                                T.C. Memo. 1996-473


                            UNITED STATES TAX COURT



   JOSEPH B. LEONARD AND DOROTHY A. COLE LEONARD, Petitioners v.
            COMMISSIONER OF INTERNAL REVENUE, Respondent



       Docket Nos. 16749-91,                       Filed October 22, 1996.
                   10399-93.


       C. A. Teklinski, for petitioners.

       Thomas A. Dombrowski and Valerie N. Larson, for respondent.



                    MEMORANDUM FINDINGS OF FACT AND OPINION


       JACOBS, Judge:      By separate notices of deficiency, respondent
determined the following with regard to petitioners’ Federal income
taxes:
                                                                Accuracy-Related
                                Additions to Tax                    Penalty
Year   Deficiency   Sec. 6651    Sec. 6653(a)(1)   Sec. 6661     Sec. 6662(a)
1988   $61,855      $6,222.91    $3,385.70         $15,463.75        ---
1989    52,532         ---          ---                ---         $10,506
                                 - 2 -

       Following concessions by the parties,1 the issues for decision
are:
       (1) Whether petitioners are entitled to a claimed $650,000
theft loss in 1985 that would permit them a net operating loss
carryover deduction in 1988.      We hold that petitioners are not
entitled to the claimed theft loss in 1985.
       (2) Whether petitioners are liable for the addition to tax
under section 6653(a)(1) for 1988. We hold that petitioners are so
liable.
       (3) Whether petitioners are liable for the addition to tax
under section 6661 for 1988.          We hold that petitioners are so
liable.
       (4) Whether petitioners are liable for the accuracy-related
penalty under section 6662 (a) for 1989.       We hold that petitioners
are so liable.
       All section references are to the Internal Revenue Code for
the years under consideration.    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
stipulation of facts and the attached exhibits are incorporated
herein by this reference.
Background
       Petitioners,   husband   and    wife,   resided   in   Escondido,


       1
          Respondent has conceded that petitioners are not liable
for the sec. 6651 addition to tax for 1988. Petitioners have
conceded the deficiency for 1989.
                                    - 3 -

California, at the time they filed their petitions.
        Dorothy   Cole   Leonard   (Mrs.    Leonard)   worked   as   a    legal
secretary     for   approximately    15    years   before   attending,      and
graduating from, Western State University College of Law.                She was
admitted to the California bar in 1974.            In her law practice she
specializes in trust and estate matters.            Joseph B. Leonard (Mr.
Leonard) also is an attorney.        He was admitted to the California
bar in 1972, and has worked in the area of trusts and estates for
a corporate trust department.
     Petitioners were married in 1978. Mr. Leonard has a daughter,
Suzette, from a prior marriage.             Suzette married Robert Gindt
(Robert) in 1977.         Robert and Suzette filed for a Chapter 7
bankruptcy in 1981. Robert had been employed in several positions,
including working in floral shops operated by his mother and his
aunt.
     In late 1981 or early 1982, Robert became a stockbroker and
thereafter participated in a variety of investment transactions.
From 1981 to 1983, he was involved in a business venture with
Katherine Gatto, a friend, to renovate commercial property in
Berkeley, California, that was owned by Ms. Gatto and housed the
University Flower Shop.
        Robert and Suzette’s residence was rented from Ms. Gatto.
Robert had hoped that he and Suzette could purchase their residence
with profits generated from the flower shop venture, but that
venture was not financially successful.
                                     - 4 -

Bank Loans
       On July 9, 1982, Mrs. Leonard obtained a 2-month bank loan for
$75,000 and provided the proceeds therefrom to Robert in order that
he could pay off mechanic’s liens on the flower shop property.
Mrs. Leonard did this as a favor to Robert.               However, she expected
Robert to      be   responsible    for    the   repayment    of   principal     and
interest charged her by the bank.
       Robert repaid only a portion of the $75,000 given him by Mrs.
Leonard.     One of Robert’s checks to her, dated September 10, 1982,
bounced.       Mrs. Leonard was ultimately required to pay off the
balance of the $75,000 loan.
       Between February and April of 1983, Mrs. Leonard opened four
joint bank accounts with Robert in order that he could "have
access" to the money.       Mrs. Leonard placed no restrictions on how
Robert could use the bank account funds.                  No documentation was
prepared to define their relationship.             All bank statements were
sent    to   Mrs.   Leonard;   the    statements     revealed     a    number   of
overdrafts that began in February 1983.             In addition to the four
joint accounts with Robert, Mrs. Leonard had 12 bank accounts and
a number of trust accounts during 1983.            Between February and May
1983,    she    obtained   loans     at   four    banks     totaling   $200,000,
ostensibly for use in her law practice, but in fact, the money was
provided to Robert.
Unsupervised Investments
       During 1983, checks totaling more than $1.3 million were
written to Prudential Bache--where Robert was a stockbroker--on one
                                     - 5 -

of Mrs. Leonard’s joint accounts with Robert.            The money was used
by Robert to make investments in his own name.              He intended to
repay the principal to Mrs. Leonard and retain all investment
earnings for himself.
     Mrs. Leonard gave no thought as to how Robert was investing
the money she gave him.        Robert told Mrs. Leonard that he was using
the money from her accounts to complete the flower shop project in
Berkeley,     to    purchase    factoring    invoices,   and   to    purchase
properties in Danville, California.            Robert lost money on the
investments    he    made,   including   approximately    $340,000    in   the
factoring transactions.
        Mr. Leonard gave Robert $74,000 in May 1983 in order that he
could make a downpayment for the purchase of property located in
Danville, California (Willow Creek property).            Altogether Robert
obtained approximately $270,000 from family and friends to make the
downpayment on the $1.4 million purchase for the Willow Creek
property.    Mr. Leonard did not expect to receive an interest in the
property, and he did not require any documentation relating to the
transaction.       Robert intended to repay Mr. Leonard with proceeds
from the anticipated sale of the Willow Creek property.              The sale
fell through, and foreclosure proceedings were commenced in late
1983.
     Petitioners ultimately learned in October 1983 that title to
both the Willow Creek property and Robert’s residence was held by
Katherine Gatto.
                                        - 6 -

Access to Funds Terminated
       In July of 1983, petitioners discontinued their transactions
with Robert when they learned that he might not be able to repay
them. In the fall of that year, petitioners learned that Robert no
longer worked at Prudential Bache.
       Petitioners never attempted to obtain a note from Robert.
They did not contact Katherine Gatto to learn about her business
dealings with Robert.              Nor did petitioners file a civil action
against Robert or contact authorities about any possible crime.
Indictment
       In early 1984, Robert told petitioners that he and Suzette
were under criminal investigation related to banking activities.
At the request of Robert and Suzette, petitioners provided Suzette
with money to pay her attorney’s fees.           On November 9, 1984, Robert
and Suzette were indicted on bank larceny and conspiracy charges
concerning transactions that occurred beginning July 14, 1983, at
the    Mechanics      Bank    in    Richmond,   California.          Although   the
indictment     against       Robert    and   Suzette    did    not    involve   any
transaction with petitioners, Mrs. Leonard was notified that some
of    her   account    records      were   subpoenaed   with    respect    to   the
investigation. On February 21, 1985, Robert pleaded guilty to bank
larceny.     The indictment against Suzette was eventually dismissed.
       By early 1984, petitioners were aware that Robert and Suzette
had little money, that they were selling their personal property,
that they had borrowed money from Robert’s parents, and that their
residence and the Willow Creek property were in foreclosure.
                                     - 7 -

Robert and Suzette were evicted from their residence in June 1984,
and at that time they were unemployed.              By November 1984, their
only asset was a 1973 Chevrolet automobile, and their only source
of funds came from family members.           By the end of 1984, petitioners
had been informed by Robert that he and Suzette had no money and
petitioners had no reason to believe that Robert would be able to
repay them.
Accountant’s Advice
      Clyde N. Freeman, a certified public accountant, prepared
petitioners’ tax returns from 1983 through 1987.                  Mrs. Leonard
typically reviewed major items in the returns for errors and
personally typed the returns.         Freeman knew about the transactions
with Robert.         Petitioners presented all information about the
transactions with Robert to Freeman when their 1985 return was
being prepared.        Freeman advised petitioners that a loss with
respect to those transactions should not be claimed, and that he
believed if a deduction for the losses incurred were to be taken,
the   deduction      would   be    disallowed      because   of   the     family
relationships involved.           Petitioners did not claim a loss with
respect to their transactions with Robert on their 1983, 1984, or
1985 returns.
      In April 1989, just before the period of limitations for 1985
was to     expire,    petitioners    filed    an   amended   return   for    1985
claiming    a   $650,000     "embezzlement      loss"   arising    from     their
transactions with Robert in 1983.         The amended return was prepared
by Betty White, another accountant, with Freeman’s assistance.
                                  - 8 -

White advised petitioners that a theft deduction was appropriate.
     In October 1989, petitioners filed amended returns for 1986
and 1987.    They claimed a net operating loss carryover (from 1985)
of $578,944 in 1986 and $445,504 in 1987.          On their 1988 return,
petitioners claimed a net operating loss carryover from 1987 of
$640,600.    Their 1988 return overstated the claimed net operating
loss carryover from 1987 by approximately $316,400.2
     Petitioners    did   not   file   an   election   to    relinquish   the
carryback period with respect to the claimed net operating loss
pursuant to sec. 172(b)(3)(C) with their 1985 income tax return or
on their amended 1985 income tax return.       By letter dated August 2,
1993, petitioners submitted a request for relief under Rev. Proc.
92-85, 1992-2 C.B. 490, seeking an extension of time to make an
election under sec. 172(b)(3) to relinquish the carryback period
with respect to the claimed net operating loss.             On May 27, 1994,
respondent ruled that petitioners were not eligible for the relief
sought.     Petitioners did not appeal respondent’s ruling.
                                 OPINION
Issue 1.     Theft Loss
     Petitioners’ entitlement to a net operating loss carryover
depends upon the characterization of their transactions with


     2
          The arithmetical computation for the overstatement of
the net operating loss carryover is as follows:

NOL carryover reported on 1988 return                         $640,600
NOL carryover reported on 1987 return   $445,500
NOL carryover used on 1987 return         121,300
Unused NOL carryover from 1987                                 324,200
Overstatement of carryover on 1988 return                     $316,400
                                  - 9 -

Robert. Petitioners contend that Robert embezzled money from them,
and as a result thereof, they sustained a $650,000 theft loss in
1985 that would entitle them to a net operating loss carryover
deduction in 1988.     Respondent contends that petitioners provided
money to Robert to assist him and Suzette, and that petitioners
knew at least by 1984 that the money would not be repaid.3
      Individual taxpayers may deduct certain losses, including
theft losses, sustained during the taxable year and not compensated
for by insurance or otherwise.     Sec. 165(a), (c)(3).    A theft loss
is deductible in the year in-which the taxpayer discovers the loss.
Sec. 165(e).    Petitioners have the burden of proving a theft loss.
Rule 142(a); Malik v. Commissioner, T.C. Memo. 1995-204.
      The term "theft" includes embezzlement.          Sec. 1.165-8(d),
Income Tax Regs.     Whether a theft occurred depends on the law of
the State where the loss was sustained.      Paine v. Commissioner, 63
T.C. 736, 740 (1975), affd. without published opinion 523 F.2d 1053
(5th Cir. 1975).    Under California law, a person commits theft if
he   "shall    fraudulently   appropriate   property   which   has   been
entrusted to him, or * * * shall knowingly and designedly, by any
false or fraudulent representation or pretense, defraud any other


      3
          Petitioners did not contend, even in the alternative,
that their losses should be characterized as losses from a
business or nonbusiness bad debt. On the other hand, respondent
asserts, in her posttrial brief, that if petitioners sustained a
loss, it was a capital loss or a bad debt loss. In this regard,
we are aware that a loss from a theft can generate a net
operating loss carryback and carryover, whereas a loss from a
nonbusiness bad debt is treated as a short-term capital loss, and
its use for carryback and carryover purposes is restricted by
sec. 172(d)(4). See United States v. Generes, 405 U.S. 93, 95-96
(1972).
                                     - 10 -

person of money".       Cal. Pen. Code sec. 484 (West 1988).
      Petitioners claim that Robert advised Mrs. Leonard that by
having access to and using lines of credit he would be able to make
profitable investments in his capacity as a stockbroker with
Prudential Bache.        Petitioners contend that Robert obtained the
money under false pretenses because he did not invest the money on
Mrs. Leonard’s behalf, but rather, intended to repay her only the
principal.      Petitioners posit that Robert made the offer because
prior to 1983, Mrs. Leonard "was experiencing personal financial
difficulties due to outstanding obligations which she had incurred
from her schooling and opening her private law practice".
        The evidence shows that it was Robert, not Mrs. Leonard, who
was   having    financial     difficulties.        Mrs.    Leonard   prepared     a
personal    financial    statement     in   July    1982    that   listed   total
liabilities of only $33,400. In 1981 petitioners’ gross income was
$77,671, and in 1982 it was $73,026.                Petitioners had a gross
income of nearly $120,000 in 1983.            We believe it unlikely that
Mrs. Leonard could have obtained $200,000 in bank credit, half of
which     was    unsecured,    if    she    were    experiencing       financial
difficulties.       On the other hand, Robert and Suzette did have
financial difficulties; they filed for bankruptcy in 1981.
      In 1982, Mrs. Leonard obtained a 2-month, $75,000 bank loan
and provided the proceeds to Robert in order that he could clear
mechanic’s      liens   on   the   flower   shop   property,       which   he   was
developing.      Mrs. Leonard admitted that she did not expect to make
money on the transaction.          After Robert’s check to repay the bank
                                  - 11 -

loan did not clear, Mrs. Leonard obtained an extension of the loan.
Robert later repaid only a portion of the loan, and Mrs. Leonard
was required to make up the difference.
     We believe the understanding between Mrs. Leonard and Robert
in the 1983 transactions was similar to their treatment of the
initial $75,000 loan in 1982.        While Mrs. Leonard expected the
return of her money, and while she might have expected some sort of
financial benefit if Robert had success with his investments, her
primary purpose in providing the money was to benefit Robert and
Suzette.    In   essence,   the    moneys   advanced   to   Robert   were
noninterest-bearing loans.    Indeed, petitioners stated on their
1983 return that the purpose of the various loans was "to assist
family members with financial difficulties; hence, funds were not
used to acquire investment property or other assets".
     In our opinion, the financial arrangement between petitioners
and Robert did not give rise to a theft.      As parents, petitioners
wanted to assist their children.     In summary, we conclude that the
funds were loaned to Robert without the expectation of petitioners’
realizing a profit.   Accordingly, petitioners are not entitled to
a $650,000 theft loss in 1985,4 and thus are not entitled to a
carryover for 1988.




     4
          Even assuming, arguendo, that the financial arrangement
between Robert and petitioners gave rise to a theft loss,
petitioners failed to show that they discovered the loss in 1985.
Indeed, the record clearly shows that petitioners knew of the
loss by the end of 1984.
                                   - 12 -

Issue 2.    Negligence
      The second issue is whether petitioners are liable for the
addition to tax for negligence under section 6653(a)(1) for 1988.
Petitioners dispute the negligence addition to tax claiming they
are   not   knowledgeable      about   tax    matters     and    relied   on   an
accountant. We disagree. Freeman, the accountant who prepared the
original returns for petitioners, knew all of the facts surrounding
the transactions with Robert and informed petitioners that the
losses never could be deducted.              Not satisfied with Freeman’s
advice, petitioners later went to accountant White who advised
petitioners that the loss could be claimed.
      Section     6653(a)(1)    provides      that   if    any    part    of   an
underpayment of tax is the result of negligence or intentional
disregard of rules or regulations, 5 percent of the underpayment is
added to the tax.     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).          Reliance on professional advice, by
itself, is not an absolute defense to negligence. A taxpayer first
must demonstrate that his reliance was reasonable.                  Freytag v.
Commissioner, 89 T.C. 849, 888 (1987), affd. 904 F.2d 1011 (5th
Cir. 1990), affd. 501 U.S. 868 (1991).
      Petitioners--both experienced attorneys--undoubtedly took a
keen interest in a possible deduction of the magnitude involved in
this case.      Freeman advised petitioners against taking a theft
                                 - 13 -

loss, and petitioners did not take the loss on their original 1985
tax return.      We are not convinced that petitioners’ subsequent
"reliance" on White’s advice was reasonable.
     Petitioners obviously knew prior to 1985 that they would not
recover the money they transferred to Robert.        Thus, even assuming
arguendo, that petitioners sustained a theft loss as a result of
their transactions with Robert, it is clear that petitioners’
attempt to take the loss for 1985 was improper.            We reach this
conclusion, in part, because by the end of 1984, petitioners knew
that Robert and Suzette had.     no money, were unemployed, and ,had
no ability to repay them.   In our opinion, petitioners claimed the
deduction in 1985 because the period of limitations had closed on
their 1983 and 1984 returns.
     Petitioners   stated   on   their    1983   return   that   the   large
increase in the deduction for interest expense was because of money
borrowed "to assist family members with financial difficulties,"
and that the funds "were not used to acquire investment property or
other assets".     They did not change their position when filing
returns in later years, including the years in issue.            At trial,
however, they maintained that money was borrowed from banks by Mrs.
Leonard because she was having financial difficulties, and that the
funds were invested by Robert so that she could repay her debts.
We do not accept as credible petitioners’ testimony in this regard.
     Moreover, the claimed deduction was clearly inflated.              The
initial deduction taken in 1985 was for $650,000, although at trial
petitioners were unable to prove that they lost that much.             On
                                   - 14 -

their    1988    return,   petitioners      claimed    a    net   operating    loss
carryover from 1987 of $640,600, almost as much as was originally
claimed on the amended 1985 return.                The claimed carryover was
overstated by about $316,400.
        We hold that petitioners were negligent and intentionally
disregarded rules or regulations in claiming the "embezzlement
loss", and that they are liable for the addition to tax under
section 6653(a)(1) for 1988.
Issue 3.        Substantial Understatement
        Section 6661, applicable to 1988, imposes an addition to tax
of 25 percent of the amount of any underpayment that results from
a   substantial     understatement     of    tax.      An    understatement      is
substantial if it exceeds the greater of 10 percent of the tax
required to be shown or $5,000.             Sec.    6661(b)(1)(A).
      Petitioners reported a tax liability of $5,859 for 1988. They
had about $240,000 in income that year, and their correct tax
liability would have been much larger than reported.                We hold that
petitioners have failed to carry their burden of showing that they
are not liable for the addition to tax under section 6661 for 1988.
Issue 4.        Accuracy-Related Penalty
        Section 6662(a), applicable to 1989, imposes a penalty of 20
percent     of    the   underpayment     attributable        to   negligence     or
substantial understatement of tax.           Sec.     6662(a), (b)(1) and (2).
As previously found, petitioners were negligent and substantially
understated their tax for 1988 by claiming a carryover with respect
to the alleged theft loss in 1985.            They also were negligent and
                                   - 15 -

substantially     understated    their   tax   for    1989     by   claiming     a
carryover from the same alleged loss.
        Petitioners   conceded   the   deduction     for    1989    because   the
carryover loss had been fully utilized prior thereto5.                  We have
sustained respondent’s determination that petitioners are liable
for the section 6653(a)(1) and section 6661 addition to tax for
1988.       We   likewise   sustain    respondent’s        determination      that
petitioners are liable for the accuracy-related penalty under
section 6662(a) for 1989.
        To reflect the foregoing,
                                               Decisions will be entered
                                          under Rule 155.




        5
          Petitioners had failed to file an election to
relinquish the carryback pursuant to sec. 172(b)(3)(C). See
discussion supra, p. 8.
