                        T.C. Memo. 2004-82



                      UNITED STATES TAX COURT



         NICK KIKALOS AND HELEN KIKALOS, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 11486-01.                 Filed March 23, 2004.



     John J. Morrison, for petitioners.

     Ronald T. Jordan, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GERBER, Judge:   Respondent determined a deficiency in

petitioners’ Federal income tax for the taxable year 1997 of

$105,296 and a penalty under section 6662(a)1 in the amount of


     1
       All section references are to the Internal Revenue Code in
effect for the year at issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
                               - 2 -

$21,059.20.   After concessions,2 the issues presented for our

consideration are:   (1) Whether petitioners’ income was

understated and (2) whether petitioners are subject to section

6662(a) penalties for substantial understatement of tax or

negligent disregard of the rules or regulations.

                         FINDINGS OF FACT3

     Petitioners Nick Kikalos and Helen Kikalos resided in

Hammond, Indiana, at the time their petition was filed.    In the

statutory notice of deficiency, respondent determined that

petitioners had unreported income from the following sources:

(1) Coupon and buy-down reimbursement payments from tobacco

companies; (2) rack and promotional payments; (3) vendor refunds

and reimbursements; and (4) insurance recovery payments.

     During 1997, Nick Kikalos4 (petitioner) owned and operated

four retail stores under the name of Nick’s Liquor Mart (Nick’s

Liquors) in Hammond, Indiana, selling cigarettes, beer, liquor,

wine, and other products.   During the year at issue, cigarette

manufacturers employed “buy-down” programs to lower the cost of

cigarettes at which retailers, including Nick’s Liquors, sold to

     2
       Respondent conceded $23,244 of the $224,620 gross receipts
adjustment, as well as an adjustment of $19,652 with respect to
unreported income from H&L Display Co.
     3
       The parties’ stipulation of facts is incorporated by this
reference.
     4
       Petitioner Helen Kikalos is a party to this case by reason
of the fact that she filed a joint Federal income tax return with
Nick Kikalos for the year under consideration.
                               - 3 -

consumers.   A buy-down is a discount given to a retailer for each

carton of cigarettes sold during a given promotional period.

     Cigarette manufacturers expected the retailers to pass along

the buy-down discounts to the customers.    The manufacturers used

different approaches to verify this expectation.    Some of the

manufacturers’ sales representatives, during periodic sales

calls, confirmed that retailers complied.   Other cigarette

manufacturers required the retailers to take inventories to

reconcile with the amount of buy-down payments.    In such cases,

the buy-down amounts were computed by taking the change in

inventory for a given buy-down period and adding the total

cigarette purchases during the same period.    When required,

Nick’s Liquors performed this accounting and furnished it to

cigarette manufacturers before they paid the buy-downs.    Such

accountings were not audited or verified by the cigarette

manufacturers.   Lastly, a number of cigarette manufacturers paid

buy-down discounts to retailers based on the number of cartons

purchased during a given buy-down period.

     Because of delays in processing the buy-down information,

Nick’s Liquors received buy-down payments weeks or months after

the transactions with the ultimate consumer.   Thus, some buy-down

checks received by Nick’s Liquors in 1997 contained payments with
                               - 4 -

respect to 1996 sales activity, and some buy-down checks received

in 1998 contained payments with respect to 1997 sales activity.

     Nick’s Liquors also accepted or honored paper coupons

presented by customers.   Petitioner submitted the coupons to each

cigarette manufacturer for reimbursement of the face value of the

coupon, plus postage costs.

     Petitioner reported $653,164 in coupon and buy-down income

on his 1997 Federal income tax return.   During the audit

examination, petitioner provided respondent with four worksheets5

detailing coupon and buy-down and rack and promotional income.

Each worksheet included summary totals for all four stores.     One

worksheet reflected coupon and buy-down income totaling $777,848,

while the remaining worksheets reflected a total of $521,695.

     To protect the Government’s interest, the revenue agent

based her examination on the worksheet that reflected $777,848 of

coupon and buy-down income.   Despite requests by the revenue

agent, petitioner did not furnish respondent with adequate

records to substantiate the amount of coupon and buy-down income

recorded by each store on a daily, monthly, or annual basis.




     5
       The record is unclear as to why petitioner provided four
separate summary worksheets to the revenue agent. Petitioner did
not adequately explain why they were substantially similar with
one inconsistency as to the total.
                               - 5 -

Further, he did not provide adequate records to reconcile coupon

and buy-down reimbursement payments with amounts reported as

coupon and buy-down income.

     The revenue agent used records she requested and received

directly from cigarette manufacturers in an attempt to reconcile

the $777,848 coupon and buy-down income total with associated

payments received from cigarette manufacturers.   Some cigarette

manufacturers provided summary schedules of buy-down payments

made to petitioner.   Others provided copies of buy-down checks

sent to petitioner.   Many of the records the revenue agent

received were incomplete and/or inaccurate, and the revenue agent

was unable to reconcile petitioner’s return to the available

records.   As a result, respondent determined that petitioner’s

coupon and buy-down income was $777,848 and therefore understated

by $124,684.

     Petitioner reported $16,736 in promotional income on his

1997 Federal income tax return consisting of $11,284 in “rack and

promotional income”, and $5,452 of “8 cent coupon” income

reimbursement payments from cigarette manufacturers for the cost

of mailing paper coupons.   The summary worksheets provided by

petitioner reflected total rack and promotional income of

$63,940.   Additional documents revealed that petitioner received

$5,452 in “8 cent coupon” income and $523 in postage income.
                                - 6 -

     Petitioner entered into a promotional contract with R.J.

Reynolds Tobacco Co. (R.J. Reynolds) having an effective date of

January 1, 1996, and no specific term or ending date.      Pursuant

to the contract, petitioner was to receive quarterly promotional

payments of $13,164 upon meeting certain sales volume

requirements set by R.J. Reynolds.      During 1997, petitioner

negotiated a $13,164 check issued by R.J. Reynolds to purchase a

cashier’s check.    The check was dated October 27, 1997, and was

for the same amount as called for in the promotional contract.

     Based on petitioner’s records, respondent determined that

petitioner’s rack and promotional income totaled $69,915 ($63,940

+ $5,452 + $523).   Respondent also determined that petitioner

underreported rack and promotional income by $53,179 ($69,915

less $16,736 reported).

     During the examination, Mercantile National Bank

(Mercantile), informed respondent that during 1997, petitioner

acquired 31 cashier’s checks totaling $809,734.     Petitioner

exchanged cash and negotiated third party checks he received from

business-related and personal sources for the cashier’s checks.

Petitioner, by using third party checks and cash less than

$10,000 in amount to purchase the cashier’s checks, tried to

avoid the reporting of cash transactions exceeding $10,000 to the

Internal Revenue Service.   Petitioner did not inform his
                               - 7 -

accountant of the existence of the cashier’s checks or record the

receipt of the third party checks in the accounting records for

Nick’s Liquors.

     During 1997, Nick’s Liquors engaged in “bulk sales”, which

were large, nonitemized orders taken over the phone.     The

employee taking a bulk sales order recorded it on paper and made

a copy that was sent to the office of Nick’s Liquors.     The

employee personally delivered the order to the customer.       Payment

received for the order would either be mailed or delivered to

petitioner in the form of a check.     Some of the checks that

petitioner received for bulk sales were used to purchase

cashier’s checks.   Respondent determined that petitioner’s gross

receipts were underreported by $25,425 with respect to these

checks.   Petitioner did report $6,569 of the bulk sales checks as

income.

     During 1997, petitioner used checks received for

reimbursements and refunds from commercial vendors totaling

$3,007 to buy cashier’s checks.   Respondent determined that

petitioner’s gross receipts did not include these checks.

Petitioner did not provide adequate records to substantiate that

these payments were properly included in income.

     Petitioner also used two payments from insurance companies

to Nick’s Liquors to buy cashier’s checks.     One of the checks was

dated December 10, 1996, in the amount of $894.    The other check,
                                - 8 -

in the amount of $165, was dated January 13, 1997.      Respondent

determined that petitioner failed to include those checks

totaling $1,059 in gross receipts.      Petitioner did not provide

respondent records to substantiate that these payments were

properly included in income.

     Before their 1997 tax year, petitioners were notified on

several occasions that their records were inadequate.      In the

case of Kikalos v. Commissioner, T.C. Memo. 1998-92, revd. in

part 190 F.3d 791 (7th Cir. 1999), this Court found that

petitioner’s records with respect to Nick’s Liquors were

inadequate for 1990, 1991, and 1992.      In that opinion it was

noted that petitioner had been advised to retain adequate records

before his 1990 and 1991 tax years.      Further, on June 9, 1995,

petitioner entered into a records retention agreement with the

Internal Revenue Service agreeing that he would maintain certain

records.   Petitioner did not adequately comply with his June 9,

1995, agreement.

                               OPINION

     We consider here whether petitioner has shown that

respondent’s determination is in error.      Respondent determined

that petitioner failed to report business income from several

sources.   In spite of numerous warnings, petitioner did not

maintain adequate records for 1997.      Petitioner knowingly
                                  - 9 -

permitted this situation, and also purchased cashier’s checks in

such a manner so as to conceal certain activity from the

Government.

     Pursuant to section 61(a), gross income includes income from

whatever source derived.    Sec. 61(a); Cabirac v. Commissioner,

120 T.C. 163, 167 (2003).   In addition, taxpayers are required to

keep permanent records that are sufficient to establish the

amount of gross income, deductions, credits, or other amounts on

their tax returns.   See sec. 6001; sec. 1.6001-1, Income Tax

Regs.    In this case, petitioner bears the burden of showing that

respondent’s determination is in error.6     Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933).      Because the disputed items

of income adjustments concern several different sources, we

examine each source separately.

I.   Coupon and Buy-Down Income

     Respondent determined that petitioner failed to report

$124,684 of coupon and buy-down income.     At trial and on brief,

respondent bolstered his determination by offering an alternate

computation to measure petitioner’s total coupon and buy-down

income.



     6
       With respect to the determination of underreported income,
no question has been raised with respect to the burden of proof
under sec. 7491(a). Even if petitioner had raised the issue, his
failure to keep adequate records and substantiate items has not
met the conditions for placing the burden on respondent. See
sec. 7491(a)(2).
                                - 10 -

     As a first step, respondent reviewed copies of third party

checks that petitioner used to purchase cashier’s checks.     During

1997 petitioner purchased in excess of $800,000 in cashier’s

checks with cash, and negotiated third party business and

personal checks.   Petitioner testified that he purchased the

cashier’s checks to protect his money in case of a bank failure.

He also testified that one of his objectives in using third party

checks to purchase cashier’s checks was to prevent the bank from

reporting cash transactions exceeding $10,000 to the Internal

Revenue Service.   Significantly, petitioner failed to provide any

documentation to show that the third party checks used to

purchase cashier’s checks were included in business gross

receipts.   Finally, petitioner’s accountant testified that she

had no knowledge of the existence of the cashier’s checks.

     Because petitioner presented no evidence to account for the

third party checks, respondent designated checks from cigarette

manufacturers, and not related to other types of income, as

coupon and buy-down receipt checks.      Checks totaling $531,605 fit

into that category.

     In addition, petitioner’s accountant made a $400,746

accounting entry in petitioner’s October 1997 records with

respect to checks received from cigarette manufacturers.

Respondent accepted that entry as reflecting payments received

from cigarette manufacturers.    Because no activity was recorded
                              - 11 -

in the account until the October 1997 entry was made,

respondent concluded that the $400,746 was an accumulation of

coupon and buy-down payments received by Nick’s Liquors for the

period of January through October 1997.

     Third, petitioner admitted that $73,392 of coupon and buy-

down income from 1996 activity had been reported in 1997.

Further, respondent calculated that $100,810 of coupon and buy-

down income for 1997 activity was reported in 1998.    Due to usual

time delays in processing reimbursement payments, respondent

based this figure on petitioner’s reported November and December

1997 coupon and buy-down income.

     Lastly, respondent made a downward adjustment of $63,940 to

prevent duplication with respect to rack and promotional income.

Respondent’s calculation, which is on the basis of evidence in

the record of this case, resulted in $895,829 of coupon and buy-

down income for 1997.   Respondent’s calculation is summarized as

follows:

     Payments received in 1997:

     Coupon and buy-down checks used
       to acquire cashier’s checks                 $531,606
     Other amounts deposited and
       recorded in financial records                  400,746
                                                      932,352
     Adjustments:

     1996 income reported in 1997                     (73,392)
     1997 income reported in 1998                     100,810
     Rack and promotional income
       (duplicate adjustment)                         (63,940)

     1997 coupon and buy-down income                  895,830
                                - 12 -

     Subtracting the $653,164 reported by petitioner, respondent

arrived at unreported coupon and buy-down income of $242,666

($895,830 - $653,164).   Despite the fact that respondent’s

calculation reflected almost twice as much unreported income as

the $124,684 amount determined originally, respondent does not

seek an increased deficiency.    Petitioner argues that

respondent’s alternate calculation of coupon and buy-down income

is a new theory raised for the first time on brief, that it

violates principles of fair play and justice, and it should not

be considered by the Court.   Respondent asserts that the trial

was a de novo proceeding, and the administrative record is

irrelevant.

     Respondent’s calculation is not a new theory.   It is merely

a mathematical analysis of evidence before the Court and offered

in support of respondent’s determination.    Petitioner’s dilemma

here is one of his own making.    On the basis of the state of

petitioner’s records, neither he nor respondent may properly

substantiate his income and/or establish that the determination

was in error.   Petitioner was well aware of his obligation to

maintain adequate records and knowingly failed to do so.

     Petitioner devotes much of his brief to criticizing the

means by which respondent arrived at his determination and/or

supplementary calculation.    This criticism focuses on the lack of

adequate documentation used by respondent in the determination
                                - 13 -

and calculation.    While petitioner’s criticisms are to some

extent valid, petitioner has not provided records or a more

reliable means to account for his business income.    Moreover, the

lack of records is due to petitioner’s design.

     Petitioner also makes the theoretical argument that coupon

and buy-down income was accounted for at the point of sale.

Respondent counters that petitioner did not provide adequate

records to show that employees consistently followed the point of

sale procedure for recording coupon and buy-down income.

Therefore, petitioner has not met his burden of establishing that

respondent’s determination was in error.

     Unlike other consumer transactions, petitioner could not use

a cash method of accounting for coupon and buy-down income

because of the delay in receiving reimbursement payments.

Therefore, petitioner appears to have used a hybrid accounting

method.   Revenues from consumer purchases and other sources were

recorded on a cash basis, and coupon and buy-down income was

reported on an accrual basis.    Petitioner testified that

employees accounted for coupon and buy-down income by ringing up

on the cash register the full price of the carton or pack of

cigarettes sold, while collecting from the customer the

discounted price.   The transaction also would include ringing up

the amount of the buy-down or coupon.    As a result, petitioner

maintained that the full amount of revenue for each cigarette
                              - 14 -

sale was recorded at the time of purchase.   Therefore, any

subsequent reimbursement received by petitioner for the discounts

had no effect on income.

      Petitioner, however, failed to provide adequate

documentation to show that these procedures were consistently

followed.   Petitioner did supply records to corroborate

petitioner’s assertions for 2 days’ worth of sales activity for a

single store.   However, during the year at issue Nick’s Liquors

operated four locations with aggregate gross receipts from

cigarette sales totaling several million dollars.   Given the

volume of cigarette transactions generated by the four Nick’s

Liquors stores, the records provided by petitioner are not

sufficient evidence to establish that coupons and buy-downs were

consistently and completely recorded in all four stores.7

Petitioner’s testimony that the coupon and buy-down point of sale

procedure was consistently followed, by itself, is not sufficient

to carry his burden.   Accordingly, we hold that petitioner failed

to report coupon and buy-down income of $124,684 for 1997, as

determined by respondent.

II.   Promotional Income

      Petitioner reported $16,736 of promotional income for 1997.

Respondent determined that petitioner received $69,915 of


      7
       It is somewhat curious that petitioner was able to provide
only 2 days of tapes for a single store. That is certainly too
small a sample to provide insight into the universe we consider.
                               - 15 -

promotional income and that his gross income was understated by

$53,179.    The $69,915 amount is composed of three components.

The first and second components are $5,452 of “8 cent coupon”

income and $523 of postage income.      Petitioner reported the

$5,452 of “8 cent coupon” income as a portion of the total

$16,736 of promotional income reported on his 1997 return.

Petitioner conceded that he failed to report $523 in postage

income.

     The remaining $63,940 (third component) was derived from the

worksheets provided by petitioner.      The rack and promotional

income shown on all four worksheets totaled $63,940.      Respondent

points out that petitioner’s promotional contract with R.J.

Reynolds was in effect during 1997, a fact that supports

respondent’s determination.    Petitioner argues that the

worksheets are unreliable due to the fact that he was in the

process of learning how to use a computer and made input errors.

In addition, petitioner asserts that the R.J. Reynolds

promotional contract was not in effect during 1997 and that he

did not receive any payments under the contract.

     During 1997 petitioner received a check from R.J. Reynolds

for $13,164, the quarterly amount called for in the promotional

contract.   Although the record does not reflect the specific

purpose for the payment, it coincides with the amount called for

in the promotional contract.    Quarterly payments of $13,164 would
                                - 16 -

result in annual promotional income of $52,656 from the R.J.

Reynolds contract ($13,164 x 4).     Adding this annualized figure

to petitioner’s reported promotional income of $16,736 and

conceded postage income of $523 results in a total of $69,915,

the amount of respondent’s determination.

       Petitioner contends:   (1) He made input errors; (2)

respondent did not produce a 1997 Form 1099 from R.J. Reynolds to

petitioner; and (3) respondent failed to receive evidence from

R.J. Reynolds to prove that the payments were made under the

promotional contract.    Respondent, however, does not bear the

burden of showing that the determination is correct.     Petitioner

has the burden of establishing that the determination is

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

This is another instance where petitioner’s failure to maintain

records is the root of the problem.      We cannot allow petitioner

to hide behind his own contrivance in this setting.     Accordingly,

we hold that petitioner failed to report promotional income of

$53,179.

III.    Bulk Sales Income

       Respondent determined that $25,425 in third party checks

used by petitioner to purchase cashier’s checks were from Nick’s

Liquors bulk sales customers.     Because the checks had not been

accounted for in petitioner’s records, respondent determined

$25,425 in bulk sales was not included in income for 1997.
                               - 17 -

Petitioner did verify that $6,569 in bulk sales was included in

income.   Respondent conceded the $6,569 so that $18,856 remains

in dispute.

      Petitioner argues his combination of substantiation of

$6,569 in bulk sales and the testimony offered about the

procedures employed for recording bulk sales is sufficient to

show that all bulk sales were properly recorded.   Petitioner also

argues that the burden of reviewing a large amount of register

tapes was too great to substantiate all bulk sales transactions.

      Despite having access to records that could substantiate all

bulk sales, petitioner failed to offer this evidence.   Petitioner

had register tapes available, and self-serving testimony does not

suffice to satisfy petitioner’s burden.   We are not required to

accept such testimony.    Niedringhaus v. Commissioner, 99 T.C.

202, 212 (1992).    Accordingly, we hold that petitioner failed to

report $18,856 of bulk sales income, the amount of respondent’s

determination net of concessions.

IV.   Vendor Refunds and Reimbursements Income

      Respondent also determined that $3,007 in third party checks

used to purchase cashier’s checks was attributable to vendor

refunds and reimbursements not included in petitioner’s 1997

gross income.   Petitioner argues that the payments were included

in income, but he has not provided any records to substantiate

these assertions.   Taxpayers are required to keep permanent
                               - 18 -

records that are sufficient to establish the amount of gross

income, deductions, credits, or other amounts on their tax

returns.   See sec. 6001; sec. 1.6001-1, Income Tax Regs.

Petitioner failed to keep records so as to show respondent’s

determination is erroneous.    Accordingly, we hold that petitioner

failed to report vendor refunds and reimbursement income of

$3,007 for 1997.

V.   Insurance Recoveries

      Finally, respondent determined that two of the third party

checks totaling $1,059 were attributable to insurance recoveries

not reported as income for 1997.    The checks were from insurance

companies, in the amounts of $894 and $165, and dated December

10, 1996, and January 13, 1997, respectively.

      With respect to the $894 check, petitioner argues that the

check cannot be attributable to his 1997 income because it must

have been received in 1996.    Respondent argues that this check

was one of several checks petitioner used to purchase a cashier’s

check on January 14, 1997.    Because petitioner purchased a

cashier’s check on January 7, 1997, and did not use the $894

check, respondent maintains that petitioner must not have

received the check until after January 7, 1997.    Therefore, the

check must be attributable to petitioner’s 1997 tax year.
                              - 19 -

      Section 451(a) provides the general rule that “any item of

gross income shall be included in the gross income for the

taxable year in which received by the taxpayer, unless, under the

method of accounting used in computing taxable income, such

amount is to be properly accounted for as of a different period.”

Petitioner, who reports this type of income on the cash method,

must report income in the year it is actually or constructively

received.   See sec. 1.451-1(a), Income Tax Regs.   We agree with

petitioner that a check mailed on December 10, 1996, would likely

have been received by petitioner during 1996 and thus be

includable in 1996 income.

      With respect to the $165 check, respondent contends that the

insurance recovery relates to a claim made by Cigarette City, a

company owned by petitioner’s children.   Petitioner contends that

he reimbursed Cigarette City for the amount of the check.

Petitioner, however, has not provided any credible evidence other

than his own self-serving testimony that the reimbursement

occurred.   Accordingly, we hold that petitioner underreported his

insurance reimbursement income by $165.

VI.   Accuracy-Related Penalties Under Section 6662 for Negligence
      or Disregard of the Rules or Regulations

      Section 6662 provides for a 20-percent penalty on any

understatement of tax attributable to negligence or disregard of

the rules or regulations, or any substantial understatement of

income tax.   Pursuant to section 6662(c), negligence includes any
                                 - 20 -

failure to make a reasonable attempt to comply with the Internal

Revenue Code including a careless, reckless, or intentional

disregard of the Code.

     Section 7491(c) applies to examinations which commence after

July 22, 1998.    Pursuant to this section, respondent has the

burden of production with respect to the liability of any

individual for any penalty or addition to tax.     See sec. 7491(c).

“[F]or the Commissioner to meet his burden of production, the

Commissioner must come forward with sufficient evidence

indicating that it is appropriate to impose the relevant

penalty.”   Higbee v. Commissioner, 116 T.C. 438, 446 (2001).    In

Higbee, we found that respondent met his burden of production for

the negligence penalty by showing that petitioners failed to keep

adequate books and records or to substantiate properly the items

in question.     Id. at 449.   Consequently, we conclude that

respondent has met his burden of production for his determination

of the accuracy-related penalty based on negligence or disregard

of rules or regulations.

     Pursuant to section 6662(c), negligence includes any failure

by a taxpayer to keep adequate books or records.     See sec.

1.6662-3(b), Income Tax Regs.     For the purposes of this section,

a taxpayer is negligent when he or she fails “to do what a

reasonable and ordinarily prudent person would do under the

circumstances.”     Korshin v. Commissioner, 91 F.3d 670, 672 (4th
                               - 21 -

Cir. 1996)(quoting Schrum v. Commissioner, 33 F.3d 426, 437 (4th

Cir. 1994), affg. T.C. Memo. 1995-46).

     The record reflects that petitioner failed to maintain

adequate records after repeatedly being advised to do so by

respondent.   In the case of Kikalos v. Commissioner, T.C. Memo.

1998-92, we found that petitioner’s records were inadequate for

1990, 1991, and 1992.    In that case, we noted that before the

years at issue, petitioner was advised that his records were

inadequate.   After repeated warnings by respondent, on June 9,

1995, petitioners agreed to and signed a records retention

agreement with the Internal Revenue Service.       The agreement

specifically identified records that petitioner was to maintain

going forward.   Despite the warnings and the agreement,

petitioner still made the choice not to maintain adequate

records.   Further, we find significant petitioner’s testimony

that his practice of purchasing cashier’s checks was partly

designed to conceal large cash transactions from the Government.

     Petitioners’ actions are not what a reasonable and

ordinarily prudent person would do under the circumstances and

constitute negligence.    Accordingly, we hold that petitioner is

subject to the accuracy-related penalty under section 6662(a).

     To reflect the foregoing,

                                      Decision will be entered

                                 under Rule 155.
