                       T.C. Memo. 1998-155



                     UNITED STATES TAX COURT



                CLEO PERFUME, INC., Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 26008-96.                    Filed April 27, 1998.



     David M. Garvin, for petitioner.

     James P. Dawson, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     JACOBS, Judge: Respondent determined a $741,379 deficiency in

petitioner's Federal income tax for tax year ended June 30, 1991,

a $37,068.95 section 6651(a)(1) addition to tax, and a $148,275.80

section 6662(a) accuracy-related penalty.
                              - 2 -


     Following concessions by petitioner,1 the remaining issues for

decision are: (1) Whether petitioner had additional income of

$2,031,778 in its tax year ended June 30, 1991; (2) whether

petitioner is liable for the section 6651(a)(1) addition to tax;

and (3) whether petitioner is liable for the section 6662(a)

accuracy-related penalty.

     All section references are to the Internal Revenue Code in

effect for the year in issue, and all 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.    The

stipulations of facts and the attached exhibits are incorporated

herein by this reference.

Cleo Perfume, Inc.

     Cleo Perfume, Inc. (petitioner or CPI), a Florida corporation,

is engaged in the business of distributing perfume on a wholesale

basis.   Its principal place of business at the time the petition

was filed was Miami, Florida. It employs the accrual method of

accounting and reports its income on the basis of a fiscal year

ending June 30.




     1
          Petitioner conceded that it is entitled to neither a
$65,000 bad debt deduction nor $59,701 in "other deductions".
Petitioner also conceded that it is liable for a $400
environmental tax.
                                    - 3 -


      During the year in issue, petitioner's stockholders were:

Oscar Campos, Sr., president; Oscar Campos, Jr. (Mr. Campos, Sr.'s

son), vice president for sales; and Elisa C. Martinelli (Mr.

Campos, Sr.'s wife), treasurer.

      Petitioner     acquires     perfumes    from     numerous       suppliers,

including Aeroboutique, S.A. (ASA), of San Juan, Puerto Rico.

Between July 1, 1989, and June 30, 1990, ASA sent petitioner

merchandise valued at $2,031,778.           After examining the delivered

merchandise, Messrs. Campos, Jr. and Sr., telephoned Edgar Balzac,

the owner of ASA, threatening to return the merchandise to ASA

because the goods were at the end of their useful shelf life and

therefore   unacceptable.       Following    further   discussion,       Messrs.

Balzac, Campos, Jr., and Campos, Sr., agreed that in lieu of

returning the merchandise, petitioner would keep the perfume on

consignment and would pay ASA only for the merchandise that it was

able to sell.

      By June 30, 1990, CPI was only able to sell approximately

$100,000 of the merchandise received from ASA. (This amount was

properly included in income for the year.)                 Inasmuch as the

majority of the goods could not be sold, a decision was made to

attempt to sell the merchandise the following Christmas season.

The   consigned    merchandise    remained    in   boxes   on   the    racks   in

petitioner's warehouse.
                                 - 4 -


Credit Line With Barnett Bank and Certified Financial Statements

     In 1989, petitioner obtained a $1.5 million line of credit

with Barnett Bank.    A security interest in petitioner's accounts

receivable and inventory and a guaranty by Mr. Campos, Sr., were

given as collateral for this line of credit.         Mr. Campos, Sr.'s

guaranty was secured by a first mortgage on his residence.

     To maintain the line of credit, petitioner was required to

deliver to the bank certified financial statements. Barnett Bank's

credit department    analyzed   the   certified   financial   statements

prepared for petitioner.    On a quarterly basis, Barnett Bank sent

a group of its own auditors to conduct a review of petitioner's

accounts receivable, accounts payable, and inventory in order to

verify the correctness of the certified financial statements as

well as petitioner's books and records.       From 1989 through 1994,

there were no disparities among these various documents.

     Petitioner hired Verdeja, Iriondo & Gravier (VIG), certified

public accountants, to perform the audit and prepare the certified

financial statements for Barnett Bank. Oscar Rosales performed the

initial audit for VIG.     Petitioner later hired Mr. Rosales as its

comptroller.   (Before Mr. Rosales was hired, petitioner never had

a comptroller.)   Mr. Rosales worked for petitioner through 1992.
                              - 5 -


Incorrect Entry

     Mr. Rosales was not involved in the negotiations between

petitioner and ASA. He neither was informed nor independently

discovered that petitioner held the ASA inventory on consignment.

After taking a physical inventory of the goods in petitioner's

warehouse, Mr. Rosales mistakenly included the $2,031,778 ASA

consignment merchandise in petitioner's June 30, 1990, ending

inventory on petitioner's audited financial statements and credited

$2,031,778 to trade accounts payable (reflecting his belief that

petitioner had purchased the goods).   Mr. Rosales did not consult

with either Mr. Campos, Jr. or Sr., when making this entry.

"Correcting Entry"

     Sometime in April 1991, Mr. Rosales questioned why the trade

account payable to ASA recorded on the books remained unpaid.   Mr.

Campos, Sr. informed Mr. Rosales that there was no payable due ASA.

Mr. Rosales then stated that he would correct the books and remove

the payable.   However, instead of debiting accounts payable and

crediting beginning inventory, Mr. Rosales debited accounts payable

and credited paid-in capital (reflecting his belief that the

shareholders had assumed the liability from the account payable to

ASA). A physical inventory was taken at yearend June 30, 1991, and
                                   - 6 -


the consigned merchandise, less $100,000 which had been sold,

remained on hand.

     VIG, which prepared the financial statements for tax year

ended June 30, 1991, inquired in July 1991 as to why the $2,031,778

of trade accounts payable had been eliminated from the books.          Mr.

Rosales represented that CPI's officers had assumed responsibility

for the debt and that the amount was recorded as additional paid-in

capital.   VIG   requested   and     received   a   letter2   signed    by


     2
           The letter states:

           In connection with the audit of the financial
           statements of Cleo Perfumes, Inc., for the
           years ended June 30, 1990 and 1991, we have
           made available to you all information related
           to stockholder's equity.

           During 1991, the Company's stockholders
           assumed personally and subsequently
           capitalized as part of paid-in capital a note
           receivable from stockholder in the amount of
           $371,157, a trade accounts payable to an
           unaffiliated company in the amount of
           $2,031,778, and a note payable to bank in the
           amount of $200,000. The netting of these
           transactions increased paid-in capital by
           $1,860,621.

           The undersigned stockholders of Cleo
           Perfumes, Inc. hereby confirm to you that the
           afore-mentioned [sic] transactions were in
           due time properly and adequately approved by
           the Board of Directors and also that Mr.
           Oscar Campos, Sr., President of our
                                                    (continued...)
                                     - 7 -


petitioner's stockholders, dated July 15, 1991, confirming that the

obligation had been assumed by petitioner's stockholders and that

the comptroller had been authorized to write off the debt.

     On August 15, 1991, VIG also sent a letter to ASA requesting

confirmation that petitioner was not indebted to ASA. On September

13, 1991, ASA confirmed that petitioner had an outstanding balance

of zero as of June 30, 1991.

Destruction of Remaining ASA Merchandise

     Sometime in 1993, Martha Balzac (vice president of ASA and Mr.

Balzac's   wife)   visited    petitioner's     offices    and   informed   Mr.

Campos, Sr.,   that   he     could   destroy   the   remaining    unsold   ASA

consignment merchandise.       Accordingly, in 1995,3 CPI destroyed all

of the remaining approximately $1.8 million of ASA merchandise. On

its computer-generated June 30, 1991, inventory listing, petitioner

identified   the    discarded        merchandise     by   highlighting     the

merchandise in yellow.

New Accounting Firm


     2
      (...continued)
          Corporation, was duly authorized to take all
          actions required to implement the related
          resolutions.

     3
          The record is unclear as to why petitioner waited 2
years to destroy the unsold ASA merchandise.
                                        - 8 -


       Petitioner hired Smith, Ortiz, Gomez & Buzzi, P.A. (SOGB), to

audit its tax years ended June 30, 1992, 1993, and 1994, and

prepare certified financial statements for those years.                   SOGB was

not informed that the ASA goods were on consignment.

Federal Income Tax Returns

       VIG prepared petitioner's Federal income tax return for tax

year    ended    June   30,     1990,   based   on   its    certified    financial

statement for that year.          This return reported beginning inventory

of $2,389,349, ending inventory of $4,065,376, and purchases of

$12,093,315.

       On approximately September 13, 1991, petitioner filed a Form

7004,    Application      for    Automatic      Extension    of   Time    To   File

Corporation Income Tax Return, requesting a 6-month extension.                  On

March 23, 1992, respondent received petitioner's return for tax

year ended June 30, 1991.

       VIG also prepared petitioner's return for tax year ended June

30, 1991, based on its certified financial statement for that year.

This return reported beginning inventory of $4,065,376, ending

inventory       of   $3,074,506,    and   purchases    of     $11,700,786.      No

discharge of indebtedness income related to the $2,031,778 ASA

trade account payable was reported on this return.

        Petitioner's return for tax year ended June 30, 1992, was

based on petitioner's 1992 certified financial statements for that
                                          - 9 -


year.        This return reported beginning inventory of $3,074,506,

ending inventory of $3,673,423, and purchases of $13,758,337.

     On its return for tax year ended June 30, 1993, petitioner

adjusted      the    beginning      inventory     to   correct    the    "correcting"

journal entry Mr. Rosales made by reducing by $1,860,621 beginning

inventory and paid-in capital.

Notice of Deficiency

     In      the    notice    of    deficiency,     respondent     determined    that

petitioner was liable for a $741,379 deficiency on the theory that

it was relieved of a $2,031,778 liability during the tax year ended

June 30, 1991.         Respondent also determined a section 6651(a)(1)

addition to tax and a section 6662(a) accuracy-related penalty.

                                          OPINION

Issue 1. Additional Income

     Our       first   task    is    to    determine    whether     petitioner    had

additional income of $2,031,778 in its tax year ended June 30,

1991.         In    this   regard,     respondent      makes     three    alternative

arguments.

        A.    Discharge of Indebtedness Income

     Section 61(a)(12) provides the general rule that gross income

includes income from the cancellation of indebtedness.                     Generally,

the amount of income includable is the difference between the face

value of the debt and the amount paid in satisfaction of the debt.
                                           - 10 -


Babin v. Commissioner, 23 F.3d 1032, 1034 (6th Cir. 1994), affg.

T.C.       Memo.   1992-673.       The     income    is    recognized    in   the    year

cancellation occurs.           Montgomery v. Commissioner, 65 T.C. 511, 520

(1975).

       Respondent asserts that petitioner had a debtor relationship

with ASA, beginning on the date the goods were delivered in 1990

until       some   point     in    1991,     when    the    debt   was    discharged.

Continuing, respondent contends that there was a discharge of

$2,031,778 of indebtedness which, from a tax viewpoint, resulted in

discharge of indebtedness income to petitioner. Petitioner, on the

other hand, maintains that it never purchased the ASA perfume but

only held the merchandise on consignment. Consequently, petitioner

asserts there was no debt to be forgiven.

       We     agree   with     petitioner's         position    that     it   held   the

merchandise from ASA on consignment.                  Consequently, we find that

there was no debt owed to ASA by petitioner;4 thus, no debt

forgiveness occurred.             Accordingly, we dismiss respondent's first

argument that petitioner had discharge of indebtedness income.

       B.     Tax Benefit Rule

       The tax benefit rule includes an amount in current income to

the extent that: (1) The amount was properly deducted in a year


       4
          We recognize that pursuant to the auditor's request,
petitioner's shareholders signed a letter acknowledging their
assumption of a liability due ASA. Nonetheless, we accept Mr.
Campos, Sr.'s testimony that the letter was signed knowing that
there was no actual debt owing by petitioner to ASA.
                                              - 11 -


prior to the current year, (2) the deduction resulted in a tax

benefit,        (3)     an     event      occurs    in    the    current   year    that     is

fundamentally inconsistent with the premises on which the deduction

was originally based, and (4) a nonrecognition provision of the

Internal Revenue Code does not prevent the inclusion in gross

income.         Hillsboro Natl. Bank v. Commissioner, 460 U.S. 370, 383-

384 (1983); see Gold Kist, Inc. v. Commissioner, 110 F.3d 769, 772

(11th Cir. 1997), revg. per curiam 104 T.C. 696 (1995); Frederick

v. Commissioner, 101 T.C. 35, 41 (1993).                            A current event is

fundamentally inconsistent with the premises on which the deduction

was originally based when that event would have prevented the

deduction if the event had occurred in the year of the deduction.

Hillsboro            Natl.    Bank     v.    Commissioner,        supra;    Frederick       v.

Commissioner, supra.

       Respondent            asserts      that    petitioner      improperly      derived    a

$2,031,778           tax     benefit      because    that   amount    was    treated      (on

petitioner's books) as a purchase and consequently petitioner's

cost       of   goods        sold   for     the    year   ended    June    30,    1990,   was

overstated.            Petitioner disagrees, claiming that even though its

purchases were overstated, the ASA merchandise was included in

petitioner's           ending       inventory       and   thus    there     was    a   wash.5


       5
                 Cost of goods sold is generally determined as follows:

                           Beginning inventory
                 +         Purchases
                                                                           (continued...)
                                      - 12 -


Respondent claims that there is no evidence to prove the ASA

merchandise was included in petitioner's ending inventory for the

tax year ended June 30, 1990 or 1991.

       We    conclude   that    the   ASA   merchandise       was    included     in

petitioner's ending inventory for the tax years ended June 30, 1990

and 1991, and hence petitioner's cost of goods sold for those years

was not overstated.         Thus, petitioner received no tax benefit as a

result of mistakenly treating and reporting the ASA consigned

merchandise as a purchase.

       In reaching our conclusion that the ASA merchandise was

included in petitioner's 1990 and 1991 ending inventory, we find

that       Mr.   Rosales,    petitioner's      comptroller,         recorded     the

transaction consistent with his understanding that the consigned

goods were acquired by purchase, and thus he included all unsold

goods in inventory.         We find compelling that on petitioner's tax

return filed for the year ended June 30, 1993, petitioner made an

adjustment to its beginning inventory when it realized the error in

its reporting of the consigned goods. (Rather than carry over the

ending      inventory   balance   for   the    year   ended    June    30,     1992,

petitioner reduced beginning inventory for the year ended June 30,




       5
        (...continued)
                 Total goods available for sale
            -    Ending inventory
                 Cost of goods sold
                                 - 13 -


1993, by $1,860,621--the exact amount of the erroneous adjustment

Mr. Rosales made in the year ended June 30, 1991.)

      C.   Duty of Consistency

      The duty of consistency (also known as the doctrine of quasi-

estoppel) prevents a party from benefiting in a subsequent year

from an error that was made in a prior year.             See Southern Pac.

Transp. Co. v. Commissioner, 75 T.C. 497, 559-560 (1980).          When the

duty of consistency applies, the taxpayer must recognize income

even though the earlier deduction was improper.           Id. at 560.

      The duty of consistency applies when:        (1) The taxpayer made

a   representation   or   reported   an   item   for   Federal   income   tax

purposes in one year, (2) the Commissioner acquiesced in or relied

on that representation or report for that year, and (3) the

taxpayer attempts to change that representation or report in a

subsequent year, after the period of limitations has expired with

respect to the year of the representation or report, and the change

is detrimental to the Commissioner.         Herrington v. Commissioner,

854 F.2d 755, 758 (5th Cir. 1988), affg. Glass v. Commissioner, 87

T.C. 1087 (1986).         When the duty of consistency applies, the

Commissioner may proceed as if the representation or report on

which the Commissioner relied continues to be true, although in

fact it is not.    The taxpayer is estopped from taking a position to

the contrary.     Herrington v. Commissioner, supra.
                                      - 14 -


        Respondent contends that the duty of consistency is applicable

herein.     Petitioner disagrees.

        We conclude that the duty of consistency is not applicable

under the facts herein.            There was no erroneous deduction in a

prior    year   which   respondent      acquiesced    in   or    relied    on   to

respondent's detriment. As stated above, petitioner's misreporting

of the treatment of the consigned goods resulted in a wash when

calculating the cost of goods sold deduction such that petitioner

did not receive any benefit and respondent did not suffer any

detriment.      Respondent has not suggested any other reason why the

inflated inventory balances would cause respondent to fail to

collect the correct amount of tax.         Consequently, we hold that the

duty of consistency is inapplicable.

     In sum, we hold that petitioner did not have additional income

of $2,031,778 in its tax year ended June 30, 1991.

Issue 2.     Section 6651(a)(1) Addition to Tax

        We next determine whether petitioner is liable for an addition

to tax for failure to timely file its 1991 return.                        Section

6651(a)(1) imposes an addition to tax of 5 percent of the amount of

tax due per month for each month that a tax return is not timely

filed,    not   to   exceed   25    percent.   An    exception    is   made     for

reasonable cause not due to willful neglect.

        One of the requirements of the automatic extension of time to

file a tax return is the proper estimation of the final tax
                                      - 15 -


liability for the taxable year.           Sec. 1.6081-4(a)(4), Income Tax

Regs.    The failure to estimate properly the final tax liability on

Form 7004 can invalidate the automatic extension and subject the

taxpayer to an addition to tax pursuant to section 6651(a)(1) for

failure to timely file the return.             Crocker v. Commissioner, 92

T.C. 899 (1989). Respondent argues that petitioner failed to

estimate properly its tax liability on Form 7004 when it filed for

the automatic extension, and thus the extension is invalid.

        We agree.     Petitioner failed to report any tax liability on

its     application.        Putting    aside    petitioner's    concessions,

petitioner reported a $52,180 tax liability on its tax return for

year ended June 30, 1991, despite the fact that it estimated "0" on

its application.

        Moreover, petitioner has failed to present any evidence on

this issue (other than to contend that it is not liable for the

addition) and has accordingly failed to satisfy its burden of

proof.     Clearly, petitioner has failed to show that it estimated

properly the final tax liability on Form 7004.         See, e.g., Scott v.

Commissioner,       T.C.   Memo.   1997-507.    Consequently,    we   sustain

respondent's determination.

Issue 3.    Section 6662(a) Accuracy-Related Penalty

        The final issue is whether petitioner is liable for the

section 6662(a) accuracy-related penalty.          Section 6662 imposes an

accuracy-related penalty equal to 20 percent of any portion of an
                                 - 16 -


understatement attributable to a substantial understatement.            A

substantial understatement means an understatement which exceeds

the greater of 10 percent of the tax required to be shown on the

return or $5,000.   Sec. 6662(d)(1).      The understatement is reduced

by that portion of the understatement for which the taxpayer had

substantial   authority   or    for   which   the   taxpayer   adequately

disclosed the relevant facts in the return.         Sec. 6662(d)(2)(B).

Additionally, no penalty is imposed with respect to any portion of

an understatement as to which the taxpayer acted with reasonable

cause and in good faith.       Sec. 6664(c)(1).     Section 1.6664-4(b),

Income Tax Regs., provides that reliance on professional advice

constitutes reasonable cause and good faith if, under all the

circumstances, the reliance was reasonable and the taxpayer acted

in good faith. The taxpayer, however, must disclose to the adviser

all relevant facts regarding the proper tax treatment of an item in

order to be able to invoke the professional reliance exception.

     Although petitioner retained the services of a tax return

preparer, it did not disclose the relevant facts to the preparer.

Accordingly, petitioner is liable for the section 6662(a) accuracy-

related penalty with regard to the items it conceded.

     To reflect the foregoing and petitioner's concessions,



                                                    Decision will be

                                              entered under Rule 155.
- 17 -
