T.C. Memo. 1997-43
UNITED STATES TAX COURT
PETER S. PAU AND SUSANNA H. PAU, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 20475-94. Filed January 27, 1997.
John M. Youngquist, for petitioners.
Patricia Anne Golembiewski, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
PARR, Judge: Respondent determined a deficiency in and a
penalty on petitioners' 1990 Federal income tax as follows:
Penalty
Year Deficiency Sec. 6662(a)
1990 $438,692 $61,040
On November 7, 1994, the Paus filed a petition with this
Court. An answer was filed on December 20, 1994, in which
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respondent asserted further adjustments to petitioners' 1990
joint return, including: (1) An increase of $195,101 in the
deficiency in income tax set forth in the original notice; and
(2) an addition to tax of $373,731 under the civil fraud penalty
of section 6663 or, alternatively, an increased penalty pursuant
to section 6662(a) of $99,662.1
After concessions, two issues remain regarding petitioners'
income tax liability for 1990: (1) Whether petitioners are
liable for the penalty pursuant to section 6663 for failure to
report $990,000 of income with the intent of evading the payment
of Federal income tax. We hold they are. (2) Whether section
163(h)(3) limits petitioners' Schedule A deduction for home
mortgage interest to interest paid on acquisition debt of $1
million. We hold it does.
FINDINGS OF FACT
The parties have stipulated to some of the facts and the
Court has so found. The stipulation of facts and accompanying
exhibits are incorporated herein. Peter S. Pau (petitioner) and
Susanna H. Pau (Susanna) were married and resided in
Hillsborough, California, at the time they filed their petition
in this case.
1
All section references are to the Internal Revenue Code
in effect for the year in issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure, unless otherwise
indicated.
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I. The Unreported Income
During 1990, and at all relevant times before and after that
year, the Paus operated a real estate development, management,
and brokerage business as sole proprietors doing business as
d.b.a. Sand Hill Property Co. (Sand Hill). Petitioner was
actively engaged in the real estate management and development
side of the business; Susanna was largely concerned with
commercial real estate purchases and sales. Susanna generally
dealt with major commercial properties, and most of her clients
hailed from Hong Kong and Japan. Despite separate roles in Sand
Hill, petitioners worked together and were aware of each other's
transactions.
Petitioner began working as a developer in 1979, having
earned a bachelor's degree in civil engineering from the
University of California at Berkeley in 1975 and a master's
degree in construction management from Stanford University in
1976. Susanna earned a bachelor's degree in business
administration and accounting from the University of California
at Berkeley in 1974.
A. The Stockton Street Property Transaction
In March of 1990, Susanna brokered the sale of real property
located at 39 Stockton Street in San Francisco, California (the
Stockton Street property). Meiyan Enterprises, Inc. (Meiyan),
sold the property to Sanrio, Inc. (Sanrio), a Japanese company,
for use as a retail outlet. The sale generated a broker's
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commission of $250,000, which was paid to Sand Hill at the time
of the closing on March 15, 1990. Payment was made by a check
drawn on the escrow account by Founders Title Co.; the check was
deposited in full in Sand Hill's business checking account at the
Bank of America (the Bank of America account). The $250,000
commission was included in the total gross receipts reported on
petitioners' 1990 Schedules C.
In addition to the broker's commission, on March 20, 1990,
Meiyan paid Susanna a $150,000 finder's fee for locating the
buyer of the Stockton Street property. The payment was made by a
check in Sand Hill's name bearing the handwritten notation
"consultation fee". Susanna deposited the check in full into the
Bank of America account on March 20, 1990.
B. The Eccles Avenue Property Transaction
Beginning in March of 1990, petitioner worked with Sanrio on
a build-to-suit development deal which evolved into the purchase
of an existing building located at 570-586 Eccles Avenue in San
Francisco (the Eccles Avenue property). On June 29, 1990,
petitioner, d.b.a. Sand Hill, executed a purchase and sale
agreement (the agreement) with the seller for the purchase of the
Eccles Avenue property. When he signed the agreement, petitioner
knew that Sanrio wanted to purchase the Eccles Avenue property
for use as its headquarters. Because of a bad business
relationship between Sanrio and the seller, petitioner, rather
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than Sanrio, signed the agreement so that the seller would not
learn that in fact Sanrio was the real buyer.
Sanrio expected to pay a commission to petitioner after it
purchased the Eccles Avenue property, because he had acted as its
agent.
Petitioner expressed some concern after the deal shifted
from development to purchase as to how he would be remunerated
for his work for Sanrio. On June 12, 1990 (before he signed the
purchase agreement), petitioner sent a letter to Sanrio detailing
his negotiations for Sanrio's purchase of the property. As of
that date, petitioner expected to receive $840,000 (representing
3 percent of the purchase price) from Sanrio upon its purchase of
the property. Additionally, while petitioner worked for Sanrio
to buy the property, he had incurred expenses for inspectors and
engineers. In September of 1990, Sanrio reimbursed him for his
out-of-pocket expenses. On October 30, 1990, Sanrio paid
$840,000 to petitioners in consideration of the assignment of
petitioner's rights d.b.a. Sand Hill as purchaser of the Eccles
property.
The payment was made as follows: on October 30, 1990, at
Susanna's request, Sanrio directed the Bank of California to
debit its account there by $840,000 and remit the sum by
electronic funds transfer to the account of Susanna Pau at the
Banque Nationale de Paris (BNP) branch located in San Francisco,
California (the BNP account). On that same date, Susanna
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directed BNP to transfer $100,000 of the $840,000 to the Bank of
America account. Sanrio mistakenly failed to issue a Form 1099
to petitioner for its payment of $840,000, because the payment
was made via a wire transfer rather than through its accounts
payable system. Petitioners and Sanrio never discussed the
issuance of a Form 1099 upon the completion of the transaction.
The BNP account was an interest-bearing account from which
Susanna periodically transferred funds to the Bank of America
account or to a checking account maintained at the Bank of the
West. Except for the $840,000 from Sanrio, petitioners did not
deposit any other business income directly into the BNP account
in 1990; all other deposits in BNP were transfers from other
accounts held by petitioners.
C. Petitioners' Recordkeeping Methods
Despite Susanna's accounting background, petitioner is Sand
Hill's bookkeeper. He alone possessed signature authority over
the Bank of America account. Petitioners used that account to
deposit their commission checks, management fees, and reimbursed
expenses. Whenever the Bank of America account held a
particularly large balance, petitioner would transfer funds via
check into other accounts, especially the BNP account, for the
purpose of accruing greater interest. Petitioner claimed that
when he wrote checks on the Bank of America account for deposit
into another account, he did not verify that it contained
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sufficient funds to cover the checks because there was always a
large balance.
Business income and expenses for Sand Hill during 1990 were
evenly apportioned between petitioner and Susanna and reported on
two separate Schedules C attached to their 1990 return. To track
expenses incurred by petitioners on Sand Hill's behalf,
petitioner used the check register which showed the various types
and amounts of expenses. Petitioner did not keep copies of bank
deposit slips and did not record the sources of the deposits,
although he did have access to monthly bank statements. When
petitioner was ready to file the income tax return for himself
and Susanna, he simply resorted to his memory to determine what
transactions took place, since Susanna engaged in very few
transactions on a yearly basis which generated commissions.
Petitioner did not consult with Susanna to verify her income, nor
did he search Sand Hill's files. For miscellaneous income,
including interest from banks and brokerage firms, petitioner
relied on Forms 1099.
For petitioners' Federal income tax returns, including the
1990 return, petitioner then prepared a one-page summary of Sand
Hill's income and expenses on his computer and gave it to
petitioners' accountant. The accountant used the summary to
prepare the Paus' tax returns. The one-page summary is the only
record petitioner gave to the accountant. In the summary,
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petitioner listed expenses in categories such as travel,
telephone, and office rent. For income, he listed three sources:
Commissions earned by Susanna, management income he earned, and
miscellaneous income. In 1990, Susanna earned commissions from
four transactions, and petitioners reported the income on their
Schedules C. Sand Hill received these commission checks
generally through escrow accounts, and petitioners deposited the
checks into various bank accounts, including the Bank of America
account.
Petitioner did not include Susanna's consultation fee as
income on the one-page summary of Sand Hill's income and expenses
prepared for the Paus' accountant, even though he knew that she
had received $150,000 as a consultation fee from Meiyan.
Moreover, the same day Susanna deposited the check for $150,000
into the Bank of America account, petitioner wrote a check on
that account payable to Susanna for the same amount, which she
deposited into the BNP account. Another check for $50,000 was
also debited on March 20, 1990. Prior to the deposit of the
$150,000, the account contained a balance of $155,874.47. In
completing Sand Hill's 1990 income and expense summary for
petitioners' accountant, petitioner was aware of but
intentionally failed to include the $840,000 from Sanrio.
Petitioners did not tell their accountant of either omission
from their summary. Neither the $150,000 fee nor the $840,000
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from Sanrio was reported on the Schedules C attached to
petitioners' 1990 return.
D. Petitioners' Explanation of Unreported Sanrio Income
From 1978 to 1984 petitioners lived in Boise, Idaho, where
they engaged in real estate transactions. In 1983, they acquired
an interest in Regent Properties (Regent), a 40-acre real estate
development in Boise. In 1984, petitioners stopped paying equity
into Regent, which had generated losses for them. Since then,
they have not been actively involved in the property. At trial,
petitioner was unaware of Regent's status, although the Paus
still held their interest in it.
Since 1986, petitioners had wanted to take advantage of
projected losses from Regent but had been unsuccessful, because
their ordinary income could not be applied against capital losses
from the property. Petitioner hoped to treat the $840,000 as a
capital gain and to apply $300,000 to $350,000 of capital losses
from Regent against it if and when such losses were realized.
Petitioners deliberately did not report the $840,000 of income
from Sanrio on their 1990 income tax return, because they wanted
to wait until the losses were realized, in order to report the
income and the losses simultaneously. Therefore, they thought it
would be easier to file an amended return to report the
additional income, rather than to report it on the original
return for 1990 and later file an amended return to claim a large
refund.
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Petitioners never did file an amended return.
Petitioners did not consult a certified public accountant or
a tax attorney with respect to the tax treatment of the income
from Sanrio and losses from Regent. However, they did ask an
accountant about the extent of their mortgage interest deduction
and about amending their return to claim an additional deduction.
E. The Audit Process
Richard Clement (Clement) is respondent's revenue agent
responsible for the audit of petitioners' 1990 Federal income tax
return. He is familiar with real estate practices in the San
Francisco Bay area and has conducted audits of companies engaged
in real estate transactions.
In July of 1994, Clement examined the Federal income tax
return filed by Sanrio. While auditing this return, he noticed
Sanrio's $840,000 payment by wire transfer to Susanna's account
at BNP. Accordingly, he requested an RTVUE, which is a computer-
generated document showing certain types of information from a
tax return (such as gross receipts reported on a Schedule C).
Using the RTVUE, Clement discovered that the Paus had reported
gross receipts on their 1990 Schedules C in an amount less than
the $840,000 transfer reflected on Sanrio's return.
After reviewing the Paus' 1990 return, Clement decided to
audit it. He selected for examination gross receipts and
expenses from the Schedules C, and Schedule A deductions for home
mortgage interest and contributions. Clement left several
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messages on the Paus' telephone answering machine upon commencing
the audit. He left the initial message on July 13, 1994.
Clement spoke with Susanna for the first and only time on July
18, 1994. During that conversation, Clement told Susanna that
petitioners' 1990 return had been selected for audit and that he
wished to arrange an appointment with them. A meeting was
scheduled for July 25, 1994. On July 19, 1994, Susanna left
Clement a message on his answering machine canceling the
appointment and rescheduling it for July 27, 1994.
On July 25, 1994, Clement and petitioner spoke by telephone.
At that time, Clement asked petitioners to sign a consent form to
extend the period of limitations (Form 872) for their 1990
return, because the period was to expire on August 15, 1994.
Petitioners refused to execute the Form 872. Petitioner
erroneously told Clement that the Paus had filed their 1990 tax
return in June or July of 1991, so that the period had already
run.
Clement and petitioner engaged in another telephone
conversation on July 26, 1994, during which Clement again sought
the Paus' consent to extend the period of limitations.
Petitioner told the agent that his accountant had advised him
that the period had expired; he also indicated, without
elaborating, that the gross receipts reported on petitioners'
1990 return might have been incorrect. They discussed their
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meeting set for July 27, 1994. However, petitioners and Clement
never met that day or at any other time prior to October 31,
1995, although they did have a telephone conversation on August
1, 1994. Clement and petitioner discussed the receipt of the
$840,000 from Sanrio. Petitioner did not provide a direct answer
to Clement's inquiry about this sum. This conversation was
Clement's last personal contact with either petitioner before
respondent issued the notice of deficiency.
On August 2, 1994 petitioner left a voice message for
Clement, informing him that petitioners had received an
appointment letter, a Form 872, and an information document
request (IDR) seeking books and records needed to audit the
return. Petitioner once again stated that the Paus would not
extend the period and that they would be unable to obtain the
documents requested because of the short time left in the period.
Clement then served a summons on petitioners on August 5, 1994,
for the records identified in the IDR. Prior to the issuance of
the notice of deficiency, the Paus did not produce any books and
records requested from them by the IDR.
In addition to the summons served on petitioners, Clement
issued summonses to financial institutions and a title company.
He received the books and records from these entities after the
notice of deficiency had been mailed to petitioners.
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On August 5, 1994, Susanna informed Clement's manager that
petitioners had retained counsel. However, as of August 10,
1994, Clement had not received a power of attorney from
petitioners, and he therefore could not discuss the Paus' tax
matters with another individual. A power of attorney was not
received until after Clement prepared the notice of deficiency
and forwarded petitioners' file on August 10, 1994, to the office
responsible for mailing such notices.
The notice of deficiency was issued on August 11, 1994, and
increased petitioners' Schedule C income for 1990 by $545,000
each, for a combined increase in their taxable income of
$1,090,000, as a result of the $840,000 income from Sanrio and
the $250,000 commission from the sale of the Stockton Street
property. (That commission had in fact been reported.)
Respondent also disallowed a total of $334,073 in Schedule C
expenses and $132,261 in itemized deductions.
Clement learned of Susanna's $150,000 consultation fee only
after receiving a copy of the canceled check pursuant to the
summons served upon the Bank of America. Neither Susanna nor
petitioner explained to Clement why they had not reported the
consultation fee on their return.
After Clement notified petitioners of the audit, petitioner
prepared a bank deposits analysis to show the transfer of funds
between and among petitioners' various accounts. Petitioner did
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not give this analysis to Clement. Among the records petitioner
used to reconstruct Sand Hill's income were monthly statements
from its Bank of America account.
On October 31, 1995, Clement met with petitioner and his
accountant to review records for Sand Hill's expenses and
petitioners' deductions disallowed in the notice of deficiency.
For recording Sand Hill's expenses, petitioner used a spiral-
bound notebook with accounting paper. Using this notebook,
petitioner verified each and every expense paid by Sand Hill for
which deductions were claimed by petitioners on their Schedules
C. Clement determined that petitioner kept the notebook in the
ordinary course of business during 1990 and that it was an
adequate record for petitioners' business. Petitioner, however,
did not present records of Sand Hill's income to Clement, so the
agent used petitioners' bank records to analyze deposits and
transfers to reconstruct Sand Hill's income.
In their petition, the Paus denied that they had received
income of $840,000 that they did not report on their 1990 return.
Respondent's answer asserted that petitioners failed to report
additional Schedule C income of $616,789, including the $150,000
consultation fee received by Susanna. Respondent further
asserted that the underpayment of petitioners' tax for 1990
attributable to their unreported income was due to fraud, and
that any deficiency stemming from that income is subject to the
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penalty under section 6663. Petitioners' reply denied receipt of
the $150,000.
The parties have since stipulated that petitioners omitted
only the following items of income from their Schedules C
attached to their 1990 return: (1) The consultation fee of
$150,000 paid to Susanna d.b.a. Sand Hill on March 20, 1990, by
Meiyan; and (2) the sum of $840,000 paid to petitioners on
October 30, 1990, by Sanrio. The parties agree that section
6662(a) applies to the deficiency attributable to the unreported
income to the extent that the Court concludes that section 6663
is inapplicable.
II. The Mortgage Interest Deduction
Until 1989, petitioners owned a condominium in San Mateo,
California, that they used as their primary residence. In 1989,
after their move, petitioners subsequently reclassified the
condominium as rental property. In that year, petitioners also
purchased a home in Hillsborough, California, for use as their
primary residence and they have since lived there at all times.
The purchase price of the residence was $1,780,000. Petitioners
have a mortgage on the Hillsborough residence, the original
principal amount of which was $1,330,000.
In 1990, petitioners claimed a home mortgage interest
deduction on Schedule A of $107,226. Despite having actually
paid a greater amount of mortgage interest, petitioners limited
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their deduction to interest on $1.1 million indebtedness based on
advice from an accountant. In her notice of deficiency,
respondent completely disallowed petitioners' Schedule A
deduction for home mortgage interest.
As a result of the October 31, 1995, meeting with
petitioner, Clement allowed the Paus a home mortgage interest
deduction, but he limited the allowable deduction to the interest
on $1 million indebtedness. Consequently, he calculated that the
allowable deduction is $99,040 rather than the $107,226 claimed
by petitioners, a difference of $8,186. Clement also increased
the Schedule A deduction for personal interest by $819, from
$4,210 to $5,029.
OPINION
As a general rule, the Commissioner's determinations are
presumed correct, and taxpayers bear the burden of proving that
those determinations are erroneous. Accordingly, with respect to
deficiencies flowing from the home mortgage interest deduction
and the $840,000 omission, petitioners have the burden of proof.
Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933). Since the
$150,000 omission was asserted by respondent after the notice of
deficiency was mailed, it is new matter on which respondent bears
the burden. Rule 142(a). Respondent also bears the burden of
proving, by clear and convincing evidence, that petitioners are
liable for the civil fraud penalty. Sec. 7454(a); Rule 142(b).
Issue 1. Penalty Pursuant to Section 6663
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Section 6663 provides for a penalty equal to 75 percent of
the underpayment of tax attributable to fraud. Sec. 6663(a).
For section 6663 to apply, respondent must show that: (1) An
underpayment of tax exists for the period at issue, and (2) a
portion of the underpayment stems from fraud. Laurins v.
Commissioner, 889 F.2d 910, 913 (9th Cir. 1989), affg. Norman v.
Commissioner, T.C. Memo. 1987-265; Parks v. Commissioner, 94 T.C.
654, 660-661 (1990); Petzoldt v. Commissioner, 92 T.C. 661, 699
(1989). The mere failure to report income generally is not
sufficient to establish fraud. Switzer v. Commissioner, 20 T.C.
759, 765 (1953).
A. Underpayment of Tax
There is no question that petitioners underpaid their tax
due for 1990, given their admission that they did not report
income of $990,000 on their return. Thus, we may proceed with
the second prong of the analysis. See Niedringhaus v.
Commissioner, 99 T.C. 202, 210 (1992).
B. Fraudulent Intent
Fraud is intentional wrongdoing on the part of the taxpayer
with the specific purpose of evading a tax believed to be owing.
Petzoldt v. Commissioner, supra at 698; McGee v. Commissioner, 61
T.C. 249, 256 (1973), affd. 519 F.2d 1121 (5th Cir. 1975). The
existence of fraud is a question of fact to be resolved from the
entire record. King's Court Mobile Home Park, Inc. v.
Commissioner, 98 T.C. 511, 516 (1992); Gajewski v. Commissioner,
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67 T.C. 181, 199 (1976), affd. without published opinion 578 F.2d
1383 (8th Cir. 1978). Direct proof of intent is rarely
available, so courts may look to circumstantial evidence and draw
reasonable inferences from the facts. Spies v. United States,
317 U.S. 492 (1943); Bradford v. Commissioner, 796 F.2d 303, 307
(9th Cir. 1986), affg. T.C. Memo. 1984-601. Fraud must be
affirmatively established and is never imputed or presumed.
Beaver v. Commissioner, 55 T.C. 85, 92 (1970).
For the Commissioner to carry her burden of proving that the
underpayment of tax is attributable to fraud, she must show that
a taxpayer intended to conceal, mislead, or otherwise prevent the
collection of taxes. Powell v. Granquist, 252 F.2d 56, 60-61
(9th Cir. 1958); Rowlee v. Commissioner, 80 T.C. 1111, 1123
(1983). A taxpayer's entire course of conduct can be indicative
of fraud. Stone v. Commissioner, 56 T.C. 213, 224 (1971); Otsuki
v. Commissioner, 53 T.C. 96, 105-106 (1969).
Over the years, courts have developed a nonexclusive list of
factors that demonstrate fraudulent intent. These badges of
fraud include: (1) Understating income, (2) keeping inadequate
records, (3) offering implausible or inconsistent explanations of
behavior, (4) concealing assets, and (5) failing to cooperate
with the Commissioner's agent. See Bradford v. Commissioner,
supra at 303, and cases cited therein; Recklitis v. Commissioner,
91 T.C. 874, 910 (1988). Although no single factor necessarily
suffices to establish fraud, a confluence of factors constitutes
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persuasive evidence. Solomon v. Commissioner, 732 F.2d 1459,
1461 (6th Cir. 1984), affg. per curiam T.C. Memo. 1982-603. Some
conduct and evidence can be classified under more than one
factor. A taxpayer's intelligence, education, and tax expertise
are also relevant in determining fraudulent intent. See
Stephenson v. Commissioner, 79 T.C. 995, 1006 (1982), affd. 748
F.2d 331 (6th Cir. 1984); Iley v. Commissioner, 19 T.C. 631, 635
(1952).
Applying the aforementioned criteria, as set out below, we
conclude that petitioners underreported their income for 1990
with the intention to evade income tax on $990,000 and are
therefore liable for a penalty under section 6663.
1. Understatement of Income
Petitioners assert that they are not liable for the civil
fraud penalty because there is no "pattern of underreporting"
income. Respondent acknowledges that the evidence does not
demonstrate such a pattern. Nevertheless, she contends that a
pattern of underreporting is not a sine qua non for the
imposition of the civil fraud penalty.
We agree with respondent that she may assert such a penalty
where a taxpayer fails to report income, even for only 1 year,
with the intention of evading tax due on that income. In
Mitchell v. Commissioner, T.C. Memo. 1994-242, the Court examined
facts relating to a corporate taxpayer and an officer. Acting
for the corporation, the officer sold its airplane and diverted
the sales proceeds to a Swiss bank account. Neither the
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corporation nor the officer reported income from the sale of the
airplane or the diversion of the sale proceeds. We held both
taxpayers were liable for the civil fraud penalty, because they
failed to report the income with the intention of evading Federal
income tax. In Mitchell, as in the case before us, the
taxpayers' conduct occurred in only 1 year, and the conduct
related to a single transaction. See also Taylor v.
Commissioner, T.C. Memo. 1993-546.
Petitioners cite Stone v. Commissioner, 22 T.C. 893 (1954),
arguing that respondent cannot establish fraud in reliance on
unreported income for 1 year. However, that case does not stand
for such a broad proposition. Rather, in Stone, we held that,
without more, a gross understatement of income in 1 year did not
establish that "there was fraud with intent to evade tax in this
instance." Id. at 904 (emphasis added). In the case before us,
respondent relied on a number of factors to prove fraud, as shown
below.
2. Inadequacy of Books and Records
In October of 1995, petitioner met with Clement for the
first time, presenting Sand Hill's records of expenses to
establish petitioners' entitlement to deductions claimed on their
Schedules C. Clement found the records adequate to verify each
and every expense claimed for Sand Hill. However, petitioner
presented no records for Sand Hill's income and conceded that his
handling of the income of Sand Hill was entirely inadequate.
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The inadequacy of the records was not due to negligence on
the part of petitioners, but fraud. Petitioners' reliance on
Tabbi v. Commissioner, T.C. Memo. 1995-463, is misplaced. In
that case, the Court held that the taxpayer was not liable for
the civil fraud penalty, in part because his failure to keep
books and records, other than checks, was due to the fact that he
was "disorganized and because he could not afford accountants."
Id. Other factors also weighed in his favor. In the instant
case, petitioners present only their self-serving testimony that
they were disorganized, which we do not find credible.
Petitioners were able to prove every expense they had claimed for
Sand Hill. They also had ready access to monthly bank statements
and the ability to use them, which petitioner showed in
conducting his deposits analysis. Even more telling, petitioners
could afford and did use an accountant but intentionally failed
to provide him with accurate records. See Korecky v.
Commissioner, 781 F.2d 1566, 1568-1569 (11th Cir. 1986), affg.
T.C. Memo. 1985-63; Merritt v. Commissioner, 301 F.2d 484, 486-
487 (5th Cir. 1962), affg. T.C. Memo. 1959-172.
3. Implausible or Inconsistent Explanations of Behavior
Petitioners refused to acknowledge their receipt of the
$840,000 from Sanrio until after respondent's answer, even though
petitioner earlier had mentioned a potential problem with the
gross receipts reported on the return, and despite the fact that
the $840,000 was specifically brought up in their conversation
with Clement on August 1, 1994. Petitioner subsequently stated
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that he failed to report the income, not to evade tax, but
because he viewed the payment as a short-term capital gain which
he intended to offset by capital losses from his interest in
Regent when such losses were realized. The Court discounts this
explanation as an afterthought. See Gajewski v. Commissioner, 67
T.C. at 202. Petitioner had at least two clear opportunities to
offer this explanation to Clement before petitioners retained
counsel, yet he said nothing.
Even if we did not regard petitioner's explanation as a
recent fabrication, we find highly improbable his testimony that
he viewed the income received from Sanrio as capital, rather than
ordinary, in nature. Although his wife usually engaged in
brokerage sales for Sand Hill, petitioner was familiar with real
estate practices. The evidence overwhelmingly suggests that
Sanrio viewed petitioner merely as an agent, and that petitioner
knew of his role as intermediary. Petitioner wrote a letter to
Sanrio before the Agreement was signed describing his fee.
Moreover, Sanrio reimbursed petitioner for his out-of-pocket
expenses. Petitioner signed the agreement, rather than Sanrio,
due to the seller's antipathy toward Sanrio. Cf. Solomon v.
Commissioner, 732 F.2d at 1461. Consequently, petitioner must
have known that the $840,000 was a commission and therefore
ordinary income against which, he was aware, capital losses could
not be applied. His explanation is incongruous with these
circumstances.
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Moreover, even if the payment from Sanrio could have been
characterized as a capital gain rather than ordinary income,
section 441 requires a taxpayer to report taxable income on the
basis of a taxable year. Petitioners had an obligation to report
the $840,000 on their 1990 return, not in the future when they
might possibly realize a capital loss. Petitioners surely
recognized that duty in light of their relative sophistication in
tax matters; they were aware that their capital losses could be
carried forward and that they could have received a refund.
Furthermore, Susanna held a bachelor's degree in accounting. Cf.
Laurins v. Commissioner, 889 F.2d at 913 (the fact that a
taxpayer is sophisticated in tax matters may permit an inference
of intent to defraud when he willfully underpays his taxes).
Finally, there is no evidence in the record before us that
petitioners realized their losses in Regent at any time from 1990
until the date of trial. Petitioner himself stated that he did
not know when, if ever, the losses from Regent would be realized.
This indicates to us that, had petitioners not been audited, the
$840,000 income would never have been disclosed.
Petitioner's claim that the omission of Susanna's $150,000
consultation fee was inadvertent also rings false. Susanna had
engaged in only a handful of transactions that year, and she
testified that petitioner was aware of her transactions and of
the consultation fee. Moreover, petitioner wrote a check to
Susanna drawn on the Bank of America account for that exact
amount on the same day the consultation fee was deposited in that
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account, which accords with petitioners' stated practice of
transferring large sums of money from their business accounts to
the BNP account to earn greater interest. Finally, contrary to
petitioner's testimony, monthly bank statements reveal that the
Bank of America account did not always carry a large balance.
Petitioner must have known of the additional income because
otherwise, given the outstanding checks he had written on that
account and its prior balance of only $155,874.47, he would have
overdrawn the account by almost $45,000.
4. Attempts To Conceal Assets
Susanna instructed Sanrio to pay $840,000 by wire transfer
into her nonbusiness account at BNP. This was the only direct
business deposit into that account in 1990. Sanrio did not issue
a Form 1099 for its payment, an error on its part because of the
method of payment. However, petitioners did not request a Form
1099, despite petitioner's knowledge of the existence of such a
form and his reliance on it in other instances to verify interest
and miscellaneous income.
Furthermore, although petitioners consulted an accountant
about the limit to their home mortgage interest deduction and
about amending their return to increase another deduction, they
did not discuss applying unrealized capital losses against the
$840,000 with an accountant. In fact, they concealed that income
completely from their tax preparer. Case law is replete with
support for holding that petitioners may be liable for the civil
fraud penalty as a result of such an action. See Korecky v.
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Commissioner, 781 F.2d at 1568; Paschal v. Commissioner, T.C.
Memo. 1994-380, affd. 76 AFTR2d 95-7975, 96-1 USTC par. 50,013
(3d Cir. 1995); Morris v. Commissioner, T.C. Memo. 1992-635,
affd. without published opinion 15 F.3d 1079 (5th Cir. 1994); cf.
Ross Glove Co. v. Commissioner, 60 T.C. 569, 608 (1973) (no fraud
demonstrated where evidence did not show the taxpayer ignored or
misinformed his attorneys or accountants); Marinzulich v.
Commissioner, 31 T.C. 487, 492 (1958) (no fraud proven where the
taxpayers' accountant had complete access to all the information
bearing on their tax liability); Dagon v. Commissioner, T.C.
Memo. 1984-138 (no fraud where the taxpayer did not conceal any
records from his tax return preparer); Compton v. Commissioner,
T.C. Memo. 1983-647 (no fraud where the taxpayer turned over
sufficient records to his tax preparer for her to accurately
determine his tax liability for the years in issue). We agree
with respondent that the only rationale for petitioners' failure
to disclose the income to the accountant was so that they could
avoid the accountant's duty to report the income.
5. Failure To Cooperate
Petitioners did not cooperate with respondent's agent
initially, canceling appointments, refusing to extend the period
of limitations, and failing to produce records and books used to
prepare their Schedules C and their tax return. Using the
limited information available to him, the agent prepared, and
respondent issued, the notice of deficiency to petitioners. Cf.
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Dagon v. Commissioner, supra (no fraud where the taxpayer met
with the Commissioner's agent several times during the course of
criminal investigation and gave the agent all books and records,
explained procedures followed in preparation of those records,
and provided complete access to personal banking records). Only
after counsel was retained did petitioners cooperate with
respondent's agent, which of course does not rectify their
previous intransigence. Cf. Badaracco v. Commissioner, 464 U.S.
386, 394 (1984).
6. Petitioners' Sophistication and Experience
Petitioners seek to portray themselves as tax naifs who
operated a "mom-and-pop" business. They rely on Cheek v. United
States, 498 U.S. 192 (1991), in arguing that a good faith
misunderstanding of the tax law may negate fraud. However,
petitioners' own testimony clearly belies their assertions of
inexperience and good faith. Petitioners are both well-educated,
adept business people who have successfully cultivated an
international clientele. Susanna has a degree in accounting. At
trial, petitioner demonstrated an awareness of capital loss
carryforwards; he knew that the general statute of limitations
for tax returns was 3 years, and that taxpayers could amend their
tax returns at any time to report additional income. Moreover,
he knew how to structure business ventures in a tax-advantaged
manner. Their experience reveals that petitioners understood the
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tax laws but chose to ignore them in their effort to evade the
payment of income tax.
Thus, we find that respondent has clearly and convincingly
proven fraud on the part of petitioners for both items of
unreported income for the year in issue, and we so hold. Our
conclusion is premised on the record as a whole and reasonable
inferences therefrom, taking into account our determination as to
the credibility of petitioners and the other witnesses presented
at trial. Therefore, we sustain respondent's determination that
petitioners are liable for the penalty for 1990 pursuant to
section 6663.
Issue 2. Section 163(h)(3) Restriction on Home Mortgage Interest
Deduction
Section 163(a) states the general rule for deductions for
interest paid or incurred on indebtedness within the taxable
year. Other provisions of section 163 limit such deductions.
Section 163(h) disallows personal interest deductions unless they
fit within certain narrowly prescribed categories. Among these
narrow exceptions is the deduction for interest on a qualified
residence. Sec. 163(h)(2)(D). The parties agree that the
interest paid on the mortgage for petitioners' home was qualified
residence interest, because the Paus paid it on acquisition
indebtedness pursuant to section 163(h)(3)(A)(i) and (B)(i). The
parties dispute only the amount of acquisition indebtedness
petitioners may use in computing their deduction.
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Section 163(h) restricts home mortgage interest deductions
to interest paid on $1 million of acquisition indebtedness for
debt incurred after October 13, 1987. Acquisition indebtedness
is defined as that which is "incurred in acquiring, constructing,
or substantially improving any qualified residence of the
taxpayer, and * * * is secured by such residence." Sec.
163(h)(3)(B). A taxpayer may be entitled to a greater deduction
if he has incurred home equity indebtedness up to $100,000, as
allowed by section 163(h)(3)(C)(ii). There can be no additional
deduction where taxpayers fail to show that they had home equity
indebtedness. See Notice 88-74, 1988-2 C.B. 385. Home equity
indebtedness is defined as "any indebtedness (other than
acquisition indebtedness) secured by a qualified residence".
Sec. 163(h)(3)(C) (emphasis added).
Petitioners, who purchased their home in 1989, did not
demonstrate that any of their debt was not incurred in acquiring,
constructing or substantially improving their residence and thus
have failed to carry their burden of proof. We therefore sustain
respondent's determination as to the amount petitioners may
properly deduct for home mortgage interest.
To reflect the foregoing and issues previously resolved,
Decision will be entered
under Rule 155.