                        T.C. Memo. 1998-288



                      UNITED STATES TAX COURT



                 LAVERN SCHERPING, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent

            LOREN AND JANE SCHERPING, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 12514-90, 12515-90.          Filed August 5, 1998.




     Lawrence H. Crosby, for petitioners.

     Tracy Anagnost Martinez, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     LARO, Judge:   LaVern Scherping petitioned the Court to

redetermine deficiencies in his 1984 through 1986 Federal income

taxes and additions to these taxes as follows:
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LaVern Scherping, docket No. 12514-90
                                                 Additions to tax



                          Sec.         Sec.              Sec.       Sec.            Sec.
Year   Deficiency      6653(a)(1)   6653(a)(2)      6653(a)(1)(A)     6653(a)(1)(B)
6661
                                       1
1984   $19,046           $952                          ---          ---           $4,762
                                       2
1985    32,217          1,611                          ---          ---            8,054
                                                                     3
1986    48,658           ---          ---             $2,433                      12,165
       1
           50 percent of the interest due on $19,046.
       2
           50 percent of the interest due on $32,217.
       3
           50 percent of the interest due on $48,658.

       Respondent reflected these determinations in a notice of

deficiency issued to petitioner on March 8, 1990.

       Loren and Jane Scherping1 petitioned the Court to

redetermine deficiencies in their 1984 through 1986 Federal

income taxes and additions to these taxes as follows:

Loren and Jane Scherping, docket No. 12515-90
                                                 Additions to tax

                          Sec.         Sec.              Sec.       Sec.            Sec.
Year   Deficiency      6653(a)(1)   6653(a)(2)      6653(a)(1)(A)     6653(a)(1)(B)
6661
                                       1
1984       $14,875       $744                          ---          ---           $3,719
                                       2
1985        25,798      1,290                          ---          ---            6,450
                                                                     3
1986        40,769       ---          ---             $2,038                      10,192
       1
           50 percent of the interest due on $14,875.
       2
           50 percent of the interest due on $25,798.
       3
           50 percent of the interest due on $40,769.

       Respondent reflected these determinations in a notice of

deficiency issued to petitioners on March 8, 1990.




       1
       Loren and Jane Scherping were copetitioners. For
simplicity and clarity, we hereafter refer to Loren Scherping as
the sole petitioner in that docket.
                                - 3 -


     Following our consolidation of these cases for purposes of

trial, briefing, and opinion, and following our rulings granting

respondent's motions for partial summary adjudication, Scherping

v. Commissioner, T.C. Memo. 1991-384, and Scherping v.

Commissioner, T.C. Memo. 1991-388, we are left to decide the

following issues:

     1.   Whether LaVern Scherping and Loren Scherping may deduct

interest expenses in amounts greater than those determined by

respondent.

     2.   Whether LaVern Scherping and Loren Scherping are liable

for the additions to tax for negligence determined by respondent

under section 6653(a)(1) and (2) for 1984 and 1985 and under

section 6653(a)(1)(A) and (B) for 1986.

     3.   Whether LaVern Scherping and Loren Scherping are liable

for the additions to tax for substantial understatement

determined by respondent under section 6661.

     We hold for respondent on all issues.    Section references

are to the Internal Revenue Code in effect for the years in

issue.    Rule references are to the Tax Court Rules of Practice

and Procedure.    The term "petitioners" refers to LaVern Scherping

and Loren Scherping collectively.

                          FINDINGS OF FACT

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

The stipulated facts and the exhibits submitted therewith are
                                 - 4 -


incorporated herein by this reference.    Petitioners resided in

Freeport, Minnesota, when they petitioned the Court.

     Petitioners are brothers.    During the years in issue they

were dairy farmers who sold milk to Modern Craftsmen Milk

Association (MCMA), or to MCMA's successors, through Imperial

Investments, Inc. (Imperial).

     Petitioners participated with Joan Noske, C.P.A., among

others, in a scheme to understate their Federal income tax

liabilities through purported transfers of farming assets and

operations to Imperial.   Ms. Noske prepared petitioners'

individual income tax returns and Imperial's corporate returns.

     For 1984 and 1985, Loren Scherping reported on each of his

tax returns that he realized $11,000 a year of sole

proprietorship income.    This was income he derived from farming.

For 1986, he reported sole proprietorship income of $11,600,

which was farming income.

     For 1984 and 1985, LaVern Scherping reported on each of his

tax returns that he realized $8,000 a year of sole proprietorship

income.   This was income he derived from farming.   For 1986, he

reported sole proprietorship income of $8,600, which was farming

income.

     Respondent determined and reflected in a separate notice of

deficiency for each petitioner that petitioners were required to
                               - 5 -


report the following amounts of income and expense which had

originally been reported by Imperial:

                                         LaVern         Loren
                                       Scherping      Scherping
       1984
              Farm gross income        $306,922       $303,922
              Farming expenses         (194,874)      (194,874)
              Depreciation              (63,334)       (63,334)
       1985
              Farm gross income         309,258         306,258
              Farming expenses         (173,110)       (173,110)
              Depreciation              (59,785)        (59,785)
       1986
              Farm gross income         303,939         300,939
              Farming expenses         (155,355)       (155,355)
              Depreciation              (40,870)        (40,870)



      In making this determination, respondent recomputed and

annualized Imperial's income and expenses from its fiscal years

to petitioners' calendar years.   In calculating depreciation,

respondent eliminated a basis step-up purportedly derived from

petitioners' sale of assets to Imperial.    Finally, respondent

allocated the income and expenses between petitioners, 50 percent

to LaVern Scherping and 50 percent to Loren Scherping, with

appropriate allowances for farm-related income each petitioner

had previously reported.   In determining petitioners' incomes,

respondent did not allow any deduction for interest expense

Imperial had claimed as a deduction on its returns.
                                - 6 -


                               OPINION

     Respondent recomputed all of the income and certain of the

expenses Imperial reported on its tax returns and reallocated

that income and expense to petitioners.    These reallocated

amounts did not reflect any deductions for interest even though

Imperial had claimed deductions for substantial amounts of

interest expense.2    Petitioners argue that insofar as they are to

be taxed on Imperial's income, they should be allowed to claim

all the deductions Imperial reported.    They also dispute

respondent's determinations of additions to tax for negligence

and for substantial understatement.

Interest Deductions

     Petitioners must prove that respondent's determinations set

forth in the notices of deficiency are incorrect.    Rule 142(a);

Welch v. Helvering, 290 U.S. 111, 115 (1933).    Petitioners must

also prove their entitlement to any claimed deduction.

Deductions are strictly a matter of legislative grace, and

petitioners must show that their claimed deductions are allowed

by the Code.   New Colonial Ice Co. v. Helvering, 292 U.S. 435

(1934).




     2
      Imperial's returns for the fiscal years ending June 30,
1984 through 1986 claimed interest expense deductions of $7,043,
$67,458, and $68,347, respectively.
                                 - 7 -


      Petitioners have known from the outset of this proceeding

that no deductions for interest expense were included in

respondent's determinations of their taxable incomes.    They have

chosen not to submit any documentation as to the amounts of

interest they (or Imperial) may have paid during the years in

issue, the fact and nature of any debt underlying the supposed

payments, the creditors to whom the interest may have been paid,

or the relationship of any such debt to the dairy farming

activities that gave rise to the income at issue here.

     Petitioners point out that respondent has offered no

explanation for not allowing them to deduct the interest expense

claimed on Imperial's returns.    They also note that in an earlier

proceeding before this Court, respondent agreed to a stipulated

decision that Imperial owed no additional income tax.

     In demanding that respondent explain the omission of the

interest deduction, petitioners proceed from a false premise.

They are required to produce persuasive evidence rebutting

respondent's determinations of their Federal income tax

liabilities.   Finesod v. Commissioner, T.C. Memo. 1994-66.   They

have not done so.   We therefore sustain respondent's

determinations on this issue.

Negligence
                                - 8 -


     Respondent also determined that both petitioners are liable

for additions to tax for negligence for each year in issue.

Petitioners must prove respondent's determination of negligence

wrong.    Rule 142(a); Bixby v. Commissioner, 58 T.C. 757, 791-792

(1972).

     For 1984 and 1985, section 6653(a)(1) imposes an addition to

tax equal to 5 percent of the underpayment if any part of the

underpayment is attributable to negligence.   Section 6653(a)(2)

imposes a further addition to tax equal to 50 percent of the

interest payable on the portion of the underpayment attributable

to negligence.   With respect to returns due after December 31,

1986 (i.e., petitioners' 1986 tax returns), section 1503(a) of

the Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085, 2742,

replaced former section 6653(a)(1) and (2) with section

6653(a)(1)(A) and (B).   Section 6653(a)(1)(A) and (B) is similar

to its predecessor.   Section 6653(a)(1)(A) imposes an addition to

tax equal to 5 percent of the underpayment if any part of the

underpayment is attributable to negligence.   Section

6653(a)(1)(B) imposes an addition to tax equal to 50 percent of

the interest payable on the portion of the underpayment

attributable to negligence.

     In contesting a finding of negligence, "the burden is on the

taxpayer to prove that he did not fail to exercise due care or do
                                - 9 -


what a reasonable and prudent person would do under similar

circumstances."   Chakales v. Commissioner, 79 F.3d 726, 729

(8th Cir. 1996), affg. T.C. Memo. 1994-408.    Petitioners argue

that they were not negligent because they relied on their C.P.A.,

Joan Noske, to prepare their returns correctly, and they were

innocent bystanders with respect to any inaccuracies in the

returns.   That argument is not persuasive.

     Petitioners colluded with Ms. Noske in fictitiously

transferring their farming assets to Imperial, and they did so to

avoid their Federal tax liabilities.    They knew or had reason to

know that Ms. Noske was incorrect when she omitted the bulk of

their farming income from their returns.   We do not believe

petitioners' testimony that they failed to understand or

appreciate the returns' inaccuracies.   We sustain respondent's

determinations of negligence in all regards.

Substantial Understatement

     Section 6661 imposes an addition to tax for substantial

understatement of income tax.   For additions assessed after

October 21, 1986, this addition equals 25 percent of the amount

attributable to the substantial understatement.     Pallottini v.

Commissioner, 90 T.C. 498, 500-503 (1988).     An understatement is

substantial if it exceeds the greater of 10 percent of the tax
                               - 10 -


required to be shown on the return or $5,000.    Sec.

6661(b)(1)(A).

     In general the amount of the understatement is reduced to

the extent an understatement is traceable to an item that is

either adequately disclosed or supported by substantial

authority.    Sec. 6661(b)(2)(B).   But this relief is curtailed if

the item that causes the understatement derives from a tax

shelter.   An understatement derived from tax shelter items is not

reduced by disclosure.    Sec. 6661(b)(2)(C)(i)(I).    Further, in

addition to showing that an item attributable to a tax shelter is

supported by substantial authority, taxpayers must show they

reasonably believed their tax treatment of any tax shelter item

"was more likely than not the proper treatment."      Sec.

6661(b)(2)(C)(i)(II).    For purposes of section 6661, the term

"tax shelter" includes any plan or arrangement aimed principally

at avoiding or evading Federal income tax.    Sec.

6661(b)(2)(C)(ii)(III).    Petitioners' purported transfer of

farming assets to Imperial constituted a tax shelter within the

meaning of this section.

     Petitioners have failed to meet their burden of proof on

this issue.    The understatements are substantial, and the record

does not establish that any of the understatements are reduced
                              - 11 -


under section 6661(b)(2).   We sustain respondent's determinations

on this issue.

     In reaching all of our holdings herein, we have considered

all arguments made by the parties, and to the extent not

mentioned above, find them to be irrelevant or without merit.

     To reflect the foregoing,

                                         Decisions will be entered

                                    for respondent.
