                          T.C. Memo. 1999-343



                       UNITED STATES TAX COURT



    MICHAEL F. LAMBAISO AND JODY D. LAMBAISO, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 11489-98.                Filed October 14, 1999.

     Mario A. Venditti, for petitioners.

     Dustin M. Starbuck, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION


     JACOBS,     Judge:    Respondent    determined     the     following

deficiencies    and   accuracy-related   penalties    with    respect   to

petitioners' Federal income taxes:
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                                                 Accuracy-Related Penalty
       Year                Deficiency                    Sec. 6662

       1991                      $600                                $120
       1992                    20,285                               4,057
       1993                    20,919                               4,170

       Following concessions by each party, the primary issue for

decision is whether petitioners understated their 1991, 1992, and

1993    income     by    $2,165,      $69,187,     and      $54,661,        respectively.

Resolution of this issue turns upon the correctness of respondent's

revenue agent's use of the markup method to reconstruct the gross

sales of alcoholic beverages of a bar/restaurant (Classic Pub) in

Virginia      Beach,     Virginia,      operated   by     Classic       Pub,     Inc.,    an

electing      S    corporation,       during     the      3    years        in   question.

Petitioners owned 28.98 percent of Classic Pub, Inc.'s stock in

1991 and all of its stock in 1992 and 1993.

       In computing Classic Pub's gross sales of alcoholic beverages,

the revenue agent first determined the potential number of drinks

that    could     be    sold   from   the   amount     of     liquor        available     for

consumption.            Petitioners      agree     with       the     revenue      agent's

computation of Classic Pub's potential gross sales of alcoholic

beverages before an allowance for drinks sold at discount prices,

as well as his computation for spillage, breakage/waste, and theft

of alcoholic beverages.           However, they posit that (1) the revenue

agent    arbitrarily       and   erroneously       used       the    markup      method   to

reconstruct Classic Pub's income for the years in issue, and (2)
                                 - 3 -


the revenue agent erred in computing the amount of sales of

alcoholic beverages sold at discounted prices during "happy hours".

     The other remaining issues are (1) whether petitioners are

entitled to deduct 1991 unreimbursed automobile expenses allegedly

incurred in connection with Classic Pub's operation, and (2)

whether petitioners are liable for the section 6662(a) accuracy-

related penalty for 1991, 1992, and 1993.

     All section references are to the Internal Revenue Code in

effect for the years under consideration.       All Rule references are

to the Tax Court Rules of Practice and Procedure.              All dollar

amounts are rounded.

                            FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.         The

stipulation of facts and the attached exhibits are incorporated

herein by this reference.

Background

     At the time Michael F. and Jody D. Lambaiso (petitioners),

husband and wife, filed their petition, they resided in Virginia

Beach, Virginia. They filed joint Federal income tax returns for

all years in issue.

Classic Pub

     Classic Pub, Inc. is a Virginia corporation.           In 1990, it

elected   S   corporation     status     for   Federal   tax    purposes;
                                         - 4 -


consequently,        its    income   and    losses    passed      through   to    its

shareholders during each of the years at issue.

       Michael Lambaiso (petitioner) owned 200 shares of Classic Pub,

Inc. stock, while Jenro and Evelyn Lambaiso, petitioner's parents,

each owned 400 shares. On November 22, 1991, petitioners purchased

Jenro and Evelyn Lambaiso's 800 shares of Classic Pub, Inc. stock.

Accordingly, the parties have stipulated that the income and losses

from Classic Pub should be allocated to petitioners as 28.98

percent for 1990, 100 percent for 1991, and 100 percent for 1992.

       Classic Pub was licensed to serve alcohol by the Virginia

Alcoholic Beverage Control Board (VABCB).                  It operated 16 hours a

day, from 10 a.m. to 2 a.m., 7 days a week.                 Classic Pub ran some

form of discounted beverage specials each day of the week.                       The

greatest number of discounted beverage sales occurred during the

Wednesday and Friday night "happy hours" from 7 p.m. to 9 p.m.                     It

had a maximum seating capacity of 144 persons.1                       Classic Pub

usually had two bartenders tending the bar at any given time and a

"bar       back"   person   in   order     to    relieve    the   bartenders     from

miscellaneous tasks.          Sales were rung up on the bar/restaurant's

cash register.

       Classic Pub submitted Mixed Beverage Annual Review (MBAR)

reports to VABCB, indicating the dollar amounts of its sales of


       1
          During the years at issue, the actual number of seats
was for 130 persons.
                                    - 5 -


food, mixed alcoholic beverages (mixed drinks), beer, and wine.

Petitioners recorded Classic Pub's sales of food, beer, wine, and

mixed drinks in handwritten monthly sales journals.                These monthly

sales   journals     were   provided   to     petitioners'    accountant,    who

prepared monthly profit and loss statements.

Tax Returns

       Petitioners filed joint Federal income tax returns for the

years in issue reporting the following:

                                    Classic Pub
Year            Wages               Sch. E Loss            Taxable Income
                                       1
1991           $31,119                   $6,673               $10,024
1992            30,200                    3,104                20,471
                                       2
1993            37,800                   23,056                41,507

During these years, Classic Pub, Inc. filed U.S. Income Tax Returns

for an S Corporation (Forms 1120S), reporting the following:

                          Cost of          Total         Total        Ordinary
Year    Gross Sales      Goods Sold        Income     Deductions   Income (Loss)
                                                                     1
1991      $294,214       $147,167          $147,276    $180,643       ($33,367)
1992       403,214        228,603           175,076     171,972           3,104
                                                                       2
1993       414,649        203,864           226,633     205,677          20,956
  1
     For 1991, petitioners reported 20 percent of Classic Pub,
Inc.'s losses. The record does not reveal why petitioners reported
20 percent rather than 28.98 percent of Classic Pub Inc.'s losses.
  2
     The record does not reveal why for 1993 petitioners reported
$23,056 of income, rather than $20,956, as reflected on the K-1
from Classic Pub, Inc.

These amounts were based upon the bar/restaurant's monthly profit

and loss statements of income and expenses, which, in turn, were

based upon Classic Pub's handwritten sales journals.
                                              - 6 -


The Audit and Respondent's Reconstruction of Gross Sales

        Revenue       Agent       William      Bixler     was    assigned          to        audit

petitioners' 1991, 1992, and 1993 tax years. During that audit, he

discovered that for 1991 Classic Pub's monthly gross sales reported

on     its    MBAR    were     less    than       the   State   average          for    similar

establishments.            Further investigation by Revenue Agent Bixler

revealed that Classic Pub, Inc. reported differing amounts of gross

sales on its Federal income tax returns, MBARs, State sales tax

returns, and profit and loss statements, and that none of the

reported gross sales were consistent with Classic Pub's daily sales

journals.        The varying amounts of gross sales as reported in these

documents are reflected in the following table:

                      Documents on Which Gross Sales Were Reported

                                       State       Profit &           Monthly Journals
          Form                          Sales Tax       Loss        Sales Including Sales
Without Year       1120S          MBAR        Return      Statement      9% Sales Tax  9%
Sales Tax

1991    $294,214       $313,667    $296,132         $291,656          $314,682           $288,699
1992     403,213        418,213     388,387          400,249           416,928            382,503
1993     414,649        441,717       ---            414,649              ---               ---

        Because of the lack of internal controls for income reporting

purposes and the inconsistencies between Classic Pub, Inc.'s Forms

1120S,       MBARs,    State      sales     tax    returns,     and     profit         and    loss

statements, Revenue Agent Bixler decided to reconstruct Classic

Pub's sales of mixed drinks, beer, and wine.                             In doing so, he

employed an indirect method to determine Classic Pub's gross sales,

utilizing        information        and     calculations        provided         to     him     by

petitioners, including Classic Pub's purchases of alcohol, prices
                                  - 7 -


and content of mixed drinks, beer, and wine, happy hour and

promotional prices, and hours of operation.2 Revenue Agent Bixler

subsequently subtracted the gross sales reported on Classic Pub

Inc.'s tax returns from the figures he determined Classic Pub, Inc.

should have reported on       the returns; the difference represented

Classic    Pub's   understated    sales     for   each   year    in   issue.

Specifically, Revenue Agent Bixler computed Classic Pub's total

gross sales of mixed drinks for 1992 and 1993 by:          (1) Determining

the potential number of drinks that could be sold from the amount

of liquor available for consumption based upon Classic Pub's

documented liquor purchases; (2) reducing the potential number of

drinks sold by 10 percent to allow for spillage; (3) multiplying

the adjusted potential number of drinks sold by Classic Pub's

published price list in a ratio of 69 percent for the lower day

prices and 31 percent for the higher evening prices (the lower day

prices were in effect for 11 of Classic Pub's 16 hours of operation

while the higher evening prices were in effect for the remaining

hours of    operation)   to   arrive   at   tentative    gross   sales;   (4)

increasing the tentative gross sales to reflect beverages that were

sold for an extra charge; (5) reducing the tentative gross sales by

20 percent to account for discounted mixed drink prices (happy hour


     2
           Revenue Agent Bixler considered the entire week's
discounted beverage prices (rather than solely the Wednesday and
Friday happy hours) in formulating a discount allowance for mixed
drinks, wine, and beer.
                                    - 8 -


and other drink specials); and (6) subtracting an additional 6

percent to account for losses due to theft.         Using this method, he

calculated that Classic Pub's gross sales from mixed drink sales

for   1992   and   1993   were   understated   by   $21,888   and   $28,313,

respectively.      (Step (5) of his computation is at issue herein.)

      Revenue Agent Bixler reconstructed the gross sales of Classic

Pub's beer and wine in a manner similar to his reconstruction of

mixed drink sales, with a few modifications.3             He reduced the

tentative gross sales by 10 percent to account for discounted wine

and beer prices. Utilizing this method, he calculated that Classic

Pub's income from beer and wine sales for 1991, 1992, and 1993, was

understated by $6,361, $33,257, and $38,147, respectively.

      In determining an appropriate discount to apply to gross sales

for mixed drinks, wine, and beer sold at discount prices, Revenue

Agent Bixler discovered that in VABCB's audits of bars/restaurants,

VABCB discounted drink prices by reducing gross sales by 5 percent.


      3
        This reconstruction involved: (1) Determining the
potential amount of beer and wine that could be sold based upon
Classic Pub's documented purchases of beer and wine; (2) reducing
the potential draft beer and wine sold by 10 percent to allow for
spillage, and bottled beer by 5 percent for breakage; (3)
multiplying the adjusted potential amount sold by Classic Pub's
published prices in a ratio of 69 percent for the lower day
prices and 31 percent for the higher evening prices to arrive at
a tentative gross sales figure; (4) reducing the tentative gross
sales by 10 percent to account for discounted wine and beer
prices (happy hour and other drink specials); and (5) subtracting
an additional 6 percent to account for losses due to theft.
(Step (4) of his computation is at issue.)
                                                 - 9 -


Initially,         he      relied      upon       VACBC's   5-percent           allowance        in

reconstructing the gross sales of Classic Pub's mixed drinks, beer,

and wine.         However, after learning from petitioners that Classic

Pub     ran       more     discounted           drink    specials        than    an     average

bar/restaurant,            he   raised          the   allowance     to    20     percent         for

discounted mixed drinks, and 10 percent for discounted beer and

wine sales.

       In light of Classic Pub, Inc.'s status as an S corporation,

respondent determined that Classic Pub's understatement of mixed

drinks, beer, and wine sales for the years in issue flowed through

to petitioners as unreported taxable income as follows:
                                       1991                    1992                     1993

Classic Pub's
 income on Form                     ($33,367)                 $3,104                  $20,956
 1120

Classic Pub's
 mixed drink
 understatement                        ---                    21,888                   28,313

Classic Pub's
 beer & wine
 understatement                        6,361                  33,257                   38,147

Adjustments/
 concessions                          11,449                  14,042                   (9,699)

Corrected income/loss
 available for distribution          (15,557)                 72,291                   77,717

Allocation of
 income/losses                        28.98%                   100%                     100%

Corrected Classic Pub
 income/loss distributed to
 petitioners                         (4,508)                  72,291                   77,717

Income/losses from
 Classic Pub reported on
 Form 1040                           (6,673)                   3,104                   23,056

Petitioners' understatement           2,165                   69,187                   54,661
                                           - 10 -


Automobile Expenses

      Petitioners maintain that they are entitled to deduct $1,581

in   unreimbursed      automobile          expenses       incurred   during      1991    in

connection with Classic Pub's operation.                    These expenses were not

claimed on their tax return.

Notice of Deficiency

      In the notice of deficiency mailed to petitioners regarding

their     1991,    1992,     and        1993   tax    years,     respondent       revised

petitioners' allowable losses and income from Classic Pub, as

described above.        Respondent also determined a section 6662(a)

accuracy-related penalty for each of the years in issue.

                                          OPINION

Issue 1.     Determination of Classic Pub's Gross Sales

      The    primary   issue       before      us    is    whether   petitioners        had

unreported income arising from Classic Pub during the years in

issue. In resolving this issue, we must determine whether Revenue

Agent     Bixler's     use     of        the   percentage        markup        method    in

reconstructing Classic Pub's gross sales was proper and whether

discounts4    he    applied        in    computing        the   amount    of    sales    of

discounted mixed drinks, wine, and beer were correct.




      4
          A higher discount percentage for items sold at
discounted prices benefits petitioners because it results in
lower total gross sales.
                                      - 11 -


     Section 6001 requires taxpayers to maintain adequate records

to determine their correct tax liabilities.                    Absent adequate

records, or if the records that are kept do not accurately reflect

income, the Commissioner may determine the existence and amount of

a taxpayer's income by using any method that clearly reflects

income.5     Sec. 446(b); United States v. Johnson, 319 U.S. 503

(1943); Burka v. Commissioner, 179 F.2d 483 (4th Cir. 1950).

Petitioners bear the burden to prove that respondent's method does

not clearly reflect income.           Rule 142(a); see sec. 446.

     The     indirect     method     used   to    calculate    income   must    be

reasonable.     See, e.g., Holland v. United States, 348 U.S. 121

(1954).    The percentage markup method is well recognized as a

reasonable    means     of    reconstructing      income,     see   Bollella    v.

Commissioner, 374 F.2d 96 (6th Cir. 1967), affg. T.C. Memo. 1965-

162, particularly when cash businesses are involved, see Webb v.

Commissioner, 394 F.2d 366 (5th Cir. 1968), affg. T.C. Memo. 1966-

81; Edgmon v. Commissioner, T.C. Memo. 1993-486.               Pursuant to this

method, gross sales are determined by adding a predetermined

percentage    to   cost      of   goods   sold.    See,   e.g.,     Cebollero   v.

Commissioner, 967 F.2d 986 (4th Cir. 1992), affg. T.C. Memo. 1990-


     5
          Even if a taxpayer's books and records appear adequate,
the Commissioner may test the adequacy of the information
contained therein by any reasonable method which properly
reflects the taxpayer's income. See, e.g., Michas v.
Commissioner, T.C. Memo. 1992-161.
                                      - 12 -


618; Bernstein v. Commissioner, 267 F.2d 879, 880 (5th Cir. 1959),

affg. T.C. Memo. 1956-260.

        Because Classic Pub's records reflected inconsistent amounts

of gross sales for the years in issue, Revenue Agent Bixler

reasonably and justifiably reconstructed the bar/restaurant's gross

receipts using a form of the percentage markup method.              See, e.g.,

Rungrangsi    v.    Commissioner,      T.C.    Memo.   1998-391;   DiLando     v.

Commissioner, T.C. Memo. 1975-243; Jurkiewicz v. Commissioner, T.C.

Memo.    1955-318.       In   performing   this   reconstruction,      he    used

petitioners'       own    records    and   calculations    regarding        liquor

purchases,     prices,        and   quantities.    See,   e.g.,    Gasper      v.

Commissioner, 225 F.2d 284 (6th Cir. 1955).             Petitioners failed to

present any competent evidence that would cause us to question

Revenue Agent Bixler's reconstruction.
                                   - 13 -


     We   are   unpersuaded   by    any     of   petitioners'   arguments.6

Petitioners argue that the notice of deficiency was arbitrary

because of Revenue Agent Bixler's purported inaccurate conclusions

about Classic Pub's business and record keeping. We disagree. Not

only did petitioners fail to prove that Revenue Agent Bixler's

conclusions (which are the basis of respondent's determinations)

are arbitrary, but on the basis of the record before us, we are

satisfied that they are "reasonable in light of all surrounding

facts and circumstances". See, e.g., Schroeder v. Commissioner, 40

T.C. 30, 33 (1963).     We found Revenue Agent Bixler's testimony

credible. We therefore conclude that the reconstruction of Classic

Pub's income through the use of the percentage markup method was

proper and that the allowance for alcoholic beverages, wine, and

beer sold at discount prices was realistic.

     6
          We mention two additional arguments made by
petitioners. First, petitioners contend that they overstated
Classic Pub's 1991 and 1992 gross sales (on the Forms 1120S) by
erroneously including State sales tax. Although respondent
acknowledges that, for income tax purposes, State sales tax
should not be includable in gross sales, petitioners have not
established that they actually overstated Classic Pub's gross
sales by including State sales tax. Petitioners failed to
reconcile the amounts of State sales tax allegedly included in
reported gross sales with the stipulated amounts reflected in
Classic Pub's various records.
     Moreover, petitioners posit that two bartenders can pour
2,880 shots of liquor during a 2-hour period. In attempting to
prove this point, petitioners played a videotape (that they
prepared the night before trial) for the Court, in which two
Classic Pub bartenders poured shots of liquor. However, no
evidence was presented as to how many shots of discounted liquor
were actually poured and served on any given night.
                                   - 14 -


     Petitioner testified that based upon an examination of Classic

Pub's cash register tapes, the bar/restaurant sold an average of

700 drinks/shots during the Wednesday and Friday happy hours.

However, petitioners neither introduced the cash register tapes

into evidence nor quantified how selling 700 drinks/shots during a

Wednesday or Friday happy hour would alter the reasonableness of

respondent's reduction for discounted mixed beverage sales.

     In sum, we sustain respondent's use of the percentage markup

method and respondent's determination of a 20-percent discount with

regard to Classic Pub's discounted mixed drink sales and a 10-

percent discount for discounted beer and wine sales.               Petitioners

offered    no      reliable    evidence     to     contradict      respondent's

determinations.       We conclude that Classic Pub's gross sales of

mixed drinks during 1992 and 1993 were understated by $21,888 and

$28,313, respectively, and that its gross sales of beer and wine

during 1991, 1992, and 1993, were understated by $6,361, $33,257,

and $38,147, respectively.       Consequently, we hold that petitioners

understated their 1991, 1992, and 1993 taxable income by $2,165,

$69,187, and $54,661, respectively.

Issue 2.       Business Automobile Expenses

     The next issue is whether petitioners are entitled to deduct

$1,581    of    unreimbursed    automobile       expenses   they    purportedly

incurred during 1991 in operating Classic Pub.
                                    - 15 -


     Deductions    are   a    matter   of   legislative   grace.   See   New

Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Taxpayers

bear the burden of establishing that they are entitled to the

claimed deductions.      See Rule 142(a); Welch v. Helvering, 290 U.S.

111, 114 (1933).    This includes the burden of substantiating the

amount and purpose of the item claimed.         See sec. 6001; Hradesky v.

Commissioner, 65 T.C. 87, 90 (1975), affd. per curiam 540 F.2d 821

(5th Cir. 1976); sec. 1.6001-1(a), Income Tax Regs.

     Petitioners failed to substantiate the amount or business

purpose of the automobile expenses.           The only evidence presented

was a list of automobile expenses prepared by petitioners' counsel

on   the   basis    of       petitioner's    memory   and    not   prepared

contemporaneously with the use of the automobile.           Accordingly, we

sustain respondent on this issue.

Issue 3.   Section 6662(a) Accuracy-Related Penalty

     The final issue is whether petitioners are liable for the

section 6662(a) accuracy-related penalties for the years in issue

for negligence or disregard of rules or regulations or substantial

understatement of tax.        Petitioners generally assert a reasonable

cause defense.

     Section 6662 imposes a penalty equal to 20 percent of the

amount of the underpayment attributable to negligence or disregard

of rules or regulations or substantial understatement of tax.

"Negligence" means any failure to make a reasonable attempt to
                                     - 16 -


comply with the provisions of the Internal Revenue Code, and

"disregard" means any careless, reckless, or intentional disregard.

See sec. 6662(c).       A substantial understatement of tax means an

understatement of tax that exceeds the greater of 10 percent of the

tax required to be shown on the tax return or $5,000.                  See sec.

6662(d)(1)(A).

       No accuracy-related penalty is imposed with respect to any

portion of the understatement as to which the taxpayer acted with

reasonable cause and in good faith.           Sec. 6664(c)(1).

       Petitioners failed to establish that they were not negligent

in preparing their returns.          In fact, the record establishes that

petitioners failed to maintain adequate books and records for their

bar/restaurant.    Revenue Agent Bixler's reconstruction establishes

that    Classic   Pub's      books   and   records    were   unreliable       and

understated its income.

       In sum, we hold that petitioners failed to exercise reasonable

care both in reporting Classic Pub's gross sales and in ensuring

the accuracy of their individual tax returns.                Accordingly, we

sustain the section 6662(a) accuracy-related penalties with respect

to the years in issue.

       In   reaching   our    conclusion,     we   have   considered    all    of

petitioners' arguments and, to the extent not discussed, conclude

that each of them is without merit.
                        - 17 -


To reflect the foregoing and the concessions of the parties,



                                   Decision will be entered

                              under Rule 155.
