                        T.C. Memo. 1997-19



                      UNITED STATES TAX COURT



    P. DAVID MUSGRAVE AND BARBARA J. MUSGRAVE, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 20374-94.                    Filed January 9, 1997.



     Martin J. Horwitz, for petitioners.

     Nancy Ortmeyer Kuhn and Matthew J. Fritz, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     WELLS, Judge:   Respondent determined a deficiency of $20,343

in petitioners' 1990 Federal income tax, an addition to tax

pursuant to section 6651(a)(1) of $936, and an accuracy-related

penalty pursuant to section 6662 of $4,069.

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue, and
                                - 2 -

all Rule references are to the Tax Court Rules of Practice and

Procedure.

      The issues to be decided are as follows:

      1.   Whether petitioners are entitled to deduct a loss

carryforward attributable to the deduction by petitioner P. David

Musgrave's wholly owned S Corporation on its 1988 tax return of

an amount it paid during 1988 to settle a lawsuit;

      2.   whether the S Corporation is entitled to a deduction it

claimed on its 1990 return for attorney's fees paid during 1990;

and

      3.   whether petitioners are liable for an addition to tax

and penalty pursuant to sections 6651 and 6662 for taxable year

1990.

                          FINDINGS OF FACT

      Some of the facts have been stipulated for trial pursuant to

Rule 91.    The parties' stipulations of fact are incorporated

herein by reference and are found as facts in the instant case.

      At the time they filed their petition in the instant case,

P. David Musgrave and Barbara J. Musgrave (petitioners) resided

in Kettering, Ohio.

      Petitioner P. David Musgrave (petitioner) was, at all

relevant times, the sole shareholder of an S Corporation known

variably, in chronological order, as David Musgrave, CPA, Inc.;

Jeffcott & Musgrave CPAs, Inc.; and Musgrave & Associates CPAs,

Inc. (S Corporation).
                               - 3 -

     Petitioner received his CPA certificate during 1984.     At

that time, he began a private accounting practice and

incorporated David Musgrave CPA, Inc. (the S Corporation) to

carry on the practice.   During February 1986, William T.

Jeffcott, CPA (now deceased) and petitioner merged their

respective accounting practices.   Petitioner changed the name of

the S Corporation to Jeffcott & Musgrave, CPAs, Inc.    Petitioner,

however, remained the sole shareholder of the S Corporation.

     During September 1986, petitioner and Mr. Jeffcott each

completed an application for key man life insurance through a

group plan sponsored by the American Institute of Certified

Public Accountants and underwritten by Prudential Insurance

Company of America (Prudential).   Each policy provided for

$200,000 life insurance with double indemnity in the event of

accidental death.   The applications for both petitioner and Mr.

Jeffcott stated the insurance beneficiary as "Jeffcott &

Musgrave, CPAs, Inc."

     Sometime during December 1987, it was discovered that Mr.

Jeffcott had embezzled approximately $165,000 from Color Q, Inc.

(Color Q), a client of the S Corporation.   Mr. Jeffcott, an

employee of the S Corporation at the time of the embezzlement,

was providing services to Color Q pursuant to an engagement

letter between Color Q and the S Corporation and for which the S

Corporation was paid fees by Color Q.   On December 16, 1987, Mr.
                                 - 4 -

Jeffcott died as a result of injuries sustained in an automobile

accident.

     On December 21, 1987, Color Q filed a Complaint in the

Common Pleas Court of Montgomery County, Ohio (Montgomery County

Court), Case Number 87-4055, to recover the money allegedly

embezzled by Mr. Jeffcott (embezzlement suit).   In its complaint,

Color Q named the following defendants:   (1) Teresa L. Jeffcott

(the wife of William T. Jeffcott), (2) JNANA, Inc. (JNANA), a

corporation formed by the Jeffcotts and owned by Teresa L.

Jeffcott, (3) petitioner, and (4) the S Corporation.   The Estate

of William Jeffcott (Estate) was subsequently added as a

defendant on May 10, 1988.   Color Q sought consequential and

incidental losses that were allegedly sustained as a result of

Mr. Jeffcott's embezzlement, as well as treble damages, costs of

the suit, and attorney's fees pursuant to the Ohio Corrupt

Activities Act.

     During December 1987, the S Corporation sent to the Estate's

administrator an "Affidavit in Statement of Claim" stating that

the S Corporation was "the owner of a claim" against the Estate

for the amount of $193,500 plus interest from December 16, 1987.

The S Corporation stated that the claim was "contingent on the

outcome" of the insurance suit (described below); i.e., it was

contingent on the S Corporation's being found to be the

beneficiary of the proceeds of the Prudential life insurance

policy on Mr. Jeffcott's life.
                               - 5 -

     On March 3, 1988, the Estate's administrator filed a

Complaint for Declaratory Judgment in the Court of Common Pleas

of Warren County, Ohio (Warren County Court), Case No. 3-3-88-

102-46883 (insurance suit).   In the insurance suit, the Estate

sought a judicial determination of the relative rights of the

Estate, the S Corporation, and petitioner with regard to the

proceeds from the Prudential life insurance policy on Mr.

Jeffcott's life (insurance proceeds).

     On April 28, 1988, a status conference and hearing were held

in the embezzlement suit.   During those proceedings, Color Q

agreed that in the event that any of the defendants in the

embezzlement suit were adjudicated to be rightful beneficiaries

of the insurance proceeds as a result of the insurance suit,

Color Q would accept the amount of $190,000 in full and final

settlement of all claims with respect to all defendants in the

embezzlement suit.   Additionally, during those proceedings, each

of defendants JNANA, Teresa L. Jeffcott, the S Corporation, and

petitioner agreed that if the court in the insurance suit found

any one of them to be the rightful recipient of the insurance

proceeds, that person or entity would make payment of $190,000 to

Color Q, which agreed that, upon payment, it would dismiss all

claims against all defendants in the embezzlement suit.

     On May 11, 1988, in a status conference held in the Probate

Court of Warren County regarding the Estate, the Special
                              - 6 -

Administrator of the Estate allowed Color Q's claim in the amount

of $190,000 as a claim against the assets of the Estate.

     In July 1988, a Stipulated Entry, reflecting the settlement

made in the April 28, 1988, hearing, was signed by all of the

parties to the case and entered in the Montgomery County Court.

The Stipulated Entry provided that Color Q and defendants JNANA,

the Estate, Teresa L. Jeffcott, petitioner, and the S Corporation

"in consideration of the mutual relinquishment between plaintiff

and each of the defendants of their respective legal rights and

defenses" agree as follows:

     1.   The Special Administrator of the Estate * * * allows
     the claim of Color Q as to the assets of the Estate in the
     amount of $190,000.

     2.   Defendant * * * [petitioner] acknowledges and agrees he
     will make payment to Color Q in the amount of $190,000 in
     the event the court in the Declaratory Judgment action [the
     insurance suit] issues its order, judgment or decree that he
     is entitled to the Insurance Proceeds.

     3.   Defendant * * * [S Corporation] acknowledges and agrees
     it will make payment to Color Q * * * in the amount of
     $190,000 in the event the court in the Declaratory Judgment
     action [the insurance suit] issues an order, judgment or
     decree that it is entitled to the Insurance Proceeds.

     4.   The defendant Teresa L. Jeffcott acknowledges the
     stipulations contained in this Entry to be valid, and agrees
     that she accepts its terms, both individually and as natural
     guardian and next of kin for her minor children.

     5.   Plaintiff, in consideration of the defendants'
     covenants and agreements as aforesaid, agrees to dismiss
     with prejudice its Complaint in Case No. 87-4055 against all
     defendants upon payment to Color Q * * * in the amount of
     $190,000. Plaintiff will bring no further action based upon
     facts set forth in its Amended Complaint, and will discharge
     each defendant from claims in the Amended Complaint.
                               - 7 -

              *      *     *     *       *      *     *

     7.   It is understood that this resolution is intended to
     cover all future claims which may develop between plaintiff
     and JNANA, Inc., the Estate * * *, Teresa L. Jeffcott, * * *
     [petitioner], * * * [the S Corporation]. Each defendant
     hereby releases Color Q from possible claims, demands or
     causes of action which he, she or it may have or claim to
     have against Color Q * * *.

     8.   In the event none of the defendants is deemed entitled
     to the Insurance Proceeds or, in the event Color Q * * * has
     not been paid $190,000 on or before October 15, 1988, then
     Color Q * * * will reserve the right to declare this
     Stipulated Entry null and of no effect, and to proceed with
     all claims which it has, or may have filed, against
     defendants on the date this Entry is filed with the Court.

     Subsequently, Prudential paid the insurance proceeds in the

amount of $400,000 (twice the face amount because of the policy's

accidental death benefit) plus interest to the Clerk of the

Warren County Court and was discharged as a party to the

insurance suit.   On October 29, 1988, the Warren County Court

issued a "Journal Entry Ordering Deposit in Interest Bearing

Account, and Related Matters" in the insurance suit, ordering

that the Clerk of the Warren County Court remit the sum deposited

by Prudential "jointly to both attorneys, to Mark Bogan [sic],

Administrator of the Estate of William T. Jeffcott, Deceased and

to Carl Anthony Cramer, Attorney for Defendants P. David Musgrave

and Jeffcott & Musgrave, CPA's, Inc.".       The Warren County Court

further ordered that "said attorneys deposit said sum in one or

more joint interest bearing accounts in both of their names as

fiduciaries for their respective clients".     On October 31, 1988,

the Clerk of the Warren County Court issued a check in the amount
                                - 8 -

of $416,632 to "Mark Bogen, Attorney and Carl Anthony Cramer,

Attorney".    The check was deposited into a Fifth Third Bank

account in the name of the attorneys as fiduciaries with the

endorsement "Mark R. Bogen" and "Carl Anthony Cramer trustee

11/16/88 deposit in trust only".

     Sufficient proceeds to pay Color Q were moved from the Fifth

Third Bank account in the name of the fiduciaries to the S

Corporation's account.   On November 16, 1988, a check in the

amount of $193,500 drawn on an account held in the name of the S

Corporation was issued to Color Q et al.    The check bore the

notation:    "In full settlement of any and all claims per

Montgomery County Common Pleas Court Case #87-4055."    In issuing

such check, the S Corporation paid to Color Q and Color Q's

attorneys $193,500 in satisfaction of the Color Q claim.

     On June 22, 1990, the Warren County Court, deciding that the

S Corporation was the beneficiary of the Prudential life

insurance policy, awarded to the S Corporation the remaining

proceeds from the policy; i.e., the difference between (1)

$400,000 plus accrued interest and (2) $193,500.    By Memorandum

Decision and Judgment Entry, dated December 23, 1991, the Court

of Appeals, Twelfth Appellate District of Ohio, Warren County,

affirmed the judgment of the Warren County Court that the S

Corporation was the legal beneficiary of the insurance proceeds.

     From the day after Mr. Jeffcott's death in December 1986

until the resolution of the embezzlement suit in 1990,
                               - 9 -

petitioners were assisted by two attorneys:   Carl Anthony Cramer

and Timothy Tye, of the law firm Tye and Tye.   In representing

petitioners, Mr. Cramer and Mr. Tye worked as a team but out of

different offices.   The attorneys rendered services in defense of

both the embezzlement suit and the insurance suit.

     On its 1988 return, the S Corporation deducted the Color Q

payment as a "Client Reimbursement" and reported a loss of

$117,602 for the year.   Petitioners reported the loss on their

1988 return as petitioner's distributive share of the S

Corporation's loss, resulting in a net operating loss on

petitioners' 1988 return.   On their 1990 return, petitioners

deducted a net operating loss carryforward of $58,020, the amount

remaining from their 1988 net operating loss.   In the notice of

deficiency, respondent denied petitioners' net operating

carryforward for taxable year 1990, thereby increasing

petitioners' taxable income in the amount of $58,020.

Consequently, only the $58,020 carryforward amount is in issue.

     On its 1990 return, the S Corporation deducted legal fees in

the amount of $34,226 and reported $58,890 of income for the

year.   Petitioners reported the $58,890 amount on their 1990

return as their distributive share of ordinary income from the S

Corporation.   In the notice of deficiency, respondent denied the

S Corporation's deduction of legal fees, thereby increasing the S

Corporation's ordinary income for taxable year 1990 by $34,226.

Accordingly, respondent increased petitioner's ordinary income
                              - 10 -

for taxable year 1990 by $34,226, petitioner's distributive share

of the S Corporation's ordinary income.

                              OPINION

     The first issue to be decided is whether petitioner's wholly

owned S Corporation was entitled to deduct on its 1988 tax return

the payment of $193,500 that it made to Color Q during 1988 in

settlement of Color Q's embezzlement suit against the S

Corporation (the Color Q payment).1     Petitioners contend that the

S Corporation was entitled to deduct the Color Q payment on its

1988 return as an ordinary and necessary business expense

pursuant to section 162.   Respondent contends that, because the S

Corporation never included Mr. Jeffcott's embezzlement proceeds

in its income, the S Corporation is not entitled to a deduction.

Respondent relies on a line of cases holding that no deduction

may be taken for an expense that is associated with an income

item unless that income has been reported in the taxpayer's gross

income for the current year or some previous year.     See, e.g.,

United States v. Skelly Oil Co., 394 U.S. 678 (1969).



1
     The deduction of the Color Q payment resulted in a loss
reported by the S Corporation for 1988. Petitioners reported the
loss on their 1988 return as petitioner's distributive share of
the S Corporation's loss. As a result of their deduction of that
loss, petitioners reported on their 1988 return a net operating
loss which subsequently was carried forward to petitioners' 1990
return. It is the disallowance of the loss carryforward on
petitioners' 1990 tax return that requires an inquiry into the S
Corporation's 1988 tax return and the deductibility of the Color
Q payment by the S Corporation.
                               - 11 -

     In the instant case, Mr. Jeffcott, an employee of the S

Corporation, embezzled approximately $165,000 from Color Q, a

client of the S Corporation.   At the time of the embezzlement,

Mr. Jeffcott was an employee of the S Corporation and was

providing services to Color Q pursuant to an engagement letter

between Color Q and the S Corporation and for which the S

Corporation was paid fees by Color Q.    During the pendency of the

complaint in the embezzlement suit, Color Q discovered no

evidence that petitioner had personally participated in Mr.

Jeffcott's wrongful course of conduct.   Additionally, the record

contains no evidence and no party alleges that either petitioner

or the S Corporation ultimately received any of the embezzlement

proceeds, which we take as a concession that the S Corporation

did not receive any of the embezzlement proceeds.

     Because the S Corporation neither received nor had any claim

of right to any of the embezzlement proceeds, we find

respondent's reliance on the Skelly line of cases to be

misplaced.   As the embezzlement proceeds were appropriated by Mr.

Jeffcott and not the S Corporation, such proceeds would not be

income to the S Corporation.   Consequently, we conclude that the

Skelly line of cases is not applicable to the instant case.2

     Respondent next argues that the Color Q payment was not an

"ordinary and necessary" business expense of the S Corporation

2
     Respondent makes no argument that the deduction of the Color
Q payment should be disallowed under sec. 265.
                              - 12 -

within the meaning of section 162(a).   To qualify as an allowable

deduction pursuant to section 162(a), "an item must (1) be 'paid

or incurred during the taxable year,' (2) be for 'carrying on any

trade or business,' (3) be an 'expense,' (4) be a 'necessary'

expense, and (5) be an 'ordinary' expense."   Commissioner v.

Lincoln Sav. & Loan Association, 403 U.S. 345, 352 (1971).

     Petitioners contend that the Color Q payment was deductible

by the S Corporation based on the application of the "origin of

the claim" doctrine (see United States v. Gilmore, 372 U.S. 39

(1963)).3   Citing James E. Caldwell & Co. v. Commissioner, 234

F.2d 660 (6th Cir. 1956), revg. 24 T.C. 597 (1955), and Ostrom v

Commissioner, 77 T.C. 608 (1981), petitioners argue that the

Color Q payment was an ordinary and necessary expense of the S

Corporation because the embezzlement suit arose out of the

ordinary business operations of the S Corporation.

     Respondent argues that James E. Caldwell & Co. v.

Commissioner, supra, stands for the proposition that a judicial

determination of liability is required for deductibility pursuant

to section 162(a), quoting Judge Bruce’s dissent, "It is not the

petitioner's culpability but his liability that determines his

right to the deduction".   James E. Caldwell & Co. v.

3
     The Supreme Court held that "the origin and character of the
claim with respect to which an expense was incurred, rather than
its potential consequences upon the fortunes of the taxpayer, is
the controlling basic test of whether the expense was 'business'
or 'personal' and hence whether it is deductible or not under §
23(a)(2)." United States v. Gilmore, 372 U.S. 39, 49 (1963).
                              - 13 -

Commissioner, 24 T.C. 597, 618 (Bruce, J., dissenting), revd. 234

F.2d 660 (6th Cir. 1956) (citing Judge Bruce's dissent with

approval).   Consequently, respondent argues that, because there

has never been a judicial determination that the S Corporation

would be ultimately liable for the amount of the embezzlement,

the S Corporation is not entitled to deduct the Color Q payment.

     We do not agree with respondent.    In James E. Caldwell & Co.

v. Commissioner, supra, the Sixth Circuit Court of Appeals held,

inter alia, that an amount paid in satisfaction of a judgment

rendered against the corporate taxpayer for fraud was deductible

as an ordinary and necessary business expense.    We view the

language cited by respondent as support for the taxpayer's

entitlement to the deduction under the facts of the James E.

Caldwell & Co. case, not a statement of law that a judicial

determination of liability is a prerequisite to a deduction.

Indeed, we have held to the contrary in Waring Prods. Corp. v.

Commissioner, 27 T.C. 921, 929 (1957) and Old Town Corp. v.

Commissioner, 37 T.C. 845, 859 (1962).    Additionally, we have

allowed a deduction pursuant to section 162(a) for a payment in

settlement of a claim, even where it has not been ordered by a

court.   Old Town Corp. v. Commissioner, supra.

     As stated above, Mr. Jeffcott, who was an employee of the S

Corporation at the time of his embezzlement of funds from Color

Q, was providing services to Color Q pursuant to an engagement

letter between Color Q and the S Corporation for which the S
                              - 14 -

Corporation was paid fees by Color Q.   The embezzlement suit was

brought by Color Q to recover the money allegedly embezzled by

Mr. Jeffcott while he was providing services as an S corporation

employee to Color Q.   Under such circumstances, we conclude that

the embezzlement suit arose out of activities of the S

Corporation's business.

     Respondent next argues that the S Corporation did not

"substantively pay" Color Q, and that the S Corporation therefore

did not, within the meaning of section 162, "pay" or "incur" an

"expense" during 1988 with respect to the settlement of Color Q's

claim.   Although respondent acknowledges that "the [Color Q]

payment was routed through the S Corporation's checking account

on November 16, 1988", respondent nonetheless argues that "the

amount paid to Color Q was not reduced to the S Corporation's

possession, and neither the [Montgomery County Court] nor the

other parties intended that it be reduced to the S Corporation's

possession."

     We think that respondent's focus on the source of the funds

used to make the Color Q payment is misplaced.   The fact that the

parties to the insurance suit agreed that the insurance proceeds

would be used to settle the embezzlement suit does not diminish

the fact that the S Corporation ultimately issued its own check4

4
     As set forth above in our findings of facts, the record
contains a check drawn on the S Corporation's account to Color Q
et al. in the amount of $193,500 in full settlement of the
                                                   (continued...)
                              - 15 -

in satisfaction of Color Q's claim.    The S Corporation could have

received the funds to cover that check from a number of sources,

such as loans, capital contributions, income from operations, or

other sources.   The source of those funds is not material.   What

is controlling is the fact that the S Corporation made the Color

Q payment from its own account.   Accordingly, we find it

unnecessary to trace the source of those funds.   Consequently, we

conclude that the Color Q payment was an "expense" of the S

Corporation that it "paid or incurred" during 1988 within the

meaning of section 162(a).

     Respondent next argues that Mr. Jeffcott's embezzlement

activity was not "ordinary" because embezzlement is not part of

the trade or business of being an employee, citing Yerkie v.

Commissioner, 67 T.C. 388, 393 (1976).    We think that

respondent's argument is misplaced in that it focuses on the

wrong party.   In the instant case, the issue is not whether Mr.

Jeffcott can deduct the Color Q payment; rather, the issue is

whether the S Corporation is entitled to deduct the Color Q

payment as an ordinary and necessary expense of its business.

     We think that the proper analysis of the instant case can be

found in Old Town Corp. v. Commissioner, 37 T.C. at 858-859.    In

Old Town Corp., we set forth the standards to decide whether an

expense paid to settle a lawsuit is "necessary" within the

4
 (...continued)
embezzlement suit.
                              - 16 -

meaning of section 162(a) of the 1954 Code.   We asked the

following questions:   (1) Was the taxpayer entirely confident

that any suit which the plaintiff might bring could not succeed?

(2) did the taxpayer make the payment in question only for the

purpose of avoiding the damage to the taxpayer's credit,

reputation, and business generally which might result from such a

suit? and (3) was any such fear which the taxpayer may have had,

so far justified that a reasonable person in the taxpayer's place

would have thought a settlement at that figure less than the

damage which would follow from such a suit?    Id.

     The record establishes that the S Corporation made the Color

Q payment as a result of Mr. Jeffcott's actions performed while

he was an S Corporation employee and pursuant to an engagement

letter between Color Q and the S Corporation for which Color Q

paid fees to the S Corporation.    The S Corporation was named as a

defendant in Color Q's embezzlement suit and was potentially

liable for the damages from the suit, treble damages under the

Ohio Corrupt Activities Act, the costs of the suit, and the

attorney's fees.

     Applying the standards of Old Town Corp., we are satisfied

that it was reasonable to conclude that Color Q's claim might

succeed.   The record shows that petitioner viewed Color Q's claim

seriously and that he sought the advice of his counsel, who

advised him to settle the claim.   We are also satisfied that the

S Corporation made the payment in question to avoid damage to its
                               - 17 -

credit, reputation, and business generally which might result

from such a suit.    Petitioner testified that he was new in the

practice, that he thought he was going to lose clients because of

the publicity, and that he would be held to a higher standard

because he was in a position of integrity and trust.      Petitioner

also testified that the potential risk from the suit was treble

damages and that "It wasn't worth it."

     We also think that a reasonable person, standing in the

place of petitioner or the S Corporation, would have thought that

the settlement with Color Q would be warranted in light of the

exposure to damages from the suit.      The record shows that the

accounting firm, Arthur Andersen, performed an audit for Color Q

which showed that Mr. Jeffcott had, inter alia, changed names on

checks.   Additionally, petitioner's counsel advised him to settle

the claim, and that advice appears reasonable under the

circumstances.    In light of the S Corporation's potential

liability for the damages from the suit, treble damages under the

Ohio Corrupt Activities Act, the costs of the suit, and the

attorney's fees, we conclude that petitioner's fears were

reasonable.    We think that a reasonable person would have thought

that the settlement payment in the amount of $193,500 was less

than the damages that could be assessed if Color Q's suit

prevailed.    Additionally, we conclude that there was

justification for the belief that there existed sufficient

exposure to liability that a compromise was necessary.      Old Town
                             - 18 -

Corp. v. Commissioner, supra at 859.    Based on the record in the

instant case, we conclude that the Color Q payment meets all of

the requirements of section 162(a).

     Because we have decided that the Color Q payment is an

ordinary and necessary business expense of the S Corporation that

is deductible pursuant to section 162(a), we need not consider

the parties' arguments regarding the deductibility of the payment

as a loss pursuant to section 165.5    We have considered the

parties' remaining arguments concerning the deductibility issue

and find them to be without merit.    Consequently, we hold that

the Color Q payment is an ordinary and necessary business expense

to the S Corporation for its 1988 taxable year.    Accordingly, we

conclude that petitioners are entitled to a net operating loss

carryforward of $58,020 for their 1990 taxable year attributable

to the S Corporation's deduction of the Color Q payment for its

1988 taxable year.


5
     Citing Johnson v. Commissioner, 66 T.C. 897 (1976), affd.
574 F.2d 189 (4th Cir. 1978), respondent contends, inter alia,
that the S Corporation's "loss" was "compensated for by
insurance" within the meaning of sec. 165. Johnson is
distinguishable because we concluded in that case that the
taxpayer's insurance policy on the life of his partner "was
intended to compensate the * * * [taxpayer] for the loss of his
investment [in the partnership], and that is precisely what it
did." Johnson v. Commissioner, supra at 903. In the instant
case, however, we are satisfied that the S Corporation's life
insurance policies in the names of petitioner and Mr. Jeffcott
were not purchased to compensate for potential embezzlement
restitution payments. Consequently, we conclude that, were we to
consider the loss issue, Johnson would not be dispositive of the
instant case.
                                - 19 -

     The next issue to be decided is whether the S Corporation is

entitled to deduct, pursuant to section 162(a), attorneys' fees

in the amount of $34,226 for its 1990 taxable year.   The parties

agree that section 265(a)(1) disallows a deduction for attorneys'

fees paid by the S Corporation in recovering the insurance

proceeds.   Petitioners, however, contend that the attorneys' fees

were incurred in the defense of both the embezzlement suit and

the insurance suit.   Petitioners contend that 65 percent of the

total attorneys' fees were incurred to defend the embezzlement

suit and are deductible pursuant to section 162(a).   Respondent

concedes that the S Corporation paid $34,226 in attorneys' fees

during 1990 but contends that petitioners did not establish that

any portion of such fees related to the embezzlement suit.

     Taxpayers are required to maintain records that are

sufficient to enable the Commissioner to determine their correct

tax liability.   See sec. 6001; sec. 1.6001-1(a), Income Tax

Regs.; Meneguzzo v. Commissioner, 43 T.C. 824, 831-832 (1965).

Additionally, a taxpayer who claims a deduction must bear the

burden of substantiating the amount and purpose of the item

claimed.    Hradesky v. Commissioner, 65 T.C. 87, 90 (1975); 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), if
                               - 20 -

the taxpayer provides some rational basis upon which an estimate

may be made.    Vanicek v. Commissioner, 85 T.C. 731, 743 (1985).

     In the instant case, respondent concedes that the S

Corporation paid $34,226 in attorneys' fees during 1990.

Consequently, we only consider whether petitioners have

established that a portion of the attorneys' fees was incurred in

defense of the embezzlement suit.   At trial, Mr. Cramer and Mr.

Tye, who provided the legal services and billed the attorneys'

fees in issue, testified that, in their employment, they worked

as a team but out of different offices.   Mr. Cramer and Mr. Tye

provided legal services beginning in December 1987, and Mr.

Cramer continued to provide services until the trial of the

instant case.

     Respondent argues that the embezzlement suit was concluded

more than 17 months prior to the S Corporation's 1990 taxable

year and that the record does not establish that the attorneys

rendered any services in defense of the embezzlement suit during

1990, the year during which the attorneys' fees were paid.

Respondent argues that the record, however, does establish that

the attorneys performed substantial services in defense of the

insurance suit during 1990.

     Petitioner, however, testified that "the vast majority" of

Mr. Cramer's and Mr. Tye's time during the period from 1987 to

1990 was related to the embezzlement suit.   Petitioner also

testified that substantial legal fees were paid prior to 1990 but
                                - 21 -

that, by agreement, the payment of $34,226 during 1990 was in

part a deferral of fees from years prior to 1990.

     Mr. Cramer testified that, during the period from 1987 to

1990, he and Mr. Tye spent "more time and energy and adrenalin

and research" on the embezzlement suit than on the insurance

suit.     Mr. Cramer testified that his and Mr. Tye's work on the

embezzlement suit versus the insurance suit during the period

from 1987 to 1990 "could have been 80/20 in favor of the

embezzlement case but at least 50/50."

     We are satisfied by the record in the instant case that some

of the $34,226 in attorneys' fees paid during 1990 were incurred

in defense of the embezzlement suit.     Petitioners, however, have

not established the precise amount of the deduction; i.e., the

actual amount of attorneys' fees that were incurred in defense of

the embezzlement suit.     Nonetheless, because petitioners have

established that they are entitled to a deduction in some amount,

we shall make a reasonable approximation of the amount allowable,

"bearing heavily * * * upon the taxpayer whose inexactitude is of

his own making."     Cohan v. Commissioner, supra at 543-544.

        Mr. Cramer estimated that between 50 and 80 percent of his

and Mr. Tye's time was spent on the embezzlement suit during the

period from 1987 to 1990.     As we stated above, petitioners

proposed that 65 percent of the total attorneys' fees be

considered attributable to the embezzlement suit.     We are

persuaded by petitioner's testimony that the attorneys' fees paid
                              - 22 -

during 1990 were a deferral from prior years.    Petitioner,

however, testified that the fees in issue were only in part a

deferral from years prior to 1990.     Consequently, bearing heavily

against petitioners as authorized by Cohan, we will approximate

that 40 percent of the attorneys' fees paid during 1990 were

incurred for services rendered in defense of the embezzlement

suit.   Accordingly, we hold that the S Corporation is entitled to

deduct $13,690.40 in attorneys' fees for its 1990 taxable year,

and we sustain respondent's increase in petitioners' distributive

share of income from the S Corporation to the extent of

$20,535.60.

     The final issue to be decided is whether petitioners are

liable for an addition to tax and penalty pursuant to sections

6651 and 6662 for taxable year 1990.    Section 6651(a)(1) imposes

an addition to tax for failure to file timely a tax return unless

it is shown that such failure is due to reasonable cause and not

willful neglect.   A taxpayer can establish reasonable cause by

showing that, despite the exercise of ordinary care and prudence,

the taxpayer was unable to file the required tax return within

the prescribed time.   United States v. Boyle, 469 U.S. 241, 246

(1985); Crocker v. Commissioner, 92 T.C. 899, 913 (1989); sec.

301.6651-1(c)(1), Proced. and Admin. Regs.    Willful neglect has

been defined as a conscious, intentional failure or reckless

indifference to timely filing a return.     United States v. Boyle,
                                - 23 -

supra at 250.   Petitioners have the burden of proof.   Rule

142(a).

     It is undisputed that petitioners did not timely file their

individual tax return for taxable year 1990.    Petitioners argue

that they missed the deadline "Due to exigent business

circumstances".    Petitioners also argue that they, "in good

faith, had no expectation that any tax was due."

     We conclude that petitioners have not met their burden of

proof.    Petitioners did not explain the "exigent business

circumstances" that prevented a timely filing.    Moreover, an

unverified belief that no taxes are owing does not constitute

reasonable cause of the sort that will allow petitioners to

escape the addition to tax pursuant to section 6651(a)(1).       Olsen

v. Commissioner, T.C. Memo. 1993-432, and cases cited therein.

The question is not whether petitioners thought that they owed

tax but whether they knew or should have known that they needed

to file a return.    Jackson v. Commissioner, 864 F.2d 1521, 1527

(10th Cir. 1989), affg. 86 T.C. 492 (1986); Olsen v.

Commissioner, supra.     Consequently, we hold that petitioners have

not established reasonable cause for their failure to file timely

their 1990 tax return.    Accordingly, petitioners are liable for

the section 6651(a)(1) addition to tax relating to their tax

liability for taxable year 1990.

     Section 6662(a) imposes a 20 percent penalty on the portion

of an underpayment of tax that is attributable to, inter alia,
                              - 24 -

(1) negligence or disregard of rules or regulations or (2) any

substantial understatement of income tax.     The term "negligence"

includes any failure to make a reasonable attempt to comply with

the provisions of the Code, including failure to exercise due

care, failure to do what a reasonable person would do under the

circumstances, or failure to keep adequate books and records or

to substantiate items properly.    Sec. 1.6662-3(b)(1), Income Tax

Regs.   The term "disregard" includes any careless, reckless, or

intentional disregard of the Code or the temporary and final

regulations issued pursuant to the Code.     Sec. 6662(c); sec.

1.6662-3(b)(2), Income Tax Regs.   A substantial understatement of

tax is defined as the amount which exceeds the greater of 10

percent of the tax required to be shown on the return for the

taxable year, or $5,000.   Sec. 6662(d)(1)(A).

     The accuracy-related penalty does not apply to any portion

of an underpayment with respect to which it is shown that there

was a reasonable cause for such portion and that the taxpayer

acted in good faith with respect to such portion.     Sec.

6664(c)(1).   The decision as to whether the taxpayer acted with

reasonable cause and in good faith depends upon all pertinent

facts and circumstances.   Sec. 1.6664-4(b)(1), Income Tax Regs.

The most important factor is the extent of the taxpayer's efforts

to assess the proper tax liability.    Id.   Circumstances that may

indicate reasonable cause and good faith include an honest

misunderstanding of fact or law that is reasonable in light of
                               - 25 -

the experience, knowledge, and education of the taxpayer.     Id.

Petitioners must establish error in respondent's determination

that they are liable for the penalty provided by section 6662(a).

Rule 142(a); Estate of Monroe v. Commissioner, 104 T.C. 352, 366

(1995).

     Petitioners contend that the portion of the underpayment

resulting from the deduction of legal fees is not attributable to

negligence or disregard of rules or regulations.   Petitioners

argue that they "made a reasonable attempt to comply with the tax

law and did not disregard rules or regulations", as evidenced by

petitioner's belief "that the vast majority of the legal fees

were incurred in connection with the embezzlement suit and were

attributable to years prior to 1990", which "was supported by the

testimony of Mr. Cramer".    Additionally, petitioners argue that

the amount of the understatement subject to the penalty should be

reduced because petitioner, a certified public accountant,

"researched the issues" and believed that the deductions were

supported by "substantial authority".

     Respondent, on the other hand, argues that petitioners were

negligent in claiming a deduction for attorneys' fees incurred to

recover tax exempt income.   Respondent contends that there is "no

evidence that the attorneys' fees were paid for services rendered

for any purpose other than in pursuit of the life insurance

proceeds."   Additionally, respondent argues that the section 6662
                              - 26 -

penalty applies because of petitioners' substantial

understatement of tax.

     As to the portion of the underpayment resulting from our

holding that the S Corporation is not entitled to the entire

amount deducted for attorneys' fees, although we calculate that

no substantial understatement of tax exists, we conclude that

petitioners have not established that they kept adequate books

and records.   Sec. 6662; sec. 1.6662-3(b)(1), Income Tax Regs.

As evidence of the propriety of the deduction of attorneys' fees,

petitioners rely only on petitioner's own belief, "supported" by

the testimony of one of the attorneys who rendered services, that

the "vast majority" of the attorneys' fees were incurred in

connection with the embezzlement suit.    Petitioners, however,

produced no bills or checks documenting the nature of the $34,226

claimed as a deduction for attorneys' fees.    Moreover, Mr.

Cramer's testimony was far from conclusive as to the amount of

fees attributable to the embezzlement suit.    Consequently, we

conclude that petitioners have not satisfied the requirements of

section 1.6662-3(b)(1), Income Tax Regs.

     Nevertheless, no penalty may be imposed pursuant to section

6662 if petitioners establish that there was a reasonable cause

for the portion of the underpayment and that they acted in good

faith with respect to such portion.    Sec. 6664(c)(1).   In light

of the experience, knowledge, and education of petitioner, a

certified public accountant, we believe that he should have kept
                              - 27 -

accurate records to show the purpose of the payment for

attorneys' fees in order to allocate properly the fees between

the insurance suit and the embezzlement suit.      Because petitioner

failed to do so, we are not persuaded that he made a reasonable

attempt to comply with the regulations, and petitioners have not

shown reasonable cause for such failure.    Secs. 1.6664-4(b)(1),

1.6662-(3)(b)(1), Income Tax Regs.     Accordingly, we conclude that

the portion of petitioners' underpayment relating to the

disallowed amount of the deduction of attorneys' fees is

attributable to negligence.

     To reflect the foregoing,


                                      Decision will be entered

                                 under Rule 155.
