T.C. Memo. 1996-87
UNITED STATES TAX COURT
BILL MCDONALD, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
RICHARD D. MAYNARD, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 13218-93, 13220-93. Filed February 28, 1996.
Roderick L. MacKenzie, for petitioners.
Kathryn K. Vetter and Daniel J. Parent, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, Judge: Respondent determined deficiencies in 1989
income tax, and penalties as follows:
Fraud Penalty
Petitioner Deficiency Sec. 6663
McDonald $53,041 $39,781
Maynard 71,380 53,535
- 2 -
After considering the parties’ concessions and stipulations to be
bound by the outcome of other cases, the issues remaining for our
consideration are: (1) Whether petitioners’ partnership’s 1989
income was understated; (2) whether petitioners correctly
reported their distributive shares of partnership income;
(3) whether either petitioner failed to report income with
respect to various items respondent determined to be includable
in his income; (4) whether either petitioner is liable for
additional self-employment tax; and (5) whether either petitioner
is liable for the fraud penalty under section 6663.1
FINDINGS OF FACT2
Petitioners Bill McDonald (McDonald) and Richard D. Maynard
(Maynard) resided in California at the times each of their
petitions was filed in these cases. McDonald and Maynard each
filed his 1989 income tax return reflecting that his filing
status was “single”. Although McDonald and Maynard were each
married as of the close of 1989, they, along with their
respective spouses, filed for and received annulments of their
marriages during 1994. The question of whether McDonald and
Maynard were married or single for Federal income tax purposes,
considering the annulments of their respective marriages, was
decided by this Court in McDonald v. Commissioner, T.C. Memo.
1
Section references are to the Internal Revenue Code in
effect for the year under consideration. Rule references are to
this Court’s Rules of Practice and Procedure.
2
The parties’ stipulation of facts and exhibits are
incorporated by this reference.
- 3 -
1994-607, and Shackelford v. Commissioner, T.C. Memo. 1995-484,
respectively.3 Respondent and petitioners agreed to be bound by
the outcome of the above-referenced opinions. The above-
referenced opinions hold that the taxpayers were married for
Federal income tax purposes, although they had subsequently
obtained annulments of their marriages under the laws of the
State of California. Accordingly, petitioners’ filing status
should have been “married filing separately” for purposes of
their 1989 tax year.
Petitioners, at all pertinent times, were certified public
accountants, with more than 60 years of experience between them,
practicing together in an accounting partnership known as Maynard
& McDonald (M&M). There was no written partnership agreement
through the 1989 tax year. McDonald is also an attorney licensed
to practice in the State of Oklahoma. M&M is a cash basis
partnership that petitioners formed in 1976 and operated during
the 1989 taxable year in Sacramento, California. M&M’s principal
activities are tax return preparation, assistance to clients in
tax-related matters, providing accounting services, and
representing clients before various administrative levels of the
Internal Revenue Service. In addition, McDonald also filed
clients’ petitions with this Court. McDonald was familiar with
3
Petitioners were either the parties in the underlying
cases or referenced in several recent opinions issued by this
Court. See Bill McDonald, et al. v. Commissioner, T.C. Memo.
1994-607; Denver W. McDonald v. Commissioner, T.C. Memo. 1995-
359; Betty J. Shackelford v. Commissioner, T.C. Memo. 1995-484;
and Mary C. McDonald v. Commissioner, T.C. Memo. 1995-503.
- 4 -
the requirement that tax return preparers are to keep copies of
prepared returns or a list of clients. Petitioners’ accounting
practice specialized in the field of taxation.
M&M’s 1989 U.S. Partnership Return of Income (Form 1065),
which McDonald prepared, reflected gross receipts of $24,590 and
a single deduction of $24,590 attributable to “Guaranteed
payments to partners”. Other than on the Schedules K-1, no other
information was reflected on the partnership return (i.e., the
balance sheet was left blank, and the Schedule M for
reconciliation of partners’ capital was marked “NA”). The
Schedules K-1 revealed that Maynard and McDonald were 50-50
partners, but that McDonald was allocated $3,457 of the
guaranteed payments to partners, and the remaining $21,133 was
allocated to Maynard. McDonald's $3,457 share of M&M’s 1989
income was based on Maynard’s estimate. Petitioners did not
maintain records of the number of hours worked or number of
returns prepared by each partner.
M&M’s returns for the fiscal year ended September 30, 1987,
the period October 1 through December 31, 1987, and the 1988
calendar year each reflect that petitioners shared profits and
losses in a 50-50 ratio. These three returns reflect income and
guaranteed payments to petitioners, as follows:
Taxable Period Income McDonald Maynard
FYE 9/30/87 $5,520 $3,670 $1,850
10/01 to 12/31/87 750 500 250
Calendar 1988 24,469 3,711 20,758
- 5 -
Accordingly, for two of the reporting periods, McDonald received
about two-thirds and Maynard about one-third of M&M’s income. In
the third reporting period, Maynard received about 85 percent and
McDonald about 15 percent.
Respondent’s agents analyzed the ratio of hours spent during
1989 by Maynard and McDonald in preparing returns of M&M's
clients and found it to be about 60 percent for Maynard and 40
percent for McDonald. Respondent, in the notices of deficiency,
determined $214,393 of 1989 partnership income and attributed
$79,661 to McDonald and $134,732 to Maynard.
M&M did not have any employees, and petitioners were solely
responsible for maintaining M&M’s books and records.
Petitioners’ billing approach was to send a bill for services to
clients and retain a copy for M&M’s records. When they received
payment of a particular bill, M&M’s retained copy of the bill was
discarded. Petitioners’ billing approach made it virtually
impossible to verify whether M&M’s income was accurately
reflected on its books and Federal partnership tax return and on
petitioners’ Schedules K-1.
M&M’s rate schedule, as of January 1, 1989, was $130 per
hour for tax consulting or compliance work and a $275 minimum
rate for individual tax return preparation. Petitioners would
charge for giving advice, including advice given during telephone
calls, with a one-tenth-hour minimum charge. The printed rate
schedule contained the notation that, where advice resulted in
substantial savings or was out of the ordinary, the billing might
- 6 -
reflect petitioners’ experience and expertise, rather than the
posted rates. Occasionally, petitioners sent no bill because
they decided to provide gratuitous services. Actual charges to
M&M clients reflect that some clients were billed at a rate in
excess of and some less than M&M’s minimum rate.
During respondent’s examination of their 1989 tax years,
petitioners did not provide books, records, copies of M&M’s bills
to clients, or any other information from which petitioners’
clientele could be identified or respondent could verify
petitioners’ income for 1989. Respondent’s computers reflect
that M&M was shown as the preparer on more than 300 Federal tax
returns for the 1989 processing year. In addition, McDonald
filed 13 clients’ petitions with this Court during 1989.
Petitioners sought the protection of the Bankruptcy Code,
McDonald in December 1980 and Maynard in April 1981. To avoid
the possibility of attachment of their accounts receivable,
petitioners formed a California corporation, Gold Country
Financial, Inc. (Gold), to conduct a tax accounting business
concurrently with and at the same location as M&M. Gold also
provided petitioners with a means to obtain credit after their
bankruptcies because they were employees of Gold. Moreover,
Gold’s sole shareholder was shown as Terry Feil, a friend of
Maynard’s.
Corporate Federal income tax returns were filed for Gold’s
fiscal years ended July 31, 1989 and 1990. Gold’s income and
expenses were reported on the accrual method of tax accounting.
- 7 -
Petitioners maintained the books and records of Gold. M&M did
not claim expenses, and any expenses concerning petitioners’ tax
accounting businesses were paid and/or deducted by Gold. Gold
had no employees other than petitioners.
Similar to M&M, petitioners maintained no cash receipts
journal, accounts receivable list, or client list for Gold. Also
paralleling the practices at M&M, copies of client billing
invoices were discarded after payment was received from the
clients. Petitioners, however, maintained cash disbursements
records for Gold during 1989.
Petitioners maintained a bank account in Gold’s name at the
Merchants National Bank (Merchants Bank), and some, but not all,
of the receipts from clients were deposited into that account.
Petitioners’ method of determining Gold’s annual income for tax
purposes began by totaling the Merchants Bank deposits and
reducing the total by reimbursements for health insurance. The
difference was then adjusted by picking up net increases or
decreases in accounts receivable to convert to the accrual
method. Finally, the accrual method amount was reduced by
expenses that petitioners had billed to and collected from
clients.
For the 1989 and 1990 fiscal years, Gold’s income was
computed and reported by petitioners as follows:
- 8 -
Item 1989 1990
Deposits to bank $68,975.82 $70,669.74
Less:
Auto expenses 10,710.25 -
Insurance reimbursed 2,591.84 5,211.40
Accounts payable 13,338.00 -
Dues/publications 49.50 -
Outside services 505.83 -
Refunds 175.00 -
Accounts receivable (825.00) 15,469.78
Total 26,545.42 20,681.18
1
Income per petitioners 42,430.40 49,988.56
1
The parties stipulated that the amount of income computed
by petitioners for the 1989 fiscal year was $42,430.10, whereas
the supporting amounts stipulated by the parties results in
income of $42,430.40.
Petitioners also maintained a bank account for Gold at the Bank
of Lodi. The existence of Gold’s Bank of Lodi account was not
brought to the attention of respondent’s agent by petitioners.
Respondent’s agent discovered the Bank of Lodi account from a
review of canceled checks obtained from third-party sources
(Gold’s clients). Petitioners deposited some clients’ payments
for services by both M&M and Gold in the Bank of Lodi account for
the fiscal years 1987, 1988, 1989, and 1990. Petitioners did not
report the Bank of Lodi deposits in Gold’s income. For 1989,
checks were written on the Bank of Lodi account to Maynard and
McDonald in the total amounts of $20,421 and $6,024,
respectively. Neither Maynard nor McDonald reported funds for
1989 from Gold’s account with the Bank of Lodi.
Respondent determined that Gold’s income for the 1989 fiscal
year was understated by $63,581 and that $29,292 of deductions
were not allowable. Gold’s petition to this Court was dismissed
- 9 -
due to lack of capacity after the State of California had
suspended its charter.
Respondent’s agent, Arthur Pease (Pease), examined M&M’s
partnership returns for the taxable year ended September 30,
1987, and the calendar years 1987, 1988, and 1989. Petitioners
did not provide the identification of their clients, and Pease
was forced to reconstruct client information by using Internal
Revenue Service computer data (return preparer information) and
by canvassing third parties (petitioners’ clients and banks).
Pease obtained copies of clients’ returns prepared by petitioners
that reflected the fee for tax preparation. Pease also received
a rate sheet for M&M from one of petitioners’ clients. In
addition, Pease received numerous letters that contained
information about the fees charged for return preparation. Pease
also engaged in numerous telephone conversations with
petitioners’ clients concerning the fees that petitioners charged
them.
Based on his research, Pease prepared a schedule of clients,
referencing the accumulated information along with references to
sources for respondent’s reconstruction of petitioners’ income
for the 1989 taxable year. Where Pease determined that an
individual return had been prepared and that no invoice, deposit
information, canceled check, or client information was available
to reflect the fee charged, he used a $275 preparation fee, the
minimum charge for an individual return reflected on M&M’s rate
schedule. Based on the information available to him, Pease
- 10 -
determined that the average 1989 return preparation fee was $482
for an individual return, $1,400 for a corporate return, and
$1,250 for a partnership return. In his reconstruction, Pease
also accounted for the fact that some returns were prepared
gratuitously. Pease determined total 1989 fees of $192,201.
Based on information provided by petitioners during trial
preparation, respondent conceded on brief that total combined
reconstructed 1989 fees were $185,128.
To determine M&M’s income for 1989, deposits into Gold’s
Merchants Bank account for the first 7 months were eliminated in
the total amount of $33,388 because Gold had reported that amount
for its taxable year ended July 31, 1989. No adjustment for
Merchants Bank deposits was made for the last 5 months of 1989
because petitioners did not provide income and accounts
receivable records for that period. There was no consistency
about which entity prepared a particular client’s return (it
would indiscriminately vary between M&M and Gold from year to
year).
Petitioners, in their respective 1989 income tax returns,
did not report the $250 monthly payments for automobile expenses
received from Gold during 1989. Petitioners reduced the amount
of the Merchants Bank deposits reported in Gold’s income by the
amount petitioners paid for automobile expenses. Petitioners did
not submit any documentation to Gold in support of their
automobile mileage or expenses for 1989. Maynard conceded that
the 1989 automobile reimbursement received from Gold was income
- 11 -
to him for 1989. Maynard testified that all payments to
petitioners for 1989 from the Bank of Lodi were his income or
expense reimbursement.
Gold, during 1989, paid the California Society of Certified
Public Accountants $16,325.36 for health insurance for several
individuals, including petitioners. One of those individuals was
McDonald’s former accounting partner, who reimbursed Gold
$2,765.44 for his portion of the insurance. The remaining
insured individuals were petitioners and members of their
families. Although petitioners prepared returns on behalf of
Gold, they claim to have not received any compensation other than
the monthly automobile reimbursement and insurance coverage.
Maynard did not have a personal bank account, and he paid
bills with cash or checks from the checking account of another
individual. McDonald and Maynard, during 1989, made cash
purchases of numerous cashier’s checks in amounts of $10,000 or
less for various purposes. Maynard purchased two $7,500
cashier’s checks on June 8, 1989, from two separate banks. On
that same date, McDonald purchased a $9,000 and a $10,000
cashier’s check from separate banks. A series of cashier’s
checks, including the ones purchased on June 8, 1989, was used as
part of the purchase price of a residence which was placed in the
name of McDonald’s wife. McDonald purchased numerous cashier’s
checks, mostly with cash, during 1989. The dates, amounts, and
bank locations were as follows:
- 12 -
1989 Date Amount Location Purchased
Apr. 20 $3,000 Commerce Savings
June 8 9,000 Commerce Savings
June 8 10,000 Bank of Alex Brown
June 12 9,000 Wells Fargo
June 14 1,432 Wells Fargo
June 14 2,594 Wells Fargo
Respondent concedes that the source of the $10,000 cashier’s
check would not result in income to McDonald.
McDonald’s wife remitted three checks to Maynard during 1989
in the following amounts: $995.90, $550, and $699.50.
McDonald’s daughter also remitted a $2,500 check to Maynard
during 1989.
OPINION
Procedural Question--Initially, we consider petitioners’
procedural argument that the notices of deficiency are "arbitrary
and capricious". Petitioners argue that respondent should have
the burden of going forward with the evidence because
respondent’s determination is arbitrary and capricious and that
respondent’s determination should not enjoy a presumption of
correctness. See Jackson v. Commissioner, 73 T.C. 394, 403
(1979); Weimerskirch v. Commissioner, 596 F.2d 358, 361 (9th Cir.
1979), revg. 67 T.C. 672 (1977). By contending that the notices
are arbitrary, petitioners are essentially asking us to look
behind the notices of deficiency to examine the evidence used by
respondent in making her determinations. Riland v. Commissioner,
79 T.C. 185, 201 (1982); Jackson v. Commissioner, supra at 400;
Greenberg's Express, Inc. v. Commissioner, 62 T.C. 324, 327
- 13 -
(1974); Weimerskirch v. Commissioner, supra. We have looked
behind the notice in those rare instances where respondent relied
upon a "'naked' assessment without any foundation whatsoever".
United States v. Janis, 428 U.S. 433, 441 (1976); Jackson v.
Commissioner, supra at 401.
In Weimerskirch v. Commissioner, supra, and Dellacroce v.
Commissioner, 83 T.C. 269 (1984), the Government possessed no
evidence linking the taxpayers to illegal income. In Dellacroce,
we held the notice of deficiency to be arbitrary because the
reconstruction of income did not link the taxpayer to the income-
generating activity.
In this case, by contrast, there is ample evidence,
including numerous concessions by petitioners, reflecting that
petitioners’ income was not fully reported. Respondent has shown
a clear and direct linkage to sources of unreported income in
this case. See Adamson v. Commissioner, 745 F.2d 541 (9th Cir.
1984), affg. T.C. Memo. 1982-371. Accordingly, we find that
respondent’s determination is not arbitrary.
Income Reconstruction--Where, as here, taxpayers have failed
to provide adequate records substantiating their income, an
indirect method may be used to reconstruct their income. Holland
v. United States, 348 U.S. 121 (1954). Petitioners bear the
burden of proving that the determinations made by respondent in
the notices of deficiency are erroneous. Rule 142(a); Cracchiola
v. Commissioner, 643 F.2d 1383 (9th Cir. 1981) (citing Welch v.
Helvering, 290 U.S. 111 (1933)), affg. per curiam T.C. Memo.
- 14 -
1979-3; Webb v. Commissioner, 394 F.2d 366, 372 (5th Cir. 1968),
affg. T.C. Memo. 1966-81. Taxpayers are required to maintain
records--transactions should be documented, contracts provided,
and expenses substantiated. Sec. 6001; Norgaard v. Commissioner,
939 F.2d 874, 878 (9th Cir. 1991), affg. in part and revg. in
part T.C. Memo. 1989-390.
The Commissioner is entitled to use a reconstruction method
where a taxpayer’s books and records are either inadequate or
nonexistent. Holland v. United States, supra; United States v.
Johnson, 319 U.S. 503 (1943); Campbell v. Guetersloh, 287 F.2d
878, 880 (5th Cir. 1961); Adamson v. Commissioner, supra; Keogh
v. Commissioner, 713 F.2d 496 (9th Cir. 1983), affg. Davies v.
Commissioner, T.C. Memo. 1981-438; United States v. Stonehill,
702 F.2d 1288 (9th Cir. 1983). Petitioners do not dispute that
respondent is entitled to use a reconstruction method.
Petitioners argue that the method of reconstruction used by
respondent was flawed and/or arbitrary.4
Petitioners, who are tax professionals, failed to keep any
record of cash receipts, although they did maintain records of
their cash expenditures. Petitioners intentionally discarded the
only records from which their income could have been verified.
Although petitioners’ tax accounting business activity has been
4
Respondent's reconstruction of petitioners’ income
included any income earned through the M&M partnership. The
corporate income of Gold was the subject of another case. That
case was dismissed due to Gold’s loss of its corporate status
and, hence, capacity to file a petition in this Court for relief.
- 15 -
continuous from 1976 through 1989, the year at issue, it was
operated through several entities. Until both petitioners had
financial difficulties and went through bankruptcy, they had
operated their business as a partnership. After the financial
difficulties, petitioners interposed a corporate entity partly to
deceive creditors and others. The corporate entity allegedly
paid all expenses of petitioners’ tax accounting business, and
only a part of the income from such activity was reported by the
corporate entity. Allegedly, the corporate entity did not pay
petitioners’ salary for their return preparation activity.
Instead, petitioners allegedly received benefits such as
insurance and automobile allowances, and their business overhead
was borne by the corporation.
After the corporate formation, the partnership entity
continued to operate and report some of the business income, but
none of the expenses. The income reported on the partnership
return was distributed as guaranteed payments to partners in
unequal amounts, even though petitioners were shown in the
Schedules K-1 as 50-50 partners and no partnership agreement was
in existence. Petitioners, by commingling these entities and
their business activities, created a murky environment in which
it is difficult to discern the sources of income or the entity by
which an expense had been incurred. Petitioners’ discarding
records of income made this situation even more difficult to
unravel. Finally, petitioners did not cooperate in the
examination process, forcing respondent’s agent to seek third-
- 16 -
party records from banks and clients in order to reconstruct
income.
Under these circumstances, Pease was able to specifically
determine the identity of some clients and a range of the fees
charged. Where the amount of a client’s fee was not available,
Pease used the minimum fee. In instances where it was possible
to discern that specific income had been reported on Gold’s
return (the corporate return), Pease eliminated that amount from
his reconstruction of the partnership return. Where the
corporate income, if any, could not be discerned or verified,
Pease, in order to protect the Government’s interest, attributed
the income to the M&M partnership. In those instances, there may
have been duplication between the income reported for Gold and
the income determined for petitioners through M&M. With respect
to one of those instances, respondent conceded on brief that the
amount of partnership income determined for 1989 should be
reduced by $4,938 for the deposits in Gold’s Merchants Bank
account during the last 5 months of 1989.
Courts have approved methods of reconstruction which project
or extrapolate from a limited amount of information. See, e.g.,
Gerardo v. Commissioner, 552 F.2d 549 (3d Cir. 1977), affg. in
part and revg. in part T.C. Memo. 1975-341; Adamson v.
Commissioner, supra. In Adamson v. Commissioner, supra at 548,
the court stated as follows:
Where the government has introduced evidence
linking the taxpayer to the illegal activity, the
taxpayer should not be allowed to avoid paying taxes
- 17 -
simply because he keeps incomplete records. The
absence of tax records cannot automatically deprive the
Commissioner of a rational foundation for the income
determination. As the Fifth Circuit recognized in Webb
v. C.I.R., 394 F.2d 366, 373 (5th Cir. 1968):
[T]he absence of adequate tax records does not
give the Commissioner carte blanche for imposing
Draconian absolutes .... [However,] such absence
does weaken any critique of the Commissioner's
methodology.
Arithmetic precision was originally and
exclusively in [the taxpayer's] hands, and he had
a statutory duty to provide it .... [H]aving
defaulted in his duty, he cannot frustrate the
Commissioner's reasonable attempts by compelling
investigation and recomputation under every means
of income determination. Nor should he be overly
chagrined at the Tax Court's reluctance to credit
every word of his negative wails.
See also Figueiredo v. Commissioner, 54 T.C. 1508 (1970), affd.
per order (9th Cir., Mar. 14, 1973); Estate of Mason v.
Commissioner, 64 T.C. 651 (1975), affd. 566 F.2d 2 (6th Cir.
1977); Bradford v. Commissioner, 796 F.2d 303 (9th Cir. 1986),
affg. T.C. Memo. 1984-601. Petitioners in this case have not
provided records or a more reasonable or accurate method of
reconstructing their income.
Petitioners attacked respondent’s reconstruction method by
arguing that duplication occurred and by testifying that the
reconstruction was in error based on petitioners’ recollections
that certain clients were charged lesser fees or no fees.
Petitioners, though they are tax professionals, failed to keep
adequate records and thus created this situation in which
respondent is unable to specifically verify or reconstruct the
fees charged to certain clients or to determine whether, in some
- 18 -
instances, the corporation or partnership had earned or received
fees. As a result of the failure to maintain adequate records,
petitioners’ testimony is uncorroborated and rendered less
credible. Although petitioners pointed out situations where they
contended that no fee or a lesser fee was charged, when asked
whether Pease understated any fees, petitioners’ recollection
failed them.
Moreover, Pease was not able to secure the names of all of
petitioners' clients. Petitioners were either unable or
unwilling to disclose the identity of clients missed or not
located by Pease. Finally, petitioners were evasive and vague
when confronted by the Court with inconsistencies in their
testimony or evidence. Considering all these circumstances, we
find petitioners’ testimony to be uncorroborated and without
credibility.
Petitioners also argue that some of their clients may have
failed to pay for services performed. In those instances,
petitioners argue that M&M, which is on the cash method of
accounting, should not include those amounts for the 1989 year.
Petitioners’ argument has several fatal weaknesses. Initially,
petitioners have no proof (because they discarded the billing and
receivable records) of who actually paid and who did not. It was
the absence of those records that forced respondent to
reconstruct petitioners’ income for 1989. A reconstruction
method is not a direct method of accounting, but an indirect
method which can, to some extent, be based on judgment. Again,
- 19 -
petitioners’ attack on the judgmental aspects of respondent’s
reconstruction are dependent on information that petitioners
knowingly and intentionally discarded.5
We must emphasize that petitioners have not performed a
reconstruction of their corporate, partnership, or individual
income by which we could test the accuracy of respondent’s
method. Petitioners have provided only their self-serving
testimony, which is both uncorroborated and contradictory to the
record in this case. Accordingly, we hold that the
reconstruction is appropriate, as modified through the
concessions made by respondent.
Division of Partnership Income--Respondent contends that the
reconstructed partnership income should be split equally by
Maynard and McDonald. Petitioners have, by designation as
“guaranteed payments”, divided M&M’s $24,590 of reported income
$3,457 to McDonald and $21,133 to Maynard. That division equals
approximately 14 percent for McDonald and 86 percent for Maynard.
Through 1989, petitioners did not have a written partnership
5
Petitioners also argued that the doctrine of judicial
estoppel should be applied in this case to preclude respondent
from making the alternative determination that income from the
tax accounting practice could, in some instances, be attributed
to Gold and M&M. That doctrine is inappropriate in this setting.
Because of petitioners’ lack of adequate records, respondent has
taken alternative positions with respect to income that
petitioners could not verify or show belonged to either the
corporation or the partnership. Respondent is permitted to take
such positions, and it is petitioners’ obligation to show which
of the entities, if any, is obligated to report the income. The
mere reporting of the income on the corporate return does not
enable petitioners to meet their burden.
- 20 -
agreement, and all of their Schedules K-1 reflect that their
partnership interests were 50 percent each. Three other M&M
returns reflect conflicting and varying divisions of profits by
Maynard and McDonald. Two of them divide M&M’s profit about two-
thirds for McDonald and one-third for Maynard. The third return
reflects a division of profit of about 85 percent for Maynard and
15 percent for McDonald. This erratic pattern does not lend much
support for petitioners’ argument. Respondent contends that
petitioners manipulated their income between them depending on
the circumstances. For example, respondent contends that a large
portion of the income for 1988 and 1989 was shifted to Maynard
because he had claimed large carryover losses from prior years.
Section 702(a) requires that a partner account for her
distributive share of partnership income. In the absence of a
partnership agreement, a partner’s distributive share is to be
determined in accord with the partner’s interest in the
partnership. Sec. 704(b). Petitioners argued that their oral
partnership agreement was that McDonald’s income was not to
exceed $6,000. In their testimony, however, petitioners admitted
that no record of work completed or other measure of their
efforts was maintained. Further, petitioners testified that
Maynard would estimate an amount for McDonald at the end of each
year.
Respondent, in the notices of deficiency, determined
$214,393 of partnership income, attributing $79,661 to McDonald
and $134,732 to Maynard. That determination hypothesizes that
- 21 -
McDonald and Maynard split partnership profits by a ratio of
approximately 37 to 63 percent.
More in line with the statutory notices, Agent Pease’s
analysis reflected that the 1989 return preparation ratio between
Maynard and McDonald was about 60 percent to 40 percent,
respectively. McDonald, however was responsible for the
administrative duties, including billing, banking, record
keeping, etc. Other than their self-serving testimony,
petitioners have not produced any evidence of a partnership
agreement. In addition, petitioners’ financial transactions,
which included shifting relatively large amounts of cash between
petitioners and their families, combined with petitioners'
indiscriminate use of reported and unreported bank deposits for
personal purposes, and their failure to distinguish between
interests in the partnership and corporate entities, severely
weaken petitioners’ credibility regarding their alleged
partnership arrangements.
Petitioners’ position that Maynard was entitled to the
partnership profits in excess of $6,000 defies belief and is
wholly unsupported by the evidence in the record. On the other
hand, respondent, although determining in the notices of
deficiency a ratio of about 37 percent to 63 percent for McDonald
and Maynard, respectively, argues on brief that the partnership
income should be split 50 percent-50 percent, as reflected on the
Schedules K-1. We do not find the 50 percent-50 percent reported
position of petitioners to be any more persuasive or less self-
- 22 -
serving than their testimony that McDonald was to receive no more
than $6,000. Based on the evidence, including the flow of funds
between petitioners and petitioners’ family members, we hold that
the 37 percent to 63 percent ratio determined in the statutory
notices is the best approximation of petitioners’ partnership
arrangement to share profits and losses.
Payments From Gold to Petitioners--Respondent determined
that the 1989 payments by check, totaling $8,774 for McDonald and
$23,671 for Maynard, from Gold were income to petitioners and
should have been reported. Gold also paid for insurance for
petitioners and some of their family members, for which
respondent did not make a determination or adjustment to
petitioners’ 1989 income.
Petitioners contend that a part of the amounts paid by Gold
represented a $250 monthly automobile allowance and that the
remainder, whether received and cashed by McDonald or Maynard,
was Maynard’s funds. In that regard, Maynard testified that all
of these check payments from Gold, both for automobile and
otherwise, are either income or expense reimbursement to him,
with the exception of the $250 per month automobile allowance
from Gold to McDonald.
With respect to McDonald’s automobile expenses, McDonald did
not submit any records or documentation to Gold contemporaneously
with the monthly payments during 1989. For purposes of trial,
McDonald submitted documentation reflecting over $3,000 for
automobile expenses, including gasoline charge receipts, repair
- 23 -
and maintenance bills, and a letter from his automobile insurance
provider noting the annual premium. McDonald testified that,
during 1989, he drove his automobile 8,000 miles, 90 percent of
which represented business miles.
Under section 274(d), taxpayers are required to meet certain
substantiation requirements in order to be entitled to a
deduction for certain business expenses. Section 274(d)(4)
(which is effective for taxable years beginning on or after
January 1, 1986) requires substantiation for a taxpayer to be
entitled to deduct travel expenses. McDonald’s substantiated
expenditures connected with his automobile for the 1989 year
exceed the total of the $250 monthly payments received from Gold.
McDonald offered no records or other evidence, however, of the
business use of his automobile other than his testimony, which
was expressed in terms of a rough estimate without any meaningful
detail or contemporaneous support. McDonald has not met the
section 274(d) requirements necessary to show entitlement to
transportation deductions, and, accordingly, respondent’s income
determination regarding the monthly payments from Gold is
sustained. Rule 142(a).
Maynard and McDonald both contend that the remainder of
payments from Gold to petitioners is attributable to Maynard,
even though $6,024 of the checks was written to McDonald from
Gold’s Bank of Lodi account. Petitioners, here again, bear the
burden of showing error regarding respondent’s determination that
$6,024 is income to McDonald and $20,421 is income to Maynard.
- 24 -
Rule 142(a). Petitioners have failed to carry their burden. We
find petitioners’ explanation that the $6,024 in Gold checks was
written to McDonald and cashed by him for Maynard to be
incredible. The credibility of petitioners’ position is further
strained by the grossly disproportionate division of M&M’s income
to them. Accordingly, respondent’s determination is sustained.
Miscellaneous Controverted Items Determined by Respondent To
Be Income--McDonald’s wife remitted three checks to Maynard
during 1989 in the following amounts: $995.90, $550, and
$699.50. McDonald’s daughter also remitted a $2,500 check to
Maynard during 1989. Respondent determined that these payments
constitute income to Maynard. In addition, Maynard purchased,
with cash, two $7,500 cashier’s checks from different banks
during 1989, and respondent determined that the source of the
cash was untaxed income from clients that had not been deposited
into the bank or otherwise reported as income for financial or
tax purposes.
McDonald purchased numerous cashier’s checks, mostly with
cash, during 1989. The dates, amounts, and bank locations were
as follows:
- 25 -
1989 Date Amount Location Purchased
Apr. 20 $3,000 Commerce Savings
June 8 9,000 Commerce Savings
June 8 10,000 Bank of Alex Brown1
June 12 9,000 Wells Fargo
June 14 1,432 Wells Fargo
June 14 2,594 Wells Fargo
1
Respondent conceded that the $10,000 cashier’s check was
from a source that was not taxable to McDonald.
Respondent determined that these amounts, along with $1,000 cash
deposited by McDonald in the M&M trust account, constitute income
to McDonald because the source of the cash was untaxed income
from clients that had not been deposited into the bank or
otherwise reported as income for financial or tax purposes.
With respect to the $2,500 item from McDonald’s daughter to
Maynard, petitioners argue that Maynard first gave the $2,500 to
McDonald’s daughter, who, in turn, gave it to McDonald to
purchase the $2,594 cashier’s check that went to purchase the
home placed in McDonald’s wife’s name. Ultimately, petitioners
would have us believe that this circuitous route for the $2,500
was concluded when McDonald’s daughter repaid Maynard. Other
than the $2,500 item, petitioners make no particular argument
with respect to the cash items that respondent determined were
income to Maynard. With respect to McDonald, it is contended
that he had available to him from both taxable and nontaxable
sources almost $21,000 with which to purchase the cashier’s
checks remaining in controversy. Ostensibly, the $21,000
represents all of McDonald’s sources from which he was able to
make applications, which would include, in addition to purchasing
- 26 -
cashier’s checks for the purchase of a home placed in his wife’s
name, living and other personal expenditures.
The controverted cashier’s checks total $25,000, which,
initially, would indicate a shortfall of about $4,000 between
McDonald’s sources and applications. Further, McDonald’s
analysis does not account for living expenses. Finally,
McDonald’s analysis of the possible sources is offered in a
vacuum and does not account for undeposited receipts from
clients. Again, petitioners’ intentional discarding of the
accounts receivable information and the concealment of the
identity of their clients is the reason the source analysis is
not complete or reliable.
Under these circumstances, we find that petitioners have not
carried their burden. Hence, respondent’s determination that the
various checks and cash items are income to petitioners is
sustained.
Self Employment Tax--To the extent that additional income is
determined in these cases, petitioners agreed on brief that any
increase in self-employment tax is merely computational.
Respondent determined that additional income was derived from
petitioners’ practice of tax accounting. Such income of
petitioners is subject to self-employment tax.
Taxability of McDonald’s Social Security Benefits--This
appears to be a computational item that is dependent on the
parties’ agreement to be bound by the final outcome of an earlier
case regarding whether McDonald was married for tax purposes
- 27 -
during the period in question. The outcome of that case, along
with the holdings herein regarding the amount of unreported
income, will dictate the amount of McDonald’s taxable Social
Security benefits.
Fraud Penalty--Respondent determined, pursuant to section
6663, that each petitioner is liable for a fraud penalty with
respect to the entire income tax deficiency determined for their
respective 1989 tax years. Section 6663(a) imposes a 75-percent
addition to tax on any portion of an underpayment attributable to
fraud. Under section 6663(b), if the Commissioner establishes
that any portion of an underpayment is attributable to fraud,
then the entire underpayment is treated as attributable to fraud,
except to the extent that a taxpayer can establish by a
preponderance of the evidence that any portion of the
underpayment is not due to fraud.
Respondent has the burden of proving, by clear and
convincing evidence, that each petitioner fraudulently intended
to evade his tax. Sec. 7454(a); Rule 142(b). To meet this
burden, respondent must show that there was intent to evade taxes
known to be owing by conduct intended to mislead, conceal, or
prevent tax collection. Rowlee v. Commissioner, 80 T.C. 1111,
1123 (1983). Respondent must also show (1) that there is an
underpayment of tax, and (2) that part of such underpayment is
due to fraud. Hebrank v. Commissioner, 81 T.C. 640, 642 (1983).
Based on our holdings regarding respondent’s reconstruction
of partnership income, miscellaneous items of income, and several
- 28 -
concessions by petitioners, there can be no doubt that there was
an underpayment of tax in each petitioner’s 1989 tax year. Thus,
we must decide for each petitioner whether any portion of such
underpayment was due to fraud. Id.
Fraudulent intent is seldom proven by direct evidence;
hence, the courts have relied on certain indirect evidence in
determining whether or not fraudulent intent existed. These
"badges of fraud" include: (1) Understating income; (2) keeping
inadequate records; (3) failing to file tax returns; (4)
providing implausible or inconsistent explanations of behavior;
(5) concealing assets; and (6) failing to cooperate with tax
authorities. Bradford v. Commissioner, 796 F.2d at 307.
Respondent contends that in these consolidated cases all of
the above-referenced badges of fraud exist, except that
petitioners did not fail to file returns. Petitioners contend
that respondent has not shown fraud by clear and convincing
evidence and that Maynard “believed that he was entitled to a
large net operating loss carryforward which would alleviate any
income tax liability and that he would not be able to utilize the
balance of the loss carryforward within the statutory time.” We
find petitioners’ explanation to be disingenuous considering that
they are tax professionals. We find that respondent has shown
that each petitioner’s underpayment of tax for 1989 was due to
fraud within the meaning of section 6663. We also find that
petitioners have not shown that any part of the underpayments was
not due to fraud.
- 29 -
The record here is replete with evidence of petitioners’
fraudulent intent. Petitioners, tax professionals who prepare
tax returns for a living and represent clients before the
Internal Revenue Service, were aware of the need for
documentation and records to support the items reported on tax
returns. In light of their having that knowledge, coupled with
other evidence, we find that their discarding of their supporting
income and client documentation was an intentional act designed
to conceal and evade the reporting and payment of Federal income
tax. Other factors that support a finding of fraud include the
relatively large underpayments, use of the corporate entity to
conceal information from creditors (including respondent),
manipulation of deductions and income between the corporate and
partnership entities, dealing in cash (including the purchase of
multiple cashier’s checks on the same date in amounts less than
$10,0006), failure to deposit and account for payments for
services from clients, use of multiple bank accounts and failure
to disclose their existence to respondent’s agent, failure to
cooperate with respondent’s agent (including refusal to divulge
the names of clients), attempts to obtain corporate deductions by
making monthly payments as travel reimbursement when such travel
was both undocumented and not for business purposes, and
manipulation of income between petitioners and their family
members.
6
Financial institutions are required to report to the
Federal Government cash transactions in excess of $10,000. See
31 U.S.C. sec. 5313(a) (1994); 31 C.F.R. sec. 103.22 (1995).
- 30 -
In addition to the items specifically proven by respondent,
petitioners conceded numerous adjustments determined by
respondent to be unreported income or deductions to which
petitioners were not entitled.
To the extent no settlement or concession was made regarding
any other item determined by respondent, petitioners have not
come forward with arguments or evidence from which we could find
that respondent’s determinations are in error. Regarding the
fraud penalty, respondent has shown by clear and convincing
evidence that petitioners' underpayments of 1989 tax were due to
fraud.
To reflect the foregoing,
Decisions will be entered
under Rule 155.