                               T.C. Memo. 2012-80



                         UNITED STATES TAX COURT



          MARC S. BARNES AND ANNE M. BARNES, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 20413-08.                          Filed March 21, 2012.



      Gerald W. Kelly, Jr., and Matthew F. Penater, for petitioners.

      Erin R. Hines, for respondent.


                           MEMORANDUM OPINION


      MORRISON, Judge: Marc S. Barnes and Anne M. Barnes filed a joint

income-tax return for tax year 2003. At all relevant times, the Barneses were

husband and wife.
                                         -2-

      On June 3, 2008, respondent (“the IRS”) issued the Barneses a statutory

notice of deficiency, determining a deficiency in tax of $54,486, a section 6662(a)1

accuracy-related penalty of $10,897, and a section 6651(a)(1) late-filing addition

to tax of $5,691 with respect to their 2003 return. The deficiency was based on the

following adjustments: (1) disallowance of a $123,006 loss claimed on Schedule

E, Supplemental Income and Loss; (2) allowance of $319 in automobile expenses,

in addition to those claimed on the return; (3) allowance of $150 in “promoters

expenses”, in addition to those claimed on the return; (4) disallowance of $28,592

in talent expenses; (5) allowance of $3,679 in travel expenses, in addition to those

claimed on the return; (6) allowance of $6,067 in advertising expenses, in addition

to those claimed on the return; and (7) computational adjustments to self-

employment tax, the self-employment tax deduction, itemized deductions, and

exemptions. The Barneses agreed to the adjustments to automobile expenses,

“promoters expenses”, talent expenses, travel expenses, and advertising expenses.

      On August 19, 2008, the Barneses timely petitioned the Tax Court for a

redetermination of their income-tax deficiency for 2003. Their petition challenged

four determinations made by the IRS: (1) the disallowance of a $123,006



      1
        All section references are to the Internal Revenue Code in effect for the year
in issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure, unless otherwise indicated.
                                          -3-

Schedule E loss attributable to the Barneses’ interest in Whitney Restaurants, Inc.

(“Whitney”), an S corporation; (2) the rejection of the Barneses’ assertion that they

overreported, by $30,000, the gross receipts of a sole proprietorship reported on

Schedule C, Profit or Loss From Business; (3) the determination that the Barneses

are liable for a section 6662(a) accuracy-related penalty; and (4) the determination

that the Barneses are liable for a section 6651(a)(1) late-filing addition to tax. At

the time the case was submitted for decision, the Barneses conceded liability for the

section 6651(a)(1) late-filing addition to tax.

      Therefore, the issues remaining for decision are: (1) whether the Barneses

were entitled to claim as a deduction $123,006 in passthrough losses from Whitney

(we find that they were not so entitled); (2) whether the Barneses overreported

Schedule C gross receipts by $30,000 (we find that they did not); and (3) whether

the Barneses are subject to a section 6662(a) accuracy-related penalty attributable to

a substantial understatement of income tax (we find that they are).

      We have jurisdiction pursuant to section 6214 to redetermine the deficiency

and penalty determined in the notice of deficiency. See sec. 6214(a).

                                      Background

      The parties have submitted this case fully stipulated for decision under Rule

122. See Rule 122(a). We adopt their stipulations.
                                        -4-

      Marc S. and Anne M. Barnes are Washington, D.C.-based entrepreneurs.

During tax year 2003 the Barneses were engaged in several different lines of

business, including restaurants, nightclubs, and event promotion. They engaged in

these various businesses through several different business entities, including two S

corporations (one of which was Whitney Restaurants, Inc.), and a wholly owned

subchapter C corporation. The subchapter C corporation, Influence Entertainment,

Inc., engaged in the business of event promotion. The Barneses also engaged in the

business of event promotion via an unincorporated sole proprietorship whose

earnings were reported directly on the Barneses’ 2003 income-tax return.

      The Barneses’ 2003 joint income-tax return was prepared by an employee of

the firm Sakyi & Associates.

Whitney Restaurants, Inc.

      Whitney, known until 2001 as R.G.B., Inc., operated the Republic Gardens

restaurant in Washington, D.C. The parties disagree over the Barneses’ correct

basis in their Whitney stock for tax year 2003 and whether their basis was

sufficient to claim the disallowed $123,006 as a Schedule E deduction on their

2003 return. The IRS alleges that the Barneses erred in two respects when

calculating basis: (1) they erroneously calculated an increase in basis of $22,282
                                          -5-

for 1996 and (2) they failed to calculate a reduction in basis of $136,228.50 for

1997.

        We begin with a brief overview of the relevant rules governing taxation of S

corporation shareholders. In determining the tax liability of an S corporation

shareholder for a particular year, one preliminary step is to calculate the

shareholder’s basis in S corporation stock for the purposes of section 1366(d)(1).

That section places a limit on the amount of passthrough S corporation losses that

are deducted or other otherwise taken into account in determining the

shareholder’s income in a given year. The limit is equal to the shareholder’s basis

in the S corporation stock.2 Sec. 1366(d)(1)(A). For this purpose, the basis

calculation starts with the basis at the end of the preceding year, after all

adjustments to basis for the preceding year. The basis from the preceding year is

then adjusted for certain transactions that occur during the year of the loss. Sec.

1.1366-2(a)(3)(i), Income Tax Regs. One such adjustment is that basis is

increased by all contributions of capital by the shareholder to the corporation. See

secs. 1012, 351(a), 358(a)(1). At this stage, no adjustment is made for losses


        2
       The limit is equal to the sum of the shareholder’s basis in the S corporation
stock and basis in any indebtedness of the S corporation to the shareholder, see sec.
1366(d)(1), but the Barneses made no loans to Whitney during the years at issue.
We therefore omit any further discussion of basis in indebtedness.
                                          -6-

passed through to the shareholder in the year for which the limitation on losses is

being calculated. Sec. 1.1366-2(a)(3)(i), Income Tax Regs.

      Having ascertained the loss limit for the year, the next step is to determine

how the shareholder’s pro rata share of the S corporation’s income or loss is taken

into account in determining the shareholder’s income. The S corporation is required

to report to the shareholder his or her pro rata share of the S corporation’s tax items,

including income or loss, on a Schedule K-1, Partner’s Share of Income, Credits,

Deductions, etc. See sec. 6037(b). If the Schedule K-1 is incorrect, the shareholder

must report the correct pro rata share of passthrough tax items. See sec. 1366(a)(1);

Henn v. Commissioner, T.C. Memo. 2002-261, slip op. at 10, n.2. If the S

corporation had income for the year, the shareholder’s gross income will be

increased by his or her share of the S corporation’s income. See sec.

1366(a)(1), (c). If the S corporation had a loss for the year, the shareholder’s

income will take into account the shareholder’s pro rata share of the S

corporation’s loss, see sec. 1366(a)(1), to the extent of the limitation in section

1366(d)(1). As noted before, that section provides that a shareholder’s pro rata

share of the S corporation’s loss is taken into account only to the extent of the

shareholder’s basis in his or her S corporation stock. Sec. 1366(d)(1)(A). If the

shareholder’s pro rata share of the loss exceeds the shareholder’s basis, the
                                          -7-

shareholder must incorporate into his or her income calculation for the year an

amount of the loss equal to his or her basis in the S corporation stock.3 See sec.

1366(a)(1), (d)(1). The portion of the shareholder’s pro rata share of losses that

exceeds basis is not taken into account, as a deduction or otherwise, in the current

year in computing the shareholder’s taxable income. See sec. 1366(d)(1). Losses in

excess of basis, which we refer to here as “suspended losses”, are deemed to be

incurred in the following year with respect that shareholder. See sec. 1366(d)(2).

      S corporation shareholders must make further adjustments to basis to

account for the pro rata share of income or loss required to be taken into account

by the shareholder in calculating his or her tax liability. If the shareholder had

passthrough income from the S corporation, basis is increased by the shareholder’s

pro rata share of the S corporation’s income. See sec. 1367(a)(1)(A) and (B). An

exception to this rule provides that no increase in basis is made for any amount of

passthrough income that was required to be reported by the shareholder and

included in gross income but that the shareholder failed to report on his or her

return. Sec. 1367(b)(1). If the shareholder had a passthrough loss from the S

corporation, basis is reduced (but not below zero) by the shareholder’s pro rata


      3
       If the passthrough loss is ordinary, the loss is taken into account as a
deduction against the shareholder’s ordinary income. See sec. 62(a).
                                          -8-

share of the S corporation’s loss, to the extent that it was required to be taken into

account in computing the shareholder’s income, as a deduction or otherwise. See

sec. 1367(a)(2)(B) and (C). Basis is not reduced by losses that were not taken into

account because of the section 1366(d)(1) limitation. See id. Thus, S corporation

shareholders do not reduce basis by the amount of suspended loss that was not

taken into account in calculating the shareholder’s income because of insufficient

basis. See secs. 1366(d)(1), 1367(a)(2)(B) and (C). With these additional

adjustments, a final basis figure is reached. This is the amount that is used to

calculate the section 1366(d)(1) limit on passthrough losses for the next year.

      Aside from two exceptions, the parties do not dispute this description of the

relevant statutory provisions. The Barneses offer the following interpretations of the

applicable rules: (1) basis increases for amounts reported by a shareholder as his or

her pro rata share of passthrough S corporation income, even where the reported

income amount is not actually the shareholder’s pro rata share of the S corporation’s

income for that year; and (2) basis is not reduced for passthrough S corporation

losses that the shareholder did not report on his or her return and did not claim as a

deduction, despite being required to do so by section 1366(a)(1). As we decide

below, the Barneses’ interpretations are incorrect.
                                         -9-

      In 1995 the Barneses acquired a 50% interest in Whitney by making a

$44,271 contribution of capital. No other transactions affected the Barneses’ basis

in their Whitney stock for the purposes of the section 1366(d)(1) limitation for

1995. Consequently, at the end of 1995, and for the purposes of the section

1366(d)(1) limitation on passthrough losses for 1995, the Barneses had a basis of

$44,271 in their Whitney stock. Whitney operated at a loss in 1995. The

Barneses’ pro rata share of that loss, as reported on a Schedule K-1 Whitney

issued to the Barneses, was $66,553. The parties do not dispute that $66,553--the

amount reported on the Schedule K-1--is the Barneses’ correct pro rata share of

Whitney’s losses for 1995. The parties also agree that, for 1995, the correct

amount of the Barneses’ deduction for passthrough losses from Whitney was

$44,271 (the amount of their basis in the Whitney stock).4 They agree that this

deduction required a $44,271 reduction in stock basis, leaving the Barneses with a




      4
        Because the Barneses’ 1995 tax return is not a part of the record, we cannot
ascertain what portion of the 1995 passthrough loss the Barneses actually claimed as
a deduction on their 1995 return. The IRS contends that the Barneses claimed as a
deduction the full $66,553, despite the fact that they did not have sufficient basis.
The Barneses seem to contend that they claimed as a deduction only $44,271 for
1995 and carried forward a suspended loss of $22,282. See infra p. 20.
                                           - 10 -

basis in their Whitney stock, after reduction, of zero.5 The parties agree that, at the

end of 1995, the Barneses had a suspended loss attributable to their interest in

Whitney of $22,282.6

      In 1996, the Barneses made no contributions of capital to Whitney. No

other transactions took place that affected the Barneses’ basis in the Whitney stock

for purposes of the section 1366(d)(1) limitation for 1996. Consequently, the

parties agree that the Barneses’ basis in the Whitney stock for the purposes of the

section 1366(d)(1) limitation was zero.7 Whitney reported a loss for 1996. The

Barneses’ pro rata share of that loss, as reported on a Schedule K-1 Whitney

issued to the Barneses, was $136,228.50. The parties do not dispute that the

$136,228.50 amount reported on the Schedule K-1 is the Barneses’ correct pro rata

share of Whitney’s 1996 loss. However, the Barneses reported on their 1996 return

that they had a pro rata gain from Whitney of $22,282.8 Because the


      5
          For basis calculations of both parties, see infra pp. 19, 20.
      6
       The amount of the suspended loss is equal to the amount by which the
passthrough loss, $66,553, exceeded the Barneses’ 1995 basis before adjustment for
passthrough items, $44,271. See infra pp. 19, 20.
      7
          See infra pp. 19, 20.
      8
        Although it is not necessary to determine the Barneses’ motives for
reporting their $136,228.50 pro rata share of the Whitney loss as a $22,282 gain,
the IRS speculates that the Barneses reported this “phantom” gain in order to
                                                                        (continued...)
                                       - 11 -

Barneses had a basis in the Whitney stock of zero for the purposes of the section

1366(d)(1) limitation, their deduction for their share of the $136,228.50 passthrough

loss for 1996 was limited to zero. Because the Barneses could not deduct the

$136,228.50 loss for lack of basis, there was a suspended loss for 1996 of

$136,228.50.9 Calculated correctly, the Barneses’ basis in their Whitney stock at

the end of 1996 did not increase for the $22,282 of phantom gain they reported on

their 1996 return. Such basis was also not adjusted for the zero passthrough losses

taken into account pursuant to section 1366(a)(1) and (d)(1) in 1996. Basis,

therefore, remained zero. The Barneses had a combined suspended loss at the end




      8
        (...continued)
remedy an error the IRS contends they made on their 1995 return. See supra note 4.
According to the IRS, the Barneses behaved as if they believed a shareholder could
deduct a passthrough loss in excess of basis as long as the shareholder reduced basis
below zero by the amount of the loss in excess of basis and, in the next year, had a
passthrough gain that was includable in gross income, increasing basis by the
amount of the gain to a non-negative amount. In accord with this erroneous
construction of the subch. S rules, the IRS contends that the Barneses: (1) deducted
a $66,553 loss on their 1995 return, even though their loss limitation was $44,271;
(2) calculated (erroneously) that their basis in their Whitney stock was reduced by
the $66,553 loss, to negative $22,282; (3) inaccurately reported that their share of
Whitney’s passthrough income for 1996 was $22,282 (even though their share of
Whitney’s passthrough items for that year was actually a $136,228.50 loss); and (4)
increased their basis by $22,282 to zero for 1996.
      9
          See infra p. 19.
                                        - 12 -

of 1996 of $158,510.50, consisting of the $22,282 loss suspended in 1995 and the

$136,228.50 loss suspended in 1996.10

      The Barneses agree that they made no contributions of capital to Whitney in

1996; that no other transactions took place that would have affected their basis in

the Whitney stock for purposes of the section 1366(d)(1) limitation for 1996; that

their basis in the Whitney stock, for purposes of the loss limitation for 1996, was

zero; and that they had a 1995 suspended loss of $22,282. The Barneses also do

not dispute that the $136,228.50 passthrough loss reported on the Schedule K-1

was their correct pro rata share of Whitney’s 1996 losses. However, as we noted

above, the Barneses reported income from Whitney of $22,282 on their 1996

income-tax return. Basis calculations the Barneses submitted in their brief suggest

they calculated that their basis increased by the $22,282 they reported as income

from Whitney on their 1996 return.11 The same calculations suggest that they

calculated that their basis was then reduced by the $22,282 loss suspended in

1995.12 Thus, according to the Barneses’ basis calculations, the net effect of these

      10
           See infra p. 19.
      11
           See infra p. 20.
      12
        See infra p. 20. Because the Barneses’ basis calculations appear to reflect
the theory that basis is reduced by whatever passthrough loss was actually reported

                                                                         (continued...)
                                         - 13 -

adjustments was that their basis in the Whitney stock, at the end of 1996 and after

all adjustments for the year, was zero and that they had no suspended loss.13

Correctly calculated, however, the Barneses’ basis did not increase by $22,282

because that amount does not represent the Barneses’ pro rata share of Whitney’s

passthrough income for 1996.

      The parties agree that at the beginning of 1997 the Barneses’ basis in the

Whitney stock was zero. In 1997 the Barneses made a $278,000 contribution of

capital to Whitney. As a result of this contribution, the Barneses’ basis in the

Whitney stock, for purposes of the section 1366(d)(1) limitation on the deduction

of losses for 1997, was $278,000 (equal to zero, increased by the amount of the

$278,000 contribution). Both parties agree that no other transactions affected the

Barneses’ basis in their Whitney stock for 1997 for purposes of the section

1366(d)(1) limitation. According to the Schedule K-1 Whitney issued to the

Barneses, their pro rata share of Whitney’s 1997 loss was $52,594. The parties do



      12
         (...continued)
on their individual tax returns, the fact that they calculated a $22,282 basis reduction
for 1996 for the loss suspended in 1995 suggests that they claimed the $22,282
suspended loss as a deduction on their 1996 return. However, on their 1996 tax
return the Barneses did not claim the $22,282 as a deduction. It appears from the
record that the Barneses actually overstated their 1996 income by $22,282.
      13
           See infra p. 20.
                                         - 14 -

not dispute that $52,594--the amount reported on the Schedule K-1--is the

Barneses’ correct pro rata share of Whitney’s losses for 1997 and that the same

amount--$52,594--is the correct amount of the Barneses’ deduction for Whitney’s

1997 loss. In addition, the $22,282 suspended loss for 1995 and the $136,228.50

suspended loss for 1996 were deemed to be incurred with respect to the Barneses

for 1997. The Barneses claimed a deduction for $52,594 in passthrough losses

attributable to Whitney on their 1997 tax return. On their 1997 return the

Barneses did not claim a deduction for the $22,282 loss suspended in 199514 or for

the $136,228.50 loss suspended in 1996, despite the fact that they had sufficient

stock basis to do so. They also made no adjustments to basis to account for the

1996 loss.15 However, as the IRS contends, the Barneses’ basis in the Whitney

stock was reduced for 1997 by $136,228.50, even though they did not report the

loss on their 1996 return or claim the amount of the carried-forward loss as a

deduction on their 1997 return.16 The Barneses’ correct basis, at the end of 1997


      14
        The IRS speculates that the Barneses did not claim the $22,282 suspended
loss from 1995 as a deduction on their 1997 return because they had already--and
erroneously--claimed that amount as a deduction on their 1995 return. See supra
note 4.
      15
           See infra p. 20.
      16
           In 1997 basis was also reduced by the $22,282 loss suspended in 1995.
                                                                        (continued...)
                                         - 15 -

and after all adjustments (i.e. a $52,594 reduction for the 1997 loss, a $136,228.50

reduction for the 1996 suspended loss, and a $22,282 reduction for the 1995

suspended loss) was $66,895.50.17 The Barneses contend that they “are not

required to reduce their basis for losses that were never claimed or deducted.” They

argue that their correct basis in the Whitney stock, at the end of 1997 and after all

adjustments, was $225,406.18 Both parties agree that the Barneses had no

suspended losses attributable to Whitney at the end of 1997.

      For the next five years the Barneses continued to make contributions of

capital and Whitney continued to report almost exclusively losses. The following

table summarizes the Barneses’ contributions and their pro rata share of Whitney’s

income or loss for tax years 1998 through 2002:




      16
        (...continued)
 According to basis calculations the Barneses submitted, they calculated a $22,282
reduction in basis for the 1995 suspended loss in 1996. See infra p. 20.
      17
           See infra p. 19.
      18
           See infra p. 20.
                                        - 16 -

                                                 Share of income
                      Year     Contribution        and (loss)¹


                      1998     $121,295.43         ($188,091)
                      1999      125,931.00          (168,634)
                      2000       66,613.00            72,720
                      2001      135,000.00          (155,844)
                      2002       60,922.00           (29,525)

      ¹As reported on Schedules K-1 Whitney issued to the Barneses.

The parties do not dispute that the shares of income or loss reported on the

Schedules K-1 are correct. There is also no dispute that the Barneses correctly

reported their pro rata share of income and loss from Whitney on their income-tax

returns for tax years 1998 through 200219 and that no other transactions--besides


      19
        The parties also agree that the Barneses’ reported income-tax liability
correctly reflected passthrough items from Whitney for tax years 1998, 2001, and
2002. They disagree about the correct amount of the deduction for passthrough
losses for 1999 and 2000. For tax year 1999, the Barneses’ pro rata share of
passthrough losses from Whitney was $168,634. The Barneses’ basis in their
Whitney stock, for purposes of the sec. 1366(d)(1) limitation on losses for 1999,
was $126,030.93. Therefore, the correct amount of the passthrough loss deduction
for 1999 was $126,030.93. Because the Barneses did not have sufficient basis in
1999 to claim as a deduction the full $168,634 Whitney loss, there was also a
suspended loss for that year of $42,603.07. This $42,603.07 loss suspended in
1999 should have been claimed as a deduction on the Barneses’ 2000 tax return.
See infra p. 19. However, the Barneses erroneously claimed as a deduction on
their 1999 tax return their full $168,634 share of the Whitney losses. See infra p.
                                                                        (continued...)
                                        - 17 -

contributions of capital and pro rata shares of income and loss taken into account--

affected basis in the Whitney stock for those years. However, because the parties

disagree as to the Barneses’ correct basis in the Whitney stock at the end of 1997,

they also disagree as to the correct end-of-year adjusted basis for tax years 1998

through 2002.20

      At the beginning of 2003, as the IRS contends, the Barneses had a basis of

$107,282.93 in their Whitney stock and no suspended losses attributable to

Whitney.21 The Barneses contend that their opening basis for 2003 was

$265,793.43 and that they had no suspended losses.22 Both parties agree that during

2003 the Barneses made a $46,000 contribution of capital, resulting in a $46,000

increase in stock basis. No other transactions affected the Barneses’ basis in their

Whitney stock for purposes of the section 1366(d)(1) limitation on losses for 2003.




      19
       (...continued)
20. This deduction exceeded their correct 1999 basis in the Whitney stock by
$42,603.07.
      20
           See infra pp. 19, 20.
      21
           See infra p. 19.
      22
           See infra p. 20.
                                        - 18 -

      For 2003 Whitney reported a large loss. According to the Schedule K-1

Whitney issued to the Barneses for that year, their share of the loss was $276,289.

Neither party disputes that the amount reported on the Schedule K-1 is the

Barneses’ correct pro rata share of the loss. On Schedule E of their 2003 income-

tax return, the Barneses deducted $276,289 in passthrough losses attributable to

their interest in Whitney. In its notice of deficiency, the IRS determined that

$123,006 of the deduction was not permissible because the Barneses had

insufficient basis. According to IRS calculations, the Barneses’ basis, for purposes

of the section 1366(d)(1) limitation for 2003, was $153,282.93. Therefore, the IRS

argues, the Barneses had sufficient basis to deduct only $153,282.93 of the 2003

loss. The remainder--$123,006, rounded to the nearest whole number--was

disallowed. The Barneses dispute this determination. They claim their 2003 stock

basis, for purposes of the section 1366(d)(1) limitation, was $311,793.43.23

Therefore, they contend, the correct deduction for their share of the 2003 Whitney

loss was $276,289.

      By way of summary, the IRS correctly contends that the Barneses’ basis in

the Whitney stock for each of the years 1995 through 2003 is properly calculated as

follows:

      23
           See infra p. 19.
                                         - 19 -

                                           Income or
         Initial basis   Contributions      loss from     Basis after    Suspended
 Year                     of capital¹       Whitney²      adjustment      losses


 1995         -0-          $44,271.00     ($66,553.00)        -0-        ($22,282.00)
 1996         -0-             -0-         (136,228.50)        -0-        (158,510.50)
 1997         -0-          278,000.00      (52,594.00) $66,895.50             -0-
 1998    $66,895.50        121,295.43     (188,091.00)         99.93          -0-
 1999          99.93       125,931.00     (168,634.00)        -0-         (42,603.07)
 2000         -0-           66,613.00       72,720.00      96,729.93          -0-
 2001      96,729.93       135,000.00     (155,844.00)     75,885.93          -0-
 2002      75,885.93        60,922.00      (29,525.00) 107,282.93             -0-
 2003    107,282.93         46,000.00     (276,289.00)        -0-       ³(123,006.07)

       ¹Contributions of capital are added to initial basis, increasing initial basis by
the amount of the contribution.
       ²Basis, after being increased by the amount of any capital contribution, is then
adjusted for passthrough items of income and loss. Items of income and loss for
each year match income and loss items on the Schedules K-1 issued to the Barneses.

      ³This amount, rounded to the nearest dollar, is equal to the amount of loss the
IRS disallowed in its notice of deficiency.

      The Barneses disagree. They claim that their basis in the Whitney stock is

properly calculated as follows:
                                         - 20 -

                                           Income or
                                            loss from
                                            Whitney
                         Contributions      reported     Basis after      Suspended
 Year    Initial basis    of capital¹       on return²    adjustment       losses


 1995         -0-          $44,271.00       ($66,553)         -0-          ($22,282)
 1996         -0-             -0-            ³22,282          -0-             -0-
 1997         -0-          278,000.00        (52,594)    $225,406.00          -0-
 1998    $225,406.00       121,295.43       (188,091)     158,610.43          -0-
 1999     158,610.43       125,931.00       (168,634)     115,907.43          -0-
 2000     115,907.43        66,613.00         72,720      255,240.43          -0-
 2001     255,240.43       135,000.00       (155,844)     234,396.43          -0-
 2002     234,396.43        60,922.00        (29,525)     265,793.43          -0-
 2003     265,793.43        46,000.00       (276,289)       35,504.43         -0-

       ¹Contributions of capital are added to initial basis, increasing initial basis by
the amount of the contribution.
       ²Basis, after being increased by the amount of any capital contribution, is then
adjusted for items of income and loss. Items of income and loss here are items of
income and loss attributable to Whitney that the Barneses reported on their income-
tax returns for each respective year.
       ³Income in this amount was not indicated on the Schedule K-1 that Whitney
issued to the Barneses for 1996. The parties stipulated that the Schedule K-1 for
that year reflected a loss of $136,228.50.
                                       - 21 -

Influence Entertainment, Inc., and the Sole Proprietorship

      During 2003, the Barneses engaged in the business of event promotion24 via

two separate ventures. The first event-promotion business we refer to as the “sole

proprietorship”. It is an unincorporated business venture conducted directly by

Marc Barnes, with assistance from Anne Barnes, and its income was reported on a

Schedule C attached to the Barneses’ 2003 return. In 2003, the sole proprietorship

reported gross receipts of $168,997. The Barneses did not submit any evidence

regarding how gross receipts for the sole proprietorship were calculated or what

items were included in the $168,997 total.

      The second event-promotion business was conducted by Anne Barnes’s

wholly owned C corporation, Influence Entertainment, Inc. We refer to this entity

as “Influence Entertainment”. On its Form 1120, U.S. Corporation Income Tax

Return, for 2003, Influence Entertainment reported gross receipts of $619,666. The

Barneses did not submit any evidence regarding how Influence Entertainment

calculated its gross receipts or what items were included in the $619,666.


      24
        The term “event promotion” refers to the activity of advertising or operating
concerts, sports matches, festivals, and similar live events, whether as an agent or
for one’s own account. On their 2003 income-tax return, the Barneses refer to the
sole proprietorship as “Event Promotion”, a name which we do not use because it
risks confusion with their other event-promotion venture, Influence Entertainment,
Inc.
                                         - 22 -

      During 2003 Influence Entertainment organized a concert series called “Latin

Rock en Espanol” at Dream Nightclub in Washington, D.C. Influence

Entertainment signed a related sponsorship agreement with Anheuser-Busch, Inc.

According to the agreement, dated April 21, 2003, Influence Entertainment would

be paid a sponsorship fee of $30,000 to advertise Anheuser-Busch as the “exclusive

alcohol and non-alcohol malt beverage sponsor” at a minimum of six “Latin Rock”

concerts. Influence Entertainment received a $60,000 check, dated June 4, 2003,

from Anheuser-Busch, Inc. The Barneses contend that half of this amount, $30,000,

was payment for services rendered by Influence Entertainment, and that the

remaining $30,000 was payment for services rendered by the sole proprietorship.

According to the Barneses, the full amount of the payment, $60,000, was

erroneously included in gross receipts of the sole proprietorship, resulting in a

$30,000 overstatement of its gross receipts. The IRS disputes this contention.

                                      Discussion

I.    Burden of Proof

      In proceedings before the Tax Court, the taxpayer generally bears the

burden of proving that the IRS’s determinations in a notice of deficiency are

erroneous. See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). This
                                         - 23 -

burden is satisfied by a preponderance of the evidence. See Estate of Gilford v.

Commissioner, 88 T.C. 38, 51 (1987). If the evidence is in equipoise, the taxpayer

has not met his burden and the determination of the IRS will be sustained. See

Elliott v. Commissioner, 40 T.C. 304, 311 (1963). Section 7491 imposes the

burden of proof on the IRS with respect to any factual issue relevant to determining

the taxpayer’s tax liability, provided the taxpayer has (1) complied with all

substantiation requirements, (2) maintained all required records, (3) cooperated with

all reasonable requests for information from the IRS, and (4) introduced credible

evidence with respect to the factual issue relevant to ascertaining the taxpayer’s tax

liability. Sec. 7491(a)(1) and (2); Higbee v. Commissioner, 116 T.C. 438, 440-441

(2001). “Credible evidence” is evidence that, after critical analysis, would

constitute a sufficient basis for deciding the issue in favor of the taxpayer if no

contrary evidence were submitted. Ocmulgee Fields, Inc. v. Commissioner, 132

T.C. 105, 114 (2009), aff’d, 613 F.3d 1360 (11th Cir. 2010). The taxpayer bears

the burden of proving that all the requirements of section 7491 have been satisfied.

Rolfs v. Commissioner, 135 T.C. 471, 483 (2010), aff’d, __ F.3d __ (7th Cir. Feb.

8, 2012).

      On April 29, 2009, the Barneses filed a motion to shift burden of proof,

requesting that the burden be imposed on the IRS pursuant to section 7491. On
                                        - 24 -

May 11, 2009, we denied that motion without prejudice. When the case was called

for trial on June 10, 2009, the Barneses renewed their motion. We deny this motion

because the Barneses have not presented credible evidence with respect to any

factual issue. Whether the Barneses had sufficient basis in their S corporation stock

to claim as a Schedule E deduction $123,006 in passthrough losses from Whitney is

a legal question that we resolve by applying the law to the stipulated facts.

Consequently, the allocation of the burden of proof has no bearing on that legal

issue. As for the Barneses’ other claims--that their failure to claim as a deduction

for 1997 a $136,228.50 passthrough loss from Whitney gives rise to an NOL that is

available to offset gross income in 2003, see infra pp. 34-37, and that they

overstated gross receipts of the sole proprietorship by $30,000, see infra pp. 37-38--

the Barneses have not presented credible evidence within the meaning of section

7491 with respect to the factual elements of those issues. As explained infra, the

evidence the Barneses submitted does not give us a sufficient factual basis to

resolve either of those issues in their favor. Therefore, we find that the Barneses

have not satisfied the requirements of section 7491 and the burden of proof will not

be imposed on the IRS pursuant to that provision.
                                         - 25 -

II.   Disallowance of the Schedule E Deduction

      In its notice of deficiency the IRS disallowed $123,006 of Schedule E losses

attributable to the Barneses’ interest in Whitney. It determined that, after properly

adjusting basis in accordance with the Internal Revenue Code, the Barneses did not

have sufficient basis in their Whitney stock in 2003 to deduct the disallowed

$123,006 portion of Whitney’s 2003 passthrough losses.

      The Barneses offer several theories as to why the IRS’s determination is

incorrect. We address each argument in turn.

      A.     Adjustments to Basis

      First, the Barneses dispute the IRS’s determination that they lacked sufficient

basis to claim as a deduction their full $276,289 pro rata share of passthrough losses

from Whitney on their 2003 income-tax return. According to the IRS, the Barneses

made two errors in calculating basis in their Whitney stock before tax year 2003:

(1) in 1996 the Barneses increased basis by $22,282 in putative passthrough

income, despite the fact that the Schedule K-1 Whitney issued to them for that year

reflected a passthrough loss of $136,228.50; and (2) in 1997 the Barneses failed to

reduce basis to account for $136,228.50 in passthrough losses that they were

required to take into account in that year but failed to claim as deduction on their

return.
                                        - 26 -

             1.    Upward Basis Adjustment in 1996

      The IRS takes the position that the Barneses’ basis in the Whitney stock did

not increase by $22,282 in 1996. It contends that, under section 1367, there is no

upward basis adjustment for amounts that are erroneously reported by the

shareholder as passthrough income but that do not correspond to the shareholder’s

actual pro rata share of passthrough income. The Barneses seem to argue, without

citation of authority, that the upward basis adjustment was appropriate because they

reported $22,282 in passthrough income on their 1996 return. We agree with the

position of the IRS.

      Pursuant to section 1366(a)(1)(A), S corporation shareholders take into

account their “pro rata share” of the S corporation’s income when calculating their

income-tax liability. A shareholder’s pro rata share of income is equal to the S

corporation’s income multiplied by the proportion of the corporation’s total shares

owned by the shareholder during the year in which the income was earned. See sec.

1377(a)(1). The S corporation is required to inform shareholders of their annual pro

rata share of income, which it does by issuing the shareholders Schedules K-1. See

sec. 6037(a) and (b).

      Under section 1367(a)(1)(A), an S corporation shareholder increases basis

in S corporation stock by his or her pro rata share of passthrough income for the
                                        - 27 -

year, i.e. the income items described in section 1366(a)(1)(A). Whitney issued a

Schedule K-1 to the Barneses for tax year 1996, the accuracy of which the Barneses

do not dispute. That Schedule K-1 does not reflect any 1996 passthrough income.

It reports a loss, of which the Barneses’ pro rata share was $136,228.50. Therefore,

we hold that the Barneses had no passthrough income items attributable to Whitney

in 1996, but, instead, had a passthrough loss of $136,228.50 for that year. The fact

that they reported $22,282 of passthrough income on their return is irrelevant.

Section 1367(a)(1)(A) provides only for basis adjustments which correspond to the

shareholder’s pro rata share of income. It does not provide for basis to be adjusted

for passthrough items reported by shareholders on their returns. Because the

Barneses had no passthrough income from Whitney for 1996, their basis did not

increase by $22,282 in that year.

             2.    Failure To Make Downward Basis Adjustment for 1997

      Recall that the Barneses’ basis, for purposes of the limitation on deduction of

passthrough losses from Whitney for 1997, was $278,000 and that there was a

passthrough loss from Whitney to the Barneses for 1997 of $52,594, and a

suspended loss carried forward from 1996 of $136,228.50.25 Instead of claiming a

      25
        According to IRS calculations, see supra p. 19, there should have been an
additional suspended loss carried forward from 1995 of $22,282. The IRS
                                                                       (continued...)
                                         - 28 -

deduction for Whitney losses of $188,822.50 (which is the sum of $52,594 and

$136,228.50), the Barneses reported a deduction of only $52,594 on their return.

      Pursuant to section 1366(a)(1)(A), shareholders of an S corporation take

into account a pro rata share of the S corporation’s losses in calculating their

annual tax liabilities. A shareholder’s “pro rata share” of losses is equal to the S

corporation’s loss multiplied by the proportion of the S corporation’s total shares

owned by the shareholder during the year in which the loss was incurred. See sec.

1377(a)(1). The S corporation is required to report the shareholder’s pro rata

share of the S corporation’s loss to the shareholder on a Schedule K-1. See sec.

6037(a) and (b). Section 1366(d)(1) provides that losses taken into account in

computing a shareholder’s income pursuant to section 1366(a)(1) cannot exceed

the shareholder’s basis in the S corporation stock and the basis of any debt owed

to the shareholder by the corporation.26 Any passthrough losses that are

disallowed currently because a shareholder lacks sufficient basis to take them into

      25
        (...continued)
contends that this amount was erroneously claimed as a deduction by the Barneses
in 1995. See supra note 4. According to the Barneses’ basis calculations, this
$22,282 suspended loss was absorbed by $22,282 of reported income from Whitney
in 1996. See supra p. 20.
      26
        We omit any further discussion of basis in debt of the corporation to the
shareholder because nothing in the record indicates that the Barneses made any
loans to Whitney. See supra note 2.
                                        - 29 -

account as a deduction carry forward and are treated as incurred in the subsequent

tax year with respect to that shareholder. See sec. 1366(d)(2).

      S corporation shareholders must make various adjustments to basis in their S

corporation stock. When a shareholder makes a contribution of capital to the S

corporation, the shareholder increases basis in the S corporation stock by the

amount of the contribution. See secs. 351(a), 358(a), 1012. With respect to loss,

section 1367(a)(2)(B) requires the shareholder to reduce basis, but not below zero,

by the amount of any losses described in section 1366(a)(1)(A) (generally, the

shareholder’s pro rata share of passthrough losses).

      According to the IRS, section 1367(a)(2)(B) requires an S corporation

shareholder to reduce basis by any losses that he or she is required to take into

account under section 1366(a)(1)(A). Basis is reduced, the IRS contends, even if

the shareholder does not actually claim the passthrough losses on his or her return.

Therefore, the IRS argues, the Barneses’ basis was reduced by $136,228.50 for

1997 because of the $136,228.50 loss suspended in 1996 that the Barneses were

required to take into account as a deduction for 1997.27 The Barneses’ basis


      27
        In 1997, basis was also reduced by the $22,282 loss suspended in 1995.
Pursuant to sec. 1366(d)(2), that loss was treated as incurred in 1997 with respect
to the Barneses and, pursuant to sec. 1366(a)(1)(A), they were required to claim
                                                                        (continued...)
                                        - 30 -

calculations did not incorporate this reduction. Therefore, says the IRS, their basis

calculations for subsequent years were inaccurate.

      The Barneses offer a different interpretation of the applicable statutes.

Section 1367(a)(2)(B), they argue, requires basis reduction only for losses that the S

corporation shareholder reports on his or her tax return and claims as a deduction

when calculating tax liability. Because they did not report the $136,288.50 loss for

1996 and they did not claim it as a deduction on their return for 1997 when they had

adequate basis, the theory goes, the Barneses’ basis was never reduced by the

amount of that loss. According to the Barneses’ calculations, see supra p. 20, they

had sufficient basis in 2003 to deduct their full, $276,289 share of Whitney’s

passthrough losses on their 2003 return.28

      The plain language of sections 1366 and 1367 supports the IRS’s

interpretation.




      27
         (...continued)
the loss as a deduction on their 1997 return. Instead, the Barneses calculated that
basis was reduced for this loss for 1996. See supra p. 20.
      28
        Basis would have been sufficient ($289,511.43, after increasing for the
$46,000 contribution of capital) to permit the Barneses to deduct the full $276,289
loss even if they had calculated basis without making the $22,282 upward basis
adjustment that we determined was in error supra pp. 26-27.
                                          - 31 -

      Section 1367(a)(2)(B) provides that basis in S corporation stock is reduced

by “items of loss and deduction described in subparagraph (A) of section

1366(a)(1)”. Section 1366(a)(1) provides as follows:

      SEC. 1366(a). Determination of Shareholder’s Tax Liability.--

             (1) In general.--In determining the tax under this chapter
      of a shareholder for the shareholder’s taxable year in which the
      taxable year of the S corporation ends * * * there shall be taken
      into account the shareholder’s pro rata share of the corporation’s--

                      (A) items of income (including tax exempt income),
               loss, deduction, or credit the separate treatment of which
               could affect the liability for tax of any shareholder, and

                      (B) nonseparately computed income and loss.

Therefore, one of the items described in section 1366(a)(1)(A) is a shareholder’s

pro rata share of the S corporation’s losses. The shareholder’s “pro rata share”

includes both current-year losses and--by virtue of section 1366(d)(2)--suspended

prior-year losses that the shareholder was precluded from taking into account for

the prior year by section 1366(d)(1). See sec. 1366(a)(1), (d). Section 1366(d)(2)

provides that losses that are disallowed with respect to a shareholder by reason of

section 1366(d)(1) “shall be treated as incurred by the corporation in the

succeeding taxable year with respect to that shareholder.”29 Such losses are,

      29
           With respect to the Barneses’ suspended 1996 losses, the “succeeding
                                                                         (continued...)
                                        - 32 -

therefore, an item described in section 1366(a)(1)(A) in the succeeding taxable year,

and section 1367(a)(2)(B) requires that basis be reduced (but not below zero) by the

amount of such items. The class of losses described in section 1366(a)(1)(A) is not

limited to losses that were actually claimed as a deduction by the shareholder on the

shareholder’s tax return. Therefore, the basis reduction rule in section

1367(a)(2)(B) is not limited, as the Barneses contend, to losses that were actually

claimed as a deduction on a return.

      Because of their 1997 contribution of capital and the corresponding increase

in basis, the Barneses had sufficient basis in their Whitney stock in tax year 1997 to

take into account their full $136,228.50 share of Whitney’s 1996 loss, which had

been previously disallowed by section 1366(d)(1). That loss was an item described

in section 1366(a)(1)(A) with respect to the Barneses for 1997 because section

1366(a)(1)(A) required the loss to be taken into account in determining the

Barneses’ correct tax for that year. Therefore, the IRS was correct in determining

that, pursuant to section 1367(a)(2)(B), the Barneses’ basis in their Whitney stock

was reduced for 1997 by the amount of the $136,228.50 loss.




      29
        (...continued)
taxable year” is 1997.
                                         - 33 -

      B.     Tax Benefit Rule

      The Barneses argue that, even if both the IRS’s interpretation of section 1367

and its basis calculations are correct, the exclusionary component of the tax benefit

rule permits the Barneses to claim the benefit in 2003 of the suspended loss they did

not report as a deduction in 1997.

      The tax benefit rule is a judicially created principle intended to remedy some

of the inequities that would otherwise result from the annual accounting system used

for federal income-tax purposes. See Hillsboro Nat’l Bank v. Commissioner, 460

U.S. 370, 377 (1983). The Supreme Court explains that “[t]he basic purpose of the

tax benefit rule is to achieve rough transactional parity in tax, * * * and to protect

the Government and the taxpayer from the adverse effects of reporting a transaction

on the basis of assumptions that an event in a subsequent year proves to have been

erroneous.” Id. at 383. The rule has two components: an inclusionary component

and an exclusionary component. The inclusionary component is a rule providing

that, where a taxpayer properly deducts an outlay in one year and then, in a later

year, recovers the same amount, the subsequent recovery is generally included in the

taxpayer’s gross income. See Hudspeth v. Commissioner, 914 F.2d 1207, 1212 (9th

Cir. 1990), rev’g T.C. Memo. 1985-628. The exclusionary component of the rule,

the component invoked by the Barneses,
                                         - 34 -

provides generally that gross income does not include amounts subsequently

recovered to the extent that the prior deduction did not give rise to a tax benefit.

See id. Section 111(a) partially codified the exclusionary aspect of the tax benefit

rule. Hillsboro Nat’l Bank v. Commissioner, 460 U.S. at 388. It provides: “Gross

income does not include income attributable to a recovery during the taxable year of

any amount deducted in any prior taxable year to the extent that such amount did not

reduce the amount of tax imposed by this chapter.” Sec. 111(a). The exclusionary

component of the rule does not become an issue unless, and until, the inclusionary

component of the rule is satisfied. Frederick v. Commissioner, 101 T.C. 35, 40-41

(1993); Home Mut. Ins. Co. v. Commissioner, 639 F.2d 333, 345-346 (7th Cir.

1980), aff’g in part, rev’g in part 70 T.C. 944 (1978).

      The inclusionary component of the tax benefit rule would not require the

Barneses to include in gross income for 2003 any amount deducted in a prior

taxable year and subsequently recovered. Therefore, neither component of the tax

benefit rule applies and section 111(a) does not provide for an exclusion from the

Barneses’ income for 2003.

      C.     Net Operating Loss

      Finally, the Barneses contend that, even if the IRS is correct with respect to

basis in the Whitney stock, their failure to claim $136,228.50 in passthrough
                                        - 35 -

losses on their 1997 return caused them to incorrectly calculate their net operating

loss (NOL) for that year.30 They argue that the amount of their 1997 NOL should be

recalculated, taking into account the $136,228.50 they failed to deduct and giving

rise to an NOL for 1997 of $136,228.50. They argue further that, because they

“never used” this NOL, it remains available to offset their taxable income for

2003.31

      Defined generally, an NOL is the excess of allowable deductions over gross

income for a given tax year. Sec. 172(c). In calculating the NOL amount for

individual taxpayers, only certain deductions, including passthrough S corporation

losses, are considered. See sec. 172(c) and (d); sec. 1.172-3(a), Income Tax Regs.

An NOL is first carried back to offset taxable income for the two tax years




      30
         The Barneses’ 1997 income-tax return is not in the record. However, an
electronic summary of their 1997 return that is in the record shows they reported a
net loss of $7,259 for the year.
      31
         The Barneses do not specify why their purported NOL was “unused”. In
theory, this NOL might be “unused” because the Barneses did not have sufficient
taxable income to offset it. However, the Barneses do not claim that the NOL
remained unused in 2003 for absence of taxable income, and there is insufficient
evidence in the record for us to determine their taxable income for the relevant
years. More likely, the Barneses are contending that the purported NOL remained
“unused” because they did not report it as an offset to income on a tax return.
                                        - 36 -

preceding the year in which the NOL was incurred;32 an NOL, to the extent that it

was not carried back to a previous tax year, can be carried forward to offset taxable

income for as many as 20 years after the year in which the NOL was incurred. See

sec. 172(b)(1)(A). Section 172(b)(2) requires that an NOL be consumed in the

earliest year for which there is income available to be offset by the loss. Any excess

NOL that is not consumed in one year is carried to the next earliest year. See sec.

172(b)(2).

      The Barneses claim that they are entitled to a net operating loss deduction on

their 2003 income-tax return. The ultimate source of the NOL deduction sought by

the Barneses for 2003 is their NOL for 1997. The Barneses do not explain how the

trial record supports their argument, and we observe that the record is missing the

following information necessary to establish their entitlement to a 2003 NOL

deduction:

      •      The Barneses’ income-tax returns showing their reported income (or

             NOLs) for the following years: 1995, 1997, 1998, 1999, 2000, 2001,

             and 2002.




      32
        Sec. 172(b)(3) allows a taxpayer to elect to waive the carryback period.
There is no evidence that the Barneses elected to waive the carryback period.
                                        - 37 -

       •     Evidence supporting the calculation of any elements of the correct

             computation of income (or NOLs) for the following years: 1995, 1996,

             1997, 1998, 1999, 2000, 2001, and 2002.

Although the Barneses allude to a theory that a time bar affects the 1997 tax year,

they have not provided a factual basis for carrying a 1997 NOL all the way forward

to their 2003 tax return. For its part, the IRS argues that the Barneses’ NOL

argument should be rejected because of the dearth of supporting evidence and

should not even be considered because the Barneses waited until after trial to raise

this contention. We agree with both of the IRS’s contentions and so reject the

Barneses’ NOL argument.

III.   Overstatement of Gross Receipts for the Sole Proprietorship

       The Barneses claim that a $60,000 check, written by Anheuser-Busch to

Influence Entertainment and deposited by Influence Entertainment in its bank

account, was erroneously reported in the gross receipts of the sole proprietorship.

They contend that only half of the $60,000 was earned by the sole proprietorship

and that the other half was earned by Influence Entertainment. To support this

contention, the Barneses rely on the June 4, 2003, check from Anheuser-Busch,

Inc., and an invoice attached to that check. The check was made out to “Influence

Entertainment” for $60,000. A copy of this check, which is canceled, appears to
                                        - 38 -

show that it was deposited in a bank account owned by Influence Entertainment,

and a bank statement for Influence Entertainment reflects a $60,000 deposit on June

5, 2003. An invoice from Anheuser-Busch, also dated June 4, 2003, was attached

to the check. It identifies “Influence Entertainment” as the vendor and lists two

items: “Sponsorship Mkt” for $30,000 and “Sponsorship1 Mkt”, also for $30,000.

According to the Barneses, the fact that Anheuser-Busch divided the total $60,000

payment into two, separate $30,000 invoice items indicates that $30,000 was for

services Influence Entertainment rendered and $30,000 was for services the sole

proprietorship rendered. Therefore, they contend that the sole proprietorship’s

income was $30,000 less than the amount they reported on their 2003 return.

      The Barneses did not submit evidence on how they calculated the $168,997

that they reported as gross receipts from their sole proprietorship. Consequently,

there is insufficient evidence that the $60,000 check was included in the $168,997

amount. Because we find that the Barneses have not satisfied their burden of proof,

we sustain the determination of the IRS as to this issue.

IV.   Accuracy-Related Penalty

      In the notice of deficiency, the IRS determined that the Barneses are liable

for a section 6662(a) accuracy-related penalty of $10,897. The IRS asserts that
                                         - 39 -

this penalty is appropriate because the Barneses substantially understated their

income-tax liability for 2003.33 See sec. 6662(b)(2). We agree.

      Under section 7491(c), the IRS bears the burden of production with respect to

penalties. In order to meet this burden, the IRS must come forward with sufficient

evidence that it is appropriate to impose a particular penalty. See Higbee v.

Commissioner, 116 T.C. at 446. If the IRS has satisfied its burden of production,

the taxpayer has the burden of persuading the court that the IRS’s determination is

incorrect. See Rule 142(a); Higbee v. Commissioner, 116 T.C. at 447. A taxpayer

can meet this burden by proving that he or she acted with reasonable cause and in

good faith or that there was substantial authority for the tax treatment of an item.

See Viralam v. Commissioner, 136 T.C. 151, 173 (2011).

      Section 6662(a) imposes a penalty of 20% of any underpayment attributable

to a substantial understatement of income tax. See sec. 6662(a), (b)(2). In

general, an understatement of income tax is the excess of the amount required to


      33
         In the notice of deficiency, the IRS determined two additional bases for
imposing the sec. 6662(a) penalty: (1) negligence or disregard of rules or
regulations and (2) a substantial valuation overstatement. The IRS did not address
either of these theories on brief and did not identify any facts in the record that
might support these theories. Therefore, we find the IRS has not met its burden of
production with respect to these alternative theories, see sec. 7491(c), and that the
Barneses are not liable for a sec. 6662(a) accuracy-related penalty by reason of (1)
negligence or (2) a substantial valuation overstatement.
                                          - 40 -

be shown on the taxpayer’s return for a given year over the amount actually shown

on the return. See sec. 6662(d)(2); sec. 1.6662-4(b)(2), Income Tax Regs. An

understatement is substantial if it exceeds the greater of 10% 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.

      The IRS has satisfied its burden of production. The Barneses understated

their 2003 income-tax liability by $54,486.34 This amount exceeds both 10% of the

tax required to be shown on the return35 and $5,000. Therefore, the IRS has come

forward with sufficient evidence that it is appropriate to impose an accuracy-related

penalty on the Barneses for the tax year 2003 because they substantially understated

their income tax for that year. The Barneses have the burden of demonstrating that

they are not liable for the penalty.

      The Barneses assert a number of defenses. They argue first that they are not

liable for a section 6662(a) accuracy-related penalty due to a substantial

understatement of income tax because there was substantial authority for their


      34
        The amount required to be shown on the Barneses’s 2003 income-tax return
is $85,240. The amount shown on the return filed by the Barneses for tax year 2003
is $30,754. The difference between those two amounts--the amount of the
understatement--is $54,486.
      35
           Ten percent of the tax required to be shown on the return is $8,524.
                                          - 41 -

failure to reduce basis in the S corporation stock. Any understatement of income

tax attributable to a position for which there was substantial authority is excluded in

determining whether there was a substantial understatement of income tax. See sec.

6662(d)(2)(B)(i); sec. 1.6662-4(d)(1), Income Tax Regs. Substantial authority for

the tax treatment of an item exists where the weight of the authorities supporting a

given position is substantial in relation to the weight of those supporting a contrary

position. Sec. 1.6662-4(d)(3)(i), Income Tax Regs. The substantial authority

standard is more difficult for the taxpayer to meet than the reasonable basis

standard,36 but the position need not have a greater-than-50% chance of being

upheld in litigation. See sec. 1.6662-4(d)(2), Income Tax Regs. A taxpayer may

have substantial authority for a position even where it is supported only by a well-

reasoned construction of the applicable statutory provision. Sec. 1.6662-4(d)(3)(ii),

Income Tax Regs.

      We find that there was not substantial authority for the Barneses’ treatment

of their basis in the Whitney stock. The Barneses have not identified any

authorities which support their position but have offered only their incorrect

interpretation of sections 1366 and 1367. While their interpretation is not

      36
         Sec. 1.6662-3(b)(3), Income Tax Regs., defines “reasonable basis” as a
relatively high standard; it is not satisfied by a position that is merely an arguable or
colorable claim.
                                          - 42 -

frivolous, it is not a sufficiently well-reasoned construction of the applicable statute

to qualify as “substantial authority” for their position.

      Next, the Barneses assert that they are not liable for an accuracy-related

penalty because they acted with reasonable cause and in good faith. The section

6662(a) penalty does not apply to any portion of an underpayment of tax with

respect to which there was reasonable cause and the taxpayer acted in good faith.

See sec. 6664(c)(1); sec. 1.6664-4(a), Income Tax Regs. Whether the taxpayer

acted with reasonable cause and in good faith is determined on a case-by-case basis,

taking into account all pertinent facts and circumstances. Sec. 1.6664-4(b)(1),

Income Tax Regs. An honest misunderstanding of fact or law that is reasonable in

light of the knowledge, experience, and education of the taxpayer may constitute

reasonable cause and good faith. Id.

      The Barneses assert that, because the provisions at issue here are complex,

their failure to appropriately adjust basis in their Whitney stock was just such a

reasonable mistake. However, statutory complexity alone does not constitute

reasonable cause. See Edgar v. Commissioner, 56 T.C. 717, 762-763 (1971);

Ellwest Stereo Theatres of Memphis, Inc. v. Commissioner, T.C. Memo. 1995-

610, slip op. at 12-13. The most important factor in the reasonable-cause analysis

is generally the extent of the taxpayer’s effort to accurately determine his or her
                                        - 43 -

tax liability. Sec. 1.6664-4(b)(1), Income Tax Regs. The Barneses have introduced

no evidence regarding what efforts they made to determine the proper tax treatment

of their S corporation stock, aside from hiring a professional tax adviser. The

Barneses have not offered any evidence that they were aware of the complexity of

the provisions at issue or that this complexity was the cause of their noncompliance.

They have, therefore, failed to carry their burden of proof.

      Finally, the Barneses argue that they are not liable for an accuracy-related

penalty because they relied on professional tax advice in preparing their return.

Reliance on the advice of a professional adviser may be evidence of reasonable

cause and good faith, provided the taxpayer’s reliance was reasonable under the

circumstances. Sec. 1.6664-4(b)(1), (c)(1), Income Tax Regs. Such reliance is

reasonable if the taxpayer can demonstrate, by a preponderance of the evidence, that

(1) the adviser was a competent professional with expertise sufficient to justify

reliance, (2) the taxpayer provided necessary and accurate information to the

adviser, and (3) the taxpayer relied in good faith on the judgment of the adviser.

Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299

F.3d 221 (3d Cir. 2002). The Barneses have made no such showing.

      The Barneses’ 2003 return was prepared by an employee of the firm Sakyi &

Associates. The Barneses assert on brief that this firm “held itself out as a
                                         - 44 -

professional preparer”, that they relied on the firm, and that the firm’s advice was

erroneous. But they did not support these assertions with testimony or documentary

evidence. We need not, and do not, conclude from the fact that the Barneses hired

Sakyi that the firm was solely responsible for errors on the return: the firm’s ability

to advise the Barneses and prepare their return may have been limited by inadequate

information or erroneous basis calculations from prior tax years. Consequently, we

find the Barneses have not carried their burden of proof with respect to their

reasonable cause and good faith defense.

      We have considered all arguments, and contentions not addressed are

meritless, irrelevant, or moot.

      To reflect the foregoing,


                                                        Decision will be entered

                                                  for respondent.
