                        T.C. Memo. 2006-243



                      UNITED STATES TAX COURT



           RAYMOND T. and PATRICIA MURPHY, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 3601-03.                Filed November 9, 2006.


     Gerald Katz, for petitioners.

     C. Teddy Li, for respondent.



              MEMORANDUM FINDINGS OF FACT AND OPINION


     HOLMES, Judge:   In December 1997, Raymond Murphy sent a

check to Philip Hunt for $225,000.   Murphy says the check was for

interest that he owed Hunt on two living horses; the Commissioner

says the check was a repayment of principal on a dead one.   If

Murphy is right, the entire amount is deductible; if he isn’t,

none is.
                                - 2 -

                           FINDINGS OF FACT

     Raymond Murphy has been a veterinarian specializing in

horses for forty years.    He also became a real estate developer,

and a few of the deductions originally contested in this case

come from that business.    But the bulk of this case, and Murphy’s

great pleasure, comes from breeding, raising, and trading

thoroughbred horses.   Although Murphy has owned a stableful over

the years, only three horses figure in this case:       Hamseh, Desert

Spice, and On the Piste.    All three are broodmares, and all came

to Murphy from what he described as his “wheeling and dealing”

and “whipping and dipping” with Philip DeVere Hunt of Tipperary,

Ireland, a fellow breeder whom Murphy has long known.

     Murphy bought Hamseh and Desert Spice from Hunt in 1994.

Hamseh cost him $600,000, which he financed in part with a

promissory note for $425,000 in Hunt’s favor.       Interest on this

note accrued at a rate of ten percent per annum on any unpaid

balance, and the note required interest payments in August 1995

and August 1996, and then all remaining principal and interest by

December 31, 1996.   The note stated that “all payments shall be

first applied to interest and the balance to principal.”

     Desert Spice cost Murphy $385,000.       He financed $379,000 of

the total price with a promissory note.       Like the note for

Hamseh, this note also had a specific repayment schedule:

(1) $40,000 of principal in May 1995; (2) interest at ten percent
                               - 3 -

in November 1995; (3) another $100,000 of principal in May 1996;

(4) interest on the balance in November 1996; and (5) any

remaining principal and interest by November 15, 1997.   As in the

note for Hamseh, Murphy’s payments on Desert Spice were first to

be applied to interest before any reductions in principal.

     And that leads to the third horse in this case, On the

Piste.1   Hunt apparently sold her to Murphy in July 1997; there

was no date on the bill of sale, but a copy of the fax that Hunt

sent to Murphy to confirm the sale bore a July 31, 1997 stamp.

Murphy agreed to pay $250,000, but the sale was subject to the

condition that she be carrying a foal.   Certification by a

veterinarian that On the Piste was pregnant would trigger a

payment of $25,000.   Murphy would owe the remainder on or before

December 31, 1998 but, unlike the deals for Hamseh and Desert

Spice, the deal for On the Piste did not require Murphy to pay

interest on the unpaid principal.   On August 19, 1997, Murphy

paid Hunt $25,000 after On the Piste’s pregnancy was confirmed.

He also took out an insurance policy on her for $250,000.     The

horse remained in Hunt’s stables pending shipment to Maryland,

but less than six weeks later both she and her unborn foal died

while still in Ireland.   Murphy filed a claim with his insurer,


     1
       Piste means ski trail--alluding to the names of her sire
and dam, Shirley Heights and Snowing. Her pedigree features two
appearances by Nasrullah (the grandsire of Secretariat) and one
by Native Dancer (a winner of the Preakness and Belmont), two of
the most prominent breeding stallions of the last century.
                               - 4 -

and received a check for $250,000 on December 12, 1997.    On

December 27, he sent a $225,000 check to Hunt.    The memo line on

the front of the check said that payment was being made for

“Hamseh and Desert Spice Interest.”    Of course, as the IRS

noticed, this was the same amount that Murphy still owed Hunt for

On the Piste.

     It is here that agreement between the parties ends, and we

canter into a mare’s nest of conflicting claims.    Murphy argues

that he was in arrears on his payments of principal and interest

on both Hamseh and Desert Spice.   As final payment for On the

Piste was not due until the end of 1998, Murphy claims that he

agreed with Hunt to pay off at least some of the interest owing

on the other two horses.   That the interest amount worked out to

$225,000, the amount of principal still owed for On the Piste,

simply reflects the fact that that was the money that he had in

hand as a result of the insurance settlement.    He relies for

proof on a written payment extension signed by Hunt that gave him

an additional year (to December 31, 1999), to make final payment

for On the Piste, provided that he use $225,000 of the $250,000

in insurance proceeds from the death of On the Piste to bring the

interest owed on Hamseh current through the end of 1997, and the

interest owed on Desert Spice current through the beginning of

March 1997.   Murphy claims that the agreement was based on the

interest and principal calculations of his accountant, and that
                                 - 5 -

Hunt concurred in them.   Murphy claimed the $225,000 payment as

an interest deduction on his 1997 tax return.

     The Commissioner disallowed that deduction, having

concluded that Murphy had actually already paid for Hamseh and

Desert Spice.   He believes that Murphy used the $225,000 to pay

off the balance owing for On the Piste.2   He also disallowed

various other minor expenses.    A notice of deficiency followed,

in which the Commissioner asserted an accuracy-related penalty

under section 6662 on the entire deficiency.3

     The parties originally submitted the case for decision on

stipulated facts under Rule 122, but it was then restored to the

Court’s general docket for trial.    The Murphys are residents of

Maryland, as they were when they filed their petition, and trial

was held in Baltimore.

                                OPINION

     We must decide three issues:    (1) whether Murphy has

successfully shifted the burden of proof onto the IRS; (2)

whether Murphy’s payment to Hunt was a deductible interest



     2
       Given the paperwork that Murphy produced, this might seem
to amount to an assertion that Murphy was committing fraud. This
would have triggered a larger penalty, but would also have
saddled the Commissioner with a heavier burden of proof.
     3
       Unless otherwise indicated, section references are to the
Internal Revenue Code as in effect for the years at issue, and
the Rule references are to the Tax Court Rules of Practice and
Procedure.
                               - 6 -

expense; and (3) whether Murphy is liable for an accuracy-related

penalty due to negligence or a substantial understatement.

1.   Burden of Proof

     A taxpayer usually bears the burden of proof on each

contested issue of fact.   Rule 142(a); Alt v. Commissioner, 119

T.C. 306, 311 (2002), affd. 101 Fed. Appx. 34 (6th Cir. 2004).

But section 7491(a) lets him shift that burden to the

Commissioner if he shows that he kept all the records required by

the Code and cooperated with the IRS, and if he introduces

credible evidence about the particular issue on which he is

trying to shift the burden.   Cipriano v. Commissioner, T.C. Memo.

2001-157, affd. 55 Fed. Appx. 104 (3d Cir. 2003).

     In this case, we find that the Commissioner bears the burden

of proof on the central issue of the interest deduction.    Murphy

was able to provide copies of the essential documents, and

credibly testified that his C.P.A. kept extensive records

regarding his business dealings.    The Commissioner did not refute

this claim.   Murphy was also able to substantiate the interest

transaction through canceled checks and payment agreements.      And

we believed his testimony that he had cooperated with the IRS

during the audit of his return.    This is enough to shift the

burden, though we do note that this usually doesn’t matter very

much--most cases will be decided on a preponderance of the

evidence.   Shifting the burden may, however, affect the way we
                                 - 7 -

view possible gaps in the evidence.

2.   Deductibility of Interest

     Turning to the main issue in the case--Murphy’s attempted

$225,000 deduction for interest--we begin with the law.     Section

163(a) states as a general rule that “there shall be allowed as a

deduction all interest paid or accrued within the taxable year on

indebtedness.”   In First Natl. Co. v. Commissioner, 32 T.C. 798,

807 (1959), revd. and remanded on other grounds 289 F.2d 861 (6th

Cir. 1961), we defined indebtedness as “an existing,

unconditional, and legally enforceable obligation for the payment

of money.”

     Recognizing this, the Commissioner argues first that the

disputed check couldn’t have gone to pay interest on Hamseh and

Desert Spice because Murphy had already paid off those notes,

meaning there was no underlying valid debt between Murphy and

Hunt.   The Commissioner’s strongest argument is the presence of

the legend “paid in full” marked on the promissory notes for both

Hamseh and Desert Spice.   If Murphy had paid these notes

according to their original terms, they would both have been paid

off by December 1997.   The problem, however, is that neither

party introduced documentary or expert evidence of when the notes

were marked as “paid in full.”    Murphy himself testified that the

promissory notes were marked “paid in full” only much later.    At

the end of 1997, he said he still had not ponied up enough money
                               - 8 -

to extinguish the debt for either Hamseh or Desert Spice.

According to Murphy, he and Hunt modified their sales contracts

for Hamseh and Desert Spice to use the cash-in-hand from the

insurance settlement to pay much of the unpaid interest on those

horses.   The debt was finally extinguished--and the notes marked

“paid in full”--only years later, when Murphy agreed to turn over

to Hunt one foal each from Hamseh and Desert Spice.    In addition

to his testimony, Murphy produced a written agreement with Hunt

ratifying the continuing existence of his obligation to pay the

outstanding principal for On the Piste.

     In judging the credibility of this story, we wondered what

was in it for Hunt--if Murphy is to be believed, by the time he

bought On the Piste in mid-1997, he was still in debt to Hunt on

the other two horses for hundreds of thousands of dollars.    If

Murphy was truly delinquent in his payments to Hunt, why would

Hunt continue to “whip and dip” by selling On the Piste to him?

Why is there no rock-solid contemporaneous documentation

regarding the many extensions, modifications, etc. of the note

payments that were to have occurred?

     It would also have been easy, one might think, for one party

or the other to have introduced Murphy’s check registers and bank

statements for 1994-97 to see the extent to which the debts on

Hamseh and Desert Spice had been paid.    But neither party did,

despite Murphy’s having turned all these records over to the IRS
                               - 9 -

during audit.   And the Commissioner invoked his right to exclude

the testimony of the accountant who’d prepared Murphy’s tax

returns on the ground that he had not been identified in Murphy’s

pretrial memorandum.

     We are therefore forced to rely mostly on our evaluations of

Murphy’s truthfulness and the rather thin paper trail.    And, in

the end, we do find that Murphy’s testimony was credible.   Due to

the length of his dealings with Hunt, including many successful

trades and coownership of some horses, we find that their

relationship was strong enough to explain Hunt’s willingness to

extend the payment schedule for Hamseh and Desert Spice.    Apart

from unsuccessfully challenging Murphy’s credibility, and despite

having the burden of proof on this issue, the IRS provided no

direct evidence that Murphy did not owe Hunt money for those two

horses when he mailed Hunt the $225,000 check.   We therefore find

that Murphy has shown that a valid indebtedness on Hamseh and

Desert Spice still existed at the end of 1997.   See First Natl.,

289 F.2d at 866 (leniency by lender in not pressing for

collection on debt does not create presumption that debt is

invalid).

     The Commissioner next argues that, even if those notes were

still outstanding, Murphy must have intended to use the money to

repay the principal owed for On the Piste, because $225,000 was

the exact amount that Murphy still owed Hunt for that horse.
                                - 10 -

Here again we find Murphy credible when he testified that he got

together with his accountant in late 1997 to calculate the number

of days’ worth of interest on Hamseh and Desert Spice that

$225,000 would pay off, and then secured Hunt’s acquiescence in

treating the payment as interest on those two horses instead of

full payment of principal for On the Piste.    A note that isn’t

paid according to its original terms is still a debt even though

overdue, see id., and Hunt was free to accept immediate payment

of interest for Hamseh and Desert Spice and equally free to

extend the due date for Murphy to finish paying for On the Piste.

See, e.g., Kluesner v. Commissioner, T.C. Memo. 1989-83 (“the

parties to a contract may modify an existing contract by mutual

consent” (citation omitted)).    We hold that the $225,000 payment

was for interest on a valid and enforceable debt between Murphy

and Hunt.   That’s all that’s required to rule in Murphy’s favor

on the issue of deductibility.

3.   Accuracy-Related Penalty

     Only the penalty issue remains.     The Commissioner can impose

a penalty for negligence on a taxpayer who fails to make a

reasonable attempt to comply with the provisions of the Code or

displays careless, reckless, or intentional disregard of the Code

or regulations.   Sec. 6662; sec. 1.6662-3, Income Tax Regs.   In

this case, the Commissioner asserted the penalty against the

entire deficiency.
                                - 11 -

     Most of the asserted penalty disappears with our ruling that

Murphy was entitled to treat the $225,000 payment as interest.

There were, however, other adjustments in the notice of

deficiency.    These were comparatively small and, in a burst of

lawyerly horse-trading before the trial began, they were all

settled with reciprocal concessions.     Murphy conceded the

following:

       Description                                Amount
       Capitalization of electrical               $4,500
       Legal expenses                              1,850
       Utilities                                   3,995
       Telephone                                   2,869
       Dues and subscriptions                        900
         Total                                    14,114

     The parties did not settle the question of whether the

section 6662 penalty would apply to these items.     The Court

warned them that they should introduce some evidence on these

items because the penalty remained in dispute.     They did not do

so, and now we have to decide the issue in the absence of any

evidence.

     We solve this problem by relying on Swain v. Commissioner,

118 T.C. 358, 364-65 (2002), where we said:

            An individual must first challenge a penalty
            by filing a petition alleging some error in
            the determination of the penalty. If the
            individual challenges a penalty in that
            manner, the challenge generally will succeed
            unless the Commissioner produces evidence
            that the penalty is appropriate.
                                - 12 -


     In this case, Murphy did contest in his petition the penalty

on all the items that the Commissioner disallowed.    It was

therefore up to the Commissioner to come forward with at least

some evidence that their imposition was justified--for example,

by showing that Murphy hadn’t kept adequate books and records on

those items.   See, e.g., Higbee v. Commissioner, 116 T.C. 438,

449 (2001); Biazar v. Commissioner, T.C. Memo. 2004-270.

     This he did not do.   Instead, he argues that Murphy’s

concession to the disallowance of these minor items is ipso facto

proof of Murphy’s negligence.    This argument is much too broad--

conceding that a deduction is not allowable is not the same as

conceding that it was taken negligently or in intentional

disregard of the rules and regulations.

     The Commissioner’s alternate basis for the penalty is that

Murphy substantially understated his tax liability.    An

understatement is deemed “substantial” if it exceeds the greater

of ten percent of the tax required to be shown on the return, or

$5,000.   Sec. 6662(d)(1)(A); sec. 1.6662-4(b)(1), Income Tax

Regs.   As we reasoned in Perry Funeral Home v. Commissioner, T.C.

Memo. 2003-340, the Commissioner satisfies his burden under

section 7491(c) to show some evidence of understatement by

pointing to a taxpayer’s concession that at least some deductions

were not allowable.   Whether any understatement resulting from
                             - 13 -

Murphy’s concessions on these smaller items is “substantial” or

not is a computational issue, and so


                                   Decision will be entered

                              under Rule 155.
