                        T.C. Memo. 1996-118



                      UNITED STATES TAX COURT



             MTS INTERNATIONAL, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent


               ROBERT C. HUGHES III, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 2161-93, 2247-93.1           Filed March 12, 1996.



     Gary L. Goble, for petitioners.

     Frederick W. Krieg and D. Lyndell Pickett, for respondent.




             MEMORANDUM FINDINGS OF FACT AND OPINION

     COLVIN, Judge:   Respondent determined deficiencies in

petitioners’ Federal income tax and additions to tax as follows:

     1
       These cases were consolidated for purposes of trial,
briefing, and opinion.
                                      - 2 -


                           MTS International, Inc.

                                        Additions to Tax
Year       Deficiency    Sec. 6651(a)    Sec. 6653(a)(1)(A)1   Sec. 6661

1987         $217,716       $54,429           $10,885           $54,429

       1
       Respondent determined an addition to tax under sec.
6653(a)(1)(B) of 50 percent of the interest due on $217,716 for
1987.


                               Robert C. Hughes III

                                        Additions to Tax
Year       Deficiency     Sec. 6651(a)(1)   Sec. 6653(a)(1)(A)1     Sec. 6661
1986         $31,740         $13,179              $3,236               $7,935
1987         202,446          49,951              11,190               50,612

       1
       Respondent determined additions to tax under sec.
6653(a)(1)(B) of 50 percent of the interest due on $31,740 for
1986, and 50 percent of the interest due on $202,446 for 1987.


       After concessions, the issues for decision are:

       1.    Whether the loss petitioner Robert C. Hughes III

sustained when he sold ZZZZ Best Co. stock in 1987 is deductible

as a theft loss.        We hold that it is not.

       2.    Whether petitioner Robert C. Hughes III’s withdrawals

from petitioner MTS International, Inc. (MTS), and what

petitioners contend was its forgiveness of his debts were

constructive dividend income to him in the amount of $194,224 in

1987.       We hold that they were, except as discussed below.
                                 - 3 -


       3.   Whether petitioner MTS International, Inc., may deduct

$196,672 for travel and entertainment expenses for 1987.     We hold

that it may not.

       References to petitioner are to Robert C. Hughes III.

References to petitioner corporation are to MTS International,

Inc.    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.

                           FINDINGS OF FACT

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

A.     Petitioner and Petitioner Corporation

       Petitioner resided in Prospect, Kentucky, when he filed the

petition in this case.

       Petitioner corporation had its principal place of business

in Louisville, Kentucky, during the years in issue.     Petitioner

has been the sole shareholder, director, and president of

petitioner corporation at all times since it was incorporated.

Petitioner controlled petitioner corporation, including its

financing, dividends, and loans.

       Petitioner corporation was in the business of collecting

debts for creditors.     It was also in the factoring business;

i.e., it bought accounts receivable from businesses for a

percentage of face value and then tried to collect the

receivables.
                               - 4 -


B.   Petitioner’s Dealings With ZZZZ Best Co.

     1.   1986

     In early 1986, petitioner advertised in the Los Angeles

Times for businesses that wanted to factor receivables.    Barry

Minkow (Minkow), the president of ZZZZ Best Co., Inc. (ZZZZ

Best), in Los Angeles, saw the ad and contacted petitioner.

Petitioner and Mark Morze (Morze), Minkow’s accountant, met in

Los Angeles in April or May 1986 to discuss petitioner’s purchase

of ZZZZ Best receivables.   Morze gave him balance sheets,

operating statements, press clippings on Minkow and ZZZZ Best,

and other documents purporting to show the financial strength of

Minkow and ZZZZ Best.   Petitioner and Minkow spoke several times

during the summer of 1986 about petitioner corporation’s possible

purchase of ZZZZ Best receivables.     ZZZZ Best claimed to perform

insurance restoration work on buildings damaged by water and

fire.

     Minkow knew the receivables were fraudulent and that ZZZZ

Best’s financial statements contained false information about

its profitability.   Minkow needed capital in 1986 because he

frequently borrowed from one investor to repay another investor.

On July 10, 1986, Minkow sent documents to petitioner from

Interstate Appraisal Services (Interstate) purporting to show

that ZZZZ Best’s accounts receivable were legitimate.    Petitioner

examined ZZZZ Best’s financials and the Interstate documents in
                               - 5 -


July and August 1986, but could not verify the amount of

receivables.   Petitioner analyzed the financials and bank

statements Morze gave him and concluded that they did not make

financial sense.

     In December 1986, ZZZZ Best went public.   Its stock began to

be publicly traded on the National Association of Securities

Dealers Automated Quotations (NASDAQ).

     2.   1987

     By April 1987, petitioner thought that Minkow and ZZZZ Best

stock were legitimate because of the December 1986 public

offering of ZZZZ Best stock, Minkow’s appearances on talk shows

and in business magazines, and other institutions’ purchases of

ZZZZ Best stock.   Petitioner bought 60,000 shares of ZZZZ Best

common stock for $912,560.69 in early April 1987.   He sold the

60,000 shares on or before April 15, 1987, for $1,014,621.75,

resulting in a profit of $102,061.06.

     Minkow spoke with petitioner frequently from late April

to mid-June 1987 to encourage petitioner corporation to buy

$1,269,328.80 of ZZZZ Best receivables.   Minkow thought

petitioner might buy some of ZZZZ Best’s receivables.   Minkow

told petitioner that ZZZZ Best’s stock was one of the best NASDAQ

stocks, but he did not try to sell ZZZZ Best stock to petitioner.

     Minkow held a press conference on May 28, 1987, to respond

to a newspaper article alleging wrongdoings by him.   He announced
                                 - 6 -


that investigators who had reviewed allegations about a junk bond

offering by ZZZZ Best through Drexel, Burnham & Lambert (Drexel,

Burnham) found nothing wrong and that the offering would proceed.

Drexel, Burnham ended its relationship with ZZZZ Best because

Minkow’s press conference violated rules regarding public

offerings.

     In early June 1987, ZZZZ Best stock was one of the most

actively traded NASDAQ stocks.    Petitioner believed that Minkow

was one of the most prominent and successful entrepreneurs in the

country at that time.   From June 1 to June 4, 1987, petitioner

bought 50,000 shares of ZZZZ Best stock for $532,161.40.

     On June 4, 1987, shareholders of ZZZZ Best filed a class

action suit against ZZZZ Best, Minkow, and others.    In re ZZZZ

Best Co. SEC Litigation, docket No. CV 87-3574 RSWL (Bx) (C.D.

Cal.).   Petitioner became a plaintiff in the shareholder class

action suit at a time not specified in the record.

     In mid-June 1987, Minkow was desperate to raise capital

because banks had called his loans and ZZZZ Best stock had lost

value due to negative press.   On June 12, 1987, Minkow telefaxed

a letter to petitioner purporting to confirm ZZZZ Best’s sale to

petitioner corporation of $1,189,874 in receivables for $600,000.

ZZZZ Best did not sell its receivables to petitioner or

petitioner corporation then or at any time.
                               - 7 -


     On June 16, 1987, petitioner bought 20,000 shares of ZZZZ

Best stock for $146,650.2   He paid a total of $678,811.40 for the

70,000 shares he bought in June.   He bought all of his ZZZZ Best

stock through stockbrokers; i.e., Merrill Lynch and Drexel,

Burnham.   He did not buy any ZZZZ Best stock from ZZZZ Best,

Minkow, or any other officer or director of ZZZZ Best. Minkow did

not try to sell ZZZZ Best stock to petitioner and did not

encourage him to buy it.

     Minkow telefaxed various documents to petitioner corporation

on June 16, 1987.3   These included a Form 10-Q, undated ZZZZ Best

financial statements, the May 28, 1987, press release concerning

ZZZZ Best’s future operations, a security agreement, Minkow’s

personal guarantee of the receivables, Minkow’s personal

financial statement (as of January 31, 1987), an irrevocable

stock/bond power in which Minkow assigned to MTS 200,000 shares

of restricted stock in ZZZZ Best, and documents from Interstate

purporting to show that the accounts receivable were legitimate.

Minkow also telefaxed a June 16, 1987, agreement to buy accounts

receivable that included a blank signature line for petitioner


     2
       The trade date of petitioner’s purchase of the 20,000
shares of ZZZZ Best stock was June 16, 1987; the settlement date
was June 23, 1987.
     3
       Minkow telefaxed these documents to petitioner at 5 p.m.
on June 16, 1987. Petitioner did not try to show that he
received these documents before he bought 20,000 shares of ZZZZ
Best stock described above.
                                 - 8 -


corporation (By:   Robert Hughes, President).   Minkow’s and ZZZZ

Best’s financial statements were false.

     Petitioner examined ZZZZ Best’s financial statements in mid

to late June 1987 and concluded that its balance sheets were

unusually skewed toward accounts receivable.    He believed that

nearly 80 percent of ZZZZ Best’s assets were receivables.    He

concluded that ZZZZ Best’s “nominal balance” did not match the

total amount of receivables.   Petitioner corporation did not buy

ZZZZ Best receivables because petitioner could not verify the

source of the receivables.

     On June 23, July 13, and July 24, 1987, petitioner sold the

70,000 shares of ZZZZ Best stock he bought in June.    His sale

price was $45,270.72, and his loss was $633,540.68.

C.   Minkow’s Conviction and ZZZZ Best Class Action Suit

     In June 1988, Minkow and other officers of ZZZZ Best were

charged with the crimes of conspiracy, unauthorized use of access

devices, money laundering, interstate transportation of stolen

securities and money, and securities, mail, bank and tax fraud.

Minkow was convicted early in 1989.

     At various times not specified in the record, petitioner

contacted the attorneys who represent the plaintiffs in the

shareholder class action suit.    A recovery agreement on the class

action suit was reached in 1991.    It was signed by the parties in

July 1994.
                                - 9 -


D.   Petitioner Corporation’s Transfer of Funds to Petitioner

     Petitioner corporation transferred an amount of funds not

specified in the record to petitioner before and during its 1987

tax year.   Petitioner corporation’s minutes for April 15, 1981,

stated that it would lend money to petitioner as needed at a 9-

percent interest rate.   Petitioner corporation did not require

and petitioner did not give collateral for any transfers of funds

from petitioner corporation to him.     Petitioner did not pay

interest to petitioner corporation on the transfers at issue or

for any prior transfers.   There was no limit on the amount

petitioner could borrow from petitioner corporation.     The

purported loans had no maturity dates.     Petitioner executed no

notes evidencing debt to petitioner corporation.

     Petitioner corporation has never formally declared or paid

dividends to petitioner.

E.   Petitioner’s 1987 Tax Return

     Petitioner filed his 1987 income tax return on June 14,

1989.   He claimed a $463,881 capital loss, and a long-term

capital gain of $3,898, from his 1987 sales of 26 different

securities, including Texaco, Exxon, Navistar, Crazy Eddies, Chi-

Chi’s, and ZZZZ Best.    The loss included a $531,480 net loss from

his sales of ZZZZ Best stock.   He filed an amended 1987 return on
                               - 10 -


June 25, 1991, on which he claimed a $1,319,311 theft loss for

the ZZZZ Best stock.4

     Petitioner corporation filed a tax return for its 1987 tax

year on January 3, 1989.   It reported unappropriated retained

earnings of $324,760 at the end of its 1987 tax year.

                               OPINION

A.   Theft Loss

     1.   Background

     Petitioner contends that he may deduct the loss on his

investment in ZZZZ Best stock as a theft loss for 1987.

     Generally, a taxpayer may deduct a theft loss in the year in

which the taxpayer discovers the loss.   Sec. 165(a), (e); Asphalt

Indus., Inc. v. Commissioner, 411 F.2d 13, 15-16 (3d Cir. 1969),

affg. T.C. Memo. 1968-155.   Whether there is a theft for purposes

of section 165(e) is determined by applicable State law.    Paine

v. Commissioner, 63 T.C. 736, 740 (1975), affd. without published

opinion 523 F.2d 1053 (5th Cir. 1975).   A conviction for theft

under State law is not required for a taxpayer to be eligible for

a theft loss deduction.    Vietzke v. Commissioner, 37 T.C. 504,

510 (1961).   Petitioner bears the burden of proving that he is




     4
       Petitioner did not explain how he figured the $1,319,311
theft loss amount. On brief, he claimed that he had a $531,480
theft loss when he sold ZZZZ Best stock. This is the amount we
treat as in dispute.
                               - 11 -


entitled to deduct a theft loss.       Rule 142(a);       Welch v.

Helvering, 290 U.S. 111, 115 (1933).

     The parties agree that Kentucky law applies here.

Petitioner points out that Minkow knowingly misrepresented the

value of the ZZZZ Best receivables and stock to petitioner and

argues that Minkow’s conduct was theft by deception under

Kentucky law.

     2.   Theft by Deception

     Section 514.040 of the Kentucky Penal Code, Ky. Rev. Stat.

Ann. sec. 514.040 (Michie 1990), provides that

     Theft by deception. -- (1) A person is guilty of theft
     by deception when he obtains property or services of
     another by deception with intent to deprive him
     thereof. A person deceives when he intentionally:

          (a) Creates or reinforces a false impression,
     including false impressions as to law, value, intention
     or other state of mind;

                 *    *    *       *      *    *      *

          (c) Fails to correct a false impression which the
     deceiver previously created or reinforced * * *

     “Obtain” means “to bring about a transfer or purported

transfer from another person of a legal interest in the property,

whether to the obtainer or another”.       Ky. Rev. Stat. Ann. sec.

514.010(4)(a) (Michie 1990).

     For us to find that Minkow committed theft by deception,

petitioner must show that Minkow intentionally deprived

petitioner of property through deception or false representations
                                  - 12 -


on which petitioner relied.      Ky. Rev. Stat. Ann. sec. 514.040

(Michie 1990); Commonwealth v. Burnette, 875 S.W.2d 865, 868 (Ky.

1994); Brown v. Commonwealth, 656 S.W.2d 727, 728 (Ky. 1983).

       Petitioner contends that he bought ZZZZ Best stock in

reliance on Minkow’s representations and material Minkow sent

him.       Petitioner contends that Minkow’s intent to deceive him

about the receivables also showed that Minkow intended to deceive

him to buy ZZZZ Best stock.       Petitioner argues that Minkow’s

fraudulent misrepresentation of the value of the receivables

caused petitioner to buy ZZZZ Best stock.       See Ky. Rev. Stat.

Ann. sec. 501.060 (Michie 1990).5




       5
       Sec. 501.060, Ky. Rev. Stat. Ann. (Michie 1990), provides
in part:

       Causal relationships. -- (1) Conduct is the cause of a
       result when it is an antecedent without which the
       result in question would not have occurred.

            (2) When intentionally causing a particular result
       is an element of an offense, the element is not
       established if the actual result is not within the
       intention or the contemplation of the actor unless:
            (a) The actual result differs from that intended
       or contemplated, as the case may be, only in the
       respect that a different person or different property
       is injured or affected or that the injury or harm
       intended or contemplated would have been more serious
       or more extensive; or
            (b) The actual result involves the same kind of
       injury or harm as that intended or contemplated and
       occurs in a manner which the actor knows or should know
       is rendered substantially more probable by his conduct.
                                - 13 -


     We are not convinced by petitioner’s claim that he bought

ZZZZ Best stock in reliance on Minkow’s statements or the

documents Minkow sent to him.    Although Minkow made fraudulent

misrepresentations about the receivables, petitioner did not rely

on them.   Petitioner had reservations about the receivables and

did not buy them.   Petitioner bought 60,000 shares of ZZZZ Best

stock in early April 1987 because, based on ZZZZ Best’s December

1986 public offering, publicity surrounding Minkow and ZZZZ Best,

and other institutions’ purchases of that stock, he thought it

was a good investment.   He sold that stock for a profit of

$102,061.06 on April 15, 1987.    Petitioner bought 50,000 shares

of ZZZZ Best stock from June 1 to June 4, 1987, and 20,000 shares

on June 16, 1987, also because he thought it would be a good

investment.

     Petitioner bought all 130,000 shares of ZZZZ Best stock at

issue here before Minkow telefaxed various documents to him on

June 16, 1987.   Although Minkow talked frequently to petitioner

on the phone from late April to mid-June 1987, he was trying to

persuade petitioner to buy receivables, not stock.    Minkow told

petitioner that ZZZZ Best’s stock was one of the best NASDAQ

stocks after petitioner bought and sold 60,000 shares of it in

early April 1987.   Petitioner decided to buy ZZZZ Best stock

based on his knowledge of ZZZZ Best’s public offering, the active

trading of ZZZZ Best stock, and Minkow’s reputation as an
                               - 14 -


entrepreneur.   His investment decision was not the result of

Minkow’s misrepresentations.

     Petitioner points out that Minkow’s repeated personal

contacts with petitioner differentiate this case from most cases

where an investor buys publicly traded stock.    See, e.g., Paine

v. Commissioner, 63 T.C. at 740; Crowell v. Commissioner, T.C.

Memo. 1986-314; De Fusco v. Commissioner, T.C. Memo. 1979-230;

Barry v. Commissioner, T.C. Memo. 1978-215.     Petitioner maintains

that he bought ZZZZ Best stock based not on his own analysis or

that of a broker, but based on Minkow’s intentional

misrepresentations to petitioner.   We disagree for the reasons

stated above.

     Petitioner has not shown that there was a theft under

section 514.040 of the Kentucky Penal Code because Minkow did not

try to convince petitioner to buy ZZZZ Best stock and because

petitioner’s decision to buy the stock was not made in reliance

on Minkow’s representations.   Therefore, we conclude that

petitioner may not deduct his loss on ZZZZ Best stock as a theft

loss.

     In view of our holding, we need not reach respondent’s

argument that petitioner had a reasonable prospect of recovery at

the end of 1987.

B.   Petitioner’s Dividend Income and Petitioner Corporation’s
     Travel and Entertainment Expenses Deduction

     1.   Petitioner’s Evidence
                               - 15 -


     These cases were calendared for trial twice in Louisville.

Five months before they were first calendared for trial, we sent

a copy of the Court’s standing pretrial order to petitioner.      The

standing pretrial order stated in part:    “Any documents or

materials which a party expects to utilize in the event of trial

(except for impeachment), but which are not stipulated, shall be

identified in writing and exchanged by the parties at least 15

days before the first day of the trial session.”

     Petitioner gave respondent envelopes containing some of his

records 3 days before that trial session.    The records were

disorganized.    Respondent immediately returned the records to

petitioner so he could organize them.    Petitioner did not return

those records to respondent until the second time the cases were

set for trial.

     About 3 months before the trial of these cases, we ordered

the parties to exchange all evidence to be offered at trial

(except for impeachment purposes) 45 days before trial.    We also

told the parties that the Court may refuse to receive in evidence

any document or material not stipulated or exchanged as required

by this Court.

     Four days before trial, petitioner again gave disorganized

records to respondent.    Respondent returned them to petitioner to

organize them.    Petitioner did not return those records to

respondent before trial.
                              - 16 -


     At trial, petitioner submitted several exhibits purporting

to substantiate some of petitioner corporation’s travel and

entertainment expenses and petitioner’s claim that he made cash

advances to petitioner corporation.    They were not admitted into

evidence because they were not exchanged as required by our

pretrial orders.6   Materials not exchanged in compliance with our

pretrial orders may be excluded from evidence.   Rule 104(c)(2);

Gleason v. Commissioner, T.C. Memo. 1990-110; see Freedson v.

Commissioner, 565 F.2d 954 (5th Cir. 1978), affg. 65 T.C. 333

(1975) and 67 T.C. 931 (1977); McCoy v. Commissioner, 76 T.C.

1027 (1981), affd. 696 F.2d 1234 (9th Cir. 1983).

     At trial, petitioner’s counsel said that prior counsel for

petitioner had told him that he submitted and withdrew for

reorganization “voluminous documentation” around July 15, 1994.

Respondent’s counsel remembered receiving no such documents from

petitioner.   There is no corroboration of petitioner’s counsel’s

secondhand report that prior counsel gave records to respondent

in July 1994.   Petitioners apparently accept respondent’s

counsel’s account because they have not pursued this point

further.   Also, petitioner does not claim that he organized any

of these records and gave them to respondent before these cases

were tried.

     6
       Petitioner refrained from offering numerous documents into
evidence after we did not admit other exhibits that were not
exchanged before trial.
                               - 17 -


2.   Dividend Income

     Respondent determined that petitioner had dividend income

from petitioner corporation in 1987 as follows:

          Debt cancellation
            (forgiveness of debt)              $130,230

          Use of property and loans
            (increase in loan by 6/30/87)         346,381

                Total                             476,611

     Respondent conceded that $132,387 of this amount was an MTS

bookkeeping error and that $150,000 was transfers from petitioner

to petitioner corporation.   The parties continue to dispute

whether petitioner received $194,224 of dividend income.

     Petitioner bears the burden of proving that these payments

were not dividend income.    Rule 142(a); Welch v. Helvering, 290

U.S. at 115.   A dividend is a distribution of property by a

corporation to its shareholders from its earnings and profits.

Sec. 316(a).   Gross income includes dividends.    Sec. 61(a)(7).

     Petitioner contends that he made unreimbursed cash advances,

including mortgage payments, on petitioner corporation’s behalf.

He said that he thought the amount of the cash advances was

“around $30,000”.   Petitioner’s only evidence on this issue was

his vague testimony.

     Petitioner’s documents, which we discussed above at par. B-1

(pp. 14-15), included one check which was in the amount of

$1,590.53 and purported to be a mortgage payment written by
                                  - 18 -


petitioner for petitioner corporation, and various hotel,

restaurant, and transportation receipts which lacked complete

dates (i.e., the year was missing), or failed to adequately show

the business purpose or to show that the statement of business

purpose was made contemporaneously.        Even if we had admitted

petitioner’s exhibits, they would not have substantiated

petitioner’s claim that he made payments to or on behalf of

petitioner corporation.

       Petitioner offered no evidence that the debts were not

canceled, that he did not make withdrawals from petitioner

corporation, that the amounts were repaid, or that the

withdrawals and debt cancellations were not taxable dividends to

him.    Sec. 6001; Rule 142(a).    Petitioner’s records were totally

inadequate to convince us that he made unreimbursed payments of

mortgage and other expenses of petitioner corporation.        However,

petitioner’s testimony convinces us that he made some cash

advances to petitioner corporation.        We find that $30,000 of the

$194,224 in dispute was not dividends from petitioner corporation

to petitioner.

       Petitioner corporation had retained earnings in 1987 of

$324,670, which is enough to establish that the cash advances to

petitioner were dividends.    Sec. 316(a).      Petitioner has not

shown that petitioner corporation did not have enough retained

earnings to support respondent’s determination that he received
                              - 19 -


dividends from petitioner corporation.   We conclude that

petitioner had dividend income of $164,224 in 1987.

3.   Travel and Entertainment Expenses

     Respondent disallowed $196,672 claimed by petitioner

corporation as travel and entertainment deductions.    Respondent’s

determination is presumed to be correct, and petitioner

corporation bears the burden of proving otherwise.    Rule 142(a);

Welch v. Helvering, supra at 115.

     As discussed above at par. B-1 (pp. 14-15), we did not admit

into evidence petitioner’s exhibits purporting to substantiate

some of petitioner corporation’s travel and entertainment

expenses.   Also, petitioner did not offer numerous other

documents also purporting to substantiate travel and

entertainment expenses.   Even if the documents offered by

petitioner were in evidence, the exhibits (consisting mainly of

expense reports and Xerox copies of hotel, restaurant, and other

receipts) did not adequately substantiate any of petitioner

corporation’s travel and entertainment expenses.   Most of them

did not indicate the business purpose for the expense.

Petitioner did not testify about the travel and entertainment

expenses.   Thus, there is no evidence that petitioner corporation

incurred travel and entertainment expenses, the amount thereof,

or the business purpose for the expenses.   Secs. 6001, 274; Rule

142(a).   Petitioner corporation did not address this issue on
                              - 20 -


brief.   Petitioner corporation has not carried its burden of

proving that it may deduct travel and entertainment expenses.

     To reflect the foregoing and concessions,


                                        Decisions will be entered

                                   under Rule 155.
