                          T.C. Memo. 1997-57



                       UNITED STATES TAX COURT



           SANTAR S. YEI AND GRACE H. YEI, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 22375-93.                       Filed January 30, 1997.



     Santar S. and Grace H. Yei, pro sese.

     Dale A. Zusi and Andrew P. Crousore, for respondent.



                          MEMORANDUM OPINION


     JACOBS, Judge:    Respondent determined a $22,476 deficiency in

petitioners' 1989 Federal income tax and a $4,495 accuracy-related

penalty under section 6662(a).

     Following concessions by respondent, two issues remain for

decision   from   respondent's   notice   of   deficiency:   (1)   Whether
                                        -2-

petitioners properly claimed a $60,000 capital loss as a result of

petitioner Santar Yei's surrender of 60,000 shares of stock in

Cirtex, Inc. (Cirtex) to Cirtex, and (2) whether petitioners are

liable for the accuracy-related penalty under section 6662.

       We must also decide the following matters, which petitioners

raised in their petition: (1) Whether petitioners may reclassify as

a repayment of loans (and treat as nontaxable) $45,000 of the

$84,000 they reported as wage income; (2) whether petitioners are

entitled to an $18,241 deduction in 1989 to offset dividend income

that they received from Cirtex and reported in 1988; (3) whether

petitioners may claim bad debt deductions for: (a) a $9,100 payment

they made to Albert Chang on behalf of Cirtex to purchase his stock

in Cirtex, (b) a $1,500 loan they made to Cirtex to permit that

company to purchase shares of its stock that were owned by Ba Cac

Luong, (c) a $4,000 loan they made on Cirtex's behalf to Esstec,

and (d) $1,500 reported as income from the sale of an automobile

that petitioners claim they never received; (4) whether petitioners

are entitled to a $1,600 deduction as an unreimbursed business

expense   for    the   purchase   of    Cirtex   stock   held     by   Katherine

Cunningham; and (5) whether petitioners may reduce the amount of

gain   they     reported   from   the    sale    of   Solectron    Corporation

(Solectron) stock by $19,000, which amount petitioners gave to

family members.

       All section references are to the Internal Revenue Code for

the year under consideration.          All Rule references are to the Tax
                                       -3-

Court Rules of Practice and Procedure.

      For convenience and clarity, we have combined our findings of

fact and opinion with respect to each issue.                Some of the facts

have been stipulated and are so found.               The stipulation of facts

and   the    attached     exhibits    are    incorporated       herein    by   this

reference.

                              General Findings

      Petitioners,       husband     and     wife,    resided     in     Milpitas,

California, at the time they filed their petition.                     Petitioners

timely filed a joint Federal income tax return for 1989, the year

under consideration.        They filed an amended return for 1989 on

April 15, 1992.

      Petitioner wife, Grace Yei, has a bachelor's degree from

Taiwan University and a master's degree in business administration

from Golden Gate University. She passed the written portion of the

C.P.A. examination following completion of her course work at

Golden Gate University but did not pursue certification.

      Petitioner husband, Santar Yei, completed 4 years of college

in Taipei, Taiwan, majoring in mathematics. He obtained a master's

degree in computer engineering from San Jose State University.

      Mr. Yei worked for Solectron, located in San Jose, California,

while obtaining his master's degree.           In 1979, he purchased 10,000

shares of Solectron stock from that company for $10,000 with money

from his father.        In 1989, he tendered 19,998 shares of Solectron

stock to Solectron (pursuant to Solectron's offer to purchase) and
                                   -4-

received $99,990 therefor.1

     In 1984, Mr. Yei acquired a controlling interest in Cirtex, a

circuit board manufacturer located in Santa Clara, California, and

became its president.    Mrs. Yei maintained the company's books and

records.   Cirtex had approximately 80 employees in the mid-1980's,

but that number fell to less than 10 by 1989 because of financial

difficulties.     The company's problems, including environmental

contamination at the company's manufacturing plant, brought about

several lawsuits. Cirtex was dissolved on May 22, 1992.

     We note that for all of the issues, petitioners have the

burden of proving error in respondent's determinations.              Rule

142(a); Welch    v.   Helvering,   290   U.S.   111   (1933).   Moreover,

deductions are a matter of legislative grace, and petitioners bear

the burden of proving they are entitled to any deductions claimed.

See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).

Issue 1.    Stock Sale

     Pursuant to a written agreement dated December 9, 1989, Mr.

Yei surrendered (for cancellation) 60,000 shares of Cirtex stock to

Cirtex.    He received no money in connection with this transaction.

According to the December 9, 1989, agreement, Mr. Yei surrendered

     1
          Although the record is far from clear with respect to
this matter, it appears that from the time Mr. Yei acquired the
10,000 shares of Solectron stock in 1979 to the date he tendered
his stock to Solectron, there had been a 3 for 1 stock split or
dividend and a subsequent 2 for 3 reverse (downward) stock split.
Hence, we believe that in 1989, Mr. Yei owned 19,998 shares of
Solectron stock all of which he tendered to the Company at $5 a
share (the tender price).
                                           -5-

the 60,000 shares so that a like amount could be subsequently sold

by the corporation in order "to ease the cash flow problem caused

by buying back from old investor Mr. Chang $60,000 worth of common

stock."2    Petitioners claimed a $60,000 capital loss on Schedule D

of their 1989 return as a result of the surrender of the Cirtex

stock.      Respondent determined that section 267 precluded the

deductibility of the claimed loss.

     We agree with respondent's determination that petitioners are

not entitled to the claimed loss, but not for the reason stated by

respondent.        It is settled law that a dominant (controlling)

shareholder who voluntarily surrenders a portion of his stock to

the corporation, and continues to retain control, does not sustain

an immediate loss deductible for income tax purposes as a result of

the surrender of stock.          Rather, the surrendering shareholder must

reallocate      his    basis   in    the    surrendered    stock   to   the   stock

retained.       Commissioner v. Fink, 483 U.S. 89 (1987).

     On the date that Mr. Yei surrendered his Cirtex stock, he and

members    of    his    family      owned    more   than   50   percent   of    the

corporation's stock.           There is nothing in the record to indicate

     2
          Although the record is not clear with respect to this
matter, it appears that in 1988, Cirtex sold 62,500 shares of its
stock to a Mr. Albert Chang for $100,000 ($1.60 per share). The
$100,000 received from Mr. Chang was used by the corporation, in
part, to redeem its stock from other individuals, and in part, to
fund payment of a corporate dividend. Apparently, Mr. Chang
complained that the corporation improperly used his money and in
1989, Cirtex purchased the stock Mr. Chang owned for $110,000, as
follows: $60,000 in cash and a $50,000 interest-bearing
corporate note.
                                   -6-

that after the surrender of the Cirtex stock, Mr. Yei and members

of his family did not retain control of Cirtex.           Indeed, Cirtex's

corporate income tax returns (Forms 1120) for the corporation's

fiscal years ended November 30, 1989 and 1990 reflect that Mr. Yei

owned more than 50 percent of Cirtex's stock.

      Petitioners claim, in the alternative, that they are entitled

to a $60,000 loss deduction under section 165(a), contending that

the Cirtex stock became worthless in 1989.          Section 165(a) permits

the deduction of any loss sustained during the taxable year that is

not compensated for by insurance or otherwise.              Section 165(g)

provides that if a security which is a capital asset becomes

worthless during the taxable year, the loss is treated as a loss

from the sale or exchange of a capital asset on the last day of the

taxable year. Worthlessness of stock is determined both by lack of

liquidating value and the absence of any reasonable expectation

that the stock will become valuable in the future.                Morton v.

Commissioner, 38 B.T.A. 1270 (1938), affd. 112 F.2d 320 (7th Cir.

1940). Certain events such as bankruptcy, cessation of business,

liquidation of the corporation, or appointment of a receiver may

foreclose an expectation of future value. Id.; see also Austin Co.

v. Commissioner, 71 T.C. 955 (1979).

      In the instant case, no evidence was presented indicating that

Cirtex was insolvent in 1989.     Nor was any evidence presented as to

the   occurrence   of   an   identifiable   event    in   1989   that   would

foreclose the expectation of future value with respect to the
                                  -7-

Cirtex stock. Although Mrs. Yei testified that the company had not

been profitable since 1984, her testimony is contradicted by Mr.

Yei's statements made in a stockholders' report that Cirtex had an

$80,000 profit in 1988.    In his report, given at a stockholders'

meeting on June 10, 1989, Mr. Yei stated:

           For 1989, our new philosophy becomes more
           conservative. The objective is to give
           stockholders some returns, especially those
           who had invested for more than three years. *
           * * If we can maintain a profit level at 10-
           15%, our stock [price] per share shall have a
           market value between $2.00 to $3.00.

     In any event, Fink contemplated that no loss deduction is

available to a controlling shareholder who voluntarily surrenders

a   portion   of   his   stock   "before   the   corporation   fails".

Commissioner v. Fink, 483 U.S. at 98.      Accordingly, respondent's

disallowance of the claimed $60,000 capital loss is sustained.

Issue 2.   Wage Income

     Petitioners reported combined wages of $84,000 from Cirtex in

1989.   They contend that $45,000 of the $84,000 reported as wages

represent the repayment of loans they made in 1986 and 1989.       In

the alternative, they claim entitlement to a $45,000 bad debt

deduction under section 166.     Respondent contends that the $45,000

in payments that petitioners made to Cirtex constitute capital

contributions, not loans, and that the entire $84,000 constitutes

wages as reported on petitioners' 1989 return.

     Petitioners claim they advanced Cirtex a total of $40,000 in

1986 and $5,000 in 1989.   According to petitioners, these payments
                                 -8-

were made because the company had cash flow problems. The payments

made in 1986 are evidenced by 4 demand notes; the payment made in

1989 is not evidenced by any note.     Mrs. Yei's notation on one of

the 1986   promissory notes states, "treat it [the amount of the

payment] as paid in capital". Mrs. Yei testified that the payments

were treated as capital, at the recommendation of the corporation's

outside accountant, in order to make Cirtex's financial statements

"look better".

     Cirtex treated the $84,000 paid to petitioners as salaries,

and reported such amount on Forms 940 and 941 as business expenses.

     We find that the $84,000 petitioners received from Cirtex was

wage income.   Indeed, the wage amount in 1989 was in line with the

amount reported in 1988 ($83,539).

     We now turn to petitioners' alternative position.        Section

166 permits as a deduction any debt that becomes worthless within

the taxable year.    Only a bona fide debt can be deducted.    A bona

fide debt is a debt that arises from a debtor-creditor relationship

based upon a valid and enforceable obligation to pay a fixed or

determinable sum of money.       A contribution of capital is not

considered a debt for section 166 purposes.        Sec. 1.166-1(c),

Income Tax Regs.    Whether a transfer of money creates a bona fide

debt depends upon the intent of the parties involved in the

transaction.     Delta Plastics Corp. v. Commissioner, 54 T.C. 1287,

1291 (1970).

     Petitioners failed to prove that the $45,000 they transferred
                                       -9-

to Cirtex in 1986 and 1989 was intended to or did create a bona

fide debt Cirtex owed them. The promissory notes by themselves are

insufficient to prove the existence of a bona fide debt, especially

in view of Mrs. Yei's notation on one of the notes that it is to be

treated    as   capital    and   her   testimony    to    a   similar   effect.

Moreover, we are mindful that Cirtex's corporate returns failed to

include any loans to shareholders in the appropriate space.                  We

conclude that the $45,000 constitutes a contribution by petitioners

to the capital of Cirtex and is not allowable to petitioners as a

bad debt deduction.

Issue 3.    Dividend Income

     Petitioners claim they are entitled to an $18,241 deduction in

1989 to offset a distribution from Cirtex that they contend was

erroneously     reported    as   a     dividend    on    their   1988   return.

Petitioners' reasoning with respect to this issue is difficult to

comprehend.

     As best we can understand petitioners, they received an

$18,241 payment from Cirtex in 1988 and reported it as a dividend

on their return for that year.           They now contend that Cirtex did

not have earnings and profits in 1988 and should not have paid a

dividend, even though Mr. Yei stated at the stockholders' meeting

that the company had profits of $80,000 that year.3                Petitioners

argue that      the payment Cirtex made was funded by a capital

     3
          Petitioners claim that the $80,000 referred to at the
meeting was earnings before depreciation.
                                  -10-

contribution from Albert Chang, which they now apparently claim was

improper.    See infra note 2.

     Whether the 1988 payment was properly reported in 1988 is

outside our jurisdiction in this case. We do not have jurisdiction

to consider a claimed overpayment on petitioners' 1988 return

because the notice of deficiency at issue covers only 1989.     See

sec. 6213(a); Commissioner v. Gooch Milling & Elevator Co., 320

U.S. 418 (1943).      Petitioners' reporting of the payment as a

dividend for 1988 does not entitle them to an offset against their

income for 1989.

Issue 4.    Bad Debt Deductions

     Petitioners claim they are entitled to bad debt deductions in

1989 for:   (a) A $9,100 payment they made to Albert Chang on behalf

of Cirtex to purchase his Cirtex shares; (b) a $1,500 loan they

made to Cirtex to permit that company to purchase shares of its

stock owned by Ba Cac Luong; (c) a $4,000 loan they made on

Cirtex's behalf to Esstec; and (d) $1,500 reported as income from

the sale of an automobile that they never received.

     The basis for the first two items involves the purchase of

Cirtex stock from two separate investors (Albert Chang and Ba Cac

Luong).    Mr. Yei testified that he felt responsible for any losses

the investors sustained and agreed to repurchase personally, or

have the company repurchase, the stock when an investor complained

that the value of the stock fell below the original purchase price.

     As best we can determine from the record, Mr. Chang demanded
                                    -11-

that Cirtex purchase his Cirtex shares after his employment with

the company terminated.     Mr. Chang's accountant advised Mr. Chang

that Cirtex improperly used his $100,000 investment to pay a

dividend to existing stockholders and to purchase shares held by

some of them.    Cirtex agreed to purchase from Mr. Chang the Cirtex

stock he owned.      Mr. Chang received cash and a corporate note for

his Cirtex stock. Because of a lack of corporate funds, petitioner

paid Mr. Chang, in 1989, $9,100 that Cirtex owed him pursuant to

the corporate note.

     Petitioners were not legally obligated to make any payments to

Mr. Chang on behalf of Cirtex.        They were neither the makers nor

the guarantors of the note obligation. A corporation's business is

distinct from that of its stockholders; here, petitioners' payment

to Mr. Chang helped to discharge the obligation of Cirtex to Mr.

Chang and was in the nature of a capital contribution.        Petitioners

have not shown that the payment created a bona fide debt from the

corporation     to   petitioners.      Thus,   petitioners'    claim   of

entitlement to a bad debt deduction with respect to the payment to

Mr. Chang is incorrect.

     Petitioners claim that they advanced Cirtex $1,500 in July

1989 in order for the company to purchase 2,000 shares of its stock

held by Ba Cac Luong.     The only evidence with respect to the $1,500

is a piece of paper containing a photostat of a checkbook register

and a handwritten statement "7/12/89 paid to Ba Cac Luong for

$3,500 for Cirtex--$1,500 was never reimbursed."          There is no
                                        -12-

indication that any of the $3,500 was a loan from petitioners to

Cirtex.     Assuming that the $3,500 was a loan, and not a capital

contribution, petitioners offered no evidence to prove that the

unreimbursed portion ($1,500) became worthless. Petitioners failed

to satisfy their burden of proof establishing the existence of the

claimed loan as well as the year in which the purported loan became

worthless.     They are thus not entitled to a bad debt deduction with

respect to this purported loan.

        Petitioners    claim      they     paid     $4,000       to     Esstec,   a

nonincorporated business, on behalf of Cirtex.                        The owner of

Esstec, Stephen Williams, also was a Cirtex employee and had rented

space in Cirtex's building. Cirtex did not provide a note to

evidence petitioners' payment on its behalf.                 The only evidence

presented was petitioners' check, dated July 11, 1988, made payable

to Esstec.     The notation at the bottom of the check stated "Esstec

loan".     Mrs. Yei testified that Esstec went out of business in

1989,    but   her    testimony    in    this     regard   was    not    credible.

Petitioners did not satisfy their burden of proof to establish the

identity of the borrower, the existence of a loan, or the year in

which the purported loan became worthless.                 Thus, they are not

entitled to a bad debt deduction with respect to this purported

loan.

     Petitioners sold an automobile to Stephen Williams for $2,000

in 1988, reporting $500 in income on their 1988 return and $1,500

in income on their 1989 return.            Petitioners claim that they did
                                        -13-

not receive the $1,500 from Mr. Williams in 1989 and thus are

entitled to a bad debt deduction.             Mrs. Yei testified that she did

not   ask   her    husband    about    the   receipt    of    the    payment     until

preparing their petition, which was filed with the Court on October

18, 1993. We accept Mrs. Yei's testimony and find that petitioners

erroneously       reported    $1,500   as    income    on    their   1989      return.

Correction    of    this     mistake   should    be    made    in    the   Rule    155

computation.

Issue 5.    Unreimbursed Expense

      Mr. Yei gave 1,000 shares of his Cirtex stock to Katherine

Cunningham,       Cirtex's    quality       control    manager,      as    a    bonus.

Allegedly, the stock was given, rather than cash, due to Cirtex's

cash flow problems.        When Ms. Cunningham left the company's employ

in 1989, petitioners paid her $1.60 per share for the stock, again

due to the fact that Cirtex did not have funds to purchase the

stock and Mr. Yei's perceived personal obligation to compensate Ms.

Cunningham with cash.         Petitioners contend they are entitled to a

deduction for the $1,600 given Ms. Cunningham as an unreimbursed

business expense under section 162.             Respondent contends that the

Cirtex stock petitioners acquired is a capital asset for which

petitioners are not entitled to a deduction.

      Section 162 permits the deduction of ordinary and necessary

expenses paid or incurred in carrying on a trade or business.

Bonuses to employees will constitute allowable deductions from

gross income when such payments are made as additional compensation
                                      -14-

for services actually rendered by the employees.                Sec. 1.162-9,

Income Tax Regs. Ms. Cunningham was a Cirtex employee and rendered

services to the company, not to petitioners.          Although petitioners

were corporate officers, their personal payment of an employee

bonus would not be an ordinary and necessary expense of their

office.      See   Grossman   v.    Commissioner,   T.C.   Memo.    1974-269.

Further, petitioners received stock from Ms. Cunningham in exchange

for their $1,600 payment.          Accordingly, we hold that petitioners

may not deduct the cost of the stock purchase.

Issue 6.     Solectron Stock Basis

     On their 1989 return, petitioners reported a $10,000 basis in

their Solectron stock.        They now contend that their basis in the

Solectron stock, which Mr. Yei sold for $99,990 in 1989, should be

increased from $10,000 to $29,000 to reflect $19,000 in payments

petitioners made to family members.             As best we can understand

petitioners' position, they claim that Mr. Yei's father in effect

owned the Solectron stock because he loaned the money for its

purchase to petitioners.        They further claim that the $19,000 in

payments to family members represents part of the cost of their

debt to Mr. Yei's father.          Respondent takes the position that the

basis   of   petitioners'     stock   remains   $10,000,   as    reported   on

petitioners' tax return.

     There is no question but that the cost of the stock is

$10,000.     The stock was issued to Mr. Yei, and he used the stock to

secure a lease on the building Cirtex used.          Mr. Yei's father did
                                 -15-

not own the stock.

     The basis of property acquired through purchase generally is

its cost.   Sec. 1012; sec. 1.1012-1(a), Income Tax Regs.     There is

nothing about the $19,000 in payments to family members to suggest

that such payments be allocated to the cost basis of the stock.

The $19,000 was paid to family members who had no ownership

interests in the Solectron stock.       Accordingly, we hold that the

Solectron stock basis is $10,000, as reported on petitioners' tax

return.

Issue 7.    Accuracy-Related Penalty

     Respondent    determined   an   accuracy-related   penalty   under

section 6662(a).     Section 6662 imposes a penalty equal to 20

percent of the portion of the underpayment that is attributable to

negligence or disregard of rules or regulations.        Sec. 6662(a),

(b)(1).

     Negligence is defined as the failure to exercise the due care

that a reasonable, prudent person would exercise under similar

circumstances.    Zmuda v. Commissioner, 731 F.2d 1417, 1422 (9th

Cir. 1984), affg. 79 T.C. 714 (1982); Neely v. Commissioner, 85

T.C. 934, 947 (1985).    A taxpayer has the burden of proving that

respondent's determination is in error.     Luman v. Commissioner, 79

T.C. 846, 860-861 (1982).

     Petitioners each have graduate college degrees. Mrs. Yei, who

prepared petitioners' 1989 tax return, while not a C.P.A., passed

the written portion of the C.P.A. examination.     Mrs. Yei testified
                                  -16-

that their income tax returns contain "so many mistakes" that she

did not want them admitted into evidence.       Her casual approach to

tax return preparation is illustrated by her testimony concerning

the Cirtex corporate returns:     "There's a lot of hiding figure, or

hiding fact elicited in this return. * * * we have to file, so we

file something."

     Based on the record before us, we conclude that petitioners

were negligent and disregarded rules or regulations in preparing

their 1989 return.    Accordingly, petitioners are liable for the

accuracy-related penalty on the entire underpayment for 1989.

     To   reflect   concessions   by     respondent,   as   well   as   the

foregoing,



                                              Decision will be entered

                                         under Rule 155.
