                          T.C. Memo. 2000-345



                        UNITED STATES TAX COURT



          DAVID E. AND REBECCA NEWMAN, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 18599-98.                   Filed November 8, 2000.



     Jeffrey M. Weiss, for petitioners.

     Wendy Abkin, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     GERBER, Judge:     In a notice of deficiency addressed to

petitioners, respondent determined deficiencies in income tax and

penalties as follows:

                                         Penalty
          Year        Deficiency      Section 6662(a)
          1991         $92,042           $18,408
          1992          47,648             9,530
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     After concessions,1 the issues for our consideration are:

(1) Whether petitioners are entitled to offset gross proceeds

reported on their 1991 and 1992 Schedules C, Profit or Loss From

Business, by the amounts of $250,000 and $140,000, respectively,

that they claimed as cost of goods sold; and (2) whether

petitioners are liable for the accuracy-related penalty under

section 6662(a) for the 1991 and 1992 tax years.2

                        FINDINGS OF FACT

     The parties’ stipulation of facts and the exhibits are

incorporated herein by this reference.

     Petitioners resided at 455 Irwin Street, #201, San

Francisco, California, at the time their petition was filed.

David E. Newman (petitioner) is an entrepreneur who has been

involved in a wide range of business opportunities for the


     1
       The parties filed a stipulation of settled issues, whereby
petitioners conceded: (1) They are not entitled to Schedule C
secretarial expenses in the amount of $5,439 for the 1991 tax
year; (2) they are not entitled to Schedule C meals and
entertainment expenses in the amounts of $73,554 and $12,122 for
the 1991 and 1992 tax years, respectively; (3) they are not
entitled to Schedule C charity expenses in the amount of $8,489
for the 1991 tax year; and (4) $46,255 of their net operating
loss carryback from the 1993 tax year to the 1991 tax year is not
allowable. The parties also agree that the adjustments in the
notice of deficiency to petitioners’ 1992 self-employment tax
deduction, 1992 itemized deductions, and 1991 and 1992 deductions
for exemptions are computational adjustments and will be
determined after the remaining issues have been resolved.
     2
       Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable periods under
consideration, and all Rule references are to the Tax Court Rules
of Practice and Procedure.
                               - 3 -

purpose of securing both short- and long-term returns on his

investments.   During the years at issue, petitioner was engaged

in a business activity with Peter Lee (Lee) involving the

purchase and resale of computer chips.

     In December 1990, petitioner and Stanley M. Friedman

(Friedman) executed a joint venture agreement with Lee setting

forth the terms and conditions for the purchase and resale of

computer chips.   According to the joint venture agreement,

petitioner and Friedman were to invest approximately $1 million

and $2 million, respectively, with Lee for the purchase and

resale of computer chips.   Although petitioner and Lee formalized

their arrangement with a joint venture agreement, most of

petitioner’s transactions with Lee were done on a handshake.

     During the years at issue, petitioner advanced funds to Lee

in order to provide him with the necessary capital to buy the

computer chips.   Lee would use these funds to purchase computer

chips and then sell the chips to third parties.   After the chips

were acquired by Lee and sold to third parties, Lee would return

the funds advanced by petitioner, and pay an additional specified

rate of return on those advanced funds.   This specified return

represented some portion of Lee’s profit from the resale of the

chips.   Lee also paid petitioner a commission for referring other

investors to him.
                                 - 4 -

     While petitioner sometimes went to Lee’s office to view the

computer chips that Lee had purchased, petitioner never took

possession of the chips, did not maintain any inventory or supply

of computer chips, did not know the sales price of the computer

chips, and did not maintain any records relating to the purchase

or sale of the computer chips.    The only records petitioner

maintained were of the amount of funds that he advanced to Lee

and the amount of the return that Lee owed him on those advances.

     During 1991, petitioner received a return on his advances

and commissions from Lee in the amount of $799,550.    During 1992,

petitioner received a return on his advances from Lee in the

amount of $340,152.    As of December 31, 1991, Lee owed petitioner

expected returns of $250,000 on funds that petitioner had

advanced to him.    Likewise, as of December 31, 1992, Lee owed

petitioner expected returns of $140,000 on funds that petitioner

had advanced to him.

       For the 1991 tax year, petitioners reported $799,550 as

gross receipts and $250,000 as costs of goods sold on the

Schedule C attached to their tax return.    For the 1992 tax year,

petitioners reported $340,152 as gross receipts and $140,000 as

costs of goods sold on the Schedule C attached to their return.

The gross receipts figures shown on petitioners’ 1991 and 1992

Schedules C do not reflect the sales of the computer chips by Lee

to third parties.    Rather, the gross receipts represent
                               - 5 -

petitioner’s portion of the profit that was made on the purchase

and resale of the computer chips.

     In the notice of deficiency issued to petitioners,

respondent disallowed the Schedule C cost of goods sold for the

1991 and 1992 tax years and determined penalties for negligence.

                              OPINION

     We must decide whether petitioners (1) are entitled to claim

cost of goods sold in the amounts of $250,000 and $140,000 on

their Schedules C for the 1991 and 1992 tax years, respectively,

and (2) are liable for the accuracy-related penalty under section

6662(a) for the 1991 and 1992 tax years.

     The cost of goods purchased for resale in a taxpayer’s

business is subtracted from gross receipts to compute gross

income.   See sec. 1.61-3(a), Income Tax Regs.   This Court has

consistently held that the cost of goods sold is not a deduction

(within the meaning of section 162(a)), but is subtracted from

gross receipts in the determination of a taxpayer’s gross income.

See Max Sobel Wholesale Liquors v. Commissioner, 69 T.C. 477

(1977), affd. 630 F.2d 670 (9th Cir. 1980); secs. 1.162-1(a),

Income Tax Regs.   Taxpayers must show their entitlement to the

amount of cost of goods sold claimed.   See Rule 142(a).

Taxpayers must also keep sufficient records to substantiate the

cost of goods sold.   See sec. 6001; Wright v. Commissioner, T.C.

Memo. 1993-27.
                                - 6 -

     Petitioner claims that he was involved in the computer chip

sales business, and that he is entitled to reduce his Schedule C

gross receipts by the cost of the computer chips.     As an initial

matter, we must determine whether petitioner was in the business

of purchasing and reselling computer chips, or simply providing

Lee with a source of capital and earning a return on his

investment.

     While the parties agree that petitioner and Lee had a

business arrangement concerning the purchase and sale of computer

chips, it is apparent that petitioner’s role in the arrangement

was limited to that of an investor.     Lee had contacts with

manufacturers of computer chips and could obtain a supply of

these chips to market to purchasers.     He did not, however, have

the capital necessary to acquire the chips from the

manufacturers.   As a result, petitioner advanced funds to Lee,

who, after purchasing the computer chips, returned the funds to

petitioner with some specified rate of return.     Petitioner did

not take possession of the chips nor maintain any sort of

inventory.    In addition, he was not involved in the actual sales

of the computer chips.   Petitioner did not know the sales price

of the computer chips or how much money Lee was making on the

sales.   The only record petitioner maintained regarding this

arrangement was the amount of money advanced to Lee and the

amount of return he was to receive on the advanced funds.       In
                               - 7 -

addition, the joint venture agreement between petitioner and Lee

referred to the arrangement as an “investment”.

     Furthermore, petitioners’ Schedules C are inconsistent with

the contention that petitioner was in the business of selling

computer chips.   Petitioners’ Schedules C do not reflect the

gross receipts from the sale of the computer chips.    Rather, they

merely reflect a portion of the profit that was realized by Lee

upon the resale of the computer chips and subsequently paid to

petitioner as a return on his investment.   Accordingly, we find

that petitioner was merely a source of capital for Lee, and was

not a merchant with respect to the computer chips.    Therefore,

petitioner cannot treat the $250,000 and $140,000 amounts as

costs of goods sold in 1991 and 1992, respectively.

     We note that even if we were willing to reach the conclusion

that petitioner was engaged in the sale of computer chips and

acquired chips for resale in 1991 and 1992, petitioners have

failed to substantiate the costs of good sold and we are unable

to make an estimate.   Section 6001 requires that a taxpayer

liable for any tax shall maintain such records, render such

statements, make such returns, and comply with such regulations

as the Secretary may from time to time prescribe.    Petitioners

admit that “No testimony or other evidence has been presented as

to any specific costs,” yet claim that we can make a reasonable

estimate of petitioners’ cost of goods sold based on Cohan v.
                               - 8 -

Commissioner, 39 F.2d 540 (2d Cir. 1930).    Under Cohan, in the

event that a taxpayer establishes that he or she has incurred a

deductible expense but is unable to substantiate the precise

amount of the expense, we may estimate the amount of the

deductible expense.   We cannot, however, estimate deductible

expenses unless the taxpayer presents evidence sufficient to

provide some rational basis upon which estimates may be made.

See Vanicek v. Commissioner, 85 T.C. 731, 743 (1985).

     Petitioner kept no documentation regarding any expenses or

costs relating to the computer chip sales.    Likewise, petitioner

has no documentation regarding gross sales of the computer

chips.3   As a result, petitioners ask us to back into a cost of

sales number based on petitioner’s testimony that Lee’s return on

the computer chip sales was approximately double the return to

petitioner.   Thus, to quote petitioners, “Since * * * [petitioner

had] a 6% return, Lee’s return would be about 12%, effectively

translating into a cost of sales of 72%.”    This information

simply does not provide us with the detail needed to make an

estimate.   Accordingly, even if we were to conclude that

petitioners could claim cost of goods sold, we would be unable to

determine the proper amount.


     3
       During trial, petitioner testified that he requested his
assistant to keep records of every deal with Lee, but later
discovered that whatever records were kept were discarded by the
assistant when he was caught stealing trade secrets from
petitioner in regard to another venture.
                                   - 9 -

       Petitioners contend as an alternative argument that if they

are not allowed to treat the $250,000 and $140,000 as cost of

goods sold in 1991 and 1992, respectively, they should either be

allowed a business expense deduction under section 162(a) or a

business bad debt deduction under section 166(a).      Respondent

objects to these arguments because petitioners raised them for

the first time in their opening brief.4      While it is true that

respondent had no opportunity to explore facts regarding these

theories with petitioner during his testimony, given the fact

that they do not hold merit and can be quickly addressed, we

shall consider petitioners’ alternative arguments.

       With regard to petitioners’ assertion that the claimed cost

of goods sold should be allowed as an ordinary and necessary

business expense under section 162(a), petitioners have failed to

establish that the amounts reported as cost of goods sold are

ordinary or necessary business expenses deductible under section

162.       Indeed, the evidence supports a finding that the $250,000

and $140,000 that petitioners claim are deductible represented

simply the expected return on funds that petitioner advanced as

working capital to Lee.      As such, the amounts were more akin to a




       4
       A party may rely upon a theory only if it provided the
opposing party with fair warning that it intended to make an
argument based upon that theory. Pagel, Inc. v. Commissioner, 91
T.C. 200, 211 (1988), affd. 905 F.2d 1190 (8th Cir. 1990).
                                 - 10 -

receivable than an expense.     Accordingly, petitioner is not

entitled to a deduction for these amounts under section 162(a).

       With respect to the business bad debt claim, section 166(a)

allows a deduction for “any debt which becomes worthless within

the taxable year.”     Under section 1.166-1(c), Income Tax Regs.,

the debt must be “bona fide”, defined as “a debt which arises

from a debtor-creditor relationship based upon a valid and

enforceable obligation to pay a fixed or determinable sum of

money.”    Furthermore, taxpayers must exhaust the usual and

reasonable means of collection before they are entitled to a

deduction.    See C.S. Webb, Inc. v. Commissioner, 1 B.T.A. 269

(1925).     When efforts to collect become futile, the deduction is

allowed.     See   Alexander v. Commissioner, 26 T.C. 856 (1956).

       Petitioners’ evidence concerning their entitlement to a

business bad debt deduction consisted of petitioner’s testimony

that (1) Lee owed petitioner “over a million dollars,” and (2)

Lee filed for bankruptcy in “either December of ‘92 or January of

‘93.”     Aside from these two statements, petitioners presented no

evidence to establish their entitlement to a business bad debt

deduction under section 166(a).     Petitioners failed to show that

there was a bona fide debt that became worthless during the years

in issue, or that they attempted to collect any such debt from

Lee.    Accordingly, they are not entitled to a business bad debt

deduction under section 166(a).
                                - 11 -

     We now must decide whether petitioners are liable for the

accuracy-related penalty under section 6662(a).      Respondent, for

both of the taxable years, determined an accuracy-related

penalty, based on negligence, under section 6662(a).      That

section imposes an addition to tax in the amount of 20 percent of

any portion of the underpayment attributable to negligence or the

disregard of rules or regulations.       See sec. 6662(a) and (b)(1).

Petitioners must show that respondent’s determination is

erroneous.   See Rule 142(a).

     The term “negligence” includes any failure to make a

reasonable attempt to comply with the provisions of the tax laws,

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

intentional disregard.   Sec. 6662(c).     Negligence has also been

defined as a lack of due care or failure to do what a reasonable

person would do under the circumstances.      See Allen v.

Commissioner, 925 F.2d 348, 353 (9th Cir. 1991), affg. 92 T.C. 1

(1989); Neely v. Commissioner, 85 T.C. 934, 947-948 (1985).       To

avoid this penalty, petitioners must show that their actions were

reasonable and not careless, reckless, or made with intentional

disregard of rules or regulations.       See Delaney v. Commissioner,

743 F.2d 670 (9th Cir. 1984), affg. T.C. Memo. 1982-666.

Taxpayers are expected to maintain adequate records, and failure

to do so may constitute negligence and a disregard of rules or

regulations.   See sec. 6001.
                                 - 12 -

     Petitioners have failed to offer any evidence to suggest

that they acted with reasonable cause and good faith with respect

to their reporting of the purported cost of goods sold.

Petitioner contends that he employed a full time assistant for

the purpose of keeping records of his various business

activities.   Petitioner testified that he requested that his

assistant keep records of every deal with Lee, but later

discovered that the records had been discarded.     Petitioners

contend that “While petitioner was unable to produce any of the

records that were to be kept by his assistant through no fault of

his own, his record keeping attempts in this regard were not

unreasonable.”    We disagree.   Petitioners have failed to show

that they exercised ordinary care and business prudence in

keeping records necessary to comply with the tax laws.

Petitioner’s uncorroborated, self-serving testimony simply fails

to convince us that his record keeping attempts were reasonable,

and his attempt to shift the blame to his assistant is equally

unconvincing.    Either petitioners were not engaged in the

computer chip sales business, in which case they had no basis for

claiming cost of goods sold, or they utterly failed to maintain

any records to support the computer chip sales business and the

costs incurred in it.    To the extent that records do exist, they

do not support petitioner’s claim that he was in the computer

chip sales business or that he had cost of goods sold.
                             - 13 -

     As such, we find that petitioners failed to make any

reasonable attempt to comply with the tax laws and carelessly

disregarded rules and regulations relating to the proper

reporting of items and record keeping.   Accordingly, we sustain

respondent’s determination and hold that petitioners are liable

for the section 6662(a) accuracy-related penalty for the 1991 and

1992 tax years.

     We have considered all other arguments of the parties, and

to the extent not addressed herein, we find them to be either

meritless or irrelevant.

     To reflect the foregoing and concessions of the parties,

                                   Decision will be entered

                              under Rule 155.
