T.C. Memo. 2013-176
UNITED STATES TAX COURT
LAURA R. AMES-MECHELKE, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 4058-03, 20447-03, Filed August 1, 2013.
20448-03.
Joe Alfred Izen, Jr., for petitioner.
Steven Wendell LaBounty, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARIS, Judge: In these consolidated cases respondent issued three notices
of deficiency determining the following deficiencies in petitioner’s Federal
income tax and section 6662(a)1 accuracy-related penalties:
1
Unless otherwise indicated, all section references are to the Internal
(continued...)
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Penalty
sec.
[*2] Year Deficiency 6662(a)
1993 $15,577 $3,115.40
1994 52,833 10,566.60
1995 61,586 12,317.20
1996 84,906 16,981.00
1997 86,105 17,221.00
In the notices of deficiency respondent determined that certain trust arrangements
petitioner had used during the years in issue were shams and should be
disregarded for Federal tax purposes. Consequently, respondent determined that
petitioner was required to include in income amounts purportedly transferred to
the trusts. The parties have stipulated that petitioner’s trust arrangements may be
treated as shams for Federal tax purposes. In addition, except for her theft loss
claim, petitioner has conceded the calculations of income, deductions, and credits
for the years in issue as determined in the notices of deficiency. Thus, the
remaining issues for decision are whether respondent issued petitioner a notice of
deficiency for each year in issue within the applicable limitations period, and if so,
1
(...continued)
Revenue Code of 1986, as amended, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
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[*3] whether petitioner is liable for the section 6662(a) accuracy-related penalties
determined therein. Petitioner also asks the Court to decide whether she is entitled
to deduct a theft loss under section 165(a) for the amounts she paid to the abusive
trust promoter during the years in issue.
FINDINGS OF FACT
Some of the facts have been stipulated, and the stipulation of facts and the
exhibits attached thereto are incorporated herein by this reference. Petitioner
resided in Missouri when her petition was filed.
I. Tax Year 1993
In 1985 petitioner received her chiropractic license and began work as a
chiropractor through her sole proprietorship, Chiropractic Care Center
(Chiropractic Care). As a chiropractor petitioner has always practiced in
Effingham, Illinois.2
In 1993 petitioner met Paul E. Palmer, a.k.a. Gene Palmer, through Palmer’s
wife, a patient of petitioner. Upon sharing her concerns about her income tax
liabilities, petitioner met with Palmer as a financial planner. When Palmer also
2
According to her income tax returns, petitioner’s address for the first two
years in issue, 1993 and 1994, was also in Effingham, Illinois. Her address for the
remaining years in issue was in Webster Groves, Missouri, a suburb of St. Louis.
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[*4] claimed to be a minister, petitioner later met with him as a minister and
attended his charismatic prayer studies.
In addition to his prayer studies, Palmer met with petitioner to discuss a
purportedly legal way of reducing her taxes using trusts.3 He offered her videos
and books describing the trust arrangement. To reassure petitioner that the trusts
were legitimate, Palmer introduced her to a tax return preparer, Dwight Dennis
Larson. Petitioner did not realize that Larson did not have an accounting degree
but was aware that Larson had been a tax return preparer since 1971.
Larson had become involved with Palmer through a trust arrangement
purchased by one of his clients. Larson understood that the main object of
Palmer’s trust arrangement was tax avoidance. Palmer had explained to Larson
how the trusts operated and eventually convinced him that the trust arrangement
was legal so long as the taxpayer did not have control of the money transferred to
the trusts. Over the course of time he also grew to understand that Palmer had
“sneaky” ways of returning trust funds to the taxpayer without the funds “showing
up”.
3
The Court’s use of “trust” is for convenience only and is not intended to
impart any legal significance with respect to the characterization for Federal tax
purposes.
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[*5] Larson began to provide tax advice to taxpayers who purchased Palmer’s
trust arrangement. Larson met with petitioner to provide tax advice and to answer
her questions about the trusts. He also attended meetings with petitioner and
Palmer to learn how to transfer money to and among the trusts. Larson allegedly
understood the accounting aspects of the trusts, but he did not understand how the
money was actually transferred.
After studying Palmer’s books and materials and watching his videos,
petitioner was eventually convinced that Palmer’s trust arrangement was
legitimate, and she decided to purchase it. Petitioner hired Larson to prepare her
personal return, then extended the engagement to include corporate and trust
returns, during the years in issue.
In November 1993 petitioner purchased her first trust arrangement from
Palmer. She paid Palmer an initial fee of $30,000 for his purported financial
planning services, plus $46,000 for four trust documents, two of which cost
$11,000 each and the other two $12,000 each. Petitioner signed four checks
drawn from Chiropractic Care’s bank account totaling $46,000 and payable to
Palmer’s entities, Affluence Management Systems Trust and Specialty
Management Systems Trust. At the recommendation of Palmer and Larson,
petitioner incorporated Chiropractic Care, changing the form of the entity from a
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[*6] sole proprietorship to a C corporation called Optimum Health Care, Ltd.
(Optimum Health), in Illinois. Petitioner was Optimum Health’s sole shareholder
and was responsible for its operations.
In December 1993 petitioner used Palmer’s customized forms and
instructions to implement his trust arrangement. The trust documents, which were
dated variously from September 1992 to May 1993, formed four trusts: Jupiter
Consultants (Jupiter), Calypso Leasing Co. (Calypso), Peaceful Vistas
Management (Peaceful Vistas), and Euphoria Equities. Petitioner executed the
trust documents without completely reading them. Petitioner did not remember
applying for taxpayer ID numbers, and respondent did not receive taxpayer ID
number applications for the trusts or assign ID numbers to them. Nonetheless,
Palmer opened domestic bank accounts on petitioner’s behalf for each of the
trusts, and, without petitioner’s knowledge, used false taxpayer ID numbers.
Palmer and petitioner were signatories on the accounts. According to petitioner,
Palmer never exercised control over these bank accounts, and petitioner authorized
all withdrawals and checks from them.
Larson prepared petitioner’s tax return for 1993, which was timely filed on
April 15, 1994. On the Schedule C, Profit or Loss From Business, attached to
petitioner’s return, Larson deducted the $46,000 of trust payments as cost of sales
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[*7] and as contract services for Chiropractic Care. Petitioner reported a net profit
of $102,773, from her chiropractic business and total personal income tax due of
$24,938. Jupiter, Calypso, Peaceful Vistas, and Euphoria Equities did not file tax
returns for 1993.
II. Tax Years 1994 and 1995
During 1994 and 1995 petitioner transferred taxable income from Optimum
Health to her trusts through a series of transactions Palmer arranged. In each year,
petitioner transferred a total of $144,000 from Optimum Health to three of her
trusts, Jupiter, Calypso, and Peaceful Vistas. She then transferred the $144,000 of
trust funds to Euphoria Equities and used the funds to pay her credit card bills,
mortgage, and other personal living expenses. In addition, petitioner, on behalf of
Optimum Health, made payments to Palmer and his entities during 1994 and 1995.
In 1994 petitioner paid $10,000 to Palmer’s entity Specialty Management Systems,
and in 1995 she paid $3,000 to Palmer individually and $15,000 to his entity Eagle
Resources.
Larson prepared Optimum Health’s Form 1120, U.S. Corporation Income
Tax Return, for its fiscal years ending on November 30, 1994 and 1995.4 On the
4
On May 1, 1998, Optimum Health was involuntarily dissolved under
Illinois law for failing to file an annual report. On November 7, 2005, respondent
(continued...)
-8-
[*8] returns Larson deducted Optimum Health’s trust payments from its taxable
income as section 162 business expenses. To characterize the trust payments,
Larson relied on Optimum Health’s books and records, which he prepared using
check stubs or by conferring with petitioner and Palmer. Larson deducted the trust
payments using the following descriptions:
Trust Expense Tax year
1994 1995
Jupiter Cost of sales $48,000 $48,000
Calypso Rent 44,000 48,000
Cost of sales 4,000 --
Peaceful Vistas Management fees 48,000 44,000
Rent -- 4,000
144,000 144,000
Larson also deducted Optimum Health’s payments to Palmer and his entities as
follows: (1) for 1994, $10,000 to Specialty Management Systems as a
4
(...continued)
issued Optimum Health a notice of deficiency, and a petition was timely filed with
the Court seeking a redetermination. On January 7, 2009, the petition was
dismissed for lack of jurisdiction because it was not signed by Optimum Health or
by a party with proper authorization and capacity on Optimum Health’s behalf.
See Optimum Health Care, Ltd. v. Commissioner, T.C. Dkt. No. 3128-06 (Jan. 7,
2009).
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[*9] management fee and (2) for 1995, $3,000 to Palmer individually as dues and
subscriptions and $15,000 to Eagle Resources as cost of sales.
For fiscal years ending November 30, 1994 and 1995, Optimum Health
reported gross receipts of $362,035 and $428,527, respectively. After deducting,
inter alia, payments to petitioner’s trusts and to Palmer and his entities, Optimum
Health reported taxable income of $16,635 and $27,542 for 1994 and 1995,
respectively. Petitioner’s trusts, Jupiter, Calypso, Peaceful Vistas, and Euphoria
Equities, did not file returns for 1994 and 1995.
Larson also prepared petitioner’s individual tax returns for 1994 and 1995,
which were timely filed on April 15, 1995 and 1996, respectively. Larson did not
include Optimum Health’s trust payments as income on petitioner’s returns for
1994 and 1995.
III. Tax Years 1996 and 1997
Toward the end of 1995 Larson suggested to petitioner that she switch from
Palmer’s trust arrangements to trusts offered by the Aegis Co. (Aegis), an entity
that promoted domestic and foreign trust packages.5 When petitioner approached
5
In 2008 principals of Aegis were convicted of conspiracy to defraud the
United States in connection with their activities related to the promotion and
marketing of fraudulent trust schemes. See, e.g., Charlton v. Commissioner, T.C.
Memo. 2011-51.
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[*10] Palmer about the Aegis trusts, he offered her the same trust arrangement but
cheaper. In December 1995 petitioner adopted the new trust arrangement from
Palmer, which she used for tax years 1996 and 1997.
Pursuant to the new trust arrangement, petitioner operated her chiropractic
business through a business trust, Optimum Health Care Trust (Optimum Health
Trust). Petitioner then transferred Optimum Health Trust’s business receipts,
which were deposited in a domestic bank account in Effingham, Illinois, to
accounts outside the United States through a series of transactions Palmer
arranged.
Petitioner transferred Optimum Health Trust’s income to its beneficiary,
Euphoria Equities,6 which also had a domestic bank account in Effingham,
Illinois. Petitioner transferred Euphoria Equities’ trust income outside the United
States to Tri-Global Management, Inc., and then to Vanstar Enterprises, Ltd., both
of which were purportedly incorporated in the Bahamas and had foreign bank
accounts in St. Johns, Antigua. After moving the trust income to foreign bank
accounts, petitioner finally returned her trust income to the United States, where
6
At trial petitioner testified that she did not know whether the Euphoria
Equities in her first trust arrangement was the Euphoria Equities in her second
trust arrangement. In the second trust arrangement Euphoria Equities reported two
addresses on its tax returns, one in Effingham, Illinois, and the other in the
Bahamas.
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[*11] she deposited it in a bank account in Effingham, Illinois, for New Covenant
Trust, a beneficiary of Euphoria Equities. Petitioner used the New Covenant Trust
funds as her own to pay bills and other personal living expenses.
Larson prepared Optimum Health Trust’s Forms 1041, U.S. Income Tax
Return for Estates and Trusts, for 1996 and 1997. Attached to each trust return
was a Schedule C for petitioner’s chiropractic business reporting gross receipts of
$434,246 and $509,195 for 1996 and 1997, respectively, and a net profit of
$205,173 and $222,819, respectively. Each trust return also included a Schedule
K-1, Beneficiary’s Share of Income, Deductions, Credits, etc., for Optimum Health
Trust’s beneficiary, Euphoria Equities. The Schedules K-1 reported that Optimum
Health Trust’s income was distributed to Euphoria Equities, and as a result
Optimum Health Trust reported zero tax due for 1996 and 1997.
Larson also prepared a Form 1040NR, U.S. Nonresident Alien Income Tax
Return, for Euphoria Equities for 1996, and two Forms 1040NR for 1997, one of
which was an amendment. Like the returns filed for Optimum Health Trust,
Euphoria Equities’ returns reported that its income was distributed to its
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[*12] beneficiaries, and consequently Euphoria Equities reported zero tax due for
1996 and 1997.7
Larson prepared petitioner’s tax returns for 1996 and 1997, which were
timely filed on April 15, 1997 and 1998, respectively. Petitioner reported gross
income of $31,493 and $20,269 on her 1996 and 1997 returns, respectively. As
discussed below, during 1996 and 1997 petitioner earned additional gross income
from the operation of her chiropractic business of $434,246 and $509,195,
respectively, which was omitted from her returns. Larson did not include
Optimum Health Trust’s business receipts as income on petitioner’s returns for
1996 and 1997.
After petitioner started to accumulate what she believed to be tax savings,
Palmer convinced her to invest in his company, Wild Fire. Beginning in 1994 and
continuing through 1997 petitioner wrote Palmer a series of checks, drawn from
her individual and trust bank accounts, for investment. Palmer initially repaid
petitioner’s investments plus a return of about 15% to 20%, which she would
7
Attached to Euphoria Equities’ 1996 Form 1040NR is a Schedule K-1 for
its beneficiary, New Covenant Trust, with a reported address in Belize. Attached
to Euphoria Equities’ first 1997 Form 1040NR is a Schedule K-1 for New
Covenant Trust, and attached to its second 1997 Form 1040NR is a Schedule K-1
marked as “amended” for Tri-Global Management, Inc. New Covenant Trust did
not file a Federal tax return for 1996 or 1997.
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[*13] reinvest with Palmer. Petitioner made her last investment with Palmer in
August 1997.
IV. After 1997
After 1997 petitioner made numerous unsuccessful attempts to contact
Palmer regarding her investments, not realizing that Palmer had fled the United
States for New Zealand. It turned out that petitioner was one of many of Mr.
Palmer’s investors, and in 2001 he was extradited from New Zealand. In 2001
Palmer and Larson were indicted by a grand jury of the U.S. District Court for the
Central District of Illinois for, inter alia, conspiring to defraud the U.S.
Department of the Treasury, Internal Revenue Service (IRS), in violation of 18
U.S.C. sec. 371 by promoting, marketing, and selling abusive trusts.
In January 2002 Larson entered into a plea agreement with the United States
and pleaded guilty to, inter alia, conspiring to defraud the IRS in violation of 18
U.S.C. sec. 371 and subscribing false and fraudulent income tax returns in
violation of section 7206(1). After a jury trial in 2002 Palmer was found guilty of
all charges of conspiring to defraud the IRS and aiding and assisting in preparing
fraudulent returns and was sentenced to prison.
On December 12, 2002, respondent issued a notice of deficiency to
petitioner for tax year 1996. On August 28, 2003, respondent issued two notices
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[*14] of deficiency to petitioner, one for tax years 1993 and 1994 and the other for
tax years 1995 and 1997. Petitioner timely filed petitions with the Court seeking
redetermination.8
OPINION
I. Statute of Limitations
A. Tax Years 1993, 1994, and 1995
Section 6501(a) provides that the Commissioner must assess any income tax
within the three-year period after a taxpayer files his return, unless certain
exceptions apply. In the case of a substantial omission of income, the period of
limitations can be extended to six years. Sec. 6501(e)(1)(A). If, however, a
taxpayer files a false or fraudulent return with the intent to evade tax, the tax may
be assessed at any time. Sec. 6501(c)(1). In Allen v. Commissioner, 128 T.C. 37,
42 (2007), the Court held that section 6501(c) indefinitely extends the period of
limitations on assessment in the case of a false or fraudulent return, even though it
is the preparer and not the taxpayer who intended to evade tax.
8
On May 2, 2012, petitioner filed an amended petition in each case. In
docket No. 4058-03, petitioner expanded her claim for a theft loss deduction and a
carryback for tax year 1996. In docket Nos. 20447-03 and 20448-03, petitioner
added a claim for a theft loss deduction and a carryback for tax years 1993, 1994,
1995, and 1997.
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[*15] The definition of fraud for purposes of the section 6501(c) period of
limitations on assessment is the same as the definition of fraud for purposes of the
section 6663 fraud penalty. Rhone-Poulenc Surfactants & Specialties, L.P. v.
Commissioner, 114 T.C. 533, 548 (2000). The elements of fraud are: (1) the
taxpayer has underpaid his tax for each year and (2) some part of each
underpayment is due to fraud. See DiLeo v. Commissioner, 96 T.C. 858, 873
(1991), aff’d, 959 F.2d 16 (2d Cir. 1992).
Respondent asserts that the periods to assess petitioner’s tax liabilities for
1993, 1994, and 1995 are open under section 6501(c) because petitioner’s
underpayments of tax are due to her return preparer’s fraud. Petitioner has
conceded respondent’s calculations in the notices of deficiency and, except for her
theft loss claim, does not dispute that she underpaid her tax for the years in issue.
Thus, in order to prevail under section 6501(c), respondent must prove by clear
and convincing evidence that petitioner’s return preparer, Larson, filed false or
fraudulent returns with the intent to evade tax. See sec. 7454(a); Rule 142(b). To
meet this burden, respondent must prove that Larson intended to evade tax known
to be owing by conduct intended to conceal, mislead, or otherwise prevent the
collection of tax. See Parks v. Commissioner, 94 T.C. 654, 661 (1990).
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[*16] Fraud is the intentional commission of an act or acts for the specific
purpose of evading tax believed to be due and owing. Petzoldt v. Commissioner,
92 T.C. 661, 698 (1989). Fraud may not be imputed or presumed but must be
established by independent evidence. Id. at 699. Fraud is not synonymous with
negligence, either general or gross, because fraud requires scienter. Webb v.
Commissioner, 394 F.2d 366, 377-378 (5th Cir. 1968), aff’g T.C. Memo. 1966-81.
“Fraud implies bad faith, intentional wrong doing and a sinister motive”, whereas
negligence or gross negligence bespeaks a breach of duty of care. Davis v.
Commissioner, 184 F.2d 86, 87 (10th Cir. 1950), remanding a Memorandum
Opinion of this Court.
The existence of fraud is a factual determination upon consideration of the
entire record. Gajewski v. Commissioner, 67 T.C. 181, 199 (1976), aff’d without
published opinion, 578 F.2d 1383 (8th Cir. 1978). Among the factors to be
evaluated in determining whether a return preparer acted with fraudulent intent
are: (1) understatements of tax; (2) inadequate books and records; (3) implausible
or inconsistent explanations of behavior; (4) failure to cooperate with, or failure to
provide access to records to, tax authorities; (5) making false entries or alterations;
(6) keeping a double set of records; and (7) any other conduct the likely effect of
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[*17] which is to mislead or to conceal. See Spies v. United States, 317 U.S. 492,
499 (1943); see also Eriksen v. Commissioner, T.C. Memo. 2012-194.
1. Tax Year 1993
Respondent contends that Larson fraudulently understated petitioner’s
income tax for 1993 by deducting the $46,000 petitioner paid Palmer in November
1993 for her first abusive trust arrangement. Respondent argues that Larson knew
that the $46,000 payment was unrelated to petitioner’s chiropractic business and
therefore was an impermissible business expense deduction under section 162.
Respondent also argues that Larson knew that the purpose of the trust arrangement
was to avoid tax, and with this knowledge Larson purposefully mischaracterized
petitioner’s $46,000 payment as cost of sales and contract services so as not to
raise a “red flag” with respondent.
Although respondent correctly points out that petitioner’s $46,000 payment
for the first trust arrangement was unrelated to her chiropractic business and
therefore was improperly deducted as a section 162 business expense, Larson’s
deduction of the payment does not demonstrate a clear and convincing intent to
evade tax or a sinister motive. After reviewing Palmer’s books and videos and
meeting with him several times to question the trust arrangement, Larson believed,
albeit mistakenly, that the trust arrangement was legitimate. At that time, Larson
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[*18] also incorrectly viewed the trust arrangement as a financial planning
arrangement whereby petitioner might reduce her taxable business income.
Moreover, in exchange for petitioner’s $46,000 payment, she received four trusts
and assistance with incorporating her sole proprietorship as Optimum Health, a
fiscal year C corporation. Larson therefore reported petitioner’s $46,000 payment
as a business expense deduction on her Schedule C for 1993 and a net profit of
$102,773.
Thus, while Larson’s misdirected reliance on Palmer’s claims about the
legitimacy of his trust arrangement, combined with his misunderstanding of
business expense deductions under section 162, connote negligence, his conduct
in preparing petitioner’s 1993 return was not clearly and convincingly fraudulent.
In fact, Larson’s lack of fraudulent intent with respect to the $46,000 payment was
particularly evident at trial. Larson, almost 18 years after preparing petitioner’s
1993 return, testified that his only error with regard to the $46,000 payment was
that he should have amortized the payment as a startup business expense rather
than deducting the payment in full. Accordingly, the extended limitations period
set forth in section 6501(c) is not applicable, and respondent’s determination
relating to tax year 1993 is time barred.
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[*19] 2. Tax Years 1994 and 1995
Larson’s conduct in preparing petitioner’s returns for tax years 1994 and
1995 was more egregious. In addition to individual returns, Larson prepared the
1994 and 1995 corporate returns for petitioner’s solely owned corporation,
Optimum Health. On each of the corporate returns Larson reported Optimum
Health’s trust payments and payments to Palmer and his entities as section 162
business expense deductions. Larson lacked any evidence that the payments were
related to petitioner’s chiropractic business or, more importantly, that Optimum
Health actually received goods, services, or rental equipment in exchange for the
payments. In fact, unlike petitioner’s payment for Palmer’s trusts in 1993,
Optimum Health received nothing in exchange for its trust payments in 1994 and
1995.
Larson characterized the trust payments as “cost of sales”, “management
fees”, and “rent”. Although he claimed to rely on Optimum Health’s books and
records to characterize the payments, he prepared Optimum Health’s books and
records using, inter alia, check stub descriptions and Palmer’s instructions. Larson
was therefore responsible for any purported mischaracterizations of the trust
payments.
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[*20] Larson knew that the purpose of the trust arrangement was to reduce
Optimum Health’s taxable business income. Indeed, Optimum Health’s deductions
for its trust payments and payments to Palmer and his entities, which totaled
$154,000 and $162,000 for 1994 and 1995, respectively, significantly reduced
Optimum Health’s taxable business income to $16,635 and $27,542, respectively.
Larson also knew that petitioner’s trusts, which received $144,000 of
Optimum Health’s income each year, had not filed returns, thereby avoiding any
tax on the trust payments. Petitioner, who had complete control of the trust bank
accounts, had access to any business receipts siphoned from Optimum Health and
used the trust funds for personal expenses. Nonetheless, in preparing petitioner’s
1994 and 1995 returns, Larson omitted Optimum Health’s trust payments from
petitioner’s income. Larson therefore also knew that petitioner’s taxable income
was reduced and the tax on her trust payments would be avoided entirely.9
The Court therefore finds that Larson knew that Optimum Health’s trust
payment deductions were false, and by falsely characterizing these payments he
9
Petitioner was Optimum Health’s sole shareholder. Optimum Health’s
distribution of property, whether directly or indirectly, to petitioner was taxable
dividend income to petitioner. See infra pp. 23-25.
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[*21] demonstrated fraudulent intent.10 Moreover, by failing to report Optimum
Health’s trust payments as income to its sole shareholder, petitioner, and thereby
avoiding tax on these payments, Larson prepared petitioner’s 1994 and 1995
returns with the intent to evade tax. Accordingly, petitioner’s 1994 and 1995
returns were false and fraudulent, and section 6501(c) extends the limitations
periods for tax years 1994 and 1995. Respondent may therefore assess and collect
any deficiencies in petitioner’s 1994 and 1995 income tax.
B. Tax Years 1996 and 1997
The general three-year limitations period on assessment of tax is extended to
six years if a taxpayer omits an amount from gross income which exceeds 25% of
the amount of gross income stated on the return. Sec. 6501(e)(1)(A). Petitioner
reported gross income of $31,493 and $20,269 on her 1996 and 1997 returns,
respectively. As discussed below, during 1996 and 1997 petitioner had gross
receipts from the operation of her chiropractic business of $434,246 and $509,195,
respectively, which were omitted from her returns. The amounts of gross income
omitted from her 1996 and 1997 returns exceeded 25% of the gross income
10
In 2002 Larson entered into a plea agreement with the United States and
pleaded guilty to conspiring to defraud the IRS in the preparation of Optimum
Health’s corporate income tax returns for fiscal years ending November 30, 1994
and 1995.
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[*22] reported on her returns. Therefore, the limitations periods for assessing
petitioner’s 1996 and 1997 income tax were extended to six years. See id.
Petitioner filed her 1996 and 1997 returns on April 15, 1997 and 1998,
respectively. After applying section 6501(e)(1)(A), the limitations periods for
petitioner’s 1996 and 1997 income tax were extended to April 15, 2003 and 2004,
respectively. Respondent issued petitioner a notice of deficiency for her 1996
income tax and penalties on December 12, 2002. He issued to petitioner a notice of
deficiency for her 1997 income tax and penalties on August 28, 2003.
Accordingly, the notices of deficiency for petitioner’s 1996 and 1997 tax years
were timely, and respondent may assess and collect any deficiencies in petitioner’s
income tax for those years.
II. Deficiency
Generally, the Commissioner’s determination of a deficiency is presumed
correct, and the taxpayer bears the burden of proving it incorrect. See Rule 142(a);
Welch v. Helvering, 290 U.S. 111, 115 (1933).
For the tax years in issue respondent determined, and petitioner concedes,
that the entities involved in her trust arrangements were shams. Accordingly, the
entities may be disregarded for Federal income tax purposes, see, e.g., Markosian
v. Commissioner, 73 T.C. 1235, 1245 (1980), and the Court “will look through that
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[*23] form and apply the tax law according to the substance of the transaction”,
Zmuda v. Commissioner, 79 T.C. 714, 719-720 (1982), aff’d, 731 F.2d 1417 (9th
Cir. 1984).
In addition petitioner has conceded the calculations of income, deductions,
and credits for the years in issue as determined in the notices of deficiency but
argues that she is entitled to a theft loss deduction. Before discussing petitioner’s
theft loss claim, the Court will address the calculation of petitioner’s income tax
deficiencies for the remaining years in issue notwithstanding petitioner’s
concession. The factual and legal circumstances of petitioner’s understatements of
income tax are significant for purposes of the Court’s section 6662 accuracy-
related penalty discussion below.
A. Unreported Income
1. Tax Years 1994 and 1995
In 1994 and 1995 petitioner, following Palmer’s instructions, directed her
solely owned corporation, Optimum Health, to pay a total of $144,000 each year to
three of her trusts, Jupiter, Calypso, and Peaceful Vistas. She then transferred the
$144,000 of trust funds to Euphoria Equities’ bank account, which she controlled
and used as her own. In addition, petitioner directed Optimum Health to pay
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[*24] $10,000 in 1994 and $18,000 in 1995 to Palmer and his entities for purported
financial services.
Section 61(a) provides that gross income includes all income from whatever
source derived, including, but not limited to, dividends. Sec. 61(a)(7). A
corporation’s distribution of property to a shareholder with respect to his stock,
whether formally or informally, must be included in the shareholder’s gross income
as a dividend to the extent of the corporation’s earnings and profits. See secs.
301(a), (c)(1), 316; see also United States v. Mews, 923 F.2d 67, 68 (7th Cir.
1991). The shareholder does not need to receive the dividend directly and must
include in gross income payments made by the corporation on the shareholder’s
behalf. See Epstein v. Commissioner, 53 T.C. 459, 474-475 (1969). In
determining whether a shareholder received a constructive dividend, the Court
considers whether the payment by the corporation benefited the shareholder
personally rather than furthering the interest of the corporation. See Hagaman v.
Commissioner, 958 F.2d 684, 690-691 (6th Cir. 1992), aff’g in part and remanding
on other grounds T.C. Memo. 1987-549.
Optimum Health’s payments to petitioner’s trusts ended up in a bank account
that petitioner controlled and used to pay her personal expenses. Petitioner
concedes that the trusts were shams. Thus, Optimum Health indirectly paid
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[*25] petitioner through her trust arrangement $144,000 in 1994 and $144,000 in
1995. Petitioner must therefore include these payments in income as constructive
dividends to the extent of Optimum Health’s earnings and profits. See secs.
61(a)(7), 301(a), (c)(1), 316; see also Epstein v. Commissioner, 53 T.C. at 474-475.
Similarly, Optimum Health paid Palmer and his entities $10,000 in 1994 and
$18,000 in 1995 for purported financial services. Palmer’s alleged financial advice
was unrelated to Optimum Health’s chiropractic business but rather was personal to
petitioner. Therefore, Optimum Health’s payments to Palmer and his entities were
made on petitioner’s behalf; and provided that Optimum Health had sufficient
earnings and profits for 1994 and 1995, petitioner must include these payments in
income as constructive dividends. See secs. 61(a)(7), 301(a), (c)(1), 316.
Optimum Health operated for two fiscal years ending November 30, 1994
and 1995.11 After disallowing its payments to the trusts and to Palmer and his
entities, Optimum Health had taxable income of $170,635 and $189,542 for 1994
and 1995, respectively. Accordingly, Optimum Health had earnings and profits for
1994 and 1995 in excess of the amounts it indirectly transferred to petitioner, and
as respondent determined and petitioner concedes, petitioner should have reported
dividend income of $154,000 and $162,000 for 1994 and 1995, respectively.
11
See supra pp. 7-8 and note 4.
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[*26] 2. Tax Years 1996 and 1997
During 1996 and 1997 petitioner’s business trust, Optimum Health Trust,
reported business receipts earned solely from petitioner’s chiropractic services.
Through a series of transactions, Optimum Health Trust transferred its net business
income of $205,173 in 1996 and $214,392 in 1997 to Euphoria Equities’ bank
account. Petitioner controlled Euphoria Equities’ bank account and used the
account to pay bills and other personal expenses. On its trust returns for 1996 and
1997 Optimum Health Trust reported that it distributed its net profits to its
beneficiary and consequently reported zero tax due.
Section 61 provides that gross income includes all income from whatever
source derived and, in section 61(a)(2), specifically lists gross income derived from
business. As a general rule, items of gross income must be included in the gross
income of a cash method taxpayer for the year in which the taxpayer actually or
constructively received the income. See sec. 451(a); sec. 1.451-1(a), Income Tax
Regs. Income not actually reduced to a taxpayer’s possession is constructively
received by a taxpayer in the year during which the income is credited to an
account, set apart, or otherwise made available so that the taxpayer may draw upon
it at any time. Sec. 1.451-2(a), Income Tax Regs.
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[*27] Optimum Health Trust earned its income solely from petitioner’s
chiropractic business, and through a series of transactions it transferred all of its
income to a bank account petitioner controlled. The parties agree that Optimum
Health Trust and its related entities were shams. Thus, any transfers of income
from Optimum Health Trust to petitioner must be reported as business income to
petitioner. Petitioner therefore failed to report business income of $205,173 and
$214,392 for tax years 1996 and 1997, respectively.12
B. Theft Loss
Petitioner claims that she is entitled to a theft loss deduction for the money
she paid Palmer during the years in issue. Although petitioner did not provide any
evidence documenting the amount of the purported theft loss, she testified at trial
that Palmer owes her $570,000 plus interest. Petitioner is not sure when she
discovered the loss, but she made her last investment with Palmer in August 1997.
Around that time she tried to contact Palmer, but he did not respond. Palmer had
fled the United States and in 2001 was extradited from New Zealand. In 2002
Palmer was found guilty by a jury of defrauding the IRS and was sentenced to
12
Respondent also determined, and petitioner does not dispute, that
petitioner is liable for self-employment tax under sec. 1401 on her unreported
business income and is entitled to corresponding self-employment tax deductions.
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[*28] prison. In 2004 petitioner joined a class action suit against Palmer that is still
pending.
Although petitioner did not discover the theft until after 1997, the last tax
year in issue, the Court has jurisdiction to consider facts related to tax years not in
issue as may be necessary to redetermine the amount of a deficiency for the period
before the Court. See sec. 6214(b). In addition, deductions are a matter of
legislative grace, and the taxpayer bears the burden of proving that she is entitled to
any deductions claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84
(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). Taxpayers
must maintain sufficient records to establish the amounts of allowable deductions
and to enable the Commissioner to determine the taxpayers’ correct tax liabilities.
See sec. 6001; Shea v. Commissioner, 112 T.C. 183, 186 (1999); sec. 1.6001-1(a),
Income Tax Regs.
Section 165(a) provides that a taxpayer may deduct any loss sustained during
the taxable year and not compensated for by insurance or otherwise. For
individuals, a loss is deductible only when: (1) losses are incurred in a trade or
business; (2) losses are incurred in a transaction entered into for profit though not
connected to a trade or business; or (3) losses arise from fire, storm, shipwreck, or
other casualty, or from theft. Sec. 165(c).
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[*29] “Theft” for purposes of section 165 is a word of general and broad meaning
that includes any criminal appropriation of another’s property, including theft by
swindling, false pretenses, and other forms of guile. Edwards v. Bromberg, 232
F.2d 107, 110 (5th Cir. 1956); sec. 1.165-8(d), Income Tax Regs. Whether a theft
loss occurred depends upon the law of the State where the alleged theft occurred.
Luman v. Commissioner, 79 T.C. 846, 860 (1982). A taxpayer must prove by only
a preponderance of the evidence a theft occurred under applicable State law. Allen
v. Commissioner, 16 T.C. 163, 166 (1951).
Generally, a theft loss is treated as sustained in the taxable year in which the
taxpayer discovers it. Sec. 165(a), (e). However, if there is a claim for
reimbursement for which there is a reasonable prospect for recovery, then the loss
is treated as sustained only when it can be ascertained with reasonable certainty
that the reimbursement will not be obtained. Secs. 1.165-1(d)(2)(i), (3), 1.165-
8(a)(2), Income Tax Regs.
Although a theft loss may create a net operating loss, the general rule for
carrying back a net operating loss is that it may be first deducted from income in
the tax year that is two years before the year of the net operating loss. Sec.
172(b)(1)(A)(i). A net operating loss is the excess of deductions over gross
income. Sec. 172(c).
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[*30] Assuming petitioner can prove that a theft occurred under the law of Illinois,
the State in which the alleged theft occurred, she cannot establish the amount of the
loss or whether she will receive reimbursement. At the earliest, petitioner’s theft
loss was sustained in 1998 and may be carried back to 1996. However, petitioner
may claim a net operating loss carryback deduction for her 1996 tax year only to
the extent that her deductions for 1998, including the theft loss deduction,
exceeded her gross income for 1998. Petitioner has not provided any evidence of a
net operating loss in 1998. Her testimony that Palmer owes her $570,000 plus
interest is self-serving and without more is insufficient to substantiate the amount
of her alleged theft loss. Moreover, petitioner joined a class action lawsuit against
Palmer seeking reimbursement for her losses, and the lawsuit is still pending.
Petitioner may therefore have a reasonable prospect for recovery, and she has not
proven otherwise. Accordingly, petitioner is not entitled to a theft loss deduction
for any of the years in issue.
III. Accuracy-Related Penalty
Respondent determined that petitioner is liable for accuracy-related penalties
under section 6662(a) and (b)(1) and (2) for negligence and for substantial
understatements of income tax. Negligence includes any failure to make a
reasonable attempt to comply with the law, including any failure to maintain
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[*31] adequate books and records or to substantiate items properly. Sec. 6662(c);
sec. 1.6662-3(b)(1), Income Tax Regs. In the case of an individual, an
understatement of income tax is substantial if it exceeds the greater of 10% of the
tax required to be shown on the return or $5,000. Sec. 6662(d)(1)(A). Petitioner’s
understatements of income tax for tax years 1994 through 1997 are substantial
because for each year her understatement exceeds 10% of the tax required to be
shown on her income tax return, which is greater than $5,000.
Taxpayers may, however, avoid the accuracy-related penalty under section
6662(a) by establishing that they acted with reasonable cause and in good faith.
Sec. 6664(c)(1); Higbee v. Commissioner, 116 T.C. 438, 448 (2001). Reasonable
cause and good faith include reliance on professional advice if, under all the
circumstances, such reliance was reasonable and the taxpayer acted in good faith.
Sec. 1.6664-4(b)(1), Income Tax Regs. A taxpayer asserting reliance on
professional advice must prove that: (1) the adviser was a competent professional
with sufficient expertise to justify reliance; (2) the taxpayer provided necessary and
accurate information to the adviser; and (3) the taxpayer actually relied in good
faith on the adviser’s judgment. See Neonatology Assocs., P.A. v. Commissioner,
115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). Good-faith reliance,
however, does not include reliance on a “promoter”, “‘an adviser who participated
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[*32] in structuring the transaction or is otherwise related to, has an interest in, or
profits from the transaction’” when the transaction is a tax shelter offered to
numerous parties. 106 Ltd. v. Commissioner, 136 T.C. 67, 79-80 (2011) (quoting
Tigers Eye Trading, LLC v. Commissioner, T.C. Memo. 2009-121), aff’d, 684 F.3d
84 (D.C. Cir. 2012).
Petitioner claims that section 6664(c) relieves her of the accuracy-related
penalties because she reasonably relied on Larson, her return preparer, to determine
the proper treatment of her income and business expenses. Petitioner also claims
that she trusted Palmer because he was her minister.
The parties stipulated that Palmer “promoted, marketed and sold” the trust
arrangements in issue to petitioner. Palmer was therefore a promoter, and
petitioner could not reasonably and in good faith rely on his advice with respect to
these trusts. See 106 Ltd. v. Commissioner, 136 T.C. at 79.
In addition, despite petitioner’s claim that she relied on Larson to determine
the tax consequences of her income and expenses, beginning in 1994 she was fully
aware of the tax-avoidance nature of Palmer’s trust arrangements. In 1993, which
is no longer in issue, petitioner researched Palmer’s proposed trust arrangement by
studying the books and videos he provided. She also met with Larson, who,
despite being introduced to petitioner by Palmer, also sought to ascertain the
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[*33] legality of Palmer’s trust arrangement and advised petitioner regarding the
same. Thus, it is likely that up until 1994 petitioner acted in good faith and
reasonably relied on Larson with respect to her underpayments.
However, beginning in 1994 and continuing through 1997, petitioner’s
participation in Palmer’s abusive trust arrangements escalated. Petitioner had
practiced as a sole proprietor since 1985 and therefore was at the very least familiar
with reporting receipts and expenses from her chiropractic business. Nonetheless
in 1994 and again in 1995 petitioner, at Palmer’s instructions, moved $144,000 of
her business receipts through her trusts to a trust bank account that she controlled
and used as her own. Petitioner knew that the $144,000 of trust payments was
deducted from her taxable business receipts without being reported on her
individual returns and therefore was not taxed. Accordingly, petitioner no longer
acted with good faith and any reliance on her tax advisers was unreasonable.
After about two years of purported “tax savings” or, more correctly, tax
avoidance, petitioner, at Larson’s suggestion, considered a more aggressive tax
avoidance scheme offered by Aegis.13 Although petitioner decided to stay with
Palmer, in December 1995 she adopted and implemented a second trust
arrangement that Palmer advertised as similar to the Aegis plan but at a fraction of
13
See supra p. 9 and note 5.
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[*34] the cost. Under this arrangement, petitioner reported zero tax on her business
receipts for tax years 1996 and 1997 while continuing to access her business
income deposited in a trust bank account. A taxpayer with even less tax experience
than petitioner would have been fully aware of the aggressive tax avoidance
implications of this arrangement. Petitioner therefore did not act with reasonable
cause and in good faith with respect to her underpayments of income tax for tax
years 1994 through 1997, and respondent’s accuracy-related penalties for those
years are sustained.
The Court has considered the parties’ arguments and, to the extent not
addressed herein, concludes that they are moot, irrelevant, or without merit.
To reflect the foregoing,
Decisions will be entered
under Rule 155.