Gandy v. Commissioner

T.C. Memo. 1997-532

UNITED STATES TAX COURT

DENNIS C. GANDY, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

DENNIS C. GANDY AND CAROLYN S. GANDY, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 26018-93, 26028-93. Filed December 1, 1997.

William A. Roberts and Jeffrey C. Adams, for petitioners.

Shelley D. Turner and Audrey M. Morris, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Chief Judge:1 Respondent determined deficiencies in

Federal income tax and additions to tax for petitioners Dennis C.

and Carolyn S. Gandy as follows:

1
These consolidated cases were tried before Judge Edna G.
Parker. Judge Parker died after completion of the trial. The
parties were afforded an opportunity for a new trial, in whole or
in part, but they consented to disposition of the cases on the
record of the trial before Judge Parker.
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Additions to Tax
Year Deficiency Sec. 6653(b) Sec. 6661
1
1985 $163,221 $ 81,611 $40,805
1
1986 240,868 180,651 60,217
1
1987 39,636 29,727 9,909

1
Plus 50 percent of the interest due on the deficiency.
In the alternative to the additions to tax for fraud, respondent

determined additions to tax for negligence and, for 1987, an

addition to tax for delinquency.

Respondent determined deficiencies in Federal income tax,

additions to tax, and a fraud penalty for petitioner Dennis C.

Gandy as follows:

Additions to Tax Penalty
Year Deficiency Sec. 6653(b) Sec. 6661 Sec. 6663

1988 $ 22,393 $16,795 $5,598 ---
1989 112,205 --- --- $84,154

In the alternative to the fraud addition to tax and penalty,

respondent determined a negligence addition to tax for 1988 and

an accuracy-related penalty under section 6662(a) for 1989. By

amendment to answer, respondent sought revised deficiencies in

income tax, additions to tax, and fraud penalty for petitioner

Dennis C. Gandy as follows:

Additions to Tax Penalty
Year Deficiency Sec. 6653(b) Sec. 6661 Sec. 6663

1988 $27,201 $20,401 $6,800 ---
1989 48,149 --- --- $36,112

Respondent reasserted a negligence addition to tax and penalty in

the alternative to fraud.
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Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the years in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.

The issues to be decided in these cases are as follows:

(1) Whether the statute of limitations precludes assessment

and collection for any of the taxable years 1985 through 1989;

(2) whether Dennis C. Gandy and Carolyn S. Gandy

(petitioners) received unreported Schedule F income from Dennis

Gandy Nursery (the nursery) for 1985 through 1987;

(3) whether Dennis C. Gandy (Mr. Gandy) received unreported

Schedule F income from the nursery for 1988 and 1989;

(4) whether petitioners received unreported interest income

for 1985 and 1986 and overreported such income for 1987;

(5) whether petitioners failed to report capital gain income

for 1987;

(6) whether petitioners are entitled to a net operating loss

deduction for 1985;

(7) whether petitioners are liable for the additions to tax

for fraud or for negligence for 1985 through 1987;

(8) whether Mr. Gandy is liable for the addition to tax for

fraud or for negligence for 1988 and for the fraud or negligence

penalty for 1989;

(9) whether petitioners are liable for an addition to tax

for delinquency for 1987;
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(10) whether petitioners are liable for the additions to tax

under section 6661 for 1985 through 1987; and

(11) whether Mr. Gandy is liable for an addition to tax

under section 6661 for 1988.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulation of facts and the exhibits attached thereto are

incorporated herein by this reference. Petitioners resided in

Ben Wheeler, Texas, at the time they filed their petitions in

these cases. During 1985 through 1989, petitioners were

residents of Van Zandt County, Texas.

Petitioners were married on August 14, 1970. Carolyn S.

Gandy (Mrs. Gandy) attended high school and completed the 10th

grade prior to marrying Mr. Gandy. Mr. Gandy received a

bachelor’s degree in management in 1971 from the University of

Texas at Austin. Petitioners were divorced on June 14, 1988.

Mrs. Gandy moved back into the marital residence in 1991;

however, petitioners remain divorced.

Burnice Gandy is Mr. Gandy's father. In 1947, Burnice Gandy

received a disability discharge from the military. From that

time, Burnice Gandy's income consisted almost exclusively of

military disability and Social Security benefits.

The Nursery

Petitioners established the nursery in 1972. The nursery

property is located 5 miles south of Van, Texas. Petitioners'
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residence is located on the nursery property. During 1985

through 1987, petitioners owned and operated the nursery as a

sole proprietorship. During 1988 and 1989, Mr. Gandy owned and

operated the nursery as a sole proprietorship. Petitioners were

cash basis taxpayers.

During the years in issue, the nursery sold trees and plants

throughout the southwestern United States. The nursery grew

approximately 70 to 90 percent of its products. Some trees were

grown in the field and, when large enough for the customers'

needs, were dug up by hand, or, if very large, by machinery; the

dirt-covered roots of the tree then were covered with burlap and

wire mesh. This method of growing trees is known as ball and

burlap (B&B). The B&B trees generally were sold to landscapers

or construction companies.

During 1985, approximately 75 percent of the nursery's

production was in B&B trees; by 1989, 95 percent was in

“container” trees. In the container method, a tree is planted

and grown in the container in which it will be sold to its

ultimate purchaser. The nursery sold many of its container trees

to chain stores for resale. During the years in issue, Army-Air

Force, Wal-Mart, K-Mart, and Sears Roebuck & Co. were the major

clients of the nursery.

The nursery grew much of its stock from small seedlings.

The nursery had approximately 200 greenhouses and covered about

450 acres. The nursery would grow seedlings for a year in the
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"seedhouse" and then transplant them into the desired containers,

usually 2-gallon or 5-gallon containers. Those containers were

moved from the seedhouse to pads where they could be spaced,

pruned, and staked. The 5-gallon container trees generally were

spaced two or three times per year as they grew. The nursery

would water the container trees on the pads an average of about

twice per day. The container trees in the field operation would

receive water and be fertilized four times a day. At each stage,

some of the plants would be culled. All aspects of this

operation were done by hand. The B&B trees that were planted in

the fields were also pruned and fertilized by hand.

The nursery hired Mexican laborers to dig up B&B trees on a

piecework basis. For a portion of the earliest years in issue,

petitioners used cash to pay the Mexican pieceworkers. Beginning

in mid-1987, the workers were paid by check. The nursery had a

pulling crew that moved the trees from the field to the loading

dock in order to fill an order. The pulling crew placed by hand

a name tag and a price tag on each of the container trees.

Generally, each year the nursery began shipping in late

December or early January and continued until June or July of the

following year. The nursery owned its delivery trucks and

employed the drivers. The nursery had a loading crew to load the

trucks. The nursery delivered the container trees to its chain

store customers using 45- to 48-foot semitrucks. Approximately

1,500 5-gallon container trees or 3,000 2-gallon container trees
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or 6,000 1-gallon container trees could fit on one truck. The

nursery infrequently shipped B&B trees.

The nursery gave its truck drivers cash advances, generally

in amounts of $300 to $500, to pay for travel expenses. The

drivers were required to bring back receipts. If the total

amount of a driver's receipts was less than the amount of the

advance, the difference was deducted from the driver’s paycheck.

At some point, the nursery changed to a system whereby the

drivers used credit or checks, rather than cash, to pay for fuel.

During harvest and shipping time, the nursery employed

almost twice as many field workers as during growing time.

During the years in issue, the nursery employed 35 to 40 field

workers during growing time and 75 to 100 during shipping time.

Counting turnover, as many as 150 workers might be employed

during a year.

Approximately 90 percent of the nursery's seasonal labor

force came from Mexico. During the earlier years in issue,

laborers were transported from Mexico by persons known as

"coyotes" who charged $500 to $1,000 per laborer. The nursery

advanced the Mexican laborers the coyote payments in cash and

then deducted payments from their paychecks. Some laborers would

leave before all of the advance had been recovered.

Some of the Mexican laborers lived on the nursery property

in a concrete bunkhouse type facility. Petitioners deducted a
 - 8 -

small amount per week from the paychecks of these men as a charge

for housing.

Every year, Mr. Gandy and some of his employees would travel

to Tennessee and dig up trees for up to a month. They would camp

out when on these trips. They would dig up trees for B&B and for

“bareroot” trees. “Bareroot” is a method of preparing trees for

immediate sale. The trees are dug up, then the dirt around the

roots is removed, and the trees are replanted into containers

with fresh soil. Mr. Gandy used cash when he traveled to

Tennessee, purchasing sleeping bags, blankets, and other camping

supplies.

Office Practices

For the first 10 years of the nursery's operation,

petitioners ran the sales and billing activities out of their

residence. At first, Mrs. Gandy prepared invoices and shipping

documents by hand; after a while, she bought and used a

typewriter. In approximately 1982, petitioners built a small

office building. At that time, the office building had three

rooms: a kitchen and tag room (where the picture tags and bands

that would be attached to the trees were stored and organized),

an office for Mr. Gandy, and an office and reception area for

Mrs. Gandy. In approximately 1984, they expanded the office

building, adding three more rooms. With the addition of these

rooms, the building had an office for the use of the nursery's
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salesmen, a separate reception area, and a larger tag room; the

former kitchen/tag room was made into a break room.

In approximately 1984, petitioners bought a Tandy computer

for the nursery. Due to the computer's limited capabilities,

petitioners decided to use it only for billing the nursery's more

detailed and frequent accounts, generally those of the chain

store customers. Petitioners continued the use of the previous

invoice system for the remaining customers; these orders were not

recorded on the computer. The two types of invoices had separate

numbering sequences. Mrs. Gandy established two ledgers, one for

each type of invoice. In 1985, petitioners bought an IBM

computer with a new accounting software package.

During 1985 through a portion of 1987, Mrs. Gandy worked in

the business office of the nursery on a daily basis. She was in

charge of the office and trained the employees who worked there.

Sometime during 1987, Mrs. Gandy quit working in the office. Ann

Dozier (Dozier) became the office manager after Mrs. Gandy left.

Mr. Gandy spent very little time in the office, spending most of

his time in the field. Many of the office employees were either

friends or relatives of petitioners or of each other.

During the years in issue, petitioners maintained a business

bank account at the First State Bank of Van styled "Dennis Gandy

Nursery" (account No. 01-0118-8), which was the business bank

account for the nursery. During 1989, Mr. Gandy maintained a

business bank account at the First National Bank of Canton styled
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"Dennis Gandy Nursery" (account No. 21-5232-0). This latter

account was opened on December 29, 1988. Thereafter, this new

account was used as the business account for the nursery. All

references to the nursery bank account refer to the business bank

account in use as of the date discussed.

During the years in issue, the nursery had office procedures

that generally were followed by petitioners and nursery

employees. Various nursery office employees would assist the

walk-in customers and write up invoices. The chain store

invoices were generated from the computer. Petitioners continued

to maintain the two sets of ledgers. During 1985 through 1989,

petitioners maintained one set of ledgers to record receipts from

the nursery that generally were not deposited into the nursery

bank account. That set consisted of the ledgers that listed the

handwritten or typed invoices; those ledgers were referred to by

the nursery employees as the cash book or cash ledger or the

walk-in book or walk-in ledger (the walk-in ledger). Petitioners

maintained a second set of ledgers to record receipts from the

nursery that generally were deposited into the nursery bank

account. This second set of ledgers contained listings of the

computer-generated invoices; employees referred to these ledgers

as the deposits ledger or deposits book or the chain store book

or the chain store ledger (the chain store ledger).

During 1985 through 1989, the nursery sales invoices were

marked with a "P" when they were first posted to the appropriate
 - 11 -

ledger. The nursery sales invoices were marked with a second "P"

("PP") when the amount due was paid by the customer. Those sales

invoices that were marked with a "PP", but were not dated, were

those sales that were generally paid by the customer on the date

of the invoice. The walk-in invoices and the chain store

invoices were kept in different file drawers. The receptionist

would post the walk-in invoices to the walk-in ledger. The walk-

in ledger was kept in the receptionist's desk, along with any

checks or cash collected. Those two or three employees who

usually worked with the computer posted the chain store invoices

to the chain store ledger. The chain store ledger was kept in

the computer room or in one of the offices.

Generally, each day, one of the nursery's employees, usually

the receptionist, would go to the bank. Certain of the checks

taken to the bank were cashed. Mrs. Gandy generally determined

which checks would be cashed and which would be deposited. The

checks that were cashed generally came from B&B customers or from

those customers who made infrequent purchases, i.e., those listed

in the walk-in ledger, not from the chain store customers. The

receptionist was instructed by Mrs. Gandy to limit the checks

cashed to an amount less than $10,000. The purpose of the

instructions was to avoid reports of currency transactions to the

Internal Revenue Service (IRS). No deposits of currency were

made into the nursery bank account during the years in issue.
 - 12 -

Cash receipts or cash from the negotiation of checks was

turned over to petitioners. Cash was kept in the receptionist's

desk drawer; if a large amount accumulated, Mr. Gandy put it in

the safe at petitioners' residence. At the end of the day, any

cash remaining in the drawer would be given to petitioners.

Mrs. Gandy sometimes used cash from the drawer to buy groceries,

putting in a receipt in order to account for the day's

transactions to Mr. Gandy each night. The office did not have a

safe or alarm system. Money that was put into the safe at

petitioners’ residence was not returned to the office.

Sometimes, Mr. Gandy would make cash payments to the laborers

from the money at the residence.

Some of petitioners' household bills were paid from the

nursery bank account. When paying utility bills that included

both the nursery and their residence, Mrs. Gandy would indicate

in the nursery checkbook what amount was for their residence.

Petitioners wrote a check from the nursery bank account to

themselves every few weeks and deposited it into their personal

checking account for living expenses; the amounts of those checks

usually were $1,000, $1,500, or $2,000. During 1985 through

1987, the total amounts that petitioners withdrew from the

nursery bank account for deposit into their personal checking

account were:
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Year Amount

1985 $6,500
1986 15,000
1987 6,500

In February 1986, petitioners engaged John E. Shinn (Shinn),

a certified public accountant, to prepare the nursery's financial

statements and petitioners' 1985 income tax return. Mr. Gandy

asked Shinn to assist them in procuring more appropriate software

to manage their accounting and inventory functions. Shinn spent

a month or two at the nursery office while analyzing the

nursery's needs. As a result, petitioners purchased new computer

software that would track inventory as well as maintain the

nursery's books and records. This new system was installed

during mid-1987, and the vendor provided training to the nursery

employees.

Loans to Petitioners

Small Business Administration

Petitioners received loans from the Small Business

Administration (SBA). The first loan was in the amount of

$200,000 after a severe drought in approximately 1980 to 1981.

The second loan was for $500,000 in 1983 to 1984, after severe

winter weather damaged the crops. The purpose of the SBA loans

was to enable petitioners to restart their nursery after these

disasters. Petitioners placed the funds from these SBA loans

into certificates of deposit (CD’s). During 1985 and 1986,

petitioners made the following payments on the SBA loans:
 - 14 -

Date Amount

Apr. 5, 1985 $22,600
Sept. 21, 1985 44,975
Mar. 25, 1986 22,600
Oct. 21, 1986 44,975

Production Credit Association

Production Credit Association (PCA) is a lending institution

that makes loans to farmers and ranchers. Petitioners began

borrowing from PCA in about 1979 and borrowed throughout the

years in issue. Generally, the activity on the PCA loans was

seasonal; petitioners received disbursements from PCA beginning

in the late summer through fall and early winter and made

payments in the spring of the year. The PCA loans had maturity

dates of 1 year or less, but any unpaid balance at the maturity

date would be renewed with a new maturity date. Disbursements of

PCA loans to petitioners during the specified years totaled:

Year Amount

1985 $505,000
1986 260,000
1987 203,700

Petitioners made payments on the PCA loans during these same

years by checks drawn on the nursery bank account.

Prior to petitioners' receiving the SBA loans, PCA held as

collateral the equipment and nursery stock inventory and some

real estate. The SBA took a blanket lien with first priority on

petitioners' assets, moving PCA to a secondary position.

Thereafter, petitioners used the CD’s that were funded with the
 - 15 -

SBA loan proceeds as collateral for the loans from PCA and from

other lenders.

On December 18, 1986, Mr. Gandy borrowed $90,000 from

Sunbelt Savings (then Independent American Savings). The

proceeds of this loan were used as a payment on the PCA loans.

On April 16, 1987, at the request of PCA, petitioners redeemed

the CD’s that were being used for collateral in order to reduce

the balance outstanding on their PCA loan; they made a payment of

$356,835.83 on that balance. At the same time, petitioners

repaid the December 18, 1986, loan for $90,000 from Sunbelt

Savings with funds from one of the redeemed CD’s.

Other Loans

On January 15, 1986, Mr. Gandy borrowed $21,000 from the

First State Bank of Van. This money was deposited in the nursery

bank account. Petitioners repaid this loan with funds from the

nursery bank account on February 18, 1986.

On March 10, 1986, Mrs. Gandy borrowed $1,500 from the First

State Bank of Van, the proceeds of which went to Vernon Sexton.

This loan was repaid in approximately monthly payments from a

bank account at Sunbelt Savings styled Carolyn Gandy, Trust for

Vernon Sexton, Jr.

On August 1, 1986, Mr. Gandy borrowed $90,000 from Sunbelt

Savings. Petitioners used the proceeds to fund a portion of a

mortgage loan that they made to Todd Fowler (Fowler), as

discussed below.
 - 16 -

On September 30, 1986, petitioners borrowed $24,836.21 from

Paccar Financial Corporation to purchase a piece of equipment.

Petitioners completed repayment of this loan by January 17, 1988,

making payments from the nursery bank account.

On October 10, 1986, petitioners borrowed $35,000 from the

First State Bank of Van. Petitioners deposited this money into

the nursery bank account. They repaid the loan on March 4, 1987,

from the nursery bank account.

During the fall of 1987, Mrs. Gandy d/b/a the Gandy Travel

Agency borrowed a total of $8,300 from First National Bank of

Canton.

Loans Made by Petitioners

In 1985, petitioners began lending money to individuals,

generally for the purchase or construction of personal

residences, residential rental properties, or commercial

buildings. During 1985 through 1987, petitioners made loans

totaling at least:

Year Amount

1985 $139,222.62
1986 371,546.98
1987 209,918.13
$720,687.73

Petitioners used funds from the nursery receipts to make many of

the mortgage loans; on one occasion, petitioners borrowed $90,000

as partial funding for a $118,500 loan to Fowler. As petitioners

began receiving payments from the early borrowers, they used some

of these funds to make new loans. The mortgage loan payments
 - 17 -

that petitioners received from the borrowers were in the form of

checks. During 1985 through 1987, petitioners received payments

totaling at least:

Year Amount

1985 $ 624.10
1986 40,306.17
1987 152,480.13
$193,410.40

For some of the loans, documents were drawn up and

settlement conducted by an attorney or a title company.

Petitioners provided the borrowers with repayment schedules

indicating the amounts of principal and interest within each

payment.

In about early 1986, Mr. Gandy approached Cary Murray

(Murray), then president of the First State Bank of Van, and told

him that he had approximately $800,000 that he wanted to invest

in real estate loans. Murray and his partner Roy Carty received

a loan from petitioners in the amount of $30,000 on June 24,

1986. Closing was conducted by a title company. Murray received

a second loan in the amount of $25,000 on October 10, 1986.

Closing was conducted by the same title company. Each time,

Mrs. Gandy brought the funds in cash to the title company, which

in turn gave the borrowers cashier's checks. Murray made

payments on these loans by checks made out to "Dennis Gandy",

beginning approximately 1 month after receipt of the loan

proceeds. Petitioners gave Murray a form each year stating the

amount of interest he had paid.
 - 18 -

Some of the closings were handled by attorney Dean White

(White). White made the following deposits of funds that were

received from petitioners for the purpose of making loans:

Date Check Cash Borrower

Aug. 1, 1986 $90,000.00 $28,000.00 Fowler
May 15, 1987 34,000.00 Tankersley
July 10, 1987 9,118.13 9,000.00 Magnusons
Sept. 24, 1987 10,000.00 8,500.00 Spradlin

In many instances, petitioners disbursed the funds directly

to the borrowers, sometimes by check, sometimes in cash. On

August 8, 1986, petitioners disbursed $41,000 in wrapped $100

bills to James E. Carter, Mr. Gandy’s first cousin, and Sandra L.

Carter at petitioners' kitchen table. Petitioners lent the

Carters an additional $30,000, with draws beginning in November

1986. The first such draw, in the amount of $5,000 on

November 14, 1986, was by check. For the subsequent draws,

Mrs. Gandy delivered cash to the Carters' business and wrote

receipts for Sandra L. Carter to sign. A second note was drawn

up on March 20, 1987, after the additional money was advanced to

the Carters. These loans to the Carters were recorded in the

county records.

Terry and Rhonda Wilson borrowed $50,000 from petitioners

to pay for the house the Wilsons were building. Closing occurred

on August 21, 1987. The Wilsons received the funds in draws

beginning in about May 1987 as the funds were needed for

construction. Two draws, one on May 15, 1987, and another on

May 28, 1987, each for $6,000, were in the form of checks.
 - 19 -

Mrs. Gandy disbursed most of the other funds in cash, in bundles

of $100 bills, at petitioners' residence.

Bank Accounts

During 1986, petitioners maintained two personal bank

accounts at the First State Bank of Ben Wheeler styled "Carolyn

or Dennis Gandy" (account No. 80-0255-0 and account No.

29-8816-0). During the 10 days in March 1986 that account No.

29-8816-0 was open, petitioners deposited two checks from

mortgage borrowers and one nursery check in the amount of

$13,871.25; they closed the account and transferred the balance

to open account No. 80-0255-0. During the approximately 4-month

period during 1986 that petitioners used account No. 80-0255-0,

they deposited a total of $428,285.42, including the transfer of

$15,052.60 from account No. 29-8816-0, proceeds of 13 checks from

mortgage borrowers, two nursery checks, and five deposits of

currency, the largest of which was $10,000; they distributed the

majority of the funds to mortgage borrowers.
 - 20 -

During some portion of the years in issue, petitioners

maintained the following personal bank accounts:
Account Name Account No.

Sunbelt Savings

Carolyn Gandy XX-XXXXXXX
Carolyn Gandy, Trust for Vernon Sexton, Jr. 03-10012208

First State Bank of Van

The Carolyn Gandy Irrevocable Trust,
Dennis Gandy, Trustee 01-0892-8
Dennis or Carolyn Gandy 10-5933-6

First National Bank of Canton

Dennis or Carolyn Gandy 12-6064-5
Carolyn Gandy 12-6133-8

Mrs. Gandy used account No. XX-XXXXXXX at Sunbelt Savings as

a personal checking account for the Gandy family until early

September 1987. She deposited checks that were written to

herself from the nursery bank account into this account.

Mrs. Gandy opened account No. 12-6133-8 at First National Bank of

Canton in September 1987. This latter account was used primarily

to pay for personal expenses.

Account No. 01-0892-8 at First State Bank of Van was opened

with a deposit of a check for $19,500 payable to Mrs. Gandy from

the nursery bank account. The funds in this account were used to

make a payment in the amount of $19,308.20 to Executive Life

Insurance Co. on September 11, 1987.

The funds of account No. 10-5933-6 at First State Bank of

Van were used to pay monthly drafts for life insurance premiums.
 - 21 -

With the exception of one check to the nursery in the amount of

$7,667.99 that was paid on September 14, 1987, nearly all of the

funds paid from this account went for the insurance premiums or

bank charges. Previously, both insurance companies were paid

from the nursery bank account. During 1986, petitioners

deposited a total of $13,000 from the nursery bank account into

this account. During 1987, petitioners transferred another

$13,000 from the nursery bank account and, during February 1987,

deposited a small amount of nursery receipts into this account.

Account No. 12-6064-5 at First National Bank of Canton was

used primarily for petitioners' mortgage lending activity. All

11 deposits made during 1986 were in cash, with the largest being

$9,000; the 1986 deposits totaled $42,796.91 and began on

July 28, 1986. All deposits from January through August 1987

were in cash; there were 11 such deposits ranging in amounts from

$1,990 to $7,476.34. Deposits occurring later in 1987 also

included mortgage payment checks from the borrowers. Deposits

during 1987 totaled $104,760.34. All identifiable checks that

were written on this account during 1986 and 1987 were payable to

mortgage borrowers, with the exception of one check for $1,000

that was payable to Mrs. Gandy during 1986 and one check for

$10,000 to the nursery in 1987.
 - 22 -

During some portion of the years in issue, petitioners

maintained the following CD accounts at Sunbelt Savings:
Account Name Account No.

Dennis Gandy 1-03-00006962
Dennis Gandy 1-03-00006970
Dennis Gandy 1-03-00007002
Dennis Gandy, Trustee for Carolyn or Dominick Gandy 1-03-00006988
Dennis Gandy, Trustee for Carolyn or Dominick Gandy 1-03-00007218

The first four CD’s listed above were funded with the

proceeds from the SBA loans. Petitioners deposited a few

mortgage payments into account No. 1-03-00007218, along with the

interest from the other four CD’s. Petitioners transferred funds

from this CD account to the nursery bank account as follows:

Date Amount

July 25, 1985 $45,000.00
Nov. 25, 1985 20,000.00
July 8, 1986 20,000.00
Oct. 1, 1986 23,158.12

Petitioners closed all five CD accounts at Sunbelt Savings on

April 16, 1987. The proceeds were used to reduce the balance of

the PCA loans and to pay off the December 18, 1986, loan for

$90,000, and the August 1, 1986, loan for $90,000.

During some portion of the years in issue, four CD accounts

were maintained with the First National Bank of Canton styled

"Carolyn Gandy" (account Nos. 50-5668-4, 50-5669-2, 50-5827-6,

50-5847-4). The four CD’s that established those four accounts

were purchased during 1987 for a total of $10,800, $8,400 of

which was presented in cash.
 - 23 -

During some portion of the years in issue, Mrs. Gandy

maintained a bank account at the First National Bank of Canton

styled "Gandy Travel Agency" (account No. 00-1471-2). The

business expenses of Gandy Travel Agency (the travel agency) were

paid from this account. Of the $8,300 in loans that Mrs. Gandy

borrowed in the name of the travel agency in 1987, $7,600 was

deposited into this account and $700 into account No. 12-6133-8.

During the years in issue, Burnice Gandy maintained a

personal bank account at the First State Bank of Van styled

"Burnice Gandy" (account No. 10-1106-3) (the Burnice Gandy

account). With very few exceptions, the deposits during 1985 and

1986 consisted of Burnice Gandy's Social Security and veterans'

benefits and interest. However, on January 28, 1985, a check

payable to the nursery in the amount of $9,831.50 was deposited

into the Burnice Gandy account; on the back of the check appeared

the handwritten endorsement "Gandy's Nursery". The total deposit

to the Burnice Gandy account on that date was $10,000. Also on

January 28, 1985, a check in the amount of $10,000 was written

from the Burnice Gandy account to Mr. Gandy. On November 24,

1985, a check in the amount of $10,000 was written from the

Burnice Gandy account to Mr. Gandy.

On March 23, 1987, petitioners deposited into the Burnice

Gandy account $5,000 out of a check for $13,437.32 payable to the

nursery. On July 1, 1987, a check for $10,000 payable to Burnice
 - 24 -

Gandy from the nursery bank account was deposited into the

Burnice Gandy account. On October 30, 1987, one check payable to

the nursery ($1,000) and checks from two of petitioners' mortgage

loan borrowers ($233 and $707.25) were deposited into the Burnice

Gandy account.

During 1987, the following deposits of currency were made

into the Burnice Gandy account:

Date Amount

June 22, 1987 $ 5,000.00
Sept. 14, 1987 4,000.00
Sept. 16, 1987 3,000.00
Oct. 6, 1987 3,000.00
Oct. 8, 1987 7,375.60
Oct. 9, 1987 2,600.00
Oct. 22, 1987 6,600.00
Oct. 30, 1987 6,459.75
Nov. 5, 1987 5,000.00
Nov. 30, 1987 5,000.00
Dec. 2, 1987 5,000.00
Dec. 8, 1987 5,000.00
Dec. 10, 1987 5,000.00
Dec. 14, 1987 9,900.00
Dec. 21, 1987 5,000.00
Dec. 23, 1987 5,000.00
$82,935.35

During 1987, the following checks were drawn on the Burnice

Gandy account and deposited into the nursery bank account.
 - 25 -

Date of Check Amount

June 22, 1987 $ 5,000
-- 1987 10,000
Sept. 14, 1987 10,000
-- 1987 10,000
Oct. 23, 1987 10,000
Oct. 31, 1987 10,000
Nov. 6, 1987 10,000
Dec. 2, 1987 10,000
Dec. 7, 1987 10,000
Dec. 13, 1987 10,000
Dec. 23, 1987 10,000
$105,000

During 1988, Mr. Gandy maintained a personal bank account at

the First National Bank of Canton styled "Dennis Gandy" (account

No. 12-6161-9).

During 1988 and 1989, Mr. Gandy and Burnice Gandy maintained

a personal bank account at the First State Bank of Ben Wheeler

styled "Burnice and Dennis Gandy" (account No. 21-4839-0) (the

B&D account). The B&D account was opened on July 19, 1988.

Mr. Gandy opened the bank account by depositing two checks

payable to the nursery that totaled $4,770.10 plus $2,000 in

cash. By late August 1988, a stamp was used to endorse checks;

that stamp read:

Gandy's Nursery
Burnice Gandy
Acct. 21-4839-0

Mr. Gandy regularly caused checks payable to the nursery to be

deposited into the B&D account. Total deposits from July 19,

1988, to December 31, 1988, were $242,172.39. Deposits during
 - 26 -

1989 totaled $249,125.89. The following deposits were in

currency:

Date Amount

1988 July 19 $ 2,000.00
July 22 3,830.00
July 25 8,675.50
July 26 5,000.00
July 29 5,000.00
Aug. 1 8,000.00
Aug. 2 8,000.00
Aug. 3 8,000.00
Aug. 4 8,000.00
Aug. 15 5,139.00
Aug. 17 9,000.00
Sept. 1 7,000.00
Sept. 9 5,000.00
Sept. 16 5,000.00
Sept. 28 5,000.00
Oct. 3 9,115.00
Oct. 7 7,000.00
Oct. 13 4,970.00
Oct. 25 5,685.00
Oct. 28 1,958.00
Nov. 23 2,500.00
Dec. 23 2,525.00
Dec. 30 578.00
1988 $126,975.50

1989 June 27 $ 9,500.00
Sept. 8 8,000.00
Sept. 25 9,800.00
Sept. 26 9,800.00
Sept. 27 9,000.00
Nov. 28 3.00
1989 $46,103.00

Mr. Gandy transferred money from the B&D account to the

nursery by check; the memo section on those checks indicated

"Loan". During 1988, a total of $224,500 was deposited into the

nursery bank account from the B&D account. During 1989, the
 - 27 -

amounts transferred into the nursery bank account from the B&D

account totaled $187,000.

At various times during the years in issue, Mr. Gandy made

statements to petitioners’ employees, relatives, and friends to

the effect that he was "sticking it to Uncle Sam" and "going to

beat the government" and that "the only way to get ahead was to

steal from yourself and cheat the government, or not to show my

cash transactions, you know, in business."

The Lake House

At some point prior to January 1985, Mr. Gandy cosigned a

loan for Doug Christensen (Christensen). The security for this

loan was a property known as the lake house. Christensen failed

to make payments, and the bank foreclosed on the mortgage.

Petitioners borrowed $115,000 from Lindale State Bank on

January 10, 1985, and, of that amount, used $99,027.67 to redeem

the lake house; the remaining $15,972.33 went to pay off a loan

of $15,000 that Mr. Gandy had borrowed from Lindale State Bank on

January 16, 1984.

Petitioners made the following payments on the loan from

Lindale State Bank, all of which were made in cash:
 - 28 -

Date Amount

1985 Jan. 27, 1985 $ 5,000.00
Feb. 28, 1985 1,106.40
Feb. 28, 1985 8,500.00
Apr. 7, 1985 1,106.40
Apr. 7, 1985 8,500.00
Apr. 10, 1985 9,500.00
Apr. 11, 1985 9,500.00
Apr. 14, 1985 9,500.00
Apr. 29, 1985 9,500.00
1985 $62,212.80

1986 Feb. 11, 1986 8,500.00
Feb. 20, 1986 9,000.00
Feb. 24, 1986 9,500.00
Feb. 25, 1986 9,500.00
Feb. 26, 1986 9,500.00
Mar. 4, 1986 8,500.00
Mar. 19, 1986 6,266.08
1986 $60,766.08

During 1987, the lake house was destroyed by fire. In 1987,

petitioners received insurance reimbursement in the amount of

$125,000 for the loss of the lake house and its contents. On

April 8, 1987, petitioners deposited the insurance check into the

nursery bank account. Petitioners did not rebuild the house.

During 1987, petitioners sold the lot on which the destroyed lake

house had been located for $31,000. Settlement was conducted on

April 23, 1987; settlement charges to petitioners totaled

$2,637.89.

Personal Expenditures

On June 28, 1985, petitioners bought a 1985 Cadillac. To

purchase this car, petitioners traded in a 1984 Cadillac Eldorado

and paid $17,750 in cash. On July 1, 1986, petitioners paid
 - 29 -

$20,501 in cash for the purchase of real estate, causing a

Currency Transaction Report to be filed by Mineola Federal

Savings and Loan Association. On December 23, 1986, petitioners

purchased a mink coat for $2,097.24; they paid $1,900 of this

amount in cash and charged the balance to their American Express

card.

Petitioners' Divorce

Petitioners were experiencing marital difficulties during

the mid-1980's. Petitioners entered into a divorce agreement on

June 13, 1988. This agreement was incorporated in the final

decree of divorce signed on June 14, 1988. The agreement awarded

the following property to Mrs. Gandy: the loan notes that were

held by petitioners (said to total approximately $869,000);

$50,000 to be paid on the date of divorce; $50,000 per year for

5 years to be paid annually commencing on June 15, 1989; a 1985

Cadillac convertible; a 1986 Chevrolet van; the travel agency;

40 percent of net recovery from a pending lawsuit; and all

personal property items in her possession. The property awarded

to Mr. Gandy was: the nursery, the marital home, 60 percent of

the net recovery from the pending lawsuit, and all personal

property items in his possession. Among the liabilities that

were assumed by Mrs. Gandy were any debts of the travel agency

and 40 percent of the tax liabilities for 1987 and prior years.

Liabilities assumed by Mr. Gandy included those of the nursery
 - 30 -

and 60 percent of the tax liabilities for 1987 and prior years.

At the time of the agreement, petitioners’ 1987 tax return had

not been filed. Petitioners each received physical custody of

one of their two children and visitation rights as to the other

child.

Financial Statements and Federal Income Tax Returns

1985 through 1987

Petitioners engaged Shinn to prepare the nursery's financial

statements and their 1985 income tax return. Mr. Gandy was

interested in seeing how well the nursery was doing, i.e., what

the income and expenses were and determining what his tax

liabilities would be based on that income. Based on

conversations with petitioners, Shinn assumed that all income was

being deposited into the nursery bank account and that all

expenses were being paid by check. Shinn informed petitioners

that he would be using the nursery bank account information to

prepare the financial statements and the tax return and that

income and expense items would have to go through the bank

account to be picked up for tax return purposes. Shinn used the

computer at his office to prepare the nursery's financial

statements, based on the nursery's bank statements. Shinn

reviewed the financial statements with Mr. Gandy regularly

throughout the year. Mr. Gandy never brought to Shinn's
 - 31 -

attention any expenses or receipts that were omitted from those

statements.

Petitioners' 1985 through 1987 Federal income tax returns

were filed reporting a status of married filing jointly. The tax

returns for 1985 through 1987 were prepared by Shinn. Shinn

prepared petitioners' 1985 through 1987 tax returns from

information supplied to him by petitioners, bank statements,

deposit tickets, canceled checks, and check stubs from the

nursery bank account. Petitioners did not provide Shinn with the

ledgers or inform him of their existence. Petitioners never told

Shinn about the checks payable to the nursery that were cashed or

about those deposited into accounts other than the nursery bank

account. Mrs. Gandy never gave personal checking account

information to Shinn. It was Shinn's understanding that

petitioners used the nursery bank account for their personal

expenses and that they did not have a personal checking account.

Shinn followed the method that had been used by the preparer

of petitioners' 1984 tax return. The records from the nursery

bank account were used by Shinn to compute the gross receipts of

the nursery. Mr. Gandy represented to Shinn that the deposits

that were identified as being from Burnice Gandy were loans.

Shinn did not include any cash income or expenses when preparing

Schedule F.
 - 32 -

Shinn used Forms 1099 to calculate petitioners' interest

income. For 1985 and 1986, Schedule B listed interest from

institutional sources only. In 1988, for preparation of their

1987 tax return, petitioners provided to Shinn a list of the

mortgage notes and payment amounts from which Shinn calculated

additional interest income. On petitioners' 1987 Federal income

tax return, they reported a $10,000 capital gain on the

destruction of the lake house ($125,000 insurance proceeds less

$115,000 basis).

Mrs. Gandy did not review or discuss the completed tax

returns with Shinn. Mr. Gandy never reviewed the returns with

Shinn prior to signing them. Later, Mr. Gandy brought to Shinn's

attention that the interest income on the 1987 tax return had

been overreported. After reviewing the list of mortgages, Shinn

realized that the 1987 interest income was overstated and also

that mortgage interest had been received in 1986 and not reported

on the returns for that year. Shinn informed Mr. Gandy of this.

Petitioners did not file amended returns for 1986 or 1987.

1988 and 1989

Mr. Gandy filed tax returns for 1988 and 1989 reporting a

filing status of single. His 1988 tax return was prepared by

Shelby L. Davidson (Davidson). Davidson was not a certified

public accountant at that time. Davidson prepared Mr. Gandy's

1988 tax return from information supplied by Mr. Gandy, including
 - 33 -

the 1988 bank statements from the nursery bank account, yearend

summary, yearend balance sheet, and profit and loss statements.

The financial statements were reports generated from the

nursery's computer. Davidson was not aware of any cash

expenditures by the nursery.

Dozier was the nursery employee who served as Davidson's

contact. Dozier supplied Davidson with a handwritten list of the

deposits into the nursery bank account and the supporting deposit

slips. Both Mr. Gandy and Dozier told Davidson that the deposits

that were identified as being from Burnice Gandy were loans;

these deposits totaled $217,500. They also identified other

purportedly nontaxable amounts, such as loans from PCA or

insurance proceeds.

The 1988 bank statements from the nursery bank account were

used by Davidson to compute the gross receipts of the nursery for

1988. Davidson compared the book amount of gross receipts to the

amount of the bank deposits, excluding those deposits that were

identified as loans or other nontaxable amounts, and used the net

deposits, which was the higher amount. Davidson was not aware of

any deposits of nursery receipts being made into any bank

accounts other than the nursery bank account, nor was he aware of

any checks to the nursery being cashed.

Mr. Gandy represented to Davidson that Mrs. Gandy had

received the mortgage notes in the divorce property settlement
 - 34 -

and that she would be reporting the interest income from those

notes. Davidson met with Mr. Gandy to review the completed

return. Thereafter, Davidson learned that the Gandys' divorce

had occurred during 1988 and, in late 1988, he sent to Mr. Gandy

a letter indicating that the 1988 tax return should be amended to

include the interest earned on the mortgage notes while they were

community property. An amended 1988 tax return was not filed for

Mr. Gandy.

Mr. Gandy's 1989 tax return was prepared by Gary W. Camp

(Camp), a certified public accountant. Camp prepared the 1989

tax return from information supplied to him by Mr. Gandy: a

balance sheet, profit and loss statement, fuel costs, and a list

of equipment that was purchased and traded. This information

provided by Mr. Gandy was used by Camp to compute the gross

receipts of the nursery for 1989. Camp did not have any bank

statements or ledgers.

Summary

The following table summarizes pertinent items from the tax

returns for the years in issue:
 - 35 -

Item 1985 1986 1987 1988 1989

Interest $66,606.75 $44,317.57 $135,924.00 --- ---
income

Capital --- --- 10,000.00 --- ---
gains

Schedule E --- 3,844.61 --- --- ---
income

Schedule F 1,706,646.90 1,971,310.40 2,210,649.00 $2,049,090.00 $2,650,964.00
sales

Schedule F 1,709,159.90 1,973,223.40 2,211,563.00 2,051,565.00 2,696,214.00
gross
income

Schedule F (88,292.14) (77,901.58) (345,272.00) (146,926.00) (140,465.00)
net income

Net (38,201.08) (25,225.39) --- --- (401,239.00)
operating
loss

Adjusted (59,886.47) (54,964.79) (199,348.00) (146,926.00) (541,704.00)
gross
income

Fuel 1,913.00 914.00 2,475.45 3,400.00 2,677.00
credit

Refund 9,913.00 914.00 2,475.45 3,400.00 2,677.00

The nursery's labor and transportation expenses as

determined by respondent were:

Labor Transportation
Percentage Percentage
of Sched. F of Sched. F
Year Dollars Gross Income Dollars Gross Income

1985 $356,607.96 16.46 $245,962.96 11.35
1986 482,581.18 19.40 218,518.61 8.78
1987 717,487.00 27.71 321,173.00 12.40
1988 751,363.00 32.90 262,931.00 11.51
1989 927,436.00 31.02 269,088.00 9.00

The following table summarizes information relating to the time

of filing of petitioners' tax returns:

1985 1986 1987 1988 1989
 - 36 -

Petitioners Aug. 12, 1986 Oct. 15, 1987 Dec. 26, 1988 Oct. 1, 1989 undated1
signed

Post- Aug. 13, 1986 Oct. 15, 1987 Dec. 29, 1988 Oct. 25, 1989 Sept. 20, 1990
marked

Received -- Oct. 16, 1987 -- -- Sept. 24, 1990

Due date -- Oct. 15, 1987 Oct. 15, 1988 Oct. 15, 1989 --
1
Signed by preparer on Sept. 12, 1990.

Criminal Investigation and Respondent's Determination

On November 1, 1989, special agents of the IRS Criminal

Investigation Division executed a search warrant on the nursery.

As a result, IRS agents seized several boxes of records. The

agents located the two sets of ledgers. On the same date,

Mr. Gandy gave his voluntary consent to a search of person,

premises or conveyance. As a result of the consensual search of

the Gandy residence, IRS agents seized several boxes of records,

including customer invoices, real estate records, financial

records, and $32,874 in currency.

For 1985, 1986, and 1987, respondent used the specific items

method to determine petitioners' income. Respondent

reconstructed petitioners' Schedule F income from the nursery's

records, using primarily the nursery's invoices. During the

course of the criminal investigation, IRS special agents sent a

form letter to more than 200 customers of the nursery requesting

information concerning their purchases from the nursery.

Information on petitioners' interest income from the mortgage

loans was obtained by contacting the individual borrowers that

were listed in the divorce records.
 - 37 -

Respondent made the following adjustments to petitioners'

income:

Item 1985 1986 1987

Interest income $519 $31,342 ($55,660)
Capital gain -- -- 13,062
Schedule F gross receipts 457,293 514,264 378,168
Net operating loss 38,201 25,225 --

Respondent allowed an investment tax credit in the amount of

$38,077 for 1985. Respondent determined self-employment tax on

the Schedule F income for each of the years in issue. Respondent

mailed a notice of deficiency for 1985 through 1987 to

petitioners on September 21, 1993.

For 1988 and 1989, respondent used the bank deposits method

to determine Mr. Gandy's income. Respondent mailed a notice of

deficiency for the taxable years 1988 and 1989 to Mr. Gandy on

September 21, 1993. In the notice of deficiency, respondent made

the following adjustments:

Item 1988 1989

Schedule F gross receipts $217,500 $521,975
Net operating loss -- 401,239

Respondent determined self-employment tax on the Schedule F

income for both years.

By amendment to answer, respondent revised adjustments to

income as follows:

Item 1988 1989

Schedule F gross receipts $232,068 $293,203
Net operating loss -- 401,239
 - 38 -

Respondent adjusted the amounts of the deficiencies in income

tax, the additions to tax, and the penalty accordingly.

On September 4, 1992, petitioners pleaded guilty and were

convicted of subscribing to a false return for 1987, in violation

of section 7206(1).

OPINION

Petitioners do not deny that they had unreported gross

receipts from the nursery during the years in issue. They also

had unreported interest income during certain of those years.

For 1986, they do not dispute that the omitted income exceeded

25 percent of the gross income stated in their return; thus, for

that year, the period of limitations is 6 years, under section

6501(e)(1)(A), and assessment is not barred.

Mr. Gandy’s return for 1989 was delivered to the IRS on

September 24, 1990. Petitioners claim that the return was

untimely filed; that pursuant to section 7502(a)(1), the return

was filed when postmarked on September 20, 1990; and, therefore,

the notice of deficiency for that year, mailed on September 21,

1993, was untimely. Section 7502(a)(1) only applies, however, if

the postmark date falls within the prescribed period or on or

before the prescribed date for the filing (including any

extension granted for such filing) of the return. Sec.

7502(a)(2). There is no evidence of an extension of time to

file. Without an extension from April 15, 1990, up to or beyond
 - 39 -

September 20, 1990, section 7502 does not apply, and the filing

date is the date received by the IRS, September 24, 1990. Emmons

v. Commissioner, 92 T.C. 342, 346-347 (1989), affd. 898 F.2d 50

(5th Cir. 1990). If Mr. Gandy had an extension until September

24 or later, the return was timely, section 7502 would not apply

and the returns would be “filed” when delivered on September 24,

1990. Estate of Mitchell v. Commissioner, 103 T.C. 520, 522

(1994). The notices of deficiency were mailed within 3 years of

that date. Therefore, assessment is not barred for 1989.

For 1985, 1986, 1987, and 1988, respondent relies on section

6501(c)(1) and, therefore, must prove that the returns for those

years were false or fraudulent with the intent to evade tax.

Respondent also has an alternative position under section 6501(e)

for 1986, based on a 25-percent omission from gross income.

Because the question of fraud is determinative as to the

statutory period of limitations for 3 of the 5 years in issue as

well as penalties or additions to tax for all years, we first

discuss the evidence and our conclusions with respect to fraud.

Proof of fraud against either spouse prevents the running of the

period of limitations as to both spouses with respect to the

income tax deficiency on a joint return. Hicks Co. v.

Commissioner, 56 T.C. 982, 1030 (1971), affd. 470 F.2d 87 (1st

Cir. 1972). In these cases, however, the evidence for 1985,

1986, and 1987 implicates both Mr. and Mrs. Gandy.
 - 40 -

Underpayments Attributable to Fraud

The addition to tax for fraud is a civil sanction provided

primarily as a safeguard for the protection of the revenue and to

reimburse the Government for the heavy expense of investigation

and the loss resulting from a taxpayer’s fraud. Helvering v.

Mitchell, 303 U.S. 391, 401 (1938).

Section 6653(b) as applicable to 1985 imposes an addition to

tax of 50 percent of the underpayment if any portion of the

underpayment is due to fraud, and an additional amount equal to

50 percent of the interest with respect to the portion of the

underpayment attributable to fraud. For 1986 and 1987, section

6653(b) imposes an addition to tax of 75 percent of the portion

of the underpayment attributable to fraud, and an additional

amount equal to 50 percent of the interest with respect to such

portion. For 1988, section 6653(b) imposes an addition to tax of

75 percent of the underpayment attributable to fraud. For 1989,

the fraud penalty imposed under section 6663 is equal to

75 percent of the portion of the underpayment attributable to

fraud.

To overcome the limitations defense and to sustain the

additions to tax or penalties for fraud, respondent must prove,

by clear and convincing evidence, for each year, an underpayment

of tax and fraudulent intent. Sec. 7454(a); Rule 142(b). Where,

as here, the allegations of fraud are intertwined with unreported
 - 41 -

and indirectly reconstructed income, respondent can satisfy the

burden of proving an underpayment in one of two ways, i.e., by

proving a likely source of the underreported income or by

disproving an alleged nontaxable source. See DiLeo v.

Commissioner, 96 T.C. 858, 873-874 (1991), affd. 959 F.2d 16 (2d

Cir. 1992); Parks v. Commissioner, 94 T.C. 654, 661 (1990).

In these cases, petitioners have admitted that they had

unreported income from nursery receipts and from interest.

Respondent reconstructed the income for the first 3 years by

reference to petitioners’ invoices and ledgers and for the last

2 years by reference to bank deposits. Respondent’s agents’

actions were reasonable in view of the state of petitioners’

records and the evidence of the manner in which petitioners’ tax

returns were prepared. Respondent is not required to prove the

exact amount of the underpayment. See Webb v. Commissioner, 394

F.2d 366, 373, 379 (5th Cir. 1968), affg. T.C. Memo. 1966-81;

DiLeo v. Commissioner, supra at 868, 873; Smith v. Commissioner,

T.C. Memo. 1976-114.

Petitioners contend that, notwithstanding their admission of

unreported income, they had additional deductions for expenses

paid by cash that offset or substantially reduce the amount of

unreported income. They further contend that they believed that

they did not owe additional tax because the unreported amounts

were reinvested in the business. However, over the years that
 - 42 -

the investigation was conducted by the Government and through

trial of these cases, they did not present any documents or

witnesses that corroborated their claims of substantial

deductible expenses not reported on their tax returns. As

discussed below, their belated attempts to reconstruct deductions

are not persuasive. Even in criminal tax evasion cases, where

the Government bears the greater burden of proof beyond a

reasonable doubt, it is well settled “that evidence of

unexplained receipts shifts to the taxpayer the burden of coming

forward with evidence as to the amount of offsetting expenses, if

any.” Siravo v. United States, 377 F.2d 469, 473 (1st Cir.

1967); accord, e.g., United States v. Hiett, 581 F.2d 1199, 1202

(5th Cir. 1978); United States v. Garguilo, 554 F.2d 59, 62 (2d

Cir. 1977); Elwert v. United States, 231 F.2d 928, 933 (9th Cir.

1956); United States v. Bender, 218 F.2d 869, 871 (7th Cir.

1955); United States v. Link, 202 F.2d 592, 593 (3d Cir. 1953).

See Franklin v. Commissioner, T.C. Memo. 1993-184; Barragan v.

Commissioner, T.C. Memo. 1993-92, affd. without published opinion

69 F.3d 543 (9th Cir. 1995). Respondent’s burden of proving an

underpayment has been satisfied.

Respondent must also prove fraudulent intent. This burden

is met if it is shown that the taxpayer intended to evade taxes

known to be owing by conduct intended to conceal, mislead, or

otherwise prevent the collection of such taxes. Webb v.
 - 43 -

Commissioner, supra at 377-380. Fraud will never be presumed.

It may be proved by circumstantial evidence, because direct proof

of the taxpayer’s intent is rarely available. The taxpayer’s

entire course of conduct may establish the requisite fraudulent

intent. Estate of Temple v. Commissioner, 67 T.C. 143, 159, 161

(1976). Both petitioners pleaded guilty and were convicted of

filing a false return for 1987, and their pleas and convictions

may also be considered as evidence of intent. Wright v.

Commissioner, 84 T.C. 636, 643-644 (1985). A pattern of

consistent and substantial understatements of income is strong

evidence of fraud. Webb v. Commissioner, 394 F.2d at 379; Marcus

v. Commissioner, 70 T.C. 562, 577 (1978), affd. without published

opinion 621 F.2d 439 (5th Cir. 1980).

The courts have developed a number of objective indicators

or “badges” of fraud that may establish fraudulent intent,

including understatement of income, inadequate records,

implausible or inconsistent explanations of behavior, concealment

of assets, and substantial dealings in cash. See, e.g., Bradford

v. Commissioner, 796 F.2d 303, 307 (9th Cir. 1986), affg. T.C.

Memo. 1984-601. In these cases, respondent contends that

petitioners engaged in a 5-year pattern of understating

substantial amounts of income, maintained inadequate books and

records, concealed assets by use of “secret” bank accounts, such

as the account in the name of Burnice Gandy and the personal
 - 44 -

checking accounts, gave implausible or inconsistent explanations

of behavior, concealed their assets and their income, and had

numerous dealings in cash.

Neither the underreporting of income nor the use of cash is

disputed by petitioners. Petitioners also acknowledge that they

kept two sets of ledgers reflecting income from two groups of

customers. Many of the customers’ checks relating to sales

recorded in one group of ledgers were cashed. The preparers of

petitioners’ tax returns were not advised of the cashing of

customers’ checks and, because the tax returns were prepared

based on records of bank deposits, receipts from the cashed

checks were not reported. We are convinced that both petitioners

knew that these methods of keeping books and preparing returns

would result in underreporting of their income. As discussed

further below, we reject petitioners’ contention that the

proceeds of cashed checks, some of which were used for interest-

bearing loans to others and some for their personal living

expenses, were all spent on deductible expenditures.

We are convinced that petitioners’ use of cash was intended

to conceal their income and their assets. Our view in this

regard is based in part on testimony, corroborated by documentary

evidence, that Mrs. Gandy instructed employees to negotiate

checks or otherwise engage in cash transactions in amounts
 - 45 -

totaling less than $10,000 in order to avoid required reporting

of those transactions to the IRS.

Mr. Gandy made several representations, including to his

preparers and to respondent’s agents, that amounts deposited in

the nursery account from Burnice Gandy constituted loans, when

the evidence is convincing that Burnice Gandy could not have made

those loans and that the source of the funds was nursery

receipts. Mr. Gandy contends that receipts were concealed in

relation to the divorce to protect them from Mrs. Gandy. Even if

such concealment served two purposes, the effect and apparent

intention was also to underreport income. Several witnesses

reported that Mr. Gandy expressed his intention to “beat the

government” by devices including use of cash. None of these

incriminating statements were refuted by petitioners.

Petitioners dispute respondent’s agents’ accounts of the

original interview with Mr. Gandy. Even disregarding

respondent’s arguments concerning inconsistencies and false

statements made during that investigation, the record reflects

many inconsistent and implausible statements. Much of the

implausibility is in the form of petitioners’ claimed defenses to

respondent’s determinations. Petitioners engage in rhetoric and

hyperbole unsupported by the record in attempts to blame others

for their current predicament and to obscure the compelling

evidence against them. For example, they assert that an
 - 46 -

unspecified amount was embezzled by a former employee, but the

only support they cite is the assertion of counsel during trial

that the employee was indicted. There is neither testimony nor

documentary evidence to substantiate the claim, and indictment

alone would not establish anything. (Counsel was warned several

times during trial that such assertions would be given no

weight.) They argue that they are handicapped by the

Government’s seizure of records, but the Court found that the

records were returned to them. They imply that certain witnesses

have grudges and are biased, but they have failed to discredit

the testimony given by those witnesses. They assert that they

did not take additional steps that would have indicated fraud,

such as asking that their mortgages be repaid in cash; these

arguments are unavailing. Presumably the borrowers wanted

evidence of interest payments for their own purposes. In any

event, it is not a defense that petitioners did not do more to

further their fraud.

Petitioners contend that they relied on their accountants to

prepare accurate returns, and reasonable reliance on a competent

agent may be a sufficient defense to fraud. However, such

reliance indicates an absence of fraudulent intent only when the

agent has been provided with complete information from which an

accurate return could have been prepared and there is no other

evidence indicating fraudulent intent. Merritt v. Commissioner,
 - 47 -

301 F.2d 484 (5th Cir. 1962), affg. T.C. Memo. 1959-172. In this

instance, there is clear and convincing evidence that petitioners

did not inform their tax return preparers of the diverted

receipts and misled the preparers about their income, assets, and

the source of deposits into their bank accounts.

Petitioners contend that they were unsophisticated and

reasonably relied on their preparers. We do not accept their

testimony in this regard. These cases are comparable to Estate

of Temple v. Commissioner, supra, and we incorporate the same

analysis here. There the Court stated:

* * * [The taxpayer’s] conduct was intimately
entwined with the inaccurate recording of his business
income. He often took receipt of incoming checks,
endorsed them, sometimes withheld cash, and carried
them to the bank for deposit. This subsequently
resulted in omitted or inaccurate journal entries.
* * * In addition, * * * [the taxpayer] had a
consistent practice of cashing checks, which generated
no deposit slips, and thereby prevented income from
being recorded in the journal.

While a taxpayer’s reliance upon his accountant to
prepare accurate returns may indicate an absence of
fraudulent intent, this is true in the first instance
only if the accountant has been supplied with all the
information necessary to prepare the returns. * * *
[The estate] argues in this regard that * * * [the
preparer] had total access to all of the * * *
[business’] books and records, so that even though the
journal was inaccurate, a thorough professional job of
accounting would have uncovered the inaccuracies. Of
course, the thorough audit conducted by respondent’s
agents did discover many omitted and erroneous entries.
However, we cannot conclude on the basis of the record
before us that * * * [the preparer] was retained to
check with * * * [the business’] customers in order to
find out whether they made payments to * * * [the
business] which were not recorded in the journal or to
 - 48 -

otherwise doublecheck the journal entries made by the
bookkeepers. The evidence points to the contrary.
* * * [Estate of Temple v. Commissioner, 67 T.C. at
162-163; citation and fn. ref. omitted.]

See also Webb v. Commissioner, 394 F.2d at 379-380; Foster v.

Commissioner, 391 F.2d 727-732 (4th Cir. 1968), affg. on this

issue and revg. on another issue T.C. Memo. 1965-246; Roose v.

Commissioner, T.C. Memo. 1995-585, affd. without published

opinion 108 F.3d 1377 (6th Cir. 1997); Morris v. Commissioner,

T.C. Memo. 1992-635, affd. without published opinion 15 F.3d 1079

(5th Cir. 1994); Becerra v. Commissioner, T.C. Memo. 1984-134.

For 1985, 1986, and 1987, respondent has presented clear and

convincing evidence of fraud as to both petitioners relating to

unreported gross receipts of the nursery. For 1988 and 1989,

respondent has presented clear and convincing evidence of fraud

with respect to Mr. Gandy. The evidence is also clear and

convincing that petitioners used cash to conceal income and

assets. That they may also have used cash for deductible

expenses was, in our view, in furtherance of their fraudulent

activities. Thus, we are convinced that the entire net

underpayments, after adjustment of the nursery income as set

forth below, are due to fraud. The statute of limitations,

therefore, does not bar assessment for any year, and the

additions to tax and penalties for fraud will be sustained for

each year.
 - 49 -

Nursery Income

Petitioners have failed to raise any bona fide disputes

about the unreported income for the years in issue, and Mr. Gandy

acknowledges that his expenses were not understated for 1988 or

1989. From the time of the investigation in 1992 through filing

of the petition in 1993 and prior to trial in 1996, petitioners

contended that their expenses were correctly reported on their

tax returns and failed to raise any claim for additional

deductions. At the time of trial, and in their briefs, however,

they assert that they are entitled to additional labor and

transportation expense deductions as follows:

Item 1985 1986 1987

Labor $346,172 $325,229 $123,094
Transportation 24,356 92,178 2,127
$370,528 $417,407 $125,221

These claims are based on their assertions that their profit

percentage for those years, under respondent’s determinations,

exceeded their profits in other years and profits earned by their

competitors. These claims are based on vague estimates by

Mr. Gandy and by competitors that are totally unsupported by

reliable evidence. The claims were neither timely nor detailed

enough to provide respondent with a reasonable opportunity to

investigate their validity. Moreover, to the extent that the

claims are based on payments in cash of expenses for wages, to
 - 50 -

“coyotes” who transported the laborers from Mexico, and

unsubstantiated trucking expenses, they are undermined by

evidence that payments to “coyotes” and trucking expenses for

which no receipts were obtained were recouped by deductions from

wages paid to the employees. Finally, the amounts claimed are

simply not credible. Petitioners seek to increase the deductions

for labor costs by nearly doubling them for 1985 (adding $346,172

to $356,607.96 claimed on the original return) and adding an

additional two-thirds of the amount claimed for 1986 (adding

$325,229 to $482,581.18 claimed on the return). We are not

persuaded that they had that much cash available, after diverting

cash to their loan business and other personal uses, unless they

had substantial amounts of unreported cash income as well.

Nonetheless, in view of the nature of petitioners’ business

during the years in issue and their use of imported labor and

payments of those laborers in cash, it is likely that some

expenses that would be deductible were paid in cash. Under these

circumstances, we must weigh heavily against petitioners, whose

inexactitude is of their own making. We also bear in mind that

petitioners had some cash sales in undetermined amounts during

the years in issue that were not included in respondent’s

computation of unreported income. Cohan v. Commissioner, 39 F.2d

540 (2d Cir. 1930). However, the Court must have some basis on

which an estimate may be made. Williams v. United States, 245
 - 51 -

F.2d 559 (5th Cir. 1957); Vanicek v. Commissioner, 85 T.C. 731,

743 (1985). We have taken into account the changing nature of

the nursery’s business from primarily B&B to container trees and

the effect on transportation costs as well as labor costs. We

conclude that petitioners may deduct an additional $100,000 for

labor in 1985 and in 1986 and $50,000 for labor in 1987. We are

not persuaded that they are entitled to deduct any additional

transportation expenses.

Interest Income

Petitioners admit making loans and receiving interest

payments beginning with the 1985 taxable year. Their argument is

that not all payments were made in a timely fashion and, thus,

respondent has overstated the amount of interest received.

Respondent obtained copies of some of the borrowers' checks

or other records of payments. They also interviewed the

borrowers. From this information, respondent calculated the

amount of petitioners' mortgage interest income. Petitioners

have submitted no records that they may have kept regarding the

borrowers' repayments of the mortgage loans. Nor have they

testified that any borrowers failed to make the payments used by

respondent in calculating the additional interest income. We are

persuaded that the amounts of interest income determined by

respondent were correct. We sustain respondent's determination

of petitioners' interest income.
 - 52 -

Capital Gains From Lake House

Sections 1001 and 61 require a taxpayer to recognize gain on

the disposition of property. The gain is the excess of the

amount realized over the adjusted basis. Sec. 1001(a). Adjusted

basis is the basis, or cost, of the property subject to certain

adjustments not pertinent here. Secs. 1001, 1012.

Petitioners paid $99,027.67 to redeem the lake house from

foreclosure. Petitioners have not proven any additional basis in

the property. They received $125,000 in insurance proceeds and

sold the property for $31,000. They paid $2,637.89 in closing

costs. The amount realized was $153,362.11 ($125,000 plus

$31,000 less $2,637.89). Petitioners' gain was thus $54,334.44

($153,362.11 less $99,027.67). Petitioners reported gain of

$10,000. In the notice of deficiency, respondent increased

petitioners' income by $13,062. The adjustment for the gain on

lake house will be sustained as to this amount.

Net Operating Losses

Petitioners contend that they are entitled to a net

operating loss carried forward to 1985 from 1983 and 1984.

Petitioners presented no evidence concerning the net operating

losses. They rely solely on a schedule attached to their return

as filed and an assertion that an audit of their return for 1984

resulted in no change. The loss claimed apparently related back

to 1981 and 1982, years for which there was no evidence at all.
 - 53 -

Petitioners merely testified vaguely about losses in 1983 and

1984. Even if respondent had audited the return for 1984 without

change, there is no evidence that the net operating loss was

correctly computed for that year or would have made a difference

for that year. To be entitled to deduct the claimed net

operating loss, petitioners would have to show that the losses

were sustained and how much was offset against taxable income in

earlier years. See sec. 172(b); Davis v. Commissioner, 674 F.2d

553 (6th Cir. 1982), affg. T.C. Memo. 1980-581; Jones v.

Commissioner, 25 T.C. 1100 (1956), revd. and remanded on another

issue 259 F.2d 300 (5th Cir. 1958); Egly v. Commissioner, T.C.

Memo. 1988-223; Naegle v. Commissioner, T.C. Memo. 1965-212,

affd. per curiam 378 F.2d 397 (9th Cir. 1967).

Additions to Tax and Penalties

Our discussion above concludes that petitioners are liable

for the additions to tax and penalties for fraud for each year,

and the alternative determinations with respect to negligence and

delinquency are therefore moot.

Respondent also determined additions to tax under section

6661 for 1985 through 1988. Section 6661 imposes an addition to

tax if there was a substantial understatement of income tax for

any taxable year. There was a substantial understatement if the

amount of the understatement exceeded the greater of

(1) 10 percent of the tax required to be shown on the return for
 - 54 -

the taxable year or (2) $5,000. Sec. 6661(b)(1). The amount of

the understatement is reduced by the portion attributable to (1)

the tax treatment of any item if there is or was substantial

authority for such treatment or (2) any item with respect to

which the relevant facts are adequately disclosed. Sec.

6661(b)(2)(B).

The understatements of income tax for 1985 through 1988 were

substantial. No authority exists for petitioners’ failure to

report income. Petitioners did not disclose any facts concerning

the unreported items in their returns. Petitioners are liable

for the additions to tax under section 6661 for 1985 through

1987, and Mr. Gandy is liable for that addition to tax for 1988.

To reflect the above holdings,

Decisions will be entered

under Rule 155.