                          T.C. Memo. 2006-169



                        UNITED STATES TAX COURT



RICHARD D. IRVING AND CYNTHIA A. BURROUGH IRVING, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 1096-05.                Filed August 16, 2006.



     Richard D. Irving and Cynthia A. Burrough Irving, pro sese.

     Miriam C. Dillard, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     WELLS, Judge:   Respondent determined the following

deficiencies, additions to tax, and penalties with respect to

petitioners’ 2000 and 2001 tax years:

                             Addition to tax          Penalty
  Year     Deficiency       Section 6651(a)(1)    Section 6662(a)

  2000     $32,133.00           $7,473.75           $6,426.60
  2001      43,431.65               --               8,634.19
                               - 2 -


Unless otherwise indicated, all section references are to the

Internal Revenue Code, as amended, and all Rule references are to

the Tax Court Rules of Practice and Procedure.    The issues to be

decided are:   (1) Whether petitioners properly reported the gross

receipts of their business; (2) whether petitioners are entitled

to the business expense deductions they claimed on their returns;

(3) whether petitioners are liable for tax on self-employment

income pursuant to section 1401; (4) whether petitioners are

liable for an addition to tax for failure to file timely pursuant

to section 6651(a)(1); and (5) whether petitioners are liable for

accuracy-related penalties pursuant to section 6662.

                         FINDINGS OF FACT

     Some of the facts in this case have been stipulated.    The

stipulated facts and accompanying exhibits are incorporated

herein by this reference.

     Petitioners are husband and wife.   We hereinafter refer to

Richard D. Irving, individually, as petitioner.   At the time of

the filing of the petition, petitioners resided in Eustis,

Florida.   During 2000 and 2001, petitioners operated Kingdom

Kreations, an embroidery business specializing in embroidery for

school uniforms.   All of petitioners’ business income and

expenses relevant to the instant case relate to their operation

of Kingdom Kreations.
                               - 3 -

     On March 19, 2002, petitioners filed a joint 2000 Form 1040,

U.S. Individual Income Tax Return (the 2000 tax return).   On

Schedule C of the 2000 tax return, petitioners reported gross

receipts of $77,894 and the following business expenses:

     Advertising                                  $850
     Car and truck expenses                      6,890
     Office expenses                             3,875
     Rent or lease
           Vehicles, machinery, & equipment     15,400
     Supplies                                   22,450
     Taxes and licenses                            100
     Travel, meals, and entertainment            1,175
     Wages                                      14,250
     Other expenses                              1,225
        Total                                   66,215

Accordingly, petitioners reported net profit of $11,679,

representing the total income reported by petitioners on the 2000

tax return.

     On April 15, 2002, petitioners filed a joint 2001 tax return

(the 2001 tax return).   On Schedule C of the 2001 tax return,

petitioners reported gross receipts of $114,589 and the following

business expenses:

     Advertising                                   $450
     Car and truck expenses                       5,710
     Office expenses                              3,650
     Rent or lease
           Vehicles, machinery, and equipment    26,400
     Supplies                                    31,642
     Travel, meals, and entertainment             1,572
     Wages                                       30,650
     Other expenses                                 950
        Total                                   101,024
                                - 4 -

Accordingly, petitioners reported net profit of $13,565,

representing the total income reported by petitioners on the 2001

tax return.

     During the years in issue, petitioners maintained ownership

of and access to the following two bank accounts with Bank of

America:    (1) Account No. xxxx xxxx 6240 under the name Richard

D. Irving d.b.a. Kingdom Kreations (Account A) and (2) Account

No. xxxx xxxx 7849 under the names Richard D. Irving and Cynthia

A. Irving (Account B).    Accounts A and B are hereinafter referred

to collectively as the bank accounts.    Petitioners concede that

they paid personal expenses from Account A during the years in

issue.    During 2000 and 2001, Bank of America issued monthly bank

statements identifying petitioners’ transactions with respect to

the bank accounts, which bank statements are hereinafter

collectively referred to as the bank statements.

     Petitioners maintained their business records with computer

software and stored the records in both electronic and paper

form.    Petitioners, however, lost the electronic records due to

computer malfunction, and they subsequently destroyed the paper

records when they ceased to operate Kingdom Kreations.1




     1
      The record does not indicate the date on which petitioners’
electronic records were lost, and the record does not indicate
the date on which petitioners ceased to operate Kingdom
Kreations.
                               - 5 -

     In August of 2003, Revenue Agent Fabian A. Gomez commenced

an examination of petitioners’ 2001 and 2002 tax returns.

Petitioners were unable to produce any business records or

substantiating documents, and, therefore, Agent Gomez used the

bank statements to reconstruct petitioners’ income.    Agent Gomez

determined petitioners’ gross receipts for the years in issue by

subtracting the deposits that he was able to identify as

nontaxable, such as loan proceeds and transfers from other bank

accounts maintained by petitioners (transfers), from the

aggregate deposits for each year.   Petitioners were given the

opportunity to but did not identify on the bank statements the

business expenses for which they claimed deductions.   Agent

Gomez, therefore, relied on his own review of the bank statements

to identify business-related payments, which he allowed as

business expense deductions for the years in issue.

     On October 15, 2004, respondent issued petitioners a

statutory notice of deficiency with respect to their 2000 and

2001 tax years.   Respondent determined that petitioners

understated their gross receipts for the 2000 tax year by $37,634

and for the 2001 tax year by $47,207.2   For both the 2000 and

     2
      Respondent determined the $37,634.02 understatement of
gross receipts for petitioners’ 2000 tax year by subtracting
gross receipts as reported by petitioners ($77,894) from gross
receipts as determined by Agent Gomez ($115,528.02). Similarly,
respondent determined the $47,207.73 understatement of gross
receipts for petitioners’ 2001 tax year by subtracting gross
                                                   (continued...)
                                - 6 -

2001 tax years, respondent allowed portions of petitioners’

claimed business expense deductions for supplies and office

expenses but disallowed all others.3      Furthermore, respondent

determined that petitioners are liable for self-employment taxes

of $12,424 for the 2000 tax year and $13,893.57 for the 2001 tax

year.    Remaining adjustments set forth by respondent in the

notice of deficiency depend on a Rule 155 computation and need

not be addressed in this opinion.

     Petitioner timely petitioned this Court for a

redetermination of the proposed deficiencies.

                               OPINION

     Section 61(a) defines gross income as “all income from

whatever source derived,” including gross income derived from

     2
      (...continued)
receipts as reported by petitioners ($114,589) from gross
receipts as determined by Agent Gomez ($161,796.73).
     3
      Specifically, respondent determined that petitioners
overstated Schedule C business expense deductions as follows:

                                    Amount of claimed deduction
                                     disallowed by respondent
     Claimed expenses                  2000            2001

     Advertising                           $850           $450
     Car and truck expenses               6,890          5,710
     Office expenses                      3,228          2,983
     Rent or lease                       15,400         26,400
     Supplies                            18,678         17,031
     Taxes and licenses                     100
     Meals and entertainment              1,175          1,573
     Wages                               14,250         30,650
     Other expenses                       1,225            950
        Total                            61,796         85,747
                                - 7 -

business.    Taxpayers are required to maintain books and records

that are sufficient to enable the Commissioner to determine their

correct tax liability.   Sec. 1.6001-1(a), Income Tax Regs.

     The Commissioner may use the bank deposits method to compute

taxpayers’ income in the absence of substantiating business

records.    Estate of Mason v. Commissioner, 64 T.C. 651, 656

(1975), affd. 566 F.2d 2 (6th Cir. 1977).     Bank deposits are

prima facie evidence of income.    Id.   The bank deposits method of

reconstruction assumes that all of the money deposited into a

taxpayer’s account is taxable income unless the taxpayer can show

that the deposits are not taxable.      DiLeo v. Commissioner, 96

T.C. 858, 868 (1991), affd. 959 F.2d 16 (2d Cir. 1992).     The

Commissioner, however, must take into account any nontaxable

items or deductible expenses of which the Commissioner has

knowledge.    Id.

     In the instant case, section 7491(a) does not shift the

burden of proof to respondent because petitioners failed to

maintain records or comply with substantiation requirements as

required under section 7491(a)(2)(A) and (B).     Consequently,

petitioners bear the burden of proving that respondent’s

determination of income based on the bank deposits method is

erroneous.   Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933).
                               - 8 -

     Petitioners do not dispute respondent’s use of the bank

deposits method of reconstruction and do not allege any specific

error in respondent’s computations.    Rather, we understand

petitioners to contend that they maintained business records

during the years in issue that were subsequently lost or

destroyed, that the 2000 and 2001 tax returns accurately reported

petitioners’ income and expenses for the years in issue in

accordance with their lost or destroyed business records, and

that respondent’s determinations are therefore erroneous.

     The record demonstrates that petitioners failed to produce

books and records from which respondent could determine their tax

liability for the years in issue.   Consequently, we conclude that

respondent’s use of the bank deposits method was proper.    See

Estate of Mason v. Commissioner, supra.    The record further

demonstrates that respondent properly computed the gross receipts

and business expenses for petitioners’ 2000 and 2001 tax years

under the bank deposits method, as discussed below.

     With respect to petitioners’ gross receipts, the parties

stipulated that deposits into the bank accounts during 2000

totaled $222,467.13, including $90,804.03 of nontaxable items and

$16,135.08 of transfers.4   Additionally, the parties stipulated

that deposits into the bank accounts during 2001 totaled


     4
      We note that such “transfers” are nontaxable and could have
been grouped together with the other nontaxable items.
                               - 9 -

$187,331.24, including $14,969.51 of nontaxable items and $10,565

of transfers.   Based upon the amounts stipulated, respondent

determined that petitioners had gross receipts of $115,528.02 in

2000 and that petitioners had gross receipts of $161,796.73 in

2001.5   As noted above, petitioners reported gross receipts of

$77,894 in 2000 and $114,589 in 2001.   In light of the parties’

stipulations, we conclude that petitioners have failed to meet

their burden of proving that respondent erred in determining that

petitioners understated their 2000 gross receipts by $37,634.02

and their 2001 gross receipts by $47,207.73.

     With respect to petitioners’ business expenses, respondent

allowed deductions of $4,419 for the 2000 tax year and $15,278

for the 2001 tax year, based upon the amounts that Agent Gomez

identified from the bank statements as business-related payments.

Although petitioners claimed business expense deductions of

$66,215 for the 2000 tax year and $101,024 for the 2001 tax year,

petitioners did not identify such expenses from the bank

statements when Agent Gomez provided them with the opportunity to

do so.   At trial, petitioners were unable to provide any credible


     5
      Respondent’s determination that petitioners had gross
receipts of $115,528.02 in 2000 represents the total deposits
into accounts A and B during 2000 ($222,467.13), less nontaxable
items ($90,804.03) and transfers ($16,135.08). Similarly,
respondent’s determination that petitioners had gross receipts of
$161,796.73 in 2001 represents the total deposits into accounts A
and B during 2001 ($187,331.24), less nontaxable items
($14,969.51) and transfers ($10,565).
                                - 10 -

evidence to substantiate the claimed business expense deductions

disallowed by respondent.   Although petitioners contend that they

incurred significant labor expenses during the years in issue,

they were able to provide no more than the names of four

employees and an estimate of weekly payments made to such

employees.6   The Court may estimate the proper amount of

deductible expense when a taxpayer establishes that he paid or

incurred the expense but does not establish the amount of the

deduction.    Boyd v. Commissioner, 122 T.C. 305, 320 (2004).

For such an estimate to be proper, however, the record must

evidence that the taxpayer paid or incurred a deductible expense

at least of the amount allowed.    Id.   The record in the instant

case provides no such evidence.    Consequently, we conclude that

petitioners have failed to meet their burden of proving that

respondent erred in disallowing claimed business expense

deductions of $61,796 for petitioners’ 2000 tax year and $85,746

for petitioners’ 2001 tax year.

     Section 1401 imposes a percentage tax on the self-employment

income of every individual.   Self-employment income is defined as

“the net earnings from self-employment derived by an individual *

* * during any taxable year”.    Sec. 1402(b).   The term “net

earnings from self-employment” is defined as “the gross income

     6
      Petitioner estimated the amounts paid to each of the four
employees per week but provided no evidence as to the number of
weeks worked by such employees.
                              - 11 -

derived by an individual from any trade or business carried on by

such individual, less the deductions * * * which are attributable

to such trade or business”.   Sec. 1402(a).   Petitioners have made

no contention and offered no evidence as to whether they are

liable for self-employment taxes during the years in issue.    The

record, however, demonstrates that petitioners’ gross receipts

during 2000 and 2001 were attributable to their business, Kingdom

Kreations.   Consequently, we conclude that respondent correctly

determined that petitioners had self-employment income of

$111,109 for the 2000 tax year and $146,518 for the 2001 tax

year, representing petitioners’ gross receipts less business

expense deductions for each respective tax year.   Accordingly, we

hold that petitioners are liable for the corresponding self-

employment taxes as determined by respondent with respect to the

years in issue.

     We now turn to the issues of whether petitioners are liable

for the addition to tax for failure to timely file pursuant to

section 6651(a)(1) with respect to petitioners’ 2000 tax year and

whether petitioners are liable for section 6662 accuracy-related

penalties for the years in issue.   Section 7491(c) provides that

respondent bears the burden of production with respect to the

liability of any individual for any addition to tax or penalty.

Consequently, respondent must produce sufficient evidence to

demonstrate that the addition to tax for failure to file timely
                              - 12 -

and the accuracy-related penalties are appropriate.    See Higbee

v. Commissioner, 116 T.C. 438, 446 (2001).    Once respondent meets

his burden of production, petitioner must produce sufficient

evidence to persuade the Court that respondent’s determination is

incorrect.   Id. at 447.

     Section 6651(a)(1) provides for an addition to tax of 5

percent of the tax required to be shown on the return for each

month or fraction thereof for which there is a failure to file,

not to exceed 25 percent.   The addition to tax for failure to

file a return timely will be imposed if the return is not filed

timely unless the taxpayer shows that the delay was due to

reasonable cause and not willful neglect.    Sec. 6651(a)(1).   In

the instant case, the parties stipulated that petitioners filed

the 2000 tax return on March 19, 2002.   Consequently, we must

determine whether petitioners have shown that the delay was due

to reasonable cause and not willful neglect.7

     A delay is due to reasonable cause if the taxpayer exercised

ordinary business care and prudence and was nevertheless unable

to file the return within the prescribed time.    Sec. 301.6651-

1(c)(1), Proced. & Admin. Regs.   “[W]illful neglect” is defined




     7
      We note that the parties have made no contentions and
offered no evidence as to whether petitioners filed a written
statement with respondent pursuant to sec. 301.6651-1(c)(1),
Proced. & Admin. Regs.
                              - 13 -

as a “conscious, intentional failure or reckless indifference.”

United States v. Boyle, 469 U.S. 241, 245 (1985).

     In the instant case, the record demonstrates that

petitioners maintained business records that ultimately provided

the financial information reported on petitioners’ 2000 and 2001

tax returns.   Prior to filing the 2000 tax return, however,

petitioner suffered a debilitating physical ailment, and

petitioner Cynthia A. Burrough Irving suffered a miscarriage.    To

access their electronically stored business records and file the

2000 tax return, petitioners sought and received assistance from

their friend, Scott Yusem.   Mr. Yusem testified credibly that he

helped petitioners file their tax returns because he “had some

knowledge of accounting from running [his own] business” and

petitioners lacked the resources to hire a professional tax-

preparer.   On the basis of the foregoing, we conclude that

petitioners’ delay in filing the 2000 tax return was due to

reasonable cause and not willful neglect.   Accordingly, we hold

that petitioners are not liable for the asserted section

6651(a)(1) addition to tax for failure to file timely with

respect to their 2000 tax year.

     Section 6662(a) imposes a 20-percent accuracy-related

penalty with respect to the portion of any underpayment of tax

attributable to a substantial understatement of income tax.    An

“understatement” is the excess of the amount of tax required to
                                  - 14 -

be shown on the return over the amount of tax that is actually

shown on the return.    Sec. 6662(d)(2)(A).      A “substantial

understatement” of income tax exists if the amount of the

understatement for the taxable year exceeds the greater of (1) 10

percent of the tax required to be shown on the return or (2)

$5,000.8    Sec. 6662(d)(1)(A).    On the basis of the record in the

instant case, we conclude that each of the underpayments for

petitioners’ 2000 and 2001 tax years is attributable to a

substantial understatement of income tax.

     Notwithstanding section 6662(a), section 6664(c)(1) provides

that the accuracy-related penalty shall not apply to any portion

of an underpayment if it is shown that there was reasonable cause

for the taxpayer’s position with respect to that portion and that

the taxpayer acted in good faith with respect to that portion.

The determination of whether a taxpayer acted with reasonable

cause and in good faith within the meaning of section 6664(c)(1)

is made on a case-by-case basis, taking into account all the

pertinent facts and circumstances.         Sec. 1.6664-4(b)(1), Income

Tax Regs.    The most important factor is the extent of the

     8
      Sec. 6662(d)(2)(B) provides that the amount of an
understatement is reduced by any portion for which (1) there was
substantial authority for the taxpayer’s treatment, or (2) the
relevant facts affecting the item’s tax treatment were adequately
disclosed and there is a reasonable basis for the tax treatment.
In light of our holding below that there was reasonable cause for
petitioners’ position and that petitioners acted in good faith,
we need not decide whether petitioners’ understatement is
properly reduced pursuant to sec. 6662(d)(2)(B).
                                - 15 -

taxpayer’s effort to assess his proper tax liability for the

year.    Id.   “Circumstances that may indicate reasonable cause and

good faith include an honest misunderstanding of fact or law that

is reasonable in light of all of the facts and circumstances,

including the experience, knowledge, and education of the

taxpayer.”     Id.

        In the instant case, the record demonstrates that

petitioners used computer software to maintain business records

for Kingdom Kreations during the years in issue and that they

delegated responsibility for maintaining the business records to

employee Monica Mann, who was unavailable to testify.       As noted

above, petitioners required the assistance of Mr. Yusem to access

their electronically stored business records and file their 2000

and 2001 tax returns.     Mr. Yusem testified credibly that the

amounts reported on petitioners’ tax returns were taken directly

from petitioners’ electronic records.     Furthermore, Agent Gomez

testified that petitioner was “very cooperative” during the

audit.     Based on the foregoing, we are satisfied that petitioners

maintained business records to the best of their ability and that

the information reported on their 2000 and 2001 tax returns

reflects the amounts recorded in such business records.      We

conclude that petitioners made a substantial effort to assess

their proper tax liabilities for the years in issue and,

consequently, that petitioners acted with reasonable cause and in
                             - 16 -

good faith for purposes of section 6664(c)(1).   Accordingly, we

hold that petitioners are not liable for section 6662 accuracy-

related penalties with respect to their 2000 and 2001 tax years.

     To summarize, we hold that petitioners are liable for a

deficiency of $32,133 with respect to their 2000 tax year and a

deficiency of $43,431.65 with respect to their 2001 tax year.

However, we hold that petitioners are not liable for the addition

to tax and accuracy-related penalties determined by respondent.

     To reflect the foregoing,


                                      Decision will be entered

                                   under Rule 155.
