Crest

for postage expenses, rental income, and other unidentified

items.   Petitioners’ corporations paid on behalf of Mrs. Bowden a

debt owed to Newport Vending in the amount of $44,250.     Payments

were also made to the Bank of Whittier and NBSC on the loans

still outstanding.    In 1989, petitioners’ corporations paid on

behalf of Mr. Bowden $8,407.42 for his credit card charges.

     Generally, taxpayers are required to maintain adequate and

complete records to substantiate their expenses.     Sec. 6001;

Meneguzzo v. Commissioner, 43 T.C. 824 (1965).      Also, it is well

settled that if a taxpayer’s obligation is paid by a third party,
                               - 38 -


the effect is the same as if the third party had paid the

taxpayer who in turn paid his creditor.      Old Colony Trust Co. v.

Commissioner, 279 U.S. 716 (1929).      Moreover, transactions

between closely held corporations and their shareholders warrant

close scrutiny.   Paula Constr. Co. v. Commissioner, 58 T.C. 1055,

1058 (1972), affd. without published opinion 474 F.2d 1345 (5th

Cir. 1973); Electric & Neon, Inc. v. Commissioner, 56 T.C. 1324,

1339 (1971), affd. without published opinion 496 F.2d 876 (5th

Cir. 1974).

     In this instance, all of these aforementioned items were

charged as corporate expenses.   Petitioners did not report them

on their income tax returns.   They contend that these items were

not items of income but were reimbursements for their payments of

corporate expenses.

     Petitioners have submitted incomplete corporate records for

the taxable years in question.   The checks submitted as evidence

merely represent payment by the corporations to petitioners.

Also, petitioners did not offer as exhibits any substantiation of

the expenses allegedly incurred on behalf of the corporations.

For example, Mr. Bowden did not proffer any of his credit card

bills that were paid by the corporations which would have

provided an opportunity to scrutinize the basis for the payments.

Paula Constr. Co. v. Commissioner, supra.      Some of the disputed

items were facially questionable.    For example, PWIC paid $700
                              - 39 -


for Mrs. Bowden’s travel to Japan where she had relatives and

allegedly explored business opportunities.   We do not accept

petitioners’ uncorroborated testimony on these items.

     We also find it telling that petitioners were able to submit

complete corporate records for certain time periods but that

records were incomplete for other time periods.    Even factoring

in a loss of records due to the Crestwood property floods, there

remain unexplained inconsistencies concerning the corporate

records.   For example, petitioners did not present a coherent

explanation why particular corporate records were located at the

Crestwood property and not at other business locations.    Also,

petitioners were able to submit to respondent the complete

general ledgers for PWIC’s 1986 calendar year.    We do not

understand why these particular ledgers were unaffected by the

Crestwood property floods while PWIC’s records for 1989 are

incomplete.

     Also, petitioners do not address the fact that C.B. Crest’s

records do not include the months of September, November, and

December 1989 as well as the complete month of August 1989.

Petitioners cannot attribute the absence of these records to the

December 1987 and June 1988 Crestwood property floods.

     Accordingly, we sustain respondent’s determination that

petitioners are liable for tax on the expenditures paid by the

corporations.   Petitioners have failed to show that these
                                 - 40 -


expenditures represent reimbursement of corporate business

expenses.

F.   Self-Employment Tax

      Section 1401 imposes a tax on the “self-employment income”

of every individual.    “[S]elf-employment income” is defined

generally in section 1402(b) as the “net earnings from self-

employment derived by an individual * * * during any taxable

year”.   Section 1402(a) defines the term “net earnings from self-

employment” as the “gross income derived by an individual from

any trade or business carried on by such individual, less the

deductions allowed by this subtitle which are attributable to

such trade or business”.     Section 1.1402(a)-2(b), Income Tax

Regs., provides that “The trade or business must be carried on by

the individual, either personally or through agents or

employees.”

      Petitioners reported $42,000 of income subject to Social

Security on Schedule SE of their 1986 Federal income tax return.

Moreover, petitioners have stipulated that $51,679.84 was

received by Mrs. Bowden from C.B. Crest during the 7-month period

ending July 31, 1989.      In the same time period, petitioners have

also stipulated that Mr. Bowden received $17,479.84 in salary.

Also, between January 1 and May 31, 1989, PWIC paid Mrs. Bowden

$4,100 in salary.
                                - 41 -


      Other than the $42,000, petitioners did not report those

amounts as income on their 1989 Federal income tax return or show

that the amounts constituted salary as opposed to self-employment

income.    Accordingly, we find that petitioners are liable for

self-employment tax on those amounts for the taxable year 1989.

G.   Underpayment Due to Negligence

      Respondent determined an addition to tax due to negligence

under section 6653(a)(1)(A) and (B) for petitioners’ 1986 taxable

year.     Respondent also determined an accuracy-related penalty due

to negligence under section 6662(a) for petitioners’ 1989 taxable

year.     The penalty under section 6662(a) for negligence is

decided under a standard similar to that of the addition to tax

for negligence under section 6653(a)(1).

      For the 1986 taxable year, section 6653(a)(1)(A) imposes an

addition to tax equal to 5 percent of the underpayment of the tax

required to be shown on a taxpayer’s return if any part of that

underpayment is due to negligence or disregard of rules or

regulations.     Section 6653(a)(1)(B) also provides for an addition

to tax of 50 percent of the interest payable under section 6601

with respect to the portion of the underpayment which is

attributable to negligence or intentional disregard of rules and

regulations.     Section 6653(a)(3) defines the term “negligence” to

include any failure to make a reasonable attempt to comply with

the provisions of the Internal Revenue Code.     This section also
                              - 42 -


defines the term “disregard” to include any careless, reckless,

or intentional disregard.   See Neely v. Commissioner, 85 T.C.

934, 947 (1985).

     Section 6662(a) and (b)(1) provides that if any portion of

an underpayment of tax is attributable to negligence or disregard

of rules or regulations, then there shall be added to the tax an

amount equal to 20 percent of the amount of the underpayment

which is so attributable.   The term “negligence” includes any

failure to make a reasonable attempt to comply with the statute,

and the term “disregard” includes any careless, reckless, or

intentional disregard.   Sec. 6662(c).   Petitioners have the

burden of proving that respondent’s determination is in error.

Rule 142(a); Welch v. Helvering, 290 U.S. at 115.

     Petitioners failed to report various items of income for the

1989 taxable year.   Petitioners also failed to provide respondent

with complete information concerning their corporations’

operations and expenses for the entire 1986 and 1989 calendar

years.   We have previously held, even factoring into account any

missing records caused by the Crestwood property floods, that

petitioners did not maintain adequate records.    For example, the

Crestwood property flood is not an excuse that can be used by

petitioners for the 1989 records of PWIC and C.B. Crest because

the floods occurred in December 1987 and June 1988.
                              - 43 -


     In addition, petitioners did not present a coherent

explanation of why certain corporate records were apparently

stored in the Crestwood property and other records stored

elsewhere for business purposes, or why only one corporation

leased part of the Crestwood residence, but several corporations’

records were allegedly lost due to floods at the residence.

Further, petitioners did not adequately explain why C.B. Crest’s

records do not include the months of September, November, and

December 1989 as well as the complete month of August 1989.20

     Finally, petitioners did not demonstrate any apportionment

between the expenses associated with the operating of the vending

machines and other water purification systems.   Petitioners

concede that they “overlooked” the other business of home water

purification units because it was “an exceedingly small amount of

revenue”.

     Mr. Bowden has an accounting background.    He knew or should

have known that he was required to maintain adequate books and

records to support the claimed deductions.   See sec. 1.6011-1(a),

Income Tax Regs.   As noted, petitioners have failed to show that

they maintained adequate books and records to support their

claimed Schedule C deductions.


     20
       Petitioners testified that “activities in C.B. Crest were
limited”, and thus, activities for August and September 1989 were
recorded in October of that year, and activities for November and
December 1989 were recorded in January 1990.
                              - 44 -


      Accordingly, we hold, to the extent that underpayments

exist, petitioners are liable for the additions to tax under

section 6653(a)(1)(A) and (B) for the 1986 taxable year and the

accuracy-related penalty under section 6662(a) for the 1989

taxable year.

H.   Substantial Understatement

      For 1986, section 6661 provides that if there is an

understatement of income tax for any tax year which exceeds the

greater of 10 percent of the tax required to be shown on the

return for the tax year or $5,000, an addition to tax shall be

imposed.   The understatement is reduced by section 6661(b)(2)(B)

by that portion for which there is “substantial authority” or

that has been “adequately disclosed”.

      For 1989, section 6662(a) and (b)(2) provides that if any

portion of an underpayment is attributable to a substantial

understatement of income tax, then there shall be added to the

tax an amount equal to 20 percent of the amount of the

underpayment.

      Petitioners have not offered any probative evidence to

support their claimed Schedule C deductions or to show why they

failed to include income and/or disclose liability for all self-

employment tax in 1989.   Therefore, petitioners did not

adequately disclose their earned compensation, and no substantial
                              - 45 -


authority has been shown to support petitioners’ deductions and

failure to report income from various sources.

      We hold, to the extent that an understatement exists,

petitioners are liable for the addition to tax under section

6661(a) for 1986 and the accuracy-related penalty pursuant to

section 6662(a) and (b)(2) for 1989.   For 1989, a single penalty

of 20 percent is imposed under section 6662 though the

underpayment for that year is attributable to both negligence and

substantial understatement.

I.   Failure To Timely File Their Return

      Respondent determined that petitioners are liable for an

addition to tax for the failure to timely file a return.      Section

6651(a)(1) imposes an addition to tax for failure to file a

timely income tax return.   Petitioners bear the burden of showing

respondent’s determination to be in error and that there was

reasonable cause for their failure to timely file.   Rule 142(a).

      Petitioners' 1986 and 1989 Federal income tax returns were

filed during July 1988 and October 1990, respectively.

Petitioners contend that they did not file because they were

unable to pay the income tax due in both taxable years due to

“insufficient funds”.   Petitioners have not demonstrated that

their lack of funds was a reasonable cause for their failure to

timely file.   Therefore, to the extent of any tax required to be

shown, which was not shown, petitioners are liable for the
                             - 46 -


addition to tax under section 6651(a)(1) for their 1986 and 1989

taxable years.

     To reflect the foregoing,

                                      Decision will be entered

                                 under Rule 155.
