                         T.C. Memo. 2010-96



                     UNITED STATES TAX COURT



          JERRY A. AND MARJO E. NELSON, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 12119-08.                Filed May 4, 2010.



     Daniel J. Frisk, for petitioners.

     Blaine Holiday, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GUSTAFSON, Judge:   The Internal Revenue Service (IRS) issued

to petitioners Jerry A. and Marjo E. Nelson a statutory notice of

deficiency on February 13, 2008, pursuant to section 6212,1



     1
      Unless otherwise indicated, all citations of sections refer
to the Internal Revenue Code of 1986 (26 U.S.C.), as amended, and
all citations of Rules refer to the Tax Court Rules of Practice
and Procedure.
                                - 2 -

showing the IRS’s determination of a deficiency of $2,910,322 in

their joint income tax for 2003 and an accuracy-related penalty

of $582,064.40 under section 6662(a).    After concessions, the

issues for decision are:    (i) whether amounts paid by the

Nelsons’ limited liability companies are deductible, either as

fees pursuant to section 162 or as interest expenses pursuant to

section 163; and (ii) whether the Nelsons are liable for the

accuracy-related penalty pursuant to section 6662(a).    On the

basis of the facts proved at trial, the Nelsons are not entitled

to deduct most of the disputed amounts, and they are liable for

the penalty.

                           FINDINGS OF FACT

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

The stipulation of facts filed September 15, 2009, and the

attached exhibits are incorporated herein by this reference.      The

Nelsons resided in North Dakota at the time they filed their

petition.   Trial of this case was held in St. Paul, Minnesota, on

September 15 and 16, 2009.

Bank conversions

     In 2003 numerous mutual savings and loan associations

proposed to go public as corporate banks, and they offered their

account holders options to purchase the new stock at advantageous

prices.   Petitioner Jerry Nelson arranged for loans to be made to

these account holders in return for a share of the profit they
                                 - 3 -

could realize upon a prompt sale of the newly acquired stock,

which share Mr. Nelson refers to as “interest”.2   To obtain funds

to lend to these account holders, Mr. Nelson arranged for limited

liability companies (L.L.C.s) that he and his wife co-owned (as

described below) to borrow money from lenders who wanted to

invest in the venture.   These lenders were usually friends,

acquaintances, or relatives of Gus Boosalis, Mr. Nelson’s son-in-

law; and the loans, though very substantial, were made under oral

agreements communicated over the telephone.   When an L.L.C. was

to pay off a loan, Mr. Nelson’s routine was to write two checks--

one check to repay the principal of the loan and a second check

to pay the interest due on the loan.

     These loans were made to three L.L.C.s of which he and

Mrs. Nelson owned 100 percent:    Long Financial L.L.C. (LF), Trust

Financial L.L.C. (TF), and Old Financial L.L.C. (OF).   The

L.L.C.s in turn lent money to the account holders.   The loans to

the account holders were documented by conventional written loan

agreements.




     2
      The amount paid by the account holder/borrower is not
conventional interest measured by a percentage rate times the
length of time the loan is outstanding. For purposes of this
case we need not and do not decide the character of these
“interest” payments, which is not in dispute.
                                - 4 -

Capital Resources Management

     When Mr. Nelson became aware of a savings and loan

association that had announced it would convert to a corporate

bank, he hired a third party (to which Mr. Nelson refers as a

“finder”) to arrange for depositors to borrow from one of

Mr. Nelson’s L.L.C.s.   One such finder (the one directly relevant

to this suit) was Capital Resources Management, Inc. (CRM).    For

a fee CRM found a local attorney to act as escrow agent, found

account holders, confirmed their suitability as borrowers,

negotiated the loan agreement with the account holder, prepared

the necessary documentation, monitored the account holder’s

purchase of stock, calculated the amount owed to the lending

L.L.C. by the borrowing account holder, made a demand of the

borrower, received the borrower’s payment, and transmitted the

payment to the L.L.C.   Mr. Nelson’s agreement with CRM, pursuant

to which CRM agreed to provide these services and Mr. Nelson

agreed to pay for them, was an oral agreement.   When a

transaction was completed, Mr. Nelson paid to CRM the fees it had

earned under their agreement.

     However, sometimes CRM also participated in the transactions

as a lender.   That is, when Mr. Nelson was obtaining and pooling

funds from his lenders in one of the L.L.C.s, CRM would sometimes

lend as one of the investors, and its lent funds were then part

of the lending pool.    Thus, for this purpose CRM transferred to
                                - 5 -

TF $450,000 on September 4, 2003, and transferred to LF $100,000

on September 4, 2003, and $300,000 on December 1, 2003.    (The

principal amounts of these loans were all returned in 2003.     See

infra notes 3 and 4 and accompanying text.)

     If a given pool of loans was for a bank conversion for which

CRM served as the finder and was also a lender, then on that

conversion CRM would make money both from its finder’s fees and

from its lending.   As a result of Mr. Nelson’s dealings with CRM

as both finder and lender, the L.L.C.s from time to time owed CRM

three types of amounts--(1) finder’s fees, (2) interest on loans

CRM had made, and (3) the principal amounts of those loans.

Mr. Nelson’s bookkeeping

     As we have noted, the Nelsons’ L.L.C.s had written

agreements with their borrowers (i.e., the account holders) but

only oral agreements with the L.L.C.s’ lenders and finders.     For

that reason, one cannot consult any written agreement to

calculate or justify the amounts paid as interest (to CRM or

others) or as finder’s fees (to CRM or others).    Mr. Nelson did

not retain whatever notes he made in 2003 to keep track of his

agreements with the various lenders and finders.   The record

includes no minutes, memoranda, phone logs, or other records that

show the identities of the lenders, the dates or amounts of their

loans, or the interest terms.   Apart from the L.L.C.s’ bank

statements, Mr. Nelson maintained no books and records for the
                                - 6 -

L.L.C.s.    Rather, for each of the three L.L.C.s, Mr. Nelson

simply composed at year’s end one handwritten page consisting of

an entry of a total amount of gross income and a list of

expenses.   He gave these three sheets to his accountant to

prepare the L.L.C.s’ Forms 1099-INT, Interest Income; Forms 1099-

MISC, Miscellaneous Income; and tax returns.

2003 payments to CRM

     In 2003 LF made one direct transfer to CRM’s account (a

supplemental payment of CRM’s fees and expenses for a

transaction) and issued nine checks to CRM.    The checks were in

the amounts listed below; and on the “Memo” lines on the checks,

the notations given below were written:

  Check No.        Date        Amount               “Memo” Line
     1181         1/31/03    $350,000.00   “Principal”
     1182         1/31/03     105,265.84   “Interest”
     1189         2/01/03     527,772.03   “Expense”
     ---          4/23/03      34,050.83   [Direct transfer]
     1129        10/20/03     100,000.00   “Principal Return”
     1131        10/20/03     110,693.40   “Int & Fees”
     1143        11/20/03     494,271.60   “Fees & Expenses Paid”
     1201        12/31/03      73,886.73   “Fees”
     1202        12/31/03     300,000.00   “Principal Return”
     1203        12/31/03      23,786.19   “Interest”
       Total                2,119,726.62

Thus, of the total of $2,119,726.62 that LF paid to CRM in 2003,

the checks marked “Principal” and “Principal Return” totaled
                                - 7 -

$750,000.3    The checks marked as interest, fees, and expenses,

along with the direct transfer, totaled $1,369,726.62.

     In 2003 TF made one direct transfer to CRM’s account (a

$50,000 repayment of principal) and issued three checks to CRM.

The checks were in the amounts listed below; and on the “Memo”

lines of the checks, the notations given below were written:

  Check No.         Date         Amount           “Memo” Line
     ---           9/15/03     $50,000.00    [Direct transfer]
     1095         11/20/03     144,696.90    “Interest”
     1096         11/20/03     279,972.10    “Fees & Expenses”
     1097         11/20/03     400,000.00    “Principal Return”
         Total                 874,669.00

Of that total of $874,669 that TF paid to CRM in 2003, the checks

marked “Principal Return” and the direct transfer totaled

$450,000.4    The checks marked as interest, fees, and expenses

totaled $424,669.




     3
      LF’s “Principal Return” of $100,000 on October 20, 2003
(check No. 1129), was evidently in repayment of CRM’s transfer to
LF of $100,000 on September 4, 2003; and LF’s “Principal return”
on December 31, 2004 (check No. 1202), was evidently in repayment
of CRM’s direct transfer to LF of $300,000 on December 1, 2003.
The record does not show the CRM-to-LF loan that was repaid by
LF’s “Principal” payment of $350,000 on January 31, 2003, and we
assume that loan was made before 2003.
     4
      The $50,000 direct transfer on September 15, 2003, and the
“Principal Return” of $400,000 on November 20, 2003 (check
No. 1097), were evidently in repayment of CRM’s direct transfer
to TF of $450,000 on September 4, 2003.
                                 - 8 -

     We find that $750,000 of the LF payments and $450,000 of the

TF payments to CRM were repayments of principal that CRM had

previously lent to the L.L.C.s, and we find that $1,369,726.62 of

the LF payments and $424,669 of the TF payments to CRM were for

interest, fees, and expenses.

The L.L.C.s’ Forms 1099 for CRM

     Sometime after the end of 2003 Mr. Nelson directed his

accountant to issue Forms 1099 for the payments that the L.L.C.s

had made to CRM in 2003.   The amounts of the L.L.C.s’ Forms 1099

were taken from the handwritten lists of income and expenses that

Mr. Nelson had prepared.   Mr. Nelson’s list for LF included two

entries for CRM, i.e.–-

     Fees       Capital Resource CRM     $1,450,000.80
     Interest   Capital Resource            155,447.78

--and LF issued to CRM a Form 1099-MISC for the first of these

amounts and a Form 1099-INT for the second.   Those amounts total

$1,605,448.58, rather than the total amount of the LF checks to

CRM marked as interest, fees, and expenses (i.e., $1,369,726.40).

The difference is $235,722.18.

     Similarly, Mr. Nelson’s list for TF included two entries for

CRM, i.e.–-

     Fees       Capital Resource CRM     $448,579.99
     Interest   Capital Resource CRM      144,696.90
                              - 9 -

--and TF issued to CRM a Form 1099-MISC for the first of these

amounts and a Form 1099-INT for the second.5   Those amounts total

$593,276.89, rather than the total amount of the TF checks to CRM

marked as interest, fees, and expenses (i.e., $424,669).    The

difference is $168,607.89.

Income tax reporting

     The Nelsons and the three L.L.C.s filed their 2003 income

tax returns on the cash-basis method of accounting.    The L.L.C.s

filed partnership tax returns6 that the Nelsons admit claimed

deductions for interest and fees that included the amounts that

were reported on the Forms 1099 issued to CRM--that is, amounts

that were greater than the total amount of the checks that were

marked as interest, fees, and expenses.    Items from the

partnership return were carried over to the Nelsons’ Form 1040,

U.S. Individual Income Tax Return.    Thus, the Nelsons reported

interest income from the L.L.C.s, and the amounts so reported had




     5
      In fact, TF’s Form 1099-INT appears to state $144,606.90,
rather than $144,696.90, but we assume that the discrepancy is
attributable to a typographical error.
     6
      The Nelsons treated their three L.L.C.s as partnerships and
filed partnership tax returns, and respondent has not contended
that this was incorrect. An L.L.C. with at least two members may
be classified for Federal income tax purposes as a partnership or
as a corporation. See 26 C.F.R. sec. 301.7701-3, Proced. &
Admin. Regs. The default classification for an L.L.C. with at
least two members is a partnership. Id. We therefore assume
that the Nelsons’ L.L.C.s are classified as partnerships for
purposes of deciding this case.
                              - 10 -

been reduced by the deductions that LF and TF had taken for

amounts allegedly paid to CRM.

Notice of deficiency

     On February 13, 2008, the IRS issued to the Nelsons a notice

of deficiency that, among other things, increased their net

income from the L.L.C.s.   That increase included certain amounts

that the parties resolved by agreement after trial, but it also

reflected the disallowance of amounts that the L.L.C.s paid to

CRM (and that the Nelsons had used to reduce their income), which

are still in dispute.   The Nelsons timely filed a petition in

this Court seeking redetermination of the deficiency.

                              OPINION

I.   Burden of proof

     At issue is the Nelsons’ entitlement to deductions for a

portion of the amounts the L.L.C.s paid to CRM as interest or

fees.   Deductions and credits are a matter of legislative grace,

and the taxpayer bears the burden of proving that he is entitled

to any deduction or credit claimed.     Rule 142(a); see also Deputy

v. du Pont, 308 U.S. 488, 493 (1940); New Colonial Ice Co. v.

Helvering, 292 U.S. 435, 440 (1934).    Generally, the

Commissioner’s determination in the notice of deficiency is

presumed to be correct, and the taxpayer bears the burden of

proving that the Commissioner’s determination is erroneous.    Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).    The
                               - 11 -

Nelsons do not argue that the burden of proof shifts to

respondent under section 7491(a)(1).

     The particular matter that the Nelsons have the burden to

prove is the character of payments made, a subject for which the

books and records of the payor would naturally be consulted.

Section 6001 requires that--

          Every person liable for any tax imposed by this
     title, or for the collection thereof, shall keep such
     records, render such statements, make such returns, and
     comply with such rules and regulations as the Secretary
     may from time to time prescribe. * * *

The regulations implementing that statute include 26 C.F.R.

section 1.6001-1(a), Income Tax Regs.,7 which provides that “any

person subject to tax” (such as the Nelsons) “or any person

required to file a return of information with respect to income”

(such as the L.L.C.s)8 is required to




     7
      See also 26 C.F.R. sec. 1.446-1(a)(4), Income Tax Regs.
(“Each taxpayer is required to make a return of his taxable
income for each taxable year and must maintain such accounting
records as will enable him to file a correct return. See section
6001 and the regulations thereunder. Accounting records include
the taxpayer’s regular books of account and such other records
and data as may be necessary to support the entries on his books
of account and on his return, as for example, a reconciliation of
any differences between such books and his return”).
     8
      An L.L.C. that is classified as a partnership is required
to file a Form 1065, U.S. Return of Partnership Income. See sec.
6031(a); sec. 1.6031(a)-1, Income Tax Regs.; see also Atl. Veneer
Corp. v. Commissioner, 85 T.C. 1075, 1079 (1985) (the requirement
for a partnership to make a return under sec. 6031(a) is
satisfied by filing a Form 1065), affd. 812 F.2d 158 (4th Cir.
1987).
                              - 12 -

      keep such permanent books of account or records * * *
      as are sufficient to establish the amount of gross
      income, deductions, credits, or other matters required
      to be shown by such person in any return of such tax or
      information.

Mr. Nelson, however, kept no “permanent books of account” for the

L.L.C.s; indeed, he kept virtually no records at all.    As we will

show, this effectively disables the Nelsons from proving their

contentions in this suit.

II.   Deductible vs. non-deductible payments

      The parties do not disagree about the general legal

principles that govern the outcome of this case.    First,

compensation for services rendered, such as a bona fide finder’s

fee or commission, is generally deductible as an ordinary and

necessary business expense under section 162.    See Lowery v.

Commissioner, T.C. Memo. 1965-206, 24 T.C.M. (CCH) 1078, 1081

(1965) (“finder’s fee”); 26 C.F.R. sec. 1.162-1(a), Income Tax

Regs. (“commissions”); 26 C.F.R. sec. 1.162-7, Income Tax Regs.

(“compensation for personal services”).     Second, interest paid on

“indebtedness” is generally deductible under section 163.

However, it is axiomatic that repayment of the principal of such

an indebtedness is not deductible.     See Crawford v. Commissioner,

11 B.T.A. 1299, 1302 (1928) (“Deductions are not permitted on

account of the repayment of loans”).    Again, the parties agree on

these principles, but they disagree about their application in

this case because they disagree about the character of the
                                - 13 -

payments that the L.L.C.s made to CRM, to which issue we now

turn.

III. The character of the amounts paid to CRM

        A.   The Nelsons’ attempted recharacterization of the
             principal repayments

        For 2003 LF deducted a total of $1,605,448.50 and TF

deducted a total of $593,276.89 for payments to CRM, and they

reported those amounts on Forms 1099.     LF and TF had each made

payments to CRM in 2003 in gross amounts greater than those

amounts (i.e., $2,119,726.40 from LF and $874,669 from TF), but

the question to be decided is whether the L.L.C.s made payments

that constituted interest, fees, and expenses--and not repayments

of principal--in amounts equal to the deductions claimed.       We

hold that, in large part, the Nelsons have not proved that they

did.

        Respondent does not dispute the deductibility of the

payments for which there are checks explicitly identifying the

payments to CRM as interest, fees, or expenses--i.e., a total of

$424,669 paid by TF and $1,335,675.57 by LF.     However, respondent

does dispute any greater deduction.

        We agree with respondent, to the extent that the Nelsons

attempt to characterize as interest or fees and expenses the

amounts paid by checks that bear the notations “Principal” or

“Principal Return”, and this accounts for the bulk of the

disputed deductions.     However, we find that the direct transfer
                              - 14 -

of $34,050.83 from LF to CRM on April 23, 2003, is not a

principal payment but is instead a payment of fees and expenses.

Unlike the principal repayments that are all round numbers, this

payment is not in an amount that suggests it is a return of

principal, and the record shows no principal payments to which it

is likely related.   Moreover, CRM’s sole owner, Bob Huff,

testified about that payment and explained credibly that it was a

supplemental payment that was determined to be appropriate after

an initial payment had been made to compensate him for a

transaction.   We therefore add this to the amount that respondent

concedes and hold that the Nelsons are entitled to deduct

$1,369,726.40 of LF’s payments to CRM.

     We hold, however, that no further amounts are deductible,

since the only other payments that were substantiated were checks

designated as returns of CRM’s principal and one direct transfer

of $50,000 that was clearly a repayment of principal.   Having

contemporaneously characterized and documented the L.L.C.s’

payments as returns of principal, Mr. Nelson cannot now credibly

revise their character to achieve a reduced tax liability.    It

may be true, as the Nelsons argue, that a notation on the “Memo”

line of a check is not necessarily dispositive of its character;9


     9
      Against any mandate supposedly arising from a memo line
entry, the Nelsons cite Christensen v. Commissioner, 40 T.C. 563
(1963). In that case, however, the memo notation “donation”, id.
at 568, did not substantiate a charitable contribution where the
                                                   (continued...)
                              - 15 -

but in this instance there is no credible evidence to contradict

the notations on the checks, and there is considerable evidence

to corroborate those notations.

     In the first place, the L.L.C.’s “Principal” checks are in

amounts consistent with CRM’s prior loans.   Second, they are

generally accompanied by separate checks paying interest.   Third,

even Mr. Nelson in his trial testimony, which addressed each of

the checks distinctly, explicitly characterized each “Principal”

check as a return of CRM’s principal.   For example, about TF’s

check No. 1097 (marked “Principal Return”), Mr. Nelson said, “I

paid Capital Resources.   They put $400,000 in the deal.   I paid

them back the principal.”   The Nelsons’ post-trial position thus

contradicts Mr. Nelson’s own trial testimony.

     The only documents consistent with the Nelsons’ position are

the Forms 1099 that the L.L.C.s issued to CRM.   However, these

documents were prepared for tax purposes after the end of the

taxable year not from bank records or business records showing

interest payments but from the handwritten lists that Mr. Nelson

prepared for the accountant, for which there are no supporting

records.   The only support that the Nelsons offered at trial to



     9
      (...continued)
check was not delivered to the alleged donee but was deposited
into the same account from which it had been drawn and was simply
credited by the donor to an internal account he maintained for
the benefit of the donee. The facts in the instant case bear no
resemblance to those of Christensen.
                              - 16 -

corroborate the Forms 1099 were checks attached to the forms--the

same checks that we have discussed here, including those that

bear the “Principal” and “Principal Return” notations that

contradict the Forms 1099.   For those reasons, the Forms 1099 are

not probative of the nature of the payments.

     B.   The Nelsons’ attempted proof of additional payments

     As an apparent alternative argument,10 the Nelsons offered

trial testimony in support of the Forms 1099.   CRM’s owner

(Mr. Huff) generally asserted that he believed that the

Forms 1099 were correct.   However, he testified that the checks

“are also correct” (“I have no reason to doubt it”).   To explain

the discrepancy between the Forms 1099 and the check totals,

Mr. Huff did not correct the notations on the checks but instead

postulated additional fees earned by CRM but not yet transmitted

by the L.L.C.s:11


     10
      The Nelsons do not state that the contention addressed
here in part II.B is an alternative to the contention addressed
in part II.A, but the two arguments are not consistent with each
other. That is, when the Nelsons contend (as they do) that a
notation on the “Memo” line of a check is not necessarily
dispositive of its character, they obviously argue that one or
more of the ostensible “Principal” checks are in fact their
payments of additional interest or expenses. But when Mr. Nelson
states that “the checks are short” (see infra note 11), he
evidently contends that the additional interest or expense
amounts were paid other than by the checks.
     11
      Mr. Nelson seemed to give a similar explanation when he
stated, “The 1099s were income that I received [from the account
holders] that I was obligated to document [i.e., to account to
CRM] for 2003, and the checks are short because it was money that
                                                   (continued...)
                               - 17 -

     I had money that I wanted to invest in those deals that
     were going early in January [2004], and I asked him
     just to retain the money. * * * He did not pay me
     some of the fees [earned in 2003] because I planned on
     investing them.

It is not inconceivable that someone entitled to receive taxable

income would recognize the income but would forgo actual transfer

of the money and would instead ask that it be reinvested with his

obligor.   (By analogy, a shareholder entitled to dividends may

automatically reinvest them in the corporation.     He receives a

Form 1099 and recognizes the dividend income but acquires

additional shares of stock.)   However, even where the obligee is

held to have “constructively received” payment, a cash-basis

obligor does not necessarily obtain a corresponding deduction for

a supposed “constructive payment”.      See Unico Sales & Mktg., Inc.

v. Commissioner, T.C. Memo. 1999-242 (and cases cited therein).

     The Nelsons disclaim any reliance on a “constructive

payment” theory; but the supposedly alternative theory they

articulate--that they actually paid the amount to CRM because

those amounts were “retained under the same terms and conditions

[as prior investments had been] and therefore has the economic

equivalent of principal”--fails for lack of proof.     Both the



     11
      (...continued)
we were putting in another deal at the end of December.” When he
was asked why he did not have checks that match the Forms 1099 in
this instance, Mr. Nelson stated, “Because at the end of December
there was money going into another deal and he left his money
with me.”
                              - 18 -

amount supposedly retained and those alleged “terms and

conditions” are unspecified and unsupported.      There are no

contracts, journal entries, statements, notes, minutes,

memoranda, or any other documents of the L.L.C.s to corroborate

or quantify any earned but unpaid fees or any terms on which they

might have been reinvested with the L.L.C.s.      The Nelsons do not

document the accounting for the distinct transactions and do not

demonstrate that, either as a matter of bookkeeping or in

economic reality, both a payment to CRM and a reinvestment with

an L.L.C. took place.   Neither Mr. Nelson nor Mr. Huff explained

what the amount of unpaid fees was or how it was computed.       Nor

did the Nelsons offer any books or records of CRM to show that

CRM had characterized the transactions according to this

scenario, nor did they offer into evidence any tax returns of CRM

to show that it had reported income consistent with this

scenario.

      The Nelsons are entitled to deduct the amounts they actually

paid to CRM as interest, expenses, or fees.      They are not

entitled to deduct amounts they paid to CRM as returns of

principal nor to deduct amounts that they did not prove that they

actually paid.

IV.   Section 6662(a) accuracy-related penalty

      The IRS determined that the Nelsons are liable for the

accuracy-related penalty of section 6662(a) because their
                               - 19 -

underpayment was a “substantial understatement of income tax”

under section 6662(b)(2).12   By definition, an understatement of

income tax is substantial if it exceeds the greater of $5,000 or

10 percent of the tax required to be shown on the return.    Sec.

6662(d)(1)(A).   Pursuant to section 7491(c), the Commissioner

bears the burden of production and must produce sufficient

evidence showing the imposition of the penalty is appropriate in

a given case.    Higbee v. Commissioner, 116 T.C. 438, 446 (2001).

Once the Commissioner meets this burden, the taxpayer must come

forward with persuasive evidence that the Commissioner’s

determination is incorrect.    Id. at 447; see also Rule 142(a).

     On their 2003 return the Nelsons reported taxable income of

$1,560,486 and total tax of $534,673.   Since we sustain the

disallowance of $404,330.07 of the interest and expenses claimed

for payments by the L.L.C.s to CRM, and since the Nelsons have

conceded more than $324,915 of unreported gain on their sale of

property, their taxable income was understated by $729,245.

Under section 1(a) their marginal tax rate was 39.6 percent, at

which rate additional income of $729,245 would yield an


     12
      Under section 6662(b)(1), the accuracy-related penalty is
also imposed where an underpayment is attributable to the
taxpayer’s negligence or disregard of rules or regulations; and
respondent argues that the Nelsons’ position reflects negligence.
However, as we show below, respondent has demonstrated that the
Nelsons substantially understated their income tax for 2003 for
purposes of section 6662(b)(2). Thus, we need not consider
whether, under section 6662(b)(1), the Nelsons were negligent or
disregarded rules or regulations.
                              - 20 -

additional liability of $288,781 and a total liability, when

combined with the amount reported on their return, of $823,454.

This very rough calculation will be corrected by the parties

under Rule 155, but for the time being it is clear that the

Nelsons’ understatement of roughly $288,781 is greater than

$5,000 and greater than 10 percent of the tax required to be

shown on the return (i.e., 10 percent of $823,454, or $82,345)

and is therefore “substantial” under section 6662(d)(1).

Respondent has carried the burden of production imposed by

section 7491(c).   The accuracy-related penalty is mandatory; the

statute provides that it “shall be added”.   Sec. 6662(a).   The

Nelsons bear the burden of proving any defenses,13 see Higbee v.




     13
      A taxpayer who is otherwise liable for the accuracy-
related penalty may avoid the liability if he successfully
invokes one of three other provisions: Section 6662 provides
that an understatement may be reduced, first, where the taxpayer
had substantial authority for his treatment of any item giving
rise to the understatement or, second, where the relevant facts
affecting the item’s treatment are adequately disclosed and the
taxpayer had a reasonable basis for his treatment of that item.
Sec. 6662(d)(2)(B). Third, section 6664(c)(1) provides that if
the taxpayer shows that there was reasonable cause for a portion
of an underpayment and that he acted in good faith with respect
to such portion, no accuracy-related penalty shall be imposed
with respect to that portion. The record suggests no basis for
any of these defenses.
                             - 21 -

Commissioner, supra at 446, but they asserted none.   We therefore

sustain the accuracy-related penalty.

     To reflect the foregoing,


                                     Decision will be entered under

                                 Rule 155.
