                      T.C. Memo. 1997-142



                  UNITED STATES TAX COURT



           WILLIAM WHELPLEY, JR., Petitioner v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent

         WILLIAM AND SARA WHELPLEY, Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 21644-93, 21690-93.   Filed March 18, 1997.



     Alan L. Frank and David Kessler, for petitioners.

     David Breen and Kenneth J. Rubin, for respondent.



          MEMORANDUM FINDINGS OF FACT AND OPINION

     WHALEN, Judge:   Respondent determined the follow-

ing deficiencies in, additions to, and penalties on

petitioners' Federal income tax for the years in issue:
                                - 2 -

William Whelpley, Jr., docket No. 21644-93:

                               Addition to Tax        Penalty
    Year       Deficiency         Sec. 6653          Sec. 6662

    1987         $3,612              $181               --
    1989          1,148               --               $230

William and Sara Whelpley, docket No. 21690-93:

                               Additions to Tax         Penalty
    Year      Deficiency     Sec. 6653   Sec. 6661     Sec. 6662

    1987      $26,076.87       $1,304       $6,519        --
    1989       22,047.87         --           --        $4,410


Unless stated otherwise, all section references are to the

Internal Revenue Code as in effect during the years in

issue.     The above-captioned cases were consolidated for

trial and briefing.

     After concessions by the parties, the issues remaining

for decision are:     (1) Whether certain payments made to

petitioners' wholly owned S corporation are includable

in petitioners' income and, if so, when the payments must

be reported; (2) whether the notices of deficiency for

petitioners' 1989 taxable year are valid; and, (3)

whether petitioners are liable for the additions to tax

and penalties determined by respondent under sections

6653(a)(1)(A), 6661, and 6662(a).


                           FINDINGS OF FACT

     Some of the facts have been stipulated and are so

found.     The stipulation of facts filed by the parties and
                             - 3 -

the attached exhibits are incorporated herein by this

reference.    Petitioner William Whelpley, Jr., resided in

Morris Plains, New Jersey, at the time he filed his

petition in the case at docket No. 21644-93.    Petitioners

William Whelpley, Sr., and Sara Whelpley resided in

Randolph, New Jersey, at the time they filed their joint

petition in the case at docket No. 21690-93.    Petitioner

William Whelpley, Jr., is the son of petitioners William

and Sara Whelpley.    References to Mr. Whelpley are to

Mr. William Whelpley, Sr.

     Mr. Whelpley is a physicist who specializes in

computers and telecommunications.    He studied physics at

the University of Iowa from 1957 to 1962.    After 1962, he

worked as a research physicist for the University of Iowa

and as a manager for Sperry Corp.    He was also employed by

American Telephone and Telegraph and Automatic Data

Processing.    In 1981, Mr. Whelpley and several other

persons founded DAMA Telecommunications Corp.    Mr. Whelpley

served on the board of directors of that company from its

inception until 1986.

     After Mr. Whelpley resigned from the board of

directors of DAMA Telecommunications Corp., he began to

provide consulting services to Weeden Capital Management,

Inc. (Weeden).    Weeden is wholly owned by Weeden & Co., and

is unrelated to petitioners.    Weeden acts as the management
                            - 4 -

company for Weeden Capital Partners, a venture investment

partnership.   Initially, Mr. Whelpley was retained to

advise Weeden about product development by Avant-Garde

Computing, Inc. (Avant-Garde), a publicly traded computer

company in which Weeden owned a 15-percent capital stock

interest.

     On January 2, 1987, Mr. Whelpley founded Whelpley

Associates, Inc. (WAI) as a vehicle for providing his

consulting services.   During each of the years in issue,

Mrs. Whelpley and Mr. Whelpley, Jr., owned 87.5 and 12.5

percent of the outstanding stock of WAI, respectively.

Mr. Whelpley served as an officer and employee of WAI but

did not own any WAI stock during any of the years in issue.

WAI elected to be an S corporation, pursuant to section

1362(a), and it filed a Form 1120S, U.S. Income Tax Return

for an S corporation, for each year of its existence.    WAI

used the accrual method of accounting in 1987 and 1988, and

a hybrid method in 1989.

     At the time Mr. Whelpley began consulting for Weeden,

both he and Weeden believed that Avant-Garde needed a new

generation of computer processor to support its products.

Mr. Whelpley and Weeden agreed to form Communications

Processors, Inc. (CPI), for the purpose of developing the

processor with capital supplied by Weeden and expertise

supplied by Mr. Whelpley.   This processor was to be
                             - 5 -

sold to Avant-Garde for use with the latest version of

its "Net/Alert" product, but Mr. Whelpley and Weeden

anticipated that it could also be sold to other purchasers.

In this opinion, we refer to the development of the

computer processor as the CPI project.

     CPI was incorporated in Delaware on January 28, 1987.

The initial directors were Mr. Whelpley and two employees

of Weeden, including Mr. Thomas L. Flaherty.   Although

Mr. Whelpley was the key employee of both WAI and CPI, and

although the companies shared office space, CPI was at all

times separate from and independent of WAI.

     Generally, Weeden's business objective was to invest

in product and service companies, and in accordance with

that investment objective, it was interested in obtaining

an equity interest in CPI.   Weeden's management was not

interested in investing in consulting businesses such as

WAI, and Weeden never considered the possibility of

becoming a shareholder of WAI.

     CPI and Avant-Garde memorialized their oral agreement

regarding the CPI project in a letter dated April 29, 1987.

As set forth therein, CPI agreed to develop "an industrial

grade, 80386-based communications processor" suitable for

Avant-Garde's Net/Alert application and to cooperate with

Avant-Garde in developing a "statement of requirements" for

the computer equipment.   In return, Avant-Garde agreed to
                                - 6 -

purchase a "perpetual license" to use the product.              The

terms of Avant-Garde's payments were set forth in the

letter as follows:

     Cash

     a) $280,000 ($100,000 payable at commencement) in payment
     with respect to * * * [phase one of the project], payable
     at $40,000 per month commencing at the date thereof.

     b) $100,000 in payment with respect to * * * [phase two
     of the project], payable at $25,000 per month at the
     commencement of this item of work.

     AVGA Stock

     190,000 shares payable as follows:

     a)   140,000 upon performance of * * * [phase one].

     b)   50,000 upon performance of * * * [phase two].


     On May 1, 1987, Weeden orally agreed to assist CPI

in completing the CPI project by advancing to CPI any

funds required in excess of the advance license payments

it was to receive from Avant-Garde.         This agreement was

memorialized in a letter dated May 12, 1987, from

Mr. Thomas Flaherty, vice president of Weeden and a member

of its board of directors, to Mr. Whelpley in his capacity

as president of CPI.      This letter states as follows:


     This letter will confirm our oral agreement of May 1st.,
     concerning commitments made by Weeden Capital Management,
     Inc. (WCMI) to Communications Processors, Inc. (CPI).

     CPI has reached an agreement with Avant-Garde Computing,
     Inc. (AVGA) for the development of certain "386" based
     hardware and software to be used in the next generation
     of AVGA's Net/Alert product. Under this agreement:
                               - 7 -
          CPI and AVGA will jointly develop a statement of
          requirements (SOR I) under which CPI will deliver
          to AVGA hardware and software that meet the
          specifications of this SOR. AVGA will advance to
          CPI the sum of $280,000 as partial payment for a
          license to those products delivered to AVGA under
          SOR I; as agreed in CPI's letter of April 29, 1987.

          CPI and AVGA have further agreed to jointly develop
          a second statement of requirements (SOR II) under
          which CPI will deliver to AVGA hardware and software
          that meet the specifications of SOR II. AVGA will
          advance to CPI the sum of $100,000 as partial
          payment for a license to those products delivered
          to AVGA under SOR II; as agreed in CPI's letter
          of April 29, 1987.

     In an effort to assure the timely delivery of those
     products to be licensed to AVGA by CPI; (sic) Weeden
     Capital Management, Inc. agrees to advance to CPI any
     funds, in excess of those committed by AVGA as advance
     license payments, reasonably required to complete CPI's
     commitments to AVGA under SOR I and SOR II.

                                        Sincerely,


                                  /s/ Thomas L. Flaherty
                                    Thomas L. Flaherty
                                      Vice President


     After CPI's incorporation, its activities consisted of

entering into the production agreement with Avant-Garde as

set forth in the letter dated April 29, 1987, entering into

the agreement with Weeden as set forth in the letter dated

May 12, 1987, quoted above, opening a bank account, and

receiving one check from Avant-Garde.        Various documents

were drafted on CPI's behalf, including bylaws, an

indemnity agreement for directors and officers of the

corporation, a common stock purchase agreement, and a

preferred stock purchase agreement, but none of these

documents were ever executed.       CPI paid the funds received
                            - 8 -

from Avant-Garde to WAI.   CPI never issued any stock, and

it never filed a Federal income tax return.

     Mr. Whelpley undertook the work relating to the CPI

project through WAI rather than CPI.   WAI received the

funds advanced by Weeden for the project, and WAI deducted

expenses relating to the project on its income tax return.

Weeden advanced a total of $103,093 to WAI for the CPI

project in 1987.   A memorandum written by Mr. Whelpley

states that "bills [were] written to CPI by WAI" for this

work.   WAI included the funds advanced by Weeden in the

gross income reported on its 1987 income tax return.

     In addition to the advances for the CPI project,

Weeden transferred funds to WAI as compensation for

Mr. Whelpley's consulting services in connection with

unrelated matters.   WAI included these other funds in gross

income, and they are not at issue.

     At the end of 1987, Weeden's general ledger trial

balance included an account labeled "RECEIVABLE FROM CPI"

which had a debit balance of $103,092.89.   The trial

balance also included an account labeled "PROFESSIONAL

FEES - CONSULTANTS."   Based upon the entries in these

two accounts, it appears that during 1987, payments to

"Whelpley Associates" were initially booked to PROFESSIONAL

FEES-CONSULTANTS and were reclassified at the end of the

year to RECEIVABLES FROM CPI.
                                - 9 -

     Mr. Flaherty sent a letter dated December 31, 1987,

to Mr. Whelpley's attention at CPI regarding the advances

Weeden had made in connection with the CPI project.                This

letter states as follows:

      Our auditors Spicer & Oppenheim, Certified Public Accountants, *
* * are now engaged in an examination of our financial statements as
of December 31, 1987.

           In connection therewith, they wish to confirm the
     following details of your note(s) and the collateral held
     by us.

     Date                   Unpaid      Interest      Interest
    of Note    Due Date    Principal      Rate        Paid to

    12/28/87   On demand   $103,093        None        None

           Please confirm the correctness or report any
     differences by completing this form and returning it
     directly to our auditors in the enclosed reply envelope.

           We would appreciate your cooperation in this matter.

                             Very truly yours,

                             Weeden Capital Management, Inc.


                             /s/ Thomas L. Flaherty
                             Thomas Flaherty
                             Vice President

     The above information regarding our notes payable to you
     is correct except as stated below:

     Date__________          Signed___________________



After a discussion with Mr. Flaherty, Mr. Whelpley signed

the letter and returned it to Spicer & Oppenheim.                Based

upon his discussion with Mr. Flaherty, Mr. Whelpley

believed that Weeden would require repayment of the
                             - 10 -

advances only with CPI stock, and that Weeden would not

require repayment in cash.

     Sometime between April 29 and September 10, 1987,

Avant-Garde withdrew its commitment to purchase a license

to use the CPI product.   Facing a shortage of capital,

Mr. Whelpley sought an outside investor to fund the

project.   WAI prepared a draft business plan for CPI, dated

September 10, 1987, to assist in this process.      However,

Mr. Whelpley was unable to secure either a new source of

financing or any new customers for the product.      In 1988,

Weeden lost interest and stopped investing in the project.

The project was then abandoned.       Mr. Whelpley resigned from

CPI's board of directors in 1988.

     Weeden neither collected nor attempted to collect the

funds it had advanced to WAI on behalf of CPI for the CPI

project.   Weeden's general ledger trial balance for 1988,

dated February 3, 1989, shows that the account RECEIVABLE

FROM CPI had a debit balance of $103,092.89 at the

beginning of 1988, and that offsetting credits were made to

the account during the year.    The trial balance also shows

the following entries in an account entitled "Loss from

CPI" which had a debit balance of $103,092.89 at the end

of 1988:
                                - 11 -

    Transaction Date1       Amount               Reference

       May 5, 1988        $43,092.89       Write off Loss in CPI
       July 31, 1988       10,000.00       Loss in CPI/Re: Mgt. Fee
       Aug. 31, 1988       10,000.00       Loss in CPI/Re: Mgt. Fee
       Sept. 30, 1988      10,000.00       Loss in CPI/Re: Mgt. Fee
       Oct. 31, 1988       10,000.00       Record loss from CPI Rec
       Nov. 30, 1988       10,000.00       Loss from Uncollect Rec
       Dec. 31, 1988       10,000.00       Loss Uncollect Rec-CPI


      1
        The "transaction date" indicates the dates on which these items
were written off in Weeden's books rather than the dates on which the
cash was transferred.


In this manner, Weeden wrote off the balance in the account

labeled RECEIVABLE FROM CPI.           On its Form 1120, U.S.

Corporation Income Tax Return for 1988, Weeden claimed a

bad debt deduction in the amount of $103,093, the amount it

had advanced for the CPI project.

      Beginning in September 1989, respondent examined WAI's

returns for 1987, 1988, and 1989.           During the examination,

WAI's representatives raised the issue whether WAI had

erred by including in WAI's gross income for 1987 the

advances that had been made by Weeden during the year.

WAI's representatives took the position that the advances

constituted either equity investments in WAI or loans to

WAI which, in either event, should not have been included

in petitioners' gross income in 1987.

      A letter dated September 18, 1991, from Mr. Flaherty

and addressed to Mr. Whelpley at WAI, states that Weeden

considered the subject advances as loans to WAI, and
                           - 12 -

expected to be repaid either in cash or with an equity

interest in CPI.   Mr. Flaherty's letter states as follows:


     Dear Mr. Whelpley:

          This letter is to confirm our conversation
     as you requested regarding the accounting
     treatment of the investment made by Weeden in
     Whelpley related projects in 1987. According
     to our records, Weeden funded the development
     of the business plan and prototype device with
     approximately $103,000.00 as confirmed by my
     1987 letter.

          Whelpley Associates, Inc. and Communications
     Processors, Inc. are thought to be essentially
     the same by Weeden Capital Management, Inc.
     They were considered to be a joint vehicle for
     developing the ideas that surrounded a certain
     business concept which you and we originated.
     Communications Processors, Inc. was intended to
     be separated from Whelpley Associates, Inc. when
     other outside funding was secured.

          Weeden was interested in accelerating the
     availability of a particular product design to
     accommodate an initial customer. To that end and
     pursuant to an agreement, Weeden advanced funds
     in the amount indicated above to cover operating
     expenses associated with that development. The
     Amounts that were advanced, as loans, to Whelpley
     Associates, Inc. and yourself were to be
     recovered either; (1) in the form of loan repay-
     ments, or (2) convertible into equity in the
     projects that CPI and WAI were pursuing. Weeden
     considers amounts advanced to be returnable as
     equity in any business entity that results from
     the activity funded in 1987.

                                    Sincerely,


                                    Thomas L. Flaherty
                            - 13 -

     In due course, respondent determined the following

adjustments to WAI's taxable income:


    Adjustments                 1987             1988    1989
Fee participation             $142,607       $51,343       --
Commissions                       --          10,515       --
Employee benefits                6,472         5,710     $5,505
Interest income                 (3,230)       (6,700)      --
Informal claim                     --            --        --
  Total adjustments            148,756        60,328      5,505

Taxable income reported       (52,045)       (111,556)   79,930
Corrected                      96,711         (51,228)   85,435


In computing the above adjustments, respondent rejected the

position of WAI's representatives that WAI's income for 1987

should be reduced by the amount of the advances received from

Weeden.   That issue is referred to above as "Informal claim".

      Based upon the above adjustments to WAI's taxable

income, respondent determined increases in the younger

Mr. Whelpley's distributable income from WAI of $17,289 in

1987 and $7,644 in 1989, computed as follows:


                                          1987             1989

WAI's corrected income               $96,711             $85,435
Distributive share, 12.5%             12,089              10,679
Section 179 deduction                 (1,231)             (1,250)
                                      10,858               9,429

Loss from WAI, per return               6,431                --
Income from WAI, per return               --              (1,785)
Adjustment                             17,289              7,644
                             - 14 -

Respondent determined the subject deficiencies in the younger

Mr. Whelpley's 1987 and 1989 returns based solely on the

above adjustments to his share of income from WAI.

     Based upon the above adjustments to WAI's taxable

income, respondent also determined increases in Mr. and

Mrs. Whelpley's distributable income from WAI of $106,860

in 1987 and $70,813 in 1989, computed as follows:


                                       1987          1989

WAI's corrected income                $96,711     $85,435
Distributable share, 87.5%             84,622      74,756
Section 179 deduction                  (8,620)     (8,750)
                                       76,002      66,006

Loss from WAI, per return              30,858        4,807
Adjustment                            106,860       70,813


Respondent made the above adjustments to Mr. and Mrs.

Whelpley's 1987 and 1989 returns in determining the subject

deficiencies.

     The only issue raised at trial involved petitioners'

claim that the advances made by Weeden should not have been

included in WAI's income.    Petitioners argued at trial that

Weeden's advances constituted either an equity investment

in WAI by an ineligible shareholder, or a second class of

stock in WAI, which in either event terminated WAI's S

corporation election.   Petitioners also argued that, if

the advances constituted loans from Weeden that were
                            - 15 -

discharged, then WAI received cancellation of indebtedness

income in some year other than 1987 or 1989.

     Shortly after trial, respondent filed Motion for Leave

to File Amendments to Answers and to Conform the Pleadings

to the Proof.   In her motion, respondent seeks to amend her

answers to raise, as an affirmative defense in both cases,

the allegation that petitioners are prohibited by the "duty

of consistency" from asserting that WAI's S corporation

election was terminated during any of the years in issue.

Respondent further seeks to amend her answers to allege

that, if the Court determines that Weeden's advances

constitute loans, then those loans were discharged and gave

rise to cancellation of indebtedness income in 1988.   In an

opposition filed in response to respondent's motion,

petitioners argue that they are not prohibited from raising

the validity of WAI's S corporation election, and that the

Court does not have jurisdiction to determine a deficiency

for 1988 because respondent had not issued a notice of

deficiency for that year.

     Subsequently, respondent issued a notice of deficiency

to each petitioner with respect to the 1988 taxable year.

In these notices, respondent determined that the advances

from Weeden in the amount of $103,093 were loans to WAI

which were discharged and gave rise to cancellation of
                                 - 16 -

indebtedness income in 1988.        Each petitioner filed a

petition in this Court contesting respondent's

determination.       See Whelpley v. Commissioner, docket No.

5394-95 (William and Sara G. Whelpley); Whelpley v.

Commissioner, docket No. 5463-95 (William Whelpley, Jr.).

References to the related cases are to these cases.

     Thereafter, the related cases were set for trial.

Shortly before the trial of those cases, the parties

filed a stipulation of settled issues which states in

part as follows:


     the parties reached a basis of settlement with
     respect to the taxable year 1988 as follows:

          b. If the Court determines the $103,693.00
     was a loan to WAI in 1987, WAI received a
     discharge of indebtedness of $103,693.00 from
     Weeden during 1988.

                 *      *    *     *      *   *   *

          e. The parties agree to be bound by the
     trial record established through oral testimony,
     stipulated facts with exhibits, and exhibits
     introduced by the parties at trial with respect
     to Docket Numbers 21644-93 and 21690-93.
                            - 17 -

                            OPINION

     At the outset, we note that there is a discrepancy

involving the amount of the adjustment at issue.      The

stipulation of facts filed by the parties states:


     17. During    the calendar year 1987, Whelpley
     Associates,   Inc[.], received at least
     $103,693.00   from Weeden Capital Management,
     Inc., which   Whelpley Associates, Inc.,
     included in   gross receipts.


The parties also base their arguments on the assumption

that the adjustment at issue is $103,693, and the

stipulation of settled issues filed by the parties in the

related cases refers to $103,693.     However, documents

entered into evidence including Mr. Flaherty's letter of

December 31, 1987, Weeden's general ledger trial balance

for 1987 and 1988, and Weeden's 1988 income tax return,

report the amount of the advances as $103,093.     The parties

have not explained the discrepancy between these figures,

and we accept the stipulation of the parties on this point.


Character of Payments From Weeden to WAI

     The principal issue in these cases involves the

characterization of the cash advances made by Weeden.

Respondent determined that the subject payments constitute

gross income to WAI in 1987 as reported on WAI's 1987
                           - 18 -

return, and rejected the informal claim made by or on

behalf of petitioners during the audit that the payments

are not includable in WAI's income.   Petitioners bear the

burden of proving that respondent's determination is in

error.   Rule 142(a), Tax Court Rules of Practice and

Procedure (hereinafter all Rule references are to the Tax

Court Rules of Practice and Procedure).

     Petitioners argue that respondent's determination is

in error because the subject payments were "never intended

to result in income" to WAI but, in fact, were made by

Weeden "to receive an equity interest".   Petitioners' post-

trial brief states as follows:


     Petitioner William Whelpley testified that
     it was his understanding that in exchange
     for these moneys, Weeden, a venture capital
     investor, was to receive an equity interest.
     This understanding was confirmed by the
     independent testimony of Thomas Flaherty, who,
     when responding to a question propounded by
     the * * * [Court] stated, under penalties of
     perjury that, in exchange for this investment,
     Weeden expected to receive an equity interest.


Petitioners do not explicitly argue that the subject

payments constitute contributions to WAI's capital, and

they do not cite section 118(a), which provides that "gross

income does not include any contribution to the capital of
                              - 19 -

the taxpayer".   Nevertheless, that is the thrust of their

argument.

     The difficulty with petitioners' argument is that

there is no evidence that Weeden sought to make an equity

investment in WAI.   To the contrary, Mr. Flaherty

testified, and we find, that Weeden did not have an

     interest in becoming a stockholder of WAI and that

Weeden's management never considered investing in WAI's

stock.   He further testified, and we find, that Weeden

intended to advance moneys to CPI, and if the CPI project

was successful, to receive an equity interest in CPI.

Mr. Flaherty testified as follows:


     Q           And what was your understanding, if
            you can recall, of Weeden's investment or
            involvement or what did it get as a result
            of transferring these monies, if anything.
            Did it have a right to be repaid, for
            example?

                      *   *    *   *   *     *   *

                 The Witness: Well, a right to be
            repaid? I guess we had a right to. I mean,
            they were advances, I guess. I -- the way
            -- I know what the intent was, if
            that's what you're asking.

     Q           What was the intent, sir?

     A           The intent was that we would advance
            monies to Cpi, Cpi would develop these
            products, we would have -- get an equity
            position eventually in Cpi and that's why
            we were doing it.
                           - 20 -


Similarly, Mr. Whelpley testified that "Weeden expected

only to receive shares in CPI in return for its investment

in CPI."

     As we view the facts, CPI had entered into the

agreement with Avant-Garde to develop a computer processor.

Weeden agreed to advance moneys to CPI to assist CPI in

performing its obligations under the agreement with Avant-

Garde.   Weeden expected to obtain stock in CPI if the

venture was successful.   Weeden made the subject payments

pursuant to its agreement with CPI.   Mr. Whelpley was the

principal officer of both WAI and CPI, but the two were

separate corporations, and WAI was not formally involved in

the CPI project.   Weeden issued the advances to WAI as a

convenience to Mr. Whelpley, but it did not intend to

obtain an equity investment in WAI or to lend money to WAI.

From Weeden's point of view, the advances were made to CPI.

This is made clear by the fact that at the end of 1987, the

advances were reclassified on Weeden's books into an

account entitled RECEIVABLE FROM CPI.

     Petitioners attempt to blur the distinction between

CPI and WAI by arguing that CPI was a "division" of WAI.

However, we find that CPI was, at all relevant times, a

separate and distinct corporation from WAI.   Although
                           - 21 -

Mr. Whelpley was a director and key employee of both WAI

and CPI, and although the two companies shared office

space, CPI was separately incorporated, maintained a

separate bank account, and established a distinct and

independent board of directors.     Moreover, Mr. Whelpley

acknowledged during his testimony at trial that CPI was a

"functioning entity".   Thus, we find that CPI was not a

"division" of WAI and we reject petitioners' argument

that Weeden's intent to make an equity investment in CPI

somehow how constituted an equity investment in WAI.     In

this connection, we note that in their post-trial briefs,

petitioners abandoned the argument advanced at trial that

CPI was "a wholly owned subsidiary of Wai."

     We note that Mr. Flaherty's letter of September 18,

1991, states as follows:


     The amounts that were advanced, as loans,
     to Whelpley Associates, Inc. and yourself
     [Mr. Whelpley] were to be recovered either;
     (1) in the form of loan repayments, or (2)
     convertible into equity in the projects that
     CPI and WAI were pursuing. Weeden considers
     amounts advanced to be returnable as equity
     in any business entity that results from the
     activity funded in 1987.


During his testimony, Mr. Flaherty stated that he did not

recall writing the letter of September 18, 1991, but he

reiterated the fact that Weeden intended to advance money
                          - 22 -

to assist CPI to develop the computer component and

eventually to obtain an equity interest in CPI.    He

testified as follows:


     Very simply, I think we were advancing monies
     for the use of CPI to develop its product and
     we would eventually own part of CPI. That was
     our goal, was to own part of Communication
     Processors, Inc. That would be a product, the
     company developed a product and that's what
     we're interested in.


Based upon Mr. Flaherty's testimony, we do not credit the

statement contained in his letter of September 18, 1991,

that Weeden made the subject advances "as loans, to

Whelpley Associates, Inc. and yourself".    We find that

Weeden made the subject advances either as loans to CPI or

contributions to CPI's capital.    Weeden issued the checks

to WAI, but it did so on behalf of CPI, and it did not

intend the advances to be loans to WAI or contributions

to WAI's capital.

     For the above reasons, we reject petitioners'

position that WAI's income for 1987 should be reduced

in the amount of $103,693, and, thus, we accept

respondent's determination that the aggregate amount of

Weeden's advances is includable in WAI's income in 1987.

In reaching this result, we note that the record suggests

that CPI constructively received the subject moneys from
                             - 23 -

Weeden, either as a loan or as a contribution to capital,

and paid the moneys to WAI in return for WAI's work on the

CPI project.    In this regard, we note that Mr. Whelpley's

memorandum dated September 9, 1991, suggests that "WAI

applied these amounts to reduce bills written to CPI by

WAI."    Mr. Whelpley also testified the he "conducted all of

the business of CPI within Whelpley Associates."    Thus, the

record suggests the possibility that CPI retained WAI to do

the work required under CPI's contract with Avant-Garde and

applied Weeden's advances to pay WAI for that work.    We

also note that because WAI reported these funds as gross

income on its 1987 return, petitioners must present cogent

evidence to overcome this admission.    See e.g., Estate of

Hall v. Commissioner, 92 T.C. 312, 337-338 (1989).     We find

that petitioners have failed to meet this burden, and thus

they have failed to prove that the amount of the advances

is not includable in WAI's income in 1987, as determined

by respondent.

        Petitioners' principal position is that, upon receipt

of the cash payments from Weeden, WAI ceased to be a "small

business corporation", as defined by section 1361(b)(1)(D),

with the result that WAI's S corporation election auto-

matically terminated as provided by section 1362(d)(2).

As a result of the termination of WAI's S corporation
                                - 24 -

election, petitioners argue that they are not subject to

tax on WAI's income because WAI would be treated as a C

corporation and "petitioners would only be taxed on

distributions received [from WAI] in the form of dividends

in 1987 of which there were none."

     Section 1361 defines a small business corporation in

relevant part as follows:


     SEC. 1361(b). Small Business Corporation--

          (1) In General.--For purposes of this
     subchapter, the term "small business corpora-
     tion" means a domestic corporation which is not
     an ineligible corporation and which does not--

                 *   *      *     *      *   *     *

               (B) have as a shareholder a person
          (other than an estate and other than a trust
          described in subsection (c)(2)) who is not
          an individual, [and]

                 *   *      *     *      *   *     *

               (D) have more than 1 class of stock.


     Petitioners contend that WAI ceased to be a small

business corporation for two reasons.            First, they contend

that Weeden obtained an equity interest in WAI and is not

an eligible shareholder for purposes of the definition of

small business corporation because it is not an individual,

as required by section 1361(b)(1)(B).            Alternatively,

petitioners contend that the interest in WAI that Weeden
                           - 25 -

obtained in exchange for the subject cash advances

constitutes a second class of stock in violation of section

1361(b)(1)(D).   Petitioners argue that Weeden's interest in

WAI constitutes a second class of stock because the

"governing provisions" of CPI give WAI and Weeden different

rights to distribution and liquidation proceeds, contrary

to the requirements of section 1.1361-1(l)(1), Income Tax

Regs.   Specifically, petitioners point to the fact that

under the stock purchase agreement prepared for CPI, Weeden

was to receive both common and preferred stock in CPI while

WAI was to receive only common stock.

     We have already considered and rejected petitioners'

argument that Weeden obtained an equity interest in WAI

in exchange for the subject payments.    Similarly, we find

no support in the record for petitioners' argument that WAI

issued a second class of stock in connection with the

subject payments.   Petitioners' argument fails to explain

what the stock purchase agreement or the other documents

prepared for CPI have to do with the "governing provisions"

of WAI, and it fails to take into account the fact that

those documents were never executed.    Therefore, we find

that petitioners have not proven that Weeden obtained an

equity interest in WAI in 1987, or that WAI issued more

than one class of stock in that year.    Accordingly, we find
                           - 26 -

that petitioners have not proven that WAI ceased to be a

small business corporation, as defined by section 1361(b),

and they have not proven that WAI's S corporation election

terminated in 1987.

     We note that petitioners' post-trial brief correctly

asserts that the subject advances do not satisfy the

straight debt safe harbor requirements of section

1361(c)(5).   Unlike respondent, however, we do not construe

petitioners' assertion as an argument that any transaction

which does not satisfy these requirements necessarily

constitutes a second class of stock.   If petitioners had

made such an argument, we would reject it for the reasons

advanced by respondent.   However, as we read their brief,

petitioners' point is simply that the subject advances do

not fit within the safe harbor provision, and we must

review the "governing provisions" of the S corporation to

determine whether all outstanding shares of WAI's stock

confer identical rights to distribution and liquidation

proceeds.   Sec. 1.1361-1(l)(2)(i), Income Tax Regs.   As

discussed above, the "governing provisions" on which

petitioners base their argument that WAI issued more than

one class of stock are documents that relate to CPI, not

WAI, and are documents that were never executed.    Thus, we
                           - 27 -

reject petitioners' argument that WAI issued more than one

class of stock.

     We also note that petitioners argued at trial that CPI

was a wholly owned subsidiary of WAI, thus violating

section 1362(b)(2)(A), which disqualifies any member of an

affiliated group from making an S corporation election.

In their post-trial briefs, petitioners argue that CPI was

a "division of" WAI.   However, they fail to mention the

argument that CPI was a subsidiary of WAI.   Accordingly,

we deem petitioners to have abandoned the latter argument.

Rule 142(a); Calcutt v. Commissioner, 84 T.C. 716, 721-722

(1985); German v. Commissioner, T.C. Memo. 1993-59, affd.

without published opinion 46 F.3d 1141 (9th Cir. 1995).

     In view of our finding that WAI's S corporation

election was not terminated during the years in issue,

we need not consider the first of the two issues raised

in respondent's amended answer that petitioners are

prohibited by the duty of consistency from asserting that

WAI's S corporation election was terminated.   The second

issue raised in respondent's amended answer is respondent's

alternative position that, if Weeden's advances are found

to be loans to WAI, then the loans were forgiven in 1988

and constitute gross income to WAI in that year.   This

issue became moot by reason of the stipulation of settled
                           - 28 -

issues that was filed in the related cases and by reason of

our finding that the advances were not loans to WAI.


Validity of the Notices of Deficiency for 1989

     In their opening brief, petitioners argue that the

notices of deficiency issued for taxable year 1989 should

be dismissed because they do not explain how the

deficiencies determined for that year were calculated,

other than by stating that the deficiencies result from a

carryforward of the 1988 redetermination.   Petitioners also

argue that respondent failed to "offer a single witness,

including the revenue agent who prepared the Notices, to

explain how they were calculated."   Petitioners maintain

that because respondent failed to present such testimony,

the burden of proof with regard to the 1989 deficiencies

shifted to respondent.

     We disagree.   Both notices of deficiency adequately

explain respondent's determination of deficiencies for 1987

and 1989.   Petitioners bear the burden of proving that

respondent's determination of a deficiency is incorrect.

Rule 142(a).   Petitioners have not met this burden, and

have not shown any reason why the burden should be shifted

to respondent.
                          - 29 -


Additions to Tax and Penalty

     In the notices of deficiency, respondent determined

that petitioners are liable for the additions to tax

under sections 6653(a)(1)(A) and 6661 with respect to

their 1987 returns, and for the penalty under section

6662(a) with respect to petitioners' 1989 returns.   We

note that sections 6653 and 6661 were repealed effective

for returns due after December 31, 1989.   See Omnibus

Budget Reconciliation Act of 1989, Pub. L. 101-239, sec.

7721(c)(1) and (2), 103 Stat. 2399.   During 1987, section

6653(a)(1)(A) imposed an addition to tax equal to 5 percent

of the underpayment of tax if any part of the underpayment

was due to negligence or disregard of rules or regulations.

Also during 1987, section 6661 imposed an addition to tax

for substantial understatement of income tax for any

taxable year equal to 25 percent of the underpayment

attributable to the understatement.   Section 6662 imposes

a penalty equal to 20 percent of the portion of an under-

payment of tax which is attributable to negligence or

disregard of the rules or regulations, or to a substantial

understatement of income tax.   Sec. 6662(b)(1) and (2).
                            - 30 -

     Petitioners bear the burden of proving that they

are not liable for the additions to tax and penalty as

determined by respondent.   Rule 142(a); Axlerod v.

Commissioner, 56 T.C. 248, 258-259 (1971).   Petitioners

did not take issue with respondent's determination in their

pleadings or post-trial briefs and have presented nothing

to show that respondent's determinations are erroneous.

Accordingly, we sustain respondent's determination and find

that petitioners are liable for the additions to tax under

sections 6653(a) and 6661, and for the penalty under

section 6662.

     In light of the foregoing, and reflecting concessions,


                                 An appropriate order will

                            be issued denying respondent's

                            motion for leave to file

                            amendments to answers and to

                            conform the pleadings to the

                            proof and decisions will be

                            entered under Rule 155.
