                             T.C. Memo. 2013-134


                        UNITED STATES TAX COURT



          ALAN J. POWERS AND SUSAN E. POWERS, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 12634-10.                         Filed May 29, 2013.



      Alan J. Powers and Susan E. Powers, pro sese.

      Heather K. McCluskey for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      LARO, Judge: The instant petition involving petitioners’ 2004, 2005, and

2006 Federal income tax returns seeks redetermination of respondent’s

determinations of deficiencies and accuracy-related penalties as follows:
                                         -2-

           [*2]                                                    Penalty
           Year                      Deficiency                   sec. 6662
           2004                      $165,638                    $33,127.60
           2005                        11,917                      2,383.40
           2006                          4,289                       857.80

      After petitioners’ concession,1 we decide the following issues: (1) whether

petitioners were entitled to a loss deduction of $998,149 claimed on Schedule E,

Supplemental Income and Loss, for 2004. We hold they were not; (2) whether

petitioners had unreported income of $93,666.44 that should have been reported

on Schedule C, Profit or Loss From Business, for 2004 and $58,855.82 for 2005.

We hold they did; (3) whether petitioners were entitled to net operating loss

carryovers of $585,587 for 2004, $1,141,260 for 2005, and $1,150,260 for 2006.

We hold they were not; (4) whether petitioners are liable for accuracy-related

penalties for the subject years. We hold they are.

      All section references are to the Internal Revenue Code (Code) in effect for

the years in issue, and all Rule references are to the Tax Court Rules of Practice

and Procedure.




      1
       Petitioners have conceded that they had unreported interest income of $501
for 2006.
                                          -3-

[*3]                            FINDINGS OF FACT

       The parties filed with the Court a stipulation of facts and related exhibits.

The stipulated facts and the accompanying exhibits are incorporated herein by this

reference. We find the facts accordingly. Petitioners resided in California when

they filed the petition.

I.     Petitioners’ Business Dealings

       A.    OneStar Entities

       At all relevant times OneStar Long Distance, Inc. (OneStar) was a telephone

company wholly owned by OneStar Holding, Inc. (OneStar Holding), an S

corporation. During the years in issue Mr. Powers, who was OneStar Holding’s

largest shareholder, owned 23.50226% of its stock and Ms. Powers owned

4.71999% of its stock. OneStar filed for bankruptcy in December 2003.

       B.    Nexes

       Before OneStar filed for bankruptcy, petitioners and some other individuals

had formed Nexes Group, LLC (Nexes), a telephone company. At all relevant

times Nexes was a partnership for Federal income tax purposes.2 Petitioners

       2
        At trial and throughout their briefs petitioners have referred to their
interests in Nexes as “stock” and themselves as shareholders or stockholders of
Nexes. However, there is nothing in evidence showing Nexes was a C corporation
or an S corporation for Federal income tax purposes. Under the check-the-box
                                                                         (continued...)
                                         -4-

[*4] submitted an unfiled Form 1065, U.S. Return of Partnership Income, for 2004

for Nexes but did not provide any Schedules K-1, Partner’s Share of Income,

Deductions, Credits, etc.

      Nexes had ownership interests in numerous entities, some of which

provided goods and services to Nexes. Nexes owned at least the following

entities: IceNet, C-Tel, CTS Management, LLC, Vantage Fund, LLC, and V Net.

      C.     AJP and SEP

      Several months before OneStar filed for bankruptcy, petitioners along with

four Nexes partners, who were also Nexes’ officers and directors, each had formed

separate companies into which their compensation from Nexes would flow. The

reason for forming the separate entities was twofold. First, petitioners and the

other partners wanted to insulate themselves from the OneStar bankruptcy.

Second, they also wanted a section 401K/profit-sharing plan that would generate a

      2
       (...continued)
regulations, “a business entity with two or more members is classified for federal
tax purposes as either a corporation or a partnership.” Sec. 301.7701-2(a), Proced.
& Admin. Regs. If no election is made, an entity with two or more members is a
partnership by default. Sec. 301.7701-3(b)(1)(i), Proced. & Admin. Regs. To
make an election, a taxpayer must file the Form 8832, Entity Classification
Election, with the Commissioner. Sec. 301.7701-3(c)(1), Proced. & Admin. Regs.
Nexes had more than one stakeholder. Petitioners did not submit a Form 8832, if
there was one, to show Nexes elected to be something other than a partnership.
Instead, petitioners submitted a Nexes partnership return. We thus find Nexes to
be a partnership for Federal income tax purposes.
                                          -5-

[*5] tax deduction but would exclude the 50 Nexes employees. To this end,

petitioners formed AJP, Inc. (AJP), and SEP, Inc. (SEP), which were Delaware

corporations that they wholly owned at all relevant times. AJP and SEP elected S

corporation status effective December 2003. Mr. Powers testified that he did not

know his and Ms. Powers’ percentage shares of ownership in AJP and SEP.

            1.     AJP

      AJP did not undertake any business activity during the relevant times. Its

Form 1120S, U.S. Income Tax Return for an S Corporation, for 2004 reported

$404,387 of gross receipts. Of that amount, $396,980 was Mr. Powers’

compensation from Nexes, which he reported on his 2004 individual return.3 The

attached Schedule L, Balance Sheet per Books, stated that the S corporation had

$145,245 of additional paid-in capital.

      AJP’s returns for 2005 and 2006 did not report any income or deductions.

            2.     SEP

      Petitioners claimed they formed SEP to hold their partnership interests in

Nexes, but they never transferred their partnership interests to SEP. The record is


      3
       Petitioners had since submitted, but did not file, an amended Form 1120S
for AJP and an amended individual return for 2004. The amended returns reported
$396,980 as wages, but there is nothing in the record to suggest that AJP treated
the amounts paid as wages.
                                         -6-

[*6] devoid of any details as to what type of business activities it undertook during

the relevant period. Its Form 1120S for 2004 reported gross receipts or sales of

-$944,669. SEP reported zero income and deductions for 2005 and 2006.

      D.     Mr. Powers and Ms. Powers

      Mr. Powers earned a bachelor of science degree in accounting from Indiana

University and became a certified public accountant (C.P.A.) in 1972. Since then,

he has acquired a fair amount of auditing experience. Between 1973 and 1981 he

worked as an accountant at a local accounting firm with about 30 employees,

where he eventually became a partner in 1977. Mr. Powers had also owned

several businesses, including Godfather’s Pizza restaurants which had locations in

three States. Beginning around 2000 Mr. Powers became involved in OneStar and

Nexes. Mr. Powers was listed as a CEO on petitioners’ 2004 return and as a

“Manager” on the 2005 and 2006 returns.

      Ms. Powers was listed as a homemaker on petitioners’ 2004 through 2006

returns.

II.   Petitioners’ Individual Returns

      A.     2003

      Petitioners’ 2003 return claimed a total loss of $159,006 and a negative

adjusted gross income (loss) of $162,006. Contributing to petitioners’ loss was
                                        -7-

[*7] their nonpassive loss from OneStar Holding of $736,023 reported on the

Schedule E attached to the return. Petitioners also claimed a deduction for a

$345,803 net operating loss (NOL) from 2000 that was carried to 2003.

      B.    2004

      Petitioners claimed a total loss of $1,074,720 and a negative adjusted gross

income of $1,089,486 for 2004. Among the income items petitioners reported was

$396,980 of business income on the Schedule C-EZ, Net Profit From Business,

which listed business consulting as Mr. Powers’ principal business; the reported

business income was Mr. Powers’ compensation from Nexes. Petitioners’

Schedule E for 2004 reported $1,057,382 of nonpassive income from OneStar

Holding and claimed a $1,022,317 nonpassive loss from AJP and SEP. Petitioners

also deducted an NOL of $606,450 that was carried over to 2004.

      C.    2005

      The only reported income item on petitioners’ 2005 return was an NOL

carryover of $1,141,260. However, petitioners reported they had a negative

adjusted gross income of $1,140,260. We attribute the difference to a

typographical error.
                                         -8-

[*8] D.         2006

        Petitioners’ 2006 return reported a negative adjusted gross income of

$1,100,260 based on a calculation provided in a statement they attached to the

return. The statement indicated the return was only “an estimated 2006 TAX

return * * * due to insufficient data and/or incomplete information and/or files and

an IRS in process audit examination.” The return statement estimated petitioners’

income to be $50,000 for 2006 and claimed a deduction for an NOL carryover

from 2005 of $1,150,260. ($1,150,260 - $50,000 = $1,100,260). Petitioners did

not explain why the NOL carryover from 2005 was $1,150,260 instead of the

$1,141,260 reported on their 2005 return.

III.    Audit

        Respondent’s revenue agent, Julie Gray, conducted petitioners’ audit for the

tax years in issue. As part of the audit, respondent summoned petitioners’ bank

records in order to prepare a bank deposits analysis for the audited years. The

accounts Ms. Gray examined included petitioners’ personal accounts, an AJP bank

account with an account number ending in 9931, a Nexes bank account with an

account number ending in 8899, a C-Tel bank account with an account number

ending in 8981, and an IceNet bank account with an account number ending in

8717.
                                            -9-

[*9] A.        Deposits Into Petitioners’ Personal Bank Accounts

      Using the bank records, Ms. Gray was able to determine the total amount of

money deposited into petitioners’ personal accounts in 2004 and 2005. She then

removed all nontaxable items from the deposits and reached the total amount of

taxable deposits for each year.

               1.     2004

      For 2004 Ms. Gray determined that petitioners had gross receipts of

$490,646.44 from consulting services. Petitioners’ taxable deposits are sourced as

follows:
                     Bank                                  Taxable deposits
          Integra Bank (account
            number ending in 8380)                           $453,963.45
          Union Planters Bank Regions
           (account number ending in
            3564)1                                             18,452.22
          Evansville Teachers Federal
           Credit Union (account number
           ending in 7073)                                     18,230.77
            Total                                             490,646.44

      1
          Petitioners conceded at trial that this deposit is taxable to them.
      The taxable deposits into petitioners’ Integra account included two types of

deposits: checks and account transfers. All the check deposits involved checks
                                       -10-

[*10] issued by AJP or Nexes and totaled $369,878.45. The account transfers

consisted of transfers from the AJP bank account of $56,385, from the IceNet bank

account of $19,700, from the C-Tel bank account of $7,000, and from the Nexes

bank account of $1,000, totaling $84,085.

      The taxable deposit into the Evansville Teachers Federal Credit Union

account consisted of one check deposit dated January 14, 2004, of $18,230.77.

AJP issued the check.

            2.     2005

      For 2005 Ms. Gray determined that petitioners had gross receipts of

$58,855.82 from consulting services, none of which was reported on petitioners’

2005 return. Ms. Gray sourced petitioners’ taxable deposits as follows:

                 Bank                                Taxable deposits
       Integra Bank (account number
         ending in 8380)                                $16,262.46
       Union Planters Bank Regions
        (account number ending in
         3564)                                            42,593.36
         Total                                            58,855.82

      The taxable deposits into petitioners’ Integra account were all check

deposits. All the checks were issued by either AJP, $5,000, or Nexes, $11,262.
                                       -11-

[*11] The taxable deposits into petitioners’ Union Planters Bank Regions account

were all wire transfers: $140.80 from Nexes; $3,275.52 from C-Tel; $114.13 from

IceNet; and $39,062.91 from “Grande Commun.” There is nothing in the record

about Grande Commun.

      B.    AJP Bank Account With Account Number Ending in 9931

      Ms. Gray also examined AJP’s bank account with an account number

ending in 9931. In 2004 $550,207.36 was deposited into the AJP bank account,

and $539,726.13 was withdrawn from the same account. Of the total withdrawal

amount, $503,222 was petitioners’ personal withdrawals consisting of checks

issued to Mr. Powers and/or Ms. Powers, wire transfers to petitioners’ personal

Integra Bank account with an account number ending in 8380, and other personal

withdrawals.4 The month-by-month breakdown of withdrawals is illustrated in the

following table:




      4
        Two transfers totaling $53,000 were made to unknown individuals and
entities in October 2004. Because petitioners bear the burden of proving the
nature of these withdrawals and have failed to explain it as to these two
withdrawals, we deem these withdrawals to be personal.
                                         -12-

 [*12] Month             Deposits         Withdrawals        Personal withdrawals
      January           $38,461.54        $37,461.54             $37,461.54
      February           38,663.16         38,523.16               37,663.16
      March              63,538.62         61,138.00               61,078.00
      April              39,819.22         39,500.00               39,500.00
      May                39,851.15         43,307.00               43,307.00
      June               79,359.96         78,477.85               76,761.00
      July               40,556.64         40,000.00               38,000.00
      August                ---                 800.00                800.00
      September          30,146.16         29,000.00               29,000.00
      October           111,981.99        102,400.00               77,400.00
      November           12,000.00         23,666.66               16,800.00
      December           55,828.92         45,451.92               45,451.92
      Total             550,207.36        539,726.13             503,222.62

IV.     Notice of Deficiency

        On June 17, 2010, respondent issued a notice of deficiency for 2004 through

2006.

        A.       2003

        For 2003, a year not subject to the notice of deficiency, Ms. Gray

discovered during the audit that petitioners had deducted $585,587 of Schedule E

losses in excess of their allowable basis in OneStar Holding. This discovery led
                                         -13-

[*13] respondent to allow $324,940 of the 2000 NOL to be carried to 2003,

resulting in only $20,863 ($345,803 - $324,940) of the NOL to be carried over to

2004.

        B.    2004

              1.     Schedule C Income

        As a result of the bank deposits analysis, respondent determined petitioners

had $490,646.44 of taxable deposits in 2004. Because petitioners reported

$396,980 of Schedule C income on their 2004 return, respondent increased

petitioners’ Schedule C income by $93,666.44.

              2.     Schedule E Loss

        Respondent determined that petitioners’ adjusted bases in AJP and SEP

were $100 and $24,068, respectively. Respondent’s determination resulted in the

disallowance of petitioners’ nonpassive losses in excess of their adjusted bases as

follows:
                                                   AJP              SEP
     Nonpassive loss per return                  $83,479          $938,838
     Adjusted basis determined in NOD                100            24,068
        Suspended losses                          83,379           914,770
                                         -14-

[*14]         3.     Deduction for NOL

        Because respondent also determined petitioners did not incur an NOL for

2003, respondent limited petitioners’ deduction for the NOL carried over to 2004

to the amount of the unused NOL carried forward from 2000, or $20,863, as

opposed to the $606,450 petitioners claimed for 2004. This resulted in an increase

in petitioners’ taxable income for 2004 by $585,587 ($606,450 - $20,863).

        C.    2005

              1.     Schedule C Income

        As a result of the bank deposits analysis, respondent determined petitioners

had $58,856 of unreported Schedule C income.

              2.     Deduction for NOL

        Because respondent determined petitioners did not incur any NOL in 2004,

he disallowed petitioners’ deduction for the NOL carryforward that they claimed

on the return. The disallowance increased petitioners’ taxable income by

$1,141,260.

        D.    2006

        Respondent determined that petitioners received interest income of $501

from the Ruth Ann Powers Children’s Trust, which petitioners failed to report on
                                         -15-

[*15] their 2006 return. Petitioners have since conceded that they received the

interest income.

      Respondent’s determination that petitioners did not incur any NOL in 2005

resulted in the disallowance of the NOL carryforward claimed on the 2006 return

and thus increased petitioners’ taxable income by $1,150,260.

                                      OPINION5

I.    Bankruptcy Proceedings

      Petitioners claim that during OneStar’s bankruptcy proceedings, see In re

OneStar Long Distance, Inc., No. 03-72697 (Bankr. S.D. Ind. filed Dec. 31, 2003),

the bankruptcy court seized or issued orders to seize their records that are relevant

to prove the claims stated in their petition. Citing specific docket entries,

petitioners argue that they have been disadvantaged because they no longer have

the relevant documents to prove their case. Petitioners further assert that they

have complied with the recordkeeping requirements under the internal revenue

laws and the rules and regulations and that they are not culpable for not having the

records in this deficiency case.


      5
        At the end of the trial the Court provided specific briefing instructions.
The Court directed each party to submit a reply brief following the opening brief
and instructed each party to only “point out any discrepancies in opposing party’s
findings of fact” and “make no legal argument” in the second brief. Petitioners’
reply brief is pervaded with arguments. Consistent with our briefing instructions
to the parties, we will disregard any arguments in petitioners’ reply brief.
                                          -16-

[*16] After reviewing the bankruptcy court’s docket entries and the underlying

documents,6 we decline to accept petitioners’ claim as a matter of fact. We find

the following docket entries particularly enlightening:

   Docket Entry                                   Summary
   ECF No. 420     Order directing OneStar to produce and make available for copying
                    certain documents.
   ECF Nos. 677    Trustee’s motion and bankruptcy court’s order authorizing trustee to
    & 708           enter into lease of storage space to store 130 boxes of documents.
   ECF No. 719     Trustee’s motion for turnover of hard drives, servers, and related
                    computer hardware (Hard Drives) in Mr. Powers’ possession that
                    contained records of or regarding OneStar.
   ECF No. 739     Bankruptcy court’s minute entry/order vacating trustee’s motion for
                    turnover of Hard Drives in ECF No. 719, per agreement between the
                    parties.
   ECF No. 756     Agreed entry regarding trustee’s motion for turnover in ECF No. 719. It
                    stated that Mr. Powers was cooperating and produced the Hard Drives
                    “for the copying of the computer data.” Trustee’s motion for turnover
                    of Hard Drives was thus resolved.


      6
        On April 26, 2013, the Court issued an order (April 26 order) directing the
parties to file a response discussing their views on the Court’s taking judicial
notice of the bankruptcy court’s proceedings, the docket entries relating to the
proceedings, and the underlying documents in In re OneStar Long Distance, Inc.,
No. 03-72697 (Bankr. S.D. Ind. filed Dec. 31, 2003). The Court is entitled to take
judicial notice of such adjudicative facts. See Fed. R. Evid. 201; McTernan v.
City of York, Pa., 577 F.3d 521, 526 (3d Cir. 2009) (“[A] court may take judicial
notice of a prior judicial opinion.”); Mangiafico v. Blumenthal, 471 F.3d 391, 398
(2d Cir. 2006) (“[D]ocket sheets are public records of which the court could take
judicial notice”.); United States v. Estep, 760 F.2d 1060, 1063 (10th Cir. 1985)
(holding that a court may take judicial notice of court records of closely related
prior litigation). The parties filed a joint response to our April 26 order agreeing
that the Court may properly take judicial notice of the matters stated in the order,
and we will do so.
                                        -17-

[*17] We found nothing in the bankruptcy court’s records that indicates the court

ordered the seizure of petitioners’ documents or computers. It is unclear from the

moving papers and the court orders whether original documents were produced or

whether only copies of the requested documents were provided. Indeed, the

bankruptcy court’s order in ECF No. 420 suggests that documents were made

available only for copying--that is, the originals were not turned over.

      Regarding the trustee’s motion for the turnover of Mr. Powers’ hard drives,

the bankruptcy court’s docket entries contradict petitioners’ claim that the

bankruptcy court confiscated their computer equipment containing the relevant

records in this case. The trustee had moved the bankruptcy court to direct Mr.

Powers to turn over his hard drives. See ECF No. 719. But ECF Nos. 739 and

756 show that the parties worked out a solution for the trustee to copy data off the

hard drives, rendering it unnecessary for Mr. Powers to surrender the computer

equipment and peripherals. Thus, we seriously doubt the bankruptcy court or the

bankruptcy trustee actually seized petitioners’ original books and records or their

computers.

      Moreover, the bankruptcy proceedings related to OneStar, and the discovery

motions in the proceedings had to do with OneStar’s books and records. So even
                                        -18-

[*18] if OneStar’s records were confiscated and are no longer in petitioners’

possession, they would have little relevance in this deficiency case. And we find

no indications that any of the records belonging to AJP, SEP, or any of the Nexes

entities were implicated in OneStar’s bankruptcy proceedings.7 In other words,

petitioners have failed to explain why records that would actually matter in this

case, such as records pertaining to their bases in AJP and SEP, would be taken

away in OneStar’s bankruptcy proceedings, when Nexes, AJP, and SEP were

entities unrelated to OneStar.8

      There are also inconsistencies in petitioners’ statements. During discovery

petitioners told respondent that they had “located and reviewed approximately

1,250 boxes and file cabinets of documentation” which they used in their

discovery responses. At trial Mr. Powers testified that he had turned over all of


      7
        Indeed, Mr. Powers testified that Nexes, AJP, and SEP were created to
insulate petitioners from OneStar’s bankruptcy. Given Mr. Powers’ business
acumen, one would think Mr. Powers would have carefully separated the business
records of Nexes, AJP, and SEP from those of OneStar in order to not tie
petitioners to the bankruptcy proceedings. In the absence of specific evidence
showing otherwise, this factual inference supports our belief that records of Nexes,
AJP, and SEP were not implicated during OneStar’s bankruptcy.
      8
       Mr. Powers testified that the trustee had an order from the bankruptcy court
and “came with a moving truck and the men got out, they emptied the file cabinets
and put the stuff in there.” Without any evidence to corroborate the assertion, we
decline to accept Mr. Powers’ self-serving testimony that we deem generally
unreliable. See infra p. 21.
                                         -19-

[*19] his records to the bankruptcy trustee. So, we do not know the relationship

between the 1,250 boxes in petitioners’ possession and the records he allegedly

surrendered in the bankruptcy case. Further, the docket entries for ECF Nos. 677

and 708 show that only 130 boxes of records--and again we do not know whether

these were originals or copies--were in the trustee’s possession, a number far less

that the 1,250 boxes petitioners claimed they had.

      Finally, aside from petitioners’ self-serving testimony, there is no evidence

to show with particularity the relevant documents that were seized and the types of

efforts petitioners actually made to retrieve any confiscated records. It appears the

trustee had 130 boxes of files. According to petitioners, they had examined 1,250

boxes of records. We do not know whether there was any overlap between these

two bodies of records. Nor do we know whether the trustees had any records of

Nexes or any records of petitioners’ wholly owned subsidiaries.

      There are many unknowns and inconsistencies in petitioners’ claims. Thus,

we decline to find as a fact that the bankruptcy court confiscated their original

records that are relevant to this proceeding.

II.   Perception of Petitioners’ Witness

      This case involves primarily disputed facts rather than opposing legal

propositions. The legal issues here are clear and not novel. Because petitioners
                                         -20-

[*20] chose to structure their business dealings through a complex web of more

than a dozen passthrough entities, any evidence that may resolve the disputed

factual issues, such as petitioners’ bases in the entities and their income from these

entities, will necessarily come from petitioners. Complicating the matter is the

scarcity of relevant and credible documentary evidence that can substantiate

petitioners’ claims. Thus, it is ever more so important for petitioners to provide

credible, persuasive, and detailed testimony to show respondent’s determinations

were erroneous. Petitioners’ presentation at trial failed in this regard.

      In all cases, we observe the candor, sincerity, and demeanor of each witness

in order to evaluate his testimony and to assign weight to that testimony for the

primary purpose of finding disputed facts. We determine the credibility of each

witness, weigh each piece of evidence, draw appropriate inferences, and choose

between conflicting inferences in finding the facts of a case. The mere fact that

one party presents unopposed testimony on his behalf does not necessarily mean

that the elicited testimony will result in a finding of fact in that party’s favor. We

will not accept a witness’ testimony on its face if we find that our impression of

the witness coupled with our review of the credible facts at hand conveys to us an

understanding contrary to the spoken word. See Neonatology Associates, P.A. v.

Commissioner, 115 T.C. 43, 84-87 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002); HIE
                                         -21-

[*21] Holdings, Inc. v. Commissioner, T.C. Memo. 2009-130, 97 T.C.M. (CCH)

1672, 1733 (2009), aff’d, ___ Fed. Appx. ___, 2013 WL 1365354 (9th Cir. Apr. 5,

2013).

      Mr. Powers testified. We find Mr. Powers’ testimony to be generally

unreliable and unhelpful as to the critical facts underlying the issues at hand.

First, Mr. Powers’ testimony lacked the level of detail and clarity, relative to

petitioners’ complex business dealings, sufficient to allow a reasonable factfinder

to find the disputed facts in petitioners’ favor. Moreover, Mr. Powers seemed to

be confused about some of the material facts and offered internally inconsistent

testimony. For example, Mr. Powers attempted to characterize all account

transfers marked by Integra Bank as “Advice of Credit” as “transfers of loans back

and forth.” But when questioned by respondent about a $9,000 deposit made on

August 4, 2004, that was marked “Advice of Credit”, Mr. Powers first testified

that it was not a loan transfer. But moments later, he recanted without offering

any explanation and stated the deposit was a loan transfer. When pressed by

respondent as to why he believed the deposit was a loan transfer, Mr. Powers

simply said: “Because that’s what I think it is” and admitted he had no

documentary evidence to support his belief. Indeed, Mr. Powers reversed his
                                        -22-

[*22] testimony or equivocated in his statements in a similar manner on multiple

occasions during his direct and cross-examination.

       Ms. Powers was present at trial but chose not to testify. This caused us to

draw an adverse inference from her failure to testify. See Baxter v. Palmigiano,

425 U.S. 308, 318-319 (1976); Petzoldt v. Commissioner, 92 T.C. 661, 685

(1989). At the same time, Mr. Powers’ testimony was for the most part

self-serving, vague, elusive, uncorroborated, and/or inconsistent with documentary

or other reliable evidence. Correspondingly, we are not required to, and we

generally do not, rely on the naked or otherwise unreliable testimony of Mr.

Powers to support our decision in this opinion. See Neonatology Associates, P.A.

v. Commissioner, 115 T.C. at 87; HIE Holdings, Inc. v. Commissioner, 97 T.C.M.

(CCH) at 1733.

III.   Burden of Proof

       Generally, the Commissioner’s determinations in a notice of deficiency are

presumed correct, and taxpayers bear the burden of proving by a preponderance of

the evidence that the Commissioner’s determinations are erroneous. Rule 142(a);

INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992); Welch v. Helvering, 290

U.S. 111, 115 (1933); Rockwell v. Commissioner, 512 F.2d 882, 885-887 (9th Cir.

1975), aff’g T.C. Memo. 1972-133.
                                         -23-

[*23] But in certain cases, the burden of proof may shift to the Commissioner with

respect to a factual issue relevant to the taxpayer’s tax liability. See sec.

7491(a)(1). Such a shift may occur when the record establishes that the taxpayer

produced credible evidence relating to the issue and that the taxpayer met the

requisite substantiation requirements, maintained all requisite records, and

cooperated with the Commissioner’s reasonable requests for information,

documents, interviews, witnesses, and meetings. Sec. 7491(a)(1) and (2).

“Credible evidence” connotes “‘the quality of evidence which, after critical

analysis, the court would find sufficient upon which to base a decision on the issue

if no contrary evidence were submitted’”. Higbee v. Commissioner, 116 T.C. 438,

442 (2001) (quoting H.R. Conf. Rept. No. 105-599, at 240-241 (1998), 1998-3

C.B. 747, 994-995)). But we need not consider the testimony of a witness to be

credible simply because it is unopposed. See HIE Holdings, Inc. v.

Commissioner, 97 T.C.M. (CCH) at 1733.

      We decline to shift the burden of proof to respondent in this case. As

discussed elsewhere in the opinion, we do not find as a factual matter that the

bankruptcy court seized petitioners’ records that are pertinent to this case; in the

same vein, we refuse to find petitioners have maintained the necessary books and

records. We have also noted elsewhere that Mr. Powers’ testimony is unreliable
                                          -24-

[*24] and that we would draw a negative inference from Ms. Powers’ failure to

testify. And there is scant documentary evidence in the record from petitioners

that is credible. Thus, under section 7491(a), the burden of proof will remain with

petitioners.

IV.   Schedule E Losses Claimed for 2004

      Deductions are a matter of legislative grace, and a taxpayer bears the burden

of producing sufficient evidence to substantiate any allowable deduction under the

Code. Sec. 6001; Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. at 84;

sec. 1.6001-1(a), Income Tax Regs.

      A.       Loss From SEP

      In general, a shareholder of an S corporation may deduct his pro rata share

of the corporation’s separately computed and nonseparately computed losses and

deductions. Sec. 1366(a). But the shareholder may deduct his pro rata share of

the corporation’s losses and deductions for any taxable year only to the extent of

his basis of his stock in the S corporation (i.e., capital basis) and his adjusted basis

in any indebtedness of the S corporation to him (disregarding any adjustment

under section 1367(b)(2)) (i.e., note basis). Sec. 1366(d)(1); see also sec. 1367(a)

and (b). Section 1366(d)(2) suspends any losses or deductions disallowed as a

result of the shareholder’s basis limitation and allows them in a later year when the
                                         -25-

[*25] shareholder has sufficient capital basis or note basis to deduct the losses or

claim the deductions.

      Petitioners have acknowledged at trial and on brief that they had only

$1,000 of capital basis and did not have any note basis in SEP in 2003 and 2004.

Thus, petitioners did not have sufficient stock basis or note basis to deduct the loss

from SEP. See sec. 1366(d)(1). To claim the loss, petitioners argue on brief that

their Schedule E loss from SEP was actually a loss flowing from Nexes and that

we should disregard SEP and allow them to deduct the loss directly as Nexes’

partners.

      To set up this argument, petitioners point out that they never transferred

their partnership interests in Nexes to SEP and that their Nexes partnership

interests remained under their names at all times. They also contend that SEP’s

2003 and 2004 returns were incorrectly prepared in that the SEP returns should not

have reported the passthrough losses from Nexes. Because petitioners claim they

had basis in Nexes on the basis of Nexes’ purported indebtedness to them, they

claim they were entitled to deduct their distributive share of Nexes’ losses.

      Petitioners’ contention that we should disregard SEP and allow them to

deduct their losses as Nexes’ partners appears to have been raised for the first time

on brief. They did not raise this issue in their petition for redetermination of the
                                         -26-

[*26] deficiency. Nor did they amend their petition to include the argument.

Petitioners were required to file a pretrial memorandum where they could have

made this argument, but they did not file any memorandum before trial.

Petitioners did not articulate this argument at trial. It appears that the only time

petitioners made this point before briefing was in a one-page self-prepared

“Summary and Facts Concerning the Petitioners’ Basis” that was buried in over

300 pages of documents that they produced to respondent during discovery.

      It is well settled that we do not consider issues raised for the first time in

posttrial briefs where there is surprise and prejudice to the opposing party. DiLeo

v. Commissioner, 96 T.C. 858, 891, 892, aff’d, 959 F.2d 16 (2d Cir. 1992);

Seligman v. Commissioner, 84 T.C. 191, 198-199, aff’d, 796 F.2d 116 (5th Cir.

1986); Rendel v. Commissioner, T.C. Memo. 1995-593, 70 T.C.M. (CCH) 1571,

1576 n.5 (1995), aff’d without published opinion, 129 F.3d 127 (9th Cir. 1997).

Because petitioners did not give respondent any notice of their argument that they

should be allowed to deduct the passthrough losses from Nexes as the

partnership’s partners, respondent was not able to produce evidence or elicit

relevant testimony from petitioners to dispute that claim and thus was prejudiced.

For example, there is no testimony or other evidence in the record to show how

much of the loss SEP reported for 2004 was loss flowing from Nexes. Further, we
                                          -27-

[*27] need not decide whether petitioners’ “Summary and Facts Concerning the

Petitioners’ Basis” produced to respondent during discovery would constitute

sufficient notice to respondent. This is because petitioners have failed in any

event to produce enough evidence to support the claim that they had sufficient

bases in Nexes to deduct the loss claimed.

      Similar to a shareholder of an S corporation, a partner of a partnership can

deduct his distributive share of partnership loss, including capital loss, to the

extent of his adjusted basis in his partnership interest (i.e., outside basis) at the end

of the partnership year in which such loss occurred. Sec. 704(d). Thus, for

petitioners to deduct their distributive shares of Nexes’ loss, they must show they

had sufficient outside bases at the end of 2004.

      But unlike a stockholder of an S corporation, a partner does not derive his

basis in his partnership interest from the partnership’s indebtedness to him in the

same manner. The starting point of our analysis is that a partner’s outside basis in

a partnership is increased by his share of the partnership liabilities. Secs. 722,

752(a). Because section 707(a) treats a partner providing a loan to his partnership

as a nonpartner with respect to the loan transaction, the tax consequences are

determined in the same way as if the transaction occurred with a nonpartner. In
                                          -28-

[*28] other words, a partner’s loan to his partnership is treated just like any

partnership liability to a third party.

      To determine how the Nexes notes to petitioners would affect petitioners’

outside bases in Nexes, it is thus necessary to determine how to allocate the

partnership liabilities among all Nexes partners. The allocation of any partnership

liability depends on the recourse nature of the indebtedness, sec. 1.752-2, Income

Tax Regs., and the same rule applies to any partnership liability that is an

indebtedness to a partner, sec. 707(a). If the partner’s loan is recourse, each

partner’s share of such partnership liability (including the lender partner’s share)

equals the portion of the liability for which the partner or related person bears the

economic risk of loss. Sec. 1.752-2(a), Income Tax Regs. A partner bears the

economic risk of loss for the partnership liability to the extent that, if the

partnership constructively liquidated, the partner (or related person) would be

obligated to make a payment to any person with no right to reimbursement. Sec.

1.752-2(b)(1), Income Tax Regs. A variety of factual considerations determines

the extent to which a partner bears the economic risk of loss for the partnership

liability. See generally sec. 1.752-2(b), Income Tax Regs. If a partner makes a

nonrecourse loan to the partnership and no partner bears the economic risk of loss

for that partnership liability, the partner making the nonrecourse loan bears the
                                          -29-

[*29] economic risk of loss for the entire nonrecourse loan, and the partnership

liability is allocated entirely to him. Sec. 1.752-2(c)(1), Income Tax Regs.

         In evidence relating to this issue are the Nexes promissory notes issued to

petitioners. Assuming they were genuine debts, they do not inform us on their

face whether they were recourse or nonrecourse. Except for the fact that Nexes

was a limited liability company, there is no evidence to suggest one way or the

other.

         If we were to treat them as recourse notes for the sake of argument, there is

nothing in the record that would enable us to allocate the partnership liabilities to

petitioners because we do not have the facts necessary to determine the extent to

which petitioners bear the economic risk of loss for the notes. The regulations

contemplate a partner’s obligation to make a payment to any person when the

partnership’s liabilities become due and payable in a deemed liquidation of the

partnership. Sec. 1.752-2(b)(1), Income Tax Regs. In a deemed liquidation, the

partnership is treated as disposing of all of its assets, which are treated as

worthless except those contributed to secure a partnership liability, in a fully

taxable transaction for no consideration and all items of income, gain, loss, or

deduction are allocated among all the partners. Id.; see also sec. 1.752-2(b)(2),

Income Tax Regs. (stating the extent to which gain or loss is recognized upon
                                         -30-

[*30] deemed disposition). The determination of which partner or related person

has an obligation to make a payment is “based on the facts and circumstances at

the time of the determination.” Sec. 1.752-2(b)(3), Income Tax Regs. Such facts

and circumstances take into account all statutory and contractual obligations

relating to the partnership liability, including contractual obligations outside of the

partnership agreement such as guaranties, indemnification agreements, and

reimbursement agreements. Id. Further, the regulations assume that all partners

and related persons who have obligations actually perform those obligations,

“unless the facts and circumstances indicate a plan to circumvent or avoid the

obligation.” Sec. 1.752-2(b)(6), Income Tax Regs.

      But here, there is not even a scintilla of evidence before us that would

enable us to make any of these factually intensive determinations. At a minimum,

petitioners needed to provide the number of partners Nexes had in 2004, the

partnership agreement or the operating agreement, Nexes’ balance sheet and

capital accounts, Schedules K-1 of the Nexes partners, any relevant contracts or

evidence of the absence of these contracts, and UCC-1 financing statements if any.

Petitioners have not provided any evidence on these critical facts.

      If we were to treat the Nexes notes as nonrecourse notes, petitioners still

failed to show that no other partner actually bore the economic risk of loss for the
                                          -31-

[*31] debts since there is no evidence or testimony showing petitioners did not

enter into other agreements that would entitle them to some type of

indemnification.

      And even if we were to treat the Nexes notes as fully nonrecourse and

allocate the liabilities solely to petitioners, there remain other material

considerations for which petitioners have not produced any evidence. After

allocating the lender partner’s share of the partnership liabilities to increase his

outside basis, it is necessary to adjust the partner’s outside basis on the basis of his

distributive share of various tax attributes of the partnership. Sec. 705. In

addition, any liquidating or nonliquidating distribution would also affect the

partner’s adjusted basis in his partnership interest. See generally sec. 733. Aside

from the unsigned partnership return for Nexes for 2004 and some scattered

documents relating to Nexes that are irrelevant to our inquiries under sections 705

and 733, petitioners did not introduce anything into evidence, not even Schedules

K-1, that are necessary to ascertain their bases in Nexes. We do not know whether

Nexes had any items of income, loss, deductions, and other tax attributes. Nor

does the record tell us whether Nexes had any liquidating or nonliquidating

distribution, and if there was a distribution, how Nexes’ cash and properties were

distributed. Even under Cohan v. Commissioner, 39 F.2d 540 (2d Cir. 1930), and
                                        -32-

[*32] its progeny, the factual record that petitioners have developed here does not

provide any ground, not to mention a reasonable ground, for us to estimate their

bases in their Nexes partnership interests.

      For these reasons, we sustain respondent’s determination to disallow

petitioners’ Schedule E loss of $914,770 from SEP.

      B.     Loss From AJP

      To deduct their Schedule E loss from AJP, petitioners must have sufficient

capital bases and/or note bases to absorb the loss. See sec. 1366(d). Respondent

suspended the loss claimed because he determined petitioners did not have the

requisite bases in AJP in 2004.

      Petitioners primarily raise two issues on brief with respect to their bases in

AJP. First, petitioners claim that AJP had made certain loans to Nexes in 2004,

totaling $84,867, and that the indebtedness of Nexes was later assigned to SEP.

Second, petitioners contend that certain deposits into AJP’s bank account in 2004

can show they had capital bases in AJP. These deposits totaling $145,875 were:

      •      $500 cash;

      •      a $11.52 check from Prudential Financial dated April 14, 2004;

      •      a $43.45 check from Leslie’s Pool Mart, Inc. dated May 11, 2004;
                                        -33-

[*33] •      $95,798.79 petitioners withdrew from their retirement savings
             account and then deposited in AJP’s bank account on October 15,
             2004;

      •      $1,440.10 and $1,433.10 in electronic transfers from Refunds Now on
             October 14, 2004, and $697.60 in an electronic transfer from Refunds
             Now on October 28, 2004;

      •      $574 in an electronic transfer from the U.S. Treasury on October 29,
             2004; and

      •      a check for $45,377 from Robert Woodward which was purportedly
             the proceeds from the sale of petitioners’ vehicle.

Petitioners seek to bolster their contention that these deposits amounted to their

capital contributions to AJP by pointing out that Ms. Gray had earlier determined

during their audit that these deposits were nonbusiness deposits. Other than the

purported $1,000 initial capital contribution to AJP, however, petitioners did not

mention at trial that they made additional capital contributions to AJP.

      Petitioners’ first argument relying on Nexes’ notes to AJP must fail. There

is nothing in the record to suggest AJP was a partner of Nexes. Thus, AJP did not

acquire basis from lending Nexes money; AJP had promissory notes from Nexes

as between a lender and a borrower, nothing more. The fact that the notes were

later assigned to SEP does not change this conclusion. Further, the issue here is
                                         -34-

[*34] whether petitioners had either capital bases or note bases in AJP to claim the

Schedule E loss from AJP. Whether AJP had basis in Nexes is irrelevant.9

      With respect to petitioners’ claim that they had sufficient capital bases in

AJP to deduct the reported loss, we find that petitioners have failed to carry their

evidentiary burden to prove the deposits into AJP’s bank account were intended to

be capital contributions.

      Of all the deposits for the AJP bank account in 2004, totaling $550,207.36,

petitioners claim that $145,875 constituted their additional capital contribution

because it originated from them personally. For a couple of reasons, the fact that

these deposits came from petitioners’ personal funds does not necessitate a

conclusion that the personal deposits constituted their capital contributions to AJP.

      First, petitioners made personal withdrawals totaling $503,222.62 (out of

$539,726.13 total withdrawals) in 2004. Because petitioners’ personal

withdrawals far exceeded all the personal deposits into the AJP bank account, it


      9
        Petitioners’ sometimes contradictory positions taken on brief compel this
conclusion. Petitioners state on brief: “The Petitioners are in error on their
testimony to having basis in notes in AJP, Inc. They only have capital basis in
AJP, Inc.” But at a later point on their brief, petitioners claim that the same notes
with the same aggregate amount were notes from AJP owed to petitioners.
However, our record contains only notes Nexes issued to AJP. If petitioners’
position is that the money AJP lent to Nexes was money AJP borrowed from
petitioners, they have not produced any evidence to support that position.
                                        -35-

[*35] would be more than reasonable to conclude that in 2004 petitioners

withdrew every penny that they had personally deposited into the AJP bank

account that year. Indeed, it defies reason that a businessman would make more

than $145,000 capital contribution into an S corporation that does nothing more

than collecting his earned income from someone else.10

      Second, the sum of the nonpersonal withdrawals ($36,503.51) plus the AJP

bank account’s remaining balance at yearend ($10,481.23) was much less than the

amount of the year’s deposits ($404,332.36) that did not come from petitioners. In

other words, what could possibly be AJP’s working capital for 2004 ($36,503.51 +

$10,481.23 = $46,984.74) could have come from sources other than petitioners’

personal funds.11




      10
           See infra note 11.
      11
         As a matter of fact, we doubt AJP had any need for working capital.
Petitioners testified at trial that AJP was set up to receive Mr. Powers’
compensation from Nexes and was not carrying any business activities otherwise.
Indeed, petitioners’ reply brief states that “the business activity of AJP, Inc. was
always clear and that was to receive compensation from Nexes for Petitioners--to
give the Petitioners the protection of a corporate veil and to provide a profit
sharing plan for the Petitioners,” and that AJP was never engaged in any “active
buying and/or selling of some things.” The mere fact that AJP’s bank account had
a balance at the end of the year does not mean it was AJP’s working capital when
there is no evidence showing AJP needed any working capital.
                                        -36-

[*36] In the light of these reasons, petitioners must show more than the fact that

they deposited personal funds into the AJP bank account; they must also produce

some evidence, documentary or otherwise, to corroborate their claim that the

deposited funds were intended to be AJP’s capital. Without more, it is impossible

to determine whether any of petitioners’ personal deposits were intended as a

capital contribution or meant to be funneled elsewhere.

      Because petitioners failed to show that they had sufficient capital bases or

note bases in AJP in 2004, we sustain respondent’s determination to disallow

petitioners’ Schedule E loss of $83,379 from AJP.

V.    Petitioners’ Unreported Income

      Gross income includes all income from whatever source derived, unless

otherwise specifically excluded. Sec. 61(a). The definition of gross income

broadly includes any instance of undeniable accessions to wealth, clearly realized,

and over which the taxpayer has complete dominion and control. Commissioner v.

Glenshaw Glass Co., 348 U.S. 426, 431 (1955).

      In the Court of Appeals for the Ninth Circuit, to which this case is

appealable barring written stipulation to the contrary, see sec. 7482(b)(1)(A), the

presumption of correctness in the Commissioner’s determinations as to unreported

income in a notice of deficiency arises only if it is supported by a minimal
                                        -37-

[*37] evidentiary foundation. Weimerskirch v. Commissioner, 596 F.2d 358, 360-

362 (9th Cir. 1979), rev’g 67 T.C. 672 (1977); see also Delaney v. Commissioner,

743 F.2d 670, 671 (9th Cir. 1984) (stating that the Commissioner must produce

“‘some substantive evidence * * * demonstrating that the taxpayer received

unreported income’”), aff’g T.C. Memo. 1982-666 (quoting Edwards v.

Commissioner, 680 F.2d 1268, 1270 (9th Cir. 1982)). Once the Commissioner

meets his burden of production, “the taxpayer must establish by a preponderance

of the evidence that the determination is arbitrary or erroneous.” Delaney v.

Commissioner, 743 F.2d at 671; United States v. Stonehill, 702 F.2d 1288, 1293-

1294 (9th Cir. 1983).

      In a case where a taxpayer has failed to maintain adequate records to allow

the Commissioner to determine his income tax liability, see sec. 6001; sec. 1.6001-

1(a), Income Tax Regs., the Commissioner may reconstruct the taxpayer’s income

using any reasonable method, including the bank deposits method, see Holland v.

United States, 348 U.S. 121, 132-133 (1954); United States v. Hall, 650 F.2d 994,

996 n.4 (9th Cir. 1981) (“The bank deposits method of proof is also a

circumstantial way of establishing unreported income.”). Under the bank deposits

method, the Commissioner must show that the taxpayer was engaged in income

producing activities, that he made regular deposits of funds into his bank accounts,
                                        -38-

[*38] and that an adequate and full investigation of those accounts was conducted

to distinguish taxable income from nontaxable deposits. United States v. Stone,

770 F.2d 842, 844 (9th Cir. 1985). “The critical question is whether the

government's investigation has provided sufficient evidence to support an

inference that an unexplained excess in bank deposits is attributable to taxable

income.” Id. at 844-845. When using the bank deposits method, the

Commissioner assumes a special responsibility of being thorough and particular in

his investigation and presentation. Hall, 650 F.2d at 999 (citing Holland, 348 U.S.

at 135-136).

      We find that respondent has met his evidentiary burden as to petitioners’

unreported income in this case. We further conclude petitioners have failed to

prove by a preponderance of the evidence that respondent’s determinations as to

petitioners’ unreported income for 2004 and 2005 were arbitrary or erroneous.

      A.       2004

      During all relevant times Mr. Powers was a business consultant who along

with Ms. Powers had ownership interests in AJP and Nexes. For 2004, Ms. Gray

summoned petitioners’ bank records and aggregated the deposits made for each of

petitioners’ bank accounts. Ms. Gray then painstakingly examined each deposit

and removed those that she determined to be from nontaxable sources. She was
                                           -39-

[*39] then able to compute the amount of taxable deposits for each account. All

the deposits that Ms. Gray determined to be taxable came from AJP, Nexes, or

Nexes’ subsidiaries, IceNet and C-Tel. Viewing these facts together, we conclude

that respondent has produced ample credible evidence allowing a very strong

inference that $490,646.44 determined to be taxable deposits were all income to

petitioners.

       Petitioners do not dispute that these deposits into their personal bank

accounts were made. They argue only that $92,740 of the deposits were

nontaxable repayments on debts.12 The following table shows the deposits that

petitioners seek to characterize as nontaxable repayments on indebtedness:

  Date of deposit   Amount        Payor           Parties to the purported debt /denotations 1

    5/14/04         $4,307        AJP                    Unknown / “[AJP, Inc.]”
     7/2/04         10,033        Nexes                  AJP (lender) and Nexes (borrower) /
                                                          “Repmt/Veraz Note”
     8/4/04          9,000        IceNet                 AJP (lender) and Nexes (borrower)
     8/4/04          1,000        IceNet                 AJP (lender) and Nexes (borrower)
     8/5/04            500        AJP                    Unknown
     8/9/04          1,000        C-Tel                  AJP (lender) and Nexes (borrower) /
                                                          “Loan Payback to C-Tel”
    8/16/04          4,000        IceNet                 AJP (lender) and Nexes (borrower) /
                                                          “Partial Repayment Nexes Loan”



       12
         At trial Mr. Powers ostensibly tried to hedge his testimony by stating that
the disputed deposits were “note transfers,” which could technically mean either
loan repayments or advances. At no point did he offer to clarify which ones were
debt payments and which ones were advances. As the table immediately below
illustrates, petitioners have consistently characterized the deposits as repayments
on indebtedness owed to them. To the extent that petitioners attempt to raise an
alternative claim that these deposits were loan advances of which they were the
debtors, they have not produced any evidence to support such claim.
                                                        -40-
 [*40] 8/16/04             2,000               IceNet                       AJP (lender) and Nexes (borrower)   /
                                                                             “Partial Repayment Nexes Loan”
     8/23/04               1,000               Nexes                        AJP (lender) and Nexes (borrower)   /
                                                                             “Other Inc: Loan Pay Back”
     8/24/04               6,000               C-Tel                        AJP (lender) and Nexes (borrower)   /
                                                                             “Other Inc: Loan Pay Back”
     8/25/04               1,500               IceNet                       AJP (lender) and Nexes (borrower)   /
                                                                             “Other Inc: Loan Pay Back”
     8/27/04               2,200               IceNet                       AJP (lender) and Nexes (borrower)   /
                                                                             “Partial Repayment Nexes Loan”
    10/12/04               2,000               AJP                          Unknown / “[AJP, Inc.]”
    10/20/04                 500               AJP                          Unknown / “[AJP, Inc.]”
    10/21/04               1,900               AJP                          Unknown / “[AJP, Inc.]”
    10/22/04               6,000               AJP                          Unknown / “[AJP, Inc.]”
    10/27/04               3,000               AJP                          Unknown / “[AJP, Inc.]”

     11/2/04               4,000               AJP                          Unknown   / “[AJP, Inc.]”
     11/3/04                 200               AJP                          Unknown   / “[AJP, Inc.]”
     11/4/04                 600               AJP                          Unknown
     11/9/04               2,000               AJP                          Unknown   /   “[AJP, Inc.]”
     12/8/04               1,000               AJP                          Unknown   /   “[AJP, Inc.]”
     12/9/04               1,000               AJP                          Unknown   /   “[AJP, Inc.]”
    12/10/04               1,000               AJP                          Unknown   /   “[AJP, Inc.]”
    12/21/04               5,000               AJP                          Unknown   /   “Misc Dep”
    12/22/04              22,000               AJP                          Unknown
     Total                92,740

         1
         Unless otherwise noted, the identities of the parties to the purported debt are listed on Nexes’ note schedule
provided by petitioners, and the denotations are those from petitioners’ purported cash disbursement journal
submitted as part of the parties’ stipulation.


         Other than Nexes, the record does not show any of the payors from whom

these deposits originated owed any debt to petitioners. Moreover, in many cases

petitioners have been unable to identify the indebtedness on which a payment was

purportedly made. In cases where petitioners have been able to identify the debt,

the debt was between AJP as the lender and Nexes as the borrower. Nothing in

the record could explain why any deposits into petitioners’ personal accounts of

purported payments on loans between AJP and Nexes would not be income to

petitioners.
                                         -41-

[*41] As to the deposits originated from Nexes, petitioners have identified certain

debts between AJP and Nexes as those to which the deposits purportedly related.

Again, there is no explanation as to why Nexes’ payments to petitioners on debts it

owed to AJP would not be income to petitioners.

      Even if we were to construe petitioners’ argument to mean that the deposits

from Nexes were repayments on its indebtedness to petitioners, this argument

must also fail. Petitioners have taken the position on brief that their loans to

Nexes created bases in their partnership interests in Nexes. They have argued that

the face amount of their loans to Nexes would create bases but have not otherwise

intimated that we need to reduce such bases to account for any relief from the

partnership liabilities because Nexes had made payments on its notes. Implicit in

this claim is that Nexes never made any payment on its notes to petitioners.

Absent any evidence to corroborate petitioners’ claim that the payments from

Nexes were intended to satisfy its debt obligations to petitioners, compounded

with petitioners’ internally inconsistent positions taken on brief, we decline to find

that these payments from Nexes were nontaxable repayments on its debts.

      In sum, the record does not support petitioners’ self-serving, vague, and

internally inconsistent claim that the referenced deposits were payments on
                                        -42-

[*42] indebtedness to them and thus nontaxable. Accordingly, we sustain

respondent’s determination that petitioners had $93,666.44 of unreported income

for 2004.

      B.    2005

      Petitioners did not report any income for 2005. While they attached a

Schedule C-EZ to their 2004 return for an unnamed consulting business, no such

schedule was attached to their 2005 return. In the absence of adequate records,

respondent reconstructed petitioners’ 2005 income using the same bank deposits

method used to determine their 2004 income. At the conclusion of the audit,

respondent determined petitioners had $58,855.82 of unreported income.

Together this is sufficient to meet respondent’s evidentiary burden.

      At trial petitioners admitted that they did not analyze their unreported

income for 2005. Nor did they provide any testimony to challenge respondent’s

unreported income determination for that year. But petitioners argue on brief that

the questioned deposits were not taxable income because (1) petitioners were not

employed in 2005 to receive any earned income and because (2) the deposits were

repayments on Nexes’ notes to petitioners.

      We first note that petitioners decided not to provide any testimony during

trial about the 2005 unreported income. We will thus draw a negative inference
                                         -43-

[*43] from petitioners’ failure to testify and to present evidence when

respondent’s probative evidence against petitioners on this particular issue is so

compelling. See Baxter, 425 U.S. at 318-319; Petzoldt v. Commissioner, 92 T.C.

at 685 (drawing adverse inference from failure to testify permitted in civil case).

In other words, we give no evidentiary weight to petitioners’ arguments on brief

that they were unemployed in 2005 and that the disputed deposits were debt

repayments.

      Even if we consider petitioners’ claims for argument’s sake, they suffer the

same infirmities that have caused us to reject their arguments concerning their

2004 unreported income. For one, petitioners have taken the position that the full

face amount of the Nexes notes should give them bases in Nexes, implying that

Nexes had not repaid any portion of its notes. Thus, petitioners cannot also argue

that the deposits originated from Nexes were loan repayments. In addition,

petitioners have failed to explain why payments from non-Nexes entities, which

were not indebted to petitioners, could be repayments on Nexes’ debts or any

debts. Finally, petitioners’ self-serving statements in their brief that some of these

deposits were reimbursements for expenses they previously paid on someone

else’s behalf are simply not supported by the record. Together, petitioners have
                                         -44-

[*44] failed to carry their burden of showing respondent’s determination of

unreported income for 2005 was erroneous.

      Accordingly, we sustain respondent’s determination that petitioners had

$58,855.82 of unreported income in 2005.13

VI.   NOL

      Section 172 allows a taxpayer to deduct an NOL for a taxable year that

equals the sum of the NOL carryovers plus NOL carrybacks to that year. Sec.

172(a). A taxpayer claiming an NOL deduction bears the burden of substantiating

the deduction by establishing both the existence of the NOL and the amount of any

NOL that may be carried over to the subject years. Rule 142(a)(1); United States

v. Olympic Radio & Television, Inc., 349 U.S. 232, 235 (1955); Green v.

Commissioner, T.C. Memo. 2003-244, 86 T.C.M. (CCH) 273, 274-275 (2003). As

part of meeting that burden, the taxpayer must file with his return for that year a

concise statement setting forth the amount of the NOL deduction claimed and all


      13
         Petitioners raise for the first time on brief that we need to determine
whether any portion of the taxable deposits for 2004 and 2005 should be treated as
distribution from an S corporation, self-employment income, or earned income.
With one exception, petitioners did not make this an issue before briefing and we
decline to consider it. Petitioners submitted an unfiled amended return for 2004 to
state that they incorrectly reported their wage income as Schedule C income, but
they did not produce any evidence to support the assertion. In all, the record
before us is insufficient to make the determination that the unreported income was
anything other than Schedule C income as petitioners originally reported.
                                        -45-

[*45] material and pertinent facts, including a detailed schedule showing the

computation of the NOL deduction. Sec. 1.172-1(c), Income Tax Regs.

      Thus, to support the claimed deduction for the NOL carried over to 2004,

petitioners must be able to prove they incurred NOLs in other years that can be

carried to 2004. Respondent agrees that petitioners had an NOL carryover from

2000 of $345,803 that could be carried to 2003. But respondent determined that

petitioners did not establish sufficient capital bases or note bases in OneStar

Holding to deduct $585,587 of the Schedule E loss flowing from the S corporation

for 2003. Consequently, respondent used $324,940 of the 2000 NOL in 2003,

allowing only $20,863 to be carried over to 2004 (as opposed to the $606,450

petitioners claimed on their return).

      The notice of determination explained that because petitioners did not incur

an NOL for 2003, respondent limited the NOL deduction for 2004 to the $20,863

carried from 2000, effectively increasing petitioners’ taxable income for 2004 by

$585,587. Again in his pretrial memorandum, respondent stated that he had

disallowed the claimed NOL carried from 2003 for lack of substantiation. Indeed,

Ms. Gray explained this determination clearly to petitioners in the following

passage in her workpapers from the audit:

      [W]hile computing Shareholder’s Basis in OneStar Holding, Inc. for
      the audit year of 2004, it was discovered [petitioners] had deducted
                                        -46-

      [*46] $585,587 pass-thru Loss on Schedule E in excess of his
      allowable Basis. Therefore, this has a direct effect on the Net
      Operating Loss generated in 2003 and carried forward to the audit
      year 2004. [Emphasis added].

Ms. Gray continued to explain in a subsequent passage:

      Alan J Powers received a Form 1099-C for $585,587 in his SSN for
      2003 from Old National Bank. A cancellation of Debt does not
      restore Loan Basis or increase Stock Basis. If anything, this should
      have been reported as COD income on his personal 2003 tax return.
      [Emphasis added].

      Instead of producing evidence to show they had sufficient bases in OneStar

Holding to deduct the loss claimed, petitioners focus their argument solely on their

apparent mistaken notion that respondent had increased petitioners’ 2003 income

by including the amount of COD income reported on the Form 1099-C,

Cancellation of Debt,14 that Ms. Gray referred to in her workpapers, which

petitioners believe in turn caused respondent to disallow a portion of the NOL

carryover from 2003 to 2004. Petitioners maintain that the Form 1099-C

erroneously reported their COD income in that they had only $254,812 of COD

income15 and the remaining balance of the COD was income to OneStar Holding

because OneStar Holding was allegedly liable for that portion of the debt that was


      14
           The Form 1099-C is not in evidence.
      15
        Petitioners reported this amount of COD income as miscellaneous income
on their 2003 return.
                                        -47-

[*47] cancelled. Petitioners further contend that any COD income to them would

be excluded under section 108(a) because they were insolvent.16

      But respondent did not disallow a portion of the NOL from 2003 because he

included the amount of COD reported on the Form 1099-C in petitioners’ income

for 2003. Respondent has always claimed only that petitioners failed to

substantiate their capital or note bases in OneStar Holding in 2003 to absorb all

the reported Schedule E losses from that year.17 Despite having ample notice of

respondent’s argument underlying the disallowance, petitioners failed to produce

any relevant and credible evidence to show they had the sufficient bases in

OneStar Holding to take the disallowed loss for 2003.

      In addition, as Ms. Gray correctly pointed out during the audit, any COD

income to petitioners would not restore their capital bases or note bases in

OneStar. Even if we were to construe petitioners argument to mean that the


      16
       There is no evidence to substantiate petitioners’ claim that they were
insolvent in 2003.
      17
         In their reply brief petitioners appear to be surprised by this claim of
respondent’s. But any claim of surprise is not supported by the record. Ms. Gray
stated repeatedly in her workpapers that the disallowance of the NOL carryover to
2004 was a result of petitioners’ deducting losses from OneStar Holding in excess
of their bases. Respondent’s pretrial memorandum clearly stated that the NOL
issue was one of substantiation, not unreported COD income. As a factual matter,
we find Mr. Powers, who is an experienced C.P.A., and Ms. Powers had adequate
notice of respondent’s claim underlying the disallowance.
                                       -48-

[*48] remaining $330,775 COD income was income to OneStar Holding and thus

an item of income passed to its shareholders,18 such COD income would not

necessarily increase petitioners’ bases in OneStar Holding under section

1367(a)(1) because an S corporation’s COD income excluded under section 108(a)

is not an item of income to its shareholders under section 1366(a). See sec.

108(d)(7)(A).19 There is nothing in the record to suggest whether any COD

income to OneStar Holding would be excluded under section 108.

      For the foregoing reasons, we sustain respondent’s determination to

disallow $585,587 of the NOL that was carried over to 2004. Because our

findings today show that petitioners did not incur an NOL for 2004, we sustain

respondent’s determination to disallow the claimed NOLs for 2005. Because the

NOL deduction was the only item reported on the 2005 return, we also sustain


      18
        The record does not have any evidence to show that OneStar Holding had
COD income. Indeed, OneStar’s Form 1120S and Schedule K-1 for 2003 did not
show any COD income. Thus, we decline to make a factual finding as to this
allegation.
      19
         On March 9, 2002, the Job Creation and Worker Assistance Act of 2002,
Pub. L. No. 107-147, sec. 402(a), 116 Stat. at 40, was signed into law, prohibiting
shareholders of an S corporation from increasing basis for their pro rata shares of
the S corporation’s excluded COD income for discharges of indebtedness after
October 11, 2001. This effectively abrogated the Supreme Court’s decision in
Gitlitz v. Commissioner, 531 U.S. 206 (2001), to allow such a basis increase. See
Ball ex rel. Ball v. Commissioner, T.C. Memo. 2013-39, at *23-*24.
                                        -49-

[*49] respondent’s determination to disallow the deduction of the NOL carryover

from 2005 claimed for 2006.

VII. Accuracy-Related Penalties

      Respondent determined that petitioners are liable for accuracy-related

penalties for 2004, and 2005, and 2006 on two alternative grounds: (1) petitioners

substantially understated their income tax or (2) they were negligent or

disregarded rules or regulations. See sec. 6662(a) and (b)(1) and (2). There is a

substantial understatement of income tax if the understatement amount for the

taxable year exceeds the greater of 10% of the tax required to be shown on a return

for a taxable year or $5,000. Sec. 6662(d)(1)(A). Alternatively, we will sustain

the Commissioner’s determination to impose an accuracy-related penalty if we

determine that the taxpayers failed to make a reasonable attempt to comply with

provisions of the internal revenue laws or disregarded rules or regulations by

acting carelessly, recklessly, or with intentional disregard. Sec. 6662(c); sec.

1.6662-3(b)(1) and (2), Income Tax Regs. Only one accuracy-related penalty may

be imposed for a given portion of an underpayment even though that portion

implicates more than one form of misconduct described in section 6662. Sec.

1.6662-2(c), Income Tax Regs. The Commissioner bears the burden of production

as to the imposition of penalties. Sec. 7491(c).
                                          -50-

[*50] A.       Respondent’s Prima Facie Case

      Our decision today shows that there was a substantial understatement of

income tax for 2004 and 2005. For 2004 petitioners understated their income tax

liability by $165,638, which far exceeded 10% of the tax required to be shown on

the 2004 return. For 2005 petitioners understated their income tax liability by

$11,917, which exceeded the $5,000 threshold.20 Thus, respondent has made his

prima facie case for imposing the accuracy-related penalties for 2004 and 2005.

      Respondent has made his prima facie case with respect to the accuracy-

related penalties asserted for 2004, 2005, and 2006 also by having produced

evidence of petitioners’ negligence and disregard of rules and regulations. This is

so because our record shows petitioners did not keep adequate books and records

to substantiate their claims. We have already noted that we do not give much

credence to petitioners’ claim that the bankruptcy court had seized their records

because any such claim is not supported by what actually transpired in the

bankruptcy proceedings on the basis of our review of the bankruptcy court’s

docket entries and various discovery orders. In any event, petitioners have not

produced any evidence, aside from Mr. Powers’ self-serving and conclusory

testimony, to show what records were seized and what efforts they made to


      20
           Ten percent of the tax required to be shown for 2005 is about $1,100.
                                          -51-

[*51] retrieve those records. It also appears petitioners have been able to turn up

some records for issues not important in this case so that they could claim they

have complied with the recordkeeping requirements. But in fact, what petitioners

have produced in the course of this litigation has not been very helpful and

occasionally amounted to a distraction.

      Moreover, we infer from Mr. Powers’ experience as an accountant that he

understands what the rules and regulations require of petitioners as taxpayers. In

the light of this observation, we are puzzled by Mr. Powers’ testimony that he did

not know his and Ms. Powers’ percentage shares of their respective ownership

interests in AJP and SEP. We are also troubled by the fact that petitioners filed

the SEP returns as if they had transferred their interests in Nexes to SEP when they

knew they had not.21 Petitioners have also admitted that they underreported

$18,452.22 of Schedule C income for 2004 and $501 interest income for 2006.

This type of behavior is not consistent with one that we would expect from an

experienced accountant who claims to be diligent in his compliance with the

internal revenue laws and their rules and regulations.



      21
        Mr. Powers’ testimony that an individual at Nexes prepared some of his
returns does not change our conclusion. Petitioners had a duty to review their tax
returns before signing and filing them. See Magill v. Commissioner, 70 T.C. 465,
479-480 (1978), aff’d, 651 F.2d 1233 (6th Cir. 1981).
                                          -52-

[*52] In sum, respondent has produced ample evidence to show culpable conduct

on the part of petitioners that supports the imposition of the accuracy-related

penalties under section 6662(a).

        B.    Petitioners’ Rebuttal

        Once respondent has proved his prima facie case for imposing the penalty

under section 6662(a), petitioners bear the burden of proving that the penalty is

unwarranted by establishing an affirmative defense such as reasonable cause or

substantial authority. See secs. 6664(c)(1), 6662(d)(2)(B).

        Petitioners have not raised any affirmative defense; they argue only that

they were not negligent in failing to comply with the rules and regulations and that

they did not disregard these rules and regulations. In support of their contention,

they point to a long history of compliance. While petitioners’ alleged 44 years of

tax compliance is noteworthy and may work as circumstantial evidence to show

they did not act negligently or disregard the rules and regulations in the years in

issue, it is insufficient standing alone to overcome respondent’s prima facie case

here.

        Accordingly, we sustain respondent’s determination to impose the accuracy-

related penalties for the tax years in issue.
                                       -53-

[*53] VIII. Epilogue

      We have considered all of petitioner’s arguments for a contrary holding, and

to the extent not discussed herein we conclude they are irrelevant, moot, or lacking

in merit.

      To reflect the foregoing,


                                                    Decision will be entered for

                                              respondent.
