                       T.C. Memo. 2006-226



                     UNITED STATES TAX COURT



 TOTAL HEALTH CENTER TRUST, BONNIE STEJSKAL, TRUSTEE, ET AL.,1
                         Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 8793-05, 8794-05,    Filed October 24, 2006.
                 8795-05, 8796-05,
                 8797-05.



     Joe Alfred Izen, Jr., for petitioners.

     Sheila R. Pattison, for respondent.




     1
      The cases of the following petitioners were consolidated
for purposes of trial, briefing, and opinion: Country Rose
Holdings Trust, Bonnie Stejskal, Trustee, docket No. 8794-05;
Bio-Active Kansas Trust, Bonnie Stejskal, Trustee, docket No.
8795-05; Stejskal Enterprises Trust, Bonnie Stejskal, Trustee,
docket No. 8796-05; and Kenneth W. Stejskal, Sr. and Jane
Stejskal, docket No. 8797-05.
                                - 2 -

                         MEMORANDUM OPINION


     GOEKE, Judge:    These cases arise from petitions for judicial

review filed in response to the notices of deficiency mailed to

Kenneth W. Stejskal, Sr. and Jane Stejskal and to several of

their trusts.    Pursuant to a stipulation of settled issues, the

income and expenses of the alleged trusts have now been collapsed

into the tax liabilities of Kenneth and Jane Stejskal

(petitioners).    The sole remaining issue for decision is the

proper amount of petitioners’ cost of goods sold in light of the

shrinkage to inventory suffered to the Kansas operation of their

dietary supplement business.   We hold that while petitioners may

subtract the amount of product that is no longer saleable from

the ending inventory, they may not also add the same amount to

product purchases in calculating their cost of goods sold.

                             Background

     These cases were submitted fully stipulated pursuant to Rule

122, and the facts are so found.2   The stipulations of facts and

the accompanying exhibits are incorporated herein by this

reference.   At the time of the filing of the petitions,

petitioners resided in Corpus Christi, Texas.




     2
      Unless otherwise indicated, all section references are to
the Internal Revenue Code, as amended, and all Rule references
are to the Tax Court Rules of Practice and Procedure.
                               - 3 -

     Petitioners operate a business selling dietary supplements

and performing certain diagnostic services with operations in

both Kansas and Texas.   The business first operated as a C

corporation and later as an S corporation.   During the mid-1990s,

petitioners began reporting their business activities to the

Internal Revenue Service through a number of trusts including

Total Health Center Trust, Country Rose Holding Trust, Bio-Active

Kansas Trust, and Stejskal Enterprises Trust.   In a stipulation

of settled issues reached with respondent, petitioners now

concede that these trusts should be disregarded for tax purposes,

and that all income attributable to the trusts is properly

reportable by petitioners on Schedule C, Profit or Loss From

Business, of their individual return.

     For the 2000 and 2001 tax years, petitioners reported the

bulk of their business activities from both the Texas and Kansas

operations under the Stejskal Enterprises Trust (SET).   SET

utilized a periodic inventory system.    Petitioners’ accountant,

Janet Wilkerson, prepared separate trial balances for each of the

Texas and Kansas operations.   Ms. Wilkerson also made adjusting

journal entries for each of the Kansas and Texas operations.
                                 - 4 -

     The adjusting journal entries for the Kansas operation for

2000 include the following entry (adjusting journal entry 18):

   Date                        Acct. No.#      Debit        Credit

12/31/00   Inventory              10500                   $48,257.92

           Product purchases      50000      $48,257.92

Ms. Wilkerson made this entry to adjust the Kansas inventory

account in accordance with the actual physical count of ending

inventory.   The $48,257.92 is the difference between the trial

balance inventory of $171,448.06 and the physical count of

inventory of $123,190.14 and reflects the reduction of inventory

caused by the shrinkage, or spoilage, of SET’s products.

     On the Schedule C attached to SET’s amended Form 1041, U.S.

Income Tax Return for Estates and Trusts, for the 2000 tax year,

petitioners reported the following amounts related to cost of

goods sold for the Kansas and Texas operations:

     Beginning inventory (line 35)          $221,908

     Purchases (line 36)                     414,832

     Ending inventory (line 41)              207,516

     Cost of goods sold (line 42)            429,224

The ending inventory amount of $207,516 reported on line 41 of

the Schedule C includes a reduction of inventory of $48,257.92

caused by shrinkage to the Kansas inventory and accounted for by

adjusting journal entry 18.    The product purchases of $414,832

reported on line 36 of the Schedule C includes an increase to
                                - 5 -

purchases of $48,257.92 from adjusting journal entry 18.    The

amount of purchases before the effect of adjusting journal entry

18 is $366,574.08.

                             Discussion

     This dispute centers on the proper treatment of petitioners’

cost of goods sold for the 2000 tax year.    Petitioners maintain

that their business suffered shrinkage of inventory in the amount

of $48,257.92 and as a result the total cost of goods sold for

2000 is $429,224.    Respondent concedes that petitioners are

permitted to adjust cost of goods sold by the amount of shrinkage

suffered.3   However, respondent maintains that petitioners are

double-counting the adjustment to cost of goods sold by including

the $48,257.92 in the line 36 purchases at the same time as

reducing the line 41 year end inventory by $48,257.92.    Thus,

according to respondent, petitioners’ product purchases should be

$366,574 and petitioners’ cost of goods sold should be $380,966.

     In order to compute the gross income of a business, gross

receipts are subtracted by the cost of goods sold.    Sec. 1.61-

3(a), Income Tax Regs.    Cost of goods sold, in turn, is computed

by subtracting the value of ending inventory for a year from the

sum of beginning inventory and purchases during that year.      See




     3
       While not at issue here, we note that sec. 471(b) permits
estimates of inventory shrinkage that are confirmed by a physical
count after the close of the taxable year.
                              - 6 -

Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 530 n.9

(1979).

     In this case, petitioners used a periodic inventory system

which requires an adjustment to inventory at the end of the year

to reflect the physical ending inventory count.    After performing

the physical count, petitioners’ accountant made an adjusting

journal entry for shrinkage, reflecting a $48,257.92 credit to

inventory and a $48,257.92 debit to product purchases.

Petitioners’ accountant then used the adjusting journal entry to

reduce the trial balance of petitioners’ yearend inventory by

$48,257.92 and at the same time to increase the trial balance of

petitioners’ product purchases by $48,257.92.     The problem is,

there is nothing in the record to suggest, and petitioners do not

argue, that they actually purchased $48,257.92 of goods to

replace the inventory that was lost.    And by including the

$48,257.92 adjustment in purchases as well as ending inventory,

petitioners increased their cost of goods sold reported on

Schedule C (and reduced gross income) by double the amount of

actual shrinkage their inventory suffered.    Thus, while it was

proper to reduce the ending inventory by the amount of shrinkage,

it was improper for petitioners to also increase the line 36

product purchases by the same amount.

     Accordingly, we find that petitioners’ product purchases for

2000 were $366,574, and their cost of goods sold was $380,966
                                 - 7 -

($221,908 + $366,574 - $207,516 = $380,966).       To the extent an

accuracy-related addition to tax was once at issue, respondent

has stipulated that no addition to tax should be imposed with

respect to adjusting journal entry 18, and thus we do not

consider it.

     To reflect the foregoing,


                                              Decisions will be entered

                                         under Rule 155.
