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required that we not treat an overstatement of cost of goods sold
as resulting in an omission from gross income. After the
amendment, the normal definition of gross income applied, and,
therefore, an overstatement of cost of goods sold resulted in an
omission from gross income. In the recent case of Lilly v.
Internal Revenue Service, 76 F.3d 568 (4th Cir. 1996), the Court
of Appeals for the Fourth Circuit adopted the conclusions and
reasoning of our cases in holding that an overstatement of cost
of goods sold results in an omission of gross income.
We conclude that in this case the overstatement of cost of
goods sold results in an omission from gross income. Therefore,
the amount of the understatement of gross income resulting from
the overstatement of cost of goods sold in this case is a grossly
erroneous item, and petitioner is entitled to innocent spouse
relief with respect to the tax resulting from this understatement
of gross income.
Respondent argues that there was a mischaracterization of
items as cost of goods sold on petitioner's return. Respondent
states that the items claimed as cost of goods sold should be
properly classified as deductions and, as such, should be treated
as deductions subject to the requirements of section
6013(e)(2)(B). We find no legal or factual support for
respondent's argument. First, it is unclear from the record to
what extent the items not allowed as cost of goods sold, if they
had been substantiated, should be properly characterized as
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