Crabtree v. Commissioner

T.C. Memo. 1999-423

UNITED STATES TAX COURT

JERRY L. CRABTREE, ET AL.,1 Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 2917-97, 2918-97, Filed December 29, 1999.
3933-97, 4026-97.

James L. Chase, for petitioners.

Alan Friday, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WHALEN, Judge: Respondent determined the following

deficiencies in and penalties with respect to the Federal

income tax of petitioner Jerry L. Crabtree:

1
Cases involving the following petitioners are con-
solidated herewith: Eddie L. Crabtree, docket No. 2918-97;
Crabtree Investments, Inc., docket Nos. 3933-97 and 4026-
97.
 - 2 -

Year Deficiency Fraud Penalty Sec. 6663

1992 $97,728 $73,296
1993 49,310 36,983
1994 76,554 57,416

Unless stated otherwise, all section references are to the

Internal Revenue Code as in effect during the years in

issue.

Respondent determined the following deficiencies in

and penalties with respect to the Federal income tax of

petitioner Eddie L. Crabtree:

Year Deficiency Fraud Penalty Sec. 6663

1992 $99,346 $74,510
1993 50,523 37,892
1994 95,103 71,327

Respondent also determined the following deficiencies

in and penalties with respect to the Federal income tax of

petitioner Crabtree Investments, Inc. (Crabtree Invest-

ments):

Year Deficiency Fraud Penalty Sec. 6663

1992 $245,051 $183,788
1993 103,218 77,414
1994 118,840 89,130

Each petitioner filed a timely petition for

redetermination in this Court, and their cases were

consolidated for trial, briefing, and opinion by order of
 - 3 -

the Court issued pursuant to Rule 141(a) of the Tax Court

Rules of Practice and Procedure. In this opinion, all Rule

references are to the Tax Court Rules of Practice and

Procedure.

After concessions, the issues for decision are:

(1) Whether Crabtree Investments underreported its gross

income for 1992, 1993, and 1994; (2) if Crabtree

Investments underreported income, whether petitioners Jerry

L. and Eddie L. Crabtree each received constructive

dividends from the corporation in 1992, 1993, and 1994 of

one-half of the gross income that went unreported; (3)

whether each petitioner is liable for the fraud penalty

under section 6663 for the years in issue; and (4) if the

fraud penalty is not applicable, whether each petitioner

is liable for the accuracy-related penalty under section

6662(a) attributable to negligence or disregard of rules

or regulations. Petitioners do not contend that the period

of limitations on assessments set forth in section 6501

applies in these cases.

FINDINGS OF FACT

Some of the facts have been stipulated and are so

found. The stipulation of facts and the attached exhibits

are incorporated herein by this reference. At the time of
 - 4 -

trial, petitioner Jerry Crabtree and her son, petitioner

Eddie Crabtree, each owned 50 percent of the stock of

Crabtree Investments. They served as the only officers of

the corporation. At the time they filed their petitions in

this Court, they resided in Pensacola, Florida. Crabtree

Investments, a Florida corporation, was incorporated on

April 1, 1985, and maintained its principal place of

business in Pensacola, Florida, at the time the instant

petitions were filed on its behalf.

During the years in issue, Crabtree Investments

operated a bar and package store in Pensacola, Florida,

trading under the name Justins. Before the incorporation

of Crabtree Investments, the individual petitioners had

owned and operated Justins since 1983 or 1984. Justins

consists of an L-shaped building with the package store in

the front and a country and western bar in the rear of the

building. Justins is located near a number of large

manufacturing companies.

During the years in issue, Ms. Crabtree managed the

package store, which generally was open Tuesday through

Saturday from 1 p.m. until 7 p.m. Mr. Crabtree managed the

bar, which was open daily from 6 p.m. until 2:30 a.m. The

bar had a maximum seating capacity of 250 persons and
 - 5 -

usually featured live bands on Friday and Saturday nights.

The bar sold prepackaged snacks and had a pay telephone.

Ms. Crabtree handled all of the bookkeeping for the

package store and the bar during the years in issue. For

Federal income tax purposes, Crabtree Investments reported

income using the calendar year and a hybrid method of

accounting, the cash receipts and disbursements method for

sales, and the accrual method for purchases.

Petitioners’ accountant, Mr. Richard Morton, prepared

a general ledger and other financial records for Crabtree

Investments for each of the years in issue. The general

ledger for each year itemizes on a monthly basis the checks

written on a checking account at First Union Bank main-

tained on behalf of Crabtree Investments. Mr. Morton

prepared the general ledgers from the records that the

individual petitioners provided to him every month. These

records included Crabtree Investments’ check stubs, bank

statements, daily reports, and other records. On the basis

of that information, Mr. Morton reconciled the bank account

and prepared a sales journal, sales tax returns, payroll

reports, and payroll tax deposits. Mr. Morton also

prepared the corporation’s income tax returns from the

above information. Mr. Morton did the audit of the records

of Crabtree Investments.
 - 6 -

The general ledgers prepared by Mr. Morton include a

liability account entitled “Loans From Shareholders”. The

balance of that account at the end of 1991 through 1994 is

as follows:

1991 $44,326.74
1992 44,326.74
1993 69,910.18
1994 100,228.68

The individual petitioners maintained two joint bank

accounts during the years in issue. One joint account was

at AmSouth Bank of Florida. The aggregate cash deposits,

aggregate noncash deposits, aggregate withdrawals, and the

yearend balance of that account for 1991 through 1994 are

as follows:

Cash Noncash
Year Deposits Deposits Withdrawals Balances
1
1991 –- –- -- $82,284.35
1992 $40,305 $2,705.02 $55,316.82 69,977.55
1993 27,936 9,872.85 92,533.16 15,253.24
1994 3,200 73,508.80 82,687.85 9,274.19
1
Balance on Jan. 28, 1992.

The other joint account was at First Union National Bank

of Florida, formerly Southeast Bank of West Florida. The

aggregate cash deposits, aggregate noncash deposits,

aggregate withdrawals, and the yearend balance of that

account for 1991 through 1994 are as follows:
 - 7 -

Cash Noncash
Year Deposits Deposits Withdrawals Balances

1991 -- -- -- $2,513.21
1992 $34,795.83 $542.86 $36,694.70 1,157.20
1993 25,500.00 -- 24,140.78 2,516.42
1994 14,300.00 377.00 15,694.50 1,498.92

Respondent audited Crabtree Investments’ corporate

income tax returns for taxable years 1992, 1993, and 1994.

During the audit, petitioners provided the following

records to the revenue agent: Canceled checks, purchase

orders, daily reports, cash register tapes, summaries of

the cash register transactions referred to as Z tapes,

deposit slips, and general ledgers. The revenue agent

analyzed the corporation’s bank account records. She found

a substantial disparity between the total deposits made to

the bank account at First Union Bank and the sales reported

on the corporation’s tax return for 1992. She also found

that relatively little cash had been deposited into the

account despite the cash nature of the business.

The revenue agent determined that the records of

Crabtree Investments were insufficient to determine gross

income. Therefore, she recomputed Crabtree Investments’

gross income for 1992, 1993, and 1994, both in the package

store and in the bar using the unit markup method. As the

starting point for the reconstruction, the revenue agent
 - 8 -

obtained from Ms. Crabtree the original purchase orders for

beer and liquor purchases.

All of Crabtree Investments’ original records that

were provided to the revenue agent, other than the general

ledgers, were returned to petitioners and afterwards lost

in the fire that destroyed Justins in 1996. They were not

available at trial.

Respondent’s determination of Crabtree Investments’

unreported income for 1992, 1993, and 1994 is based upon

eight different categories of income, as summarized in the

following schedule:

1992 1993 1994

a. Bar sales $938,199 $397,502 $426,160
b. Package store sales 54,041 63,943 99,511
c. Cover charges 91,000 91,000 91,000
d. Vending machine receipts 7,954 6,944 6,714
e. Food sales 6,500 6,500 6,500
f. Flower sales 2,314 1,220 -0-
g. Coke, juice & coffee 19,435 19,435 19,435
h. Pay telephone receipts 2,080 2,080 2,080

Total 1,121,523 588,624 651,400

Gross receipts or sales
reported on return 479,829 263,151 229,508

Adjustment 641,694 325,473 421,892
 - 9 -

On the basis of the above adjustments for 1992, 1993, and

1994, respondent computed tax increases of $245,051,

$103,218, and $118,840, respectively, with respect to the

returns of Crabtree Investments.

Bar and Package Store Sales

The following schedule summarizes the aggregate gross

receipts of the package store and the bar as determined

by the revenue agent:

Description 1992 1993 1994

.50-liter $147.00 $255.50 $87.50
.200-liter 6,938.70 3,158.08 2,177.72
.375-liter 7,224.40 4,361.77 2,716.54
.750-liter 14,019.70 7,478.99 7,497.29
1.5-liter wine 178.80 -0- -0-
1.75- & 2-liter 3,623.70 3,133.14 749.40
3-liter -0- 39.96 -0-
Miscellaneous 745.20 2,240.70 3,247.20
Liter--package 11,670.40 5,778.84 6,257.29
Liter--at bar 669,067.89 169,498.45 160,480.14
Beer 278,624.08 265,500.00 342,458.00

992,239.87 461,445.43 525,671.08

The revenue agent reconstructed Crabtree Investments’

gross receipts from bar and package store sales using the

beer, wine, and liquor purchases as shown on the purchase

orders provided to the agent by petitioners. The agent

also used the drink and package store prices supplied by

petitioners and applied a spillage or waste factor. The

agent subtracted reported sales from total gross receipts,
 - 10 -

as thus reconstructed, to arrive at the amount of

unreported gross receipts.

The purchase orders provided to the agent by

petitioners showed purchases of alcohol from six vendors.

Two of the vendors sold beer, and the other four sold

liquor. The revenue agent analyzed petitioners’ purchase

records and prepared a summary of the alcohol purchases

according to bottle size and alcohol type. The revenue

agent’s audit workpapers summarize Crabtree Investments’

purchase orders for liquor, beer, and wine as follows:

Quantity Purchased
Items Purchased 1992 1993 1994

Liquor--.50-liter bottles 195 202 60
Liquor--.200-liter bottles 2,698 999 588
Liquor--.375-liter bottles 1,678 775 496
Liquor--.750-liter bottles 1,404 634 571
Wine--1.5-liter bottles 24 -- --
Liquor--1.75 & 2-liter bottles 286 204 42
Beer--12 oz., 16 oz., 3,552 -- --
& wine cooler
Miscellaneous 401 816 1,152
Liquor--liter package 1,827 513 487
Liquor--liter at bar 7,328 1,674 1,691
Beer 131,191 57,360 56,317

150,584 63,177 61,404
 - 11 -

The original purchase orders from which the agent made the

above summary were among the records that were lost in the

December 1996 fire that destroyed Justins and are not

included as part of the record in these cases.

The revenue agent used the bottle purchases reflected

on the purchase orders provided by petitioners to

reconstruct the total sales for each year. Ms. Crabtree

informed the revenue agent that 80 percent of the liter

bottles purchased were used in the bar and 20 percent were

sold in the package store. The notices of deficiency

issued to Crabtree Investments explain the computation of

bar sales and package store sales as follows:

Bar sales were determined based on using 80
percent of your purchases. The number of unit
purchases (bottles) times the number of servings
per unit purchase times the charges per serving
equals the bar sales.

Package sales were determined based on using 20
percent of your purchases. The number of unit
purchases (bottles) times the unit sales price
equals the package sales.

The allocation described in the above explanation applies

only to liter bottles. On the basis of the statements of

petitioners, the agent treated all other bottles purchased

by Crabtree Investments as having been sold in the package

store.
 - 12 -

Throughout the years in issue, the bar at Justins sold

beer for $2 per bottle, draft beer in 10-ounce glasses for

$2 per draft, and liquor for $3, $3.25, and $3.50 per

drink, depending on the type of liquor used. Mixer liquors

increased the drink price by 25 cents. Justins also sold

liquor, wine, and beer from the package store.

Petitioners kept no record of the number of drinks

given away and did not keep records of broken bottles or

spilled drinks. During the initial audit interview,

Mr. Crabtree informed the revenue agent that there was very

little spillage of alcohol at the bar. In reconstructing

bar sales of liquor, the agent used a 10-percent spillage

or waste factor, and in reconstructing bar sales of draft

beer the agent used a 5-percent spillage or waste factor.

During the initial audit interview, petitioners told

the revenue agent that the drinks sold in the bar contained

approximately 1 ounce of liquor. This is consistent with

the practice of many other bars in the area. The revenue

agent multiplied the number of liter bottles used in the

bar by 33.8 in order to convert liters into ounces. After

reducing the total volume in ounces by the 10-percent

spillage or waste factor and assuming that each drink

contained 1 ounce of liquor, the revenue agent determined

the number of drinks available per bottle. She then
 - 13 -

multiplied the number of drinks per bottle by the price

charged per drink to obtain total liquor sales.

Ms. Crabtree told the revenue agent the prices charged

for bottles of alcohol sold in the package store. The

revenue agent multiplied the number of bottles sold in the

package store by the price per bottle to determine total

sales in the package store.

Income From Cover Charges

Respondent’s agent computed income from cover charges

of $91,000 for each of the years in issue. The notices of

deficiency issued to Crabtree Investments provide the

following explanation of the computation of this amount:

Cover Charges were determined by using a $1
charge for 52 Thursday nights per year times 250
(the lounge capacity) and a $2 charge for 104
(Friday and Saturday) nights per year times 375
(1 1/2 times the lounge capacity) or $91,000.

This adjustment is based upon the information provided by

Ms. Jerry Crabtree and Mr. Eddie Crabtree during their

initial audit interviews with the agent.

Income From Food Sales

Respondent determined food sales from the bar to be

$125 per week or $6,500 per year for each of the taxable

years in issue. The notices of deficiency issued to
 - 14 -

Crabtree Investments state as follows: “Food income was

determined using $125 per week based on Florida Department

of Revenue estimates for a business your size.” Respondent

used this estimate because Crabtree Investments did not

provide any purchase records for the food sold in the bar.

Income From Cola, Juice, and Coffee Sales

Respondent determined that sales of nonalcoholic

beverages, such as cola, juice, and coffee, were $19,435

per year for each of the years at issue. The notices of

deficiency issued to Crabtree Investments provide the

following explanation:

Coke, Juice and Coffee sales were determined
using an assumption that one quarter of the
persons paying cover charges for nights when
entertainment was provided [Thursday, Friday,
and Saturday] would pay $1.50 for these items.

Income From Pay Telephone Receipts

Respondent determined pay telephone receipts to be $40

per week or $2,080 per year for each of the years in issue.

The notices of deficiency issued to Crabtree Investments

provide the following explanation: “Pay telephone income

was determined using $40 per week based on Florida

Department of Revenue estimates for a business your size.”

The revenue agent used this estimate because petitioners
 - 15 -

did not produce any records or other evidence of pay

telephone receipts.

Agents from two State taxing authorities audited

Crabtree Investments during the years in issue. First, the

Florida Department of Business Regulation, Division of

Alcoholic Beverages and Tobacco (DABT), conducted a

beverage surcharge tax audit for the period July 1990

through December 1993. The beverage surcharge tax is a tax

on consumption of alcohol on the premises. As applied in

these cases, the surcharge tax applies to bar sales but not

to package store sales. Second, the Florida Department of

Revenue conducted a sales tax audit for the period November

1989 through July 1995. The sales tax audit was initiated

after a referral from the DABT.

OPINION

Unreported Income of Crabtree Investments

The first issue for decision is whether Crabtree

Investments underreported its gross income for 1992, 1993,

and 1994. Petitioners expressly concede the adjustments

involving vending machine receipts and flower sales. The

remaining adjustments at issue are: Bar sales, package

store sales, income from cover charges, income from food

sales, income from cola, juice, and coffee, and income from
 - 16 -

the pay telephone. Petitioners bear the burden of proving

that respondent’s determination is incorrect as to each of

those adjustments. See Rule 142(a).

Petitioners argue that respondent’s use of the unit

markup method of reconstructing income is improper because

Crabtree Investments maintained detailed and adequate

records. Petitioners reason that, because its records

were consistent with the information reported on its tax

returns, we must accept the records as clearly reflecting

its taxable income. We disagree.

Taxpayers are required to keep adequate books or

records from which their correct tax liability can be

determined. See sec. 6001. The Commissioner may test

the adequacy of a taxpayer’s books and records by any

reasonable method which, in the Commissioner’s judgment,

properly reflects taxpayer’s taxable income. See Holland

v. United States, 348 U.S. 121, 131-132 (1954); Lipsitz v.

Commissioner, 21 T.C. 917, 931 (1954), affd. 220 F.2d 871

(4th Cir. 1955). If the Commissioner determines that a

taxpayer’s books and records are not adequate, then the

Commissioner is entitled to reconstruct the taxpayer’s

income by any reasonable means. See sec. 446(b); Webb v.

Commissioner, 394 F.2d 366, 371-372 (5th Cir. 1968), affg.

T.C. Memo. 1966-81.
 - 17 -

We agree that respondent’s use of the unit markup

method is justified in the cases involving Crabtree

Investments. The revenue agent found a material

difference, approximately $400,000, between the aggregate

deposits made into Crabtree Investments’ account at First

Union Bank and the gross receipts reported on its 1992

corporate tax return. According to the bank statements,

aggregate deposits of approximately $800,000 were made into

the account in 1992. Similarly, according to the 1992

general ledger of Crabtree Investments (with the exception

of March deposits which could not be located) deposits

totaled $789,449. On the other hand, Crabtree Investments

reported sales of $479,829 on its 1992 corporate tax

return. The revenue agent also found that Crabtree

Investments did not maintain complete inventory records,

and the agent noted a substantial drop in reported sales,

from approximately $468,000 in 1992 to approximately

$260,000 in 1993. Furthermore, despite the cash nature

of the bar business, very little cash was deposited into

the corporation’s bank account. The daily records of

the business showed bar sales equal to the total checks

received with little or no cash.

In addition, two State taxing authorities noted the

inadequacy of Crabtree Investments’ records. First, the
 - 18 -

DABT conducted a beverage surcharge tax audit for the

period July 1990 through December 1993. The DABT auditor

noted that Crabtree Investments did not keep very good

records and kept only sketchy inventory records. The

auditor used the wholesale distributors’ reports (DABT

Summary of Purchases) to determine the amount of alcohol

Crabtree Investments purchased. The DABT Summary of

Purchases is a listing of all items sold by alcohol

distributors to a particular licensee. Florida law

requires all wholesalers/distributors to report to the

DABT all alcohol purchases by a licensee/retailer.

Second, the Florida Department of Revenue conducted

a sales tax audit for the period November 1989 through

July 1995. The sales tax auditor used an indirect method

of reconstructing sales for taxable year 1993. She

obtained the amount of alcohol purchased from the DABT

Summary of Purchases and marked up the purchases to arrive

at the selling price. The auditor found that for 1993

“there was a $325,000 difference between the sales that

they reported to the Department of Revenue and the sales

as they were marked up based on AB & T’s numbers.”

Petitioners gave the sales tax auditor deposit slips,

weekly reports, and cash register tapes. The auditor found

that the original records of Crabtree Investments were not
 - 19 -

organized. Furthermore, the records were not complete.

The auditor was unable to find journal tapes and the cash

register tapes for the 3 sample months that she initially

chose, and was forced to select different months. The

report of the sales tax audit states that “the accounting

records flow through to the financials without a hitch.

However, the bar business is mostly cash and income is

easily hidden from normal view.” The auditor found that

the deposit slips for the business show that deposits

consisted mostly of checks. She found that to be unusual

because bars are typically high cash businesses. The

auditor noted in the audit report that “The taxpayer did

not use due care in reporting all sales and deliberately

hid income.”

On the basis of the foregoing, we find that respondent

was justified in using an indirect method of reconstructing

income. The percentage or unit markup method is an

acceptable method of reconstructing a taxpayer’s income.

See Langworthy v. Commissioner, T.C. Memo. 1998-218;

Stewart v. Commissioner, T.C. Memo. 1990-264 (citing

Tunningley v. Commissioner, 22 T.C. 1108 (1954); Stone

v. Commissioner, 22 T.C. 893 (1954)).
 - 20 -

Bar Sales

Petitioners attack respondent’s reconstruction of bar

sales on four grounds. First, petitioners assert that

the revenue agent purportedly used the purchase
records provided by Jerry Crabtree. However, the
volume of alcohol used by the revenue agent in
her analysis of reconstructing bar sales is
inconsistent with the volume of alcohol actually
purchased by the corporate taxpayer.

Petitioners argue that the revenue agent should have used

the DABT Summary of Purchases as the starting point to

reconstruct gross receipts from alcohol sales.

Petitioners claim that the DABT Summary of Purchases

shows that Justins purchased 67,712 ounces of liquor (not

including wine or beer) during 1992. Using petitioners’

purchase orders, on the other hand, the revenue agent

determined that Justins purchased 391,294.82 ounces of

liquor during 1992. Petitioners assert that respondent’s

use of Crabtree Investments’ purchase orders rather than

the DABT Summary of Purchases results in an overstatement

of 323,582.82 ounces in liquor purchases. Petitioners do

not reconcile this difference or explain why their purchase

records reflect purchases that are so much greater than

those reflected in the DABT Summary of Purchases.
 - 21 -

Despite the large difference in ounces of liquor

purchased, petitioners’ accountant presented this

comparison for the first time at trial. Furthermore,

petitioners’ argument is based solely on taxable year 1992.

At trial, petitioners’ accountant testified that he had

made a similar analysis for 1993, but petitioners did not

seek to introduce the accountant’s 1993 analysis into

evidence. In their opening brief, petitioners assert:

“Although the DABT audit was not extended beyond 1993, the

1992 comparison of alcohol purchases testified to by the

Petitioners’ accountant indicates that the revenue agent’s

calculation of unreported income is unreliable.” Thus, it

appears that petitioners are implicitly arguing that the

revenue agent overstated the amount of alcohol purchased in

1993 and 1994, as well as in 1992.

Furthermore, petitioners have shown no reason to

believe that the DABT Summary of Purchases would yield a

more accurate amount of alcohol purchased than petitioners’

own purchase records. In fact, the opposite appears to be

the case. If we take the total dollar amount of liquor

purchases during 1992 from Crabtree Investments’ general

ledger and the gallonage of liquor purchased in 1992 by

Justins as reported in the DABT Summary of Purchases, the
 - 22 -

average monthly price of liquor purchased for 1992 is

approximately $146.13 per gallon.

Second, petitioners contend that respondent erred in

assuming that drinks contained 1 ounce of alcohol. The

revenue agent testified that petitioners told her at the

initial audit interview that all drinks contained 1 ounce

of liquor. At trial, Mr. Crabtree testified that he did

not recall making that statement to the revenue agent and

testified that a 3-ounce drink was common. In addition,

petitioners offered the testimony of three bartenders at

Justins to rebut the 1-ounce assumption. The first

bartender testified that drinks contained between 3 and 7

ounces of liquor. A second bartender testified that drink

size varied between 2 and 4 ounces. A third bartender,

who was not employed at Justins during the years in issue,

testified that she poured drinks containing between 2 and 3

ounces of liquor. On the basis of the entire record, we

find that respondent’s assumption that each drink contained

1 ounce of alcohol, which was based on petitioner’s

statement to the agent, is reasonable and that petitioners

have shown no reason for the Court to find otherwise.

Third, petitioners argue that respondent’s recon-

struction of bar sales does not take into account drink

specials offered by Justins during the years in issue.
 - 23 -

Petitioners claim that between 1992 and 1994 Justins

offered two-for-one drink specials during a happy hour

which lasted from the opening of the bar until

approximately 9 p.m. when the band began to play.

Petitioners also claim that Justins held Ladies’ Nights

during which female customers received free drinks or

drinks at a reduced price. We find that the record is

devoid of any evidence from which we can find the number

of promotion drinks during the years in issue. In fact,

there is evidence that Justins offered no drink specials.

The DABT Preaudit Questionnaire completed by Ms. Crabtree

contains the following question: “Do you have any

promotions such as, buy one get one free or all you can

drink specials?” Ms. Crabtree answered: “No”.

Finally, petitioners argue that respondent’s

recomputation is incorrect because it fails to take into

account losses due to employee theft during the years in

issue. However, the record is devoid of any evidence of

employee theft, except for the biased and unpersuasive

testimony of Mr. Eddie Crabtree. Thus, petitioners have

failed to satisfy their burden of proof on this issue.

See Rule 142(a).
 - 24 -

Income From Cover Charges

Petitioners attack respondent’s reconstruction of

income from cover charges as arbitrary upon four grounds.

First, petitioners argue that respondent erred by assuming

that a $1 cover charge was collected on Thursday nights.

Second, petitioners assert that respondent’s assumption

that the number of customers paying cover charges was equal

to capacity on Thursdays and equal to 1-1/2 capacity on

Fridays and Saturdays is false. Third, petitioners argue

that the revenue agent failed to take into account the

hours on Friday and Saturday nights during which cover

charges were not collected. Finally, petitioners claim

that in respondent’s determination of unreported income

respondent failed to give them credit for the cover charge

revenue reported on Crabtree Investments’ tax returns.

As to petitioners’ first contention, we note that

respondent’s computation is based upon the admission made

by the individual petitioners during their initial audit

interview with the revenue agent to the effect that they

collected cover charges of $1 per customer on Thursday

nights. As to petitioners’ second and third contentions,

attacking respondent’s assumptions that 250 customers paid

$1 each on Thursdays and 375 customers paid $2 each on

Fridays and Saturdays, petitioners’ contentions are based
 - 25 -

principally upon the biased testimony of Mr. Eddie

Crabtree. We find no credible evidence to support

petitioners’ argument that respondent’s determination is

wrong. In this regard, we accord no probative weight to

the testimony of petitioners’ witnesses.

As to petitioners’ final contention that respondent

failed to give them credit for the cover charges reported

on their returns for the years in issue, petitioners are

wrong. Respondent’s determination of the unreported income

of Crabtree Investments gives petitioners full credit for

the gross receipts or sales reported on each of the returns

in issue. Thus, any cover charges reported by petitioners

have been subtracted from the adjustment computed by

respondent for each of the subject years. Accordingly,

we find that petitioners have failed to prove that

respondent’s reconstruction of income from cover charges

is incorrect. See Rule 142(a).

Income From Food Sales

Petitioners argue that respondent’s estimate of food

sales is unreliable and arbitrary. Petitioners assert that

the revenue agent could have reviewed Crabtree Investments’

general ledgers to determine the actual amount of food

purchases because food was purchased by check. Petitioners
 - 26 -

bear the burden of proving respondent’s determination

wrong. See id.

We find that petitioners have failed to meet their

burden of proof for the following reasons. First,

petitioners have failed to produce any records of food

sales that refute respondent’s determination. Second,

petitioners have failed to produce any records of food

purchases from which the amount of food sales could be

determined, nor have they shown how that amount could be

determined from the general ledgers. Third, the record

does not support petitioners’ assertion that food was

purchased entirely by check. To the contrary, the Florida

sales tax auditor noted in her audit report that “The

taxpayer pays liquor bills, snack bills, and petty cash

items in cash.”

Income From Cola, Juice, and Coffee Sales

Petitioners argue that the reconstruction of

nonalcoholic beverage sales is unreliable and arbitrary.

Petitioners assert that few bar customers ordered

nonalcoholic beverages during the years in issue, and that

nonalcoholic beverages were often served to customers

without charge. Petitioners have failed to produce any

evidence of sales of nonalcoholic beverages to refute
 - 27 -

respondent’s determination, other than their own biased

testimony. Accordingly, we sustain respondent’s

determination. See Rule 142(a).

Income From Pay Telephone Receipts

Petitioners argue that respondent’s estimate of pay

telephone receipts is unreliable and arbitrary.

Petitioners claim that respondent should have subpoenaed

the telephone records to determine the actual amount of

money received. However, petitioners have failed to

produce any telephone records that would refute

respondent’s estimate. Accordingly, petitioners have not

satisfied their burden of proving respondent’s

determination wrong. See id. On the basis of our review

of the record, we find that petitioners failed to meet

their burden of proof as to each category of income that

respondent’s determination comprises. Accordingly,

we sustain respondent’s determination that Crabtree

Investments underreported its gross income in each of the

taxable years in issue.

Deficiencies

The second issue for decision is whether one-half of

the unreported income of Crabtree Investments for each of

the years in issue is a constructive dividend to each of
 - 28 -

its shareholders. The notice of deficiency issued to

petitioner Jerry Crabtree contains the following

explanation:

It is determined that, for the years ended
December 31, 1992, 1993, and 1994, you received
dividends from the corporation, Crabtree Invest-
ments, in the amount of $320,847, $162,737, and
$210,946, respectively.

Accordingly, your taxable income for the years
ended December 31, 1992, 1993, and 1994, is
increased in the amounts of $320,847, $162,737,
and $210,946, respectively.

The notice of deficiency issued to petitioner Eddie

Crabtree contains a similar explanation. Petitioners bear

the burden of proving respondent’s determination wrong.

See id.

Section 61(a) defines gross income as “all income

from whatever source derived,” including gross income

derived from dividends. See sec. 61(a)(7). Dividends may

be formally declared or they may be constructive. See

Noble v. Commissioner, 368 F.2d 439, 442 (9th Cir. 1966),

affg. T.C. Memo. 1965-84; Commissioner v. Makransky, 321

F.2d 598, 601 (3d Cir. 1963), affg. 36 T.C. 446 (1961);

Sachs v. Commissioner, 277 F.2d 879, 882 (8th Cir. 1960),

affg. 32 T.C. 815 (1959). The determination of whether a

constructive dividend was received is a question that
 - 29 -

depends on the facts of each case. See Hardin v. United

States, 461 F.2d 865, 872 (5th Cir. 1972).

In these cases, respondent argues that, as the sole

and controlling shareholders of Crabtree Investments,

petitioners “exercised the requisite substantial influence

to be taxable on these amounts.” Petitioners’ only

argument is that they could not have received constructive

dividends from Crabtree Investments because the corporation

did not receive the unreported income determined by

respondent.

As discussed earlier in this opinion, we find that

Crabtree Investments received unreported income during

1992, 1993, and 1994 in the amounts determined by

respondent. Thus, we reject the sole argument that

Ms. Jerry Crabtree and Mr. Eddie Crabtree did not receive

constructive dividends from Crabtree Investments because

the corporation had not received any unreported income.

Accordingly, we sustain respondent’s determination that

Ms. Jerry Crabtree and Mr. Eddie Crabtree received

dividends in the amounts set forth in the subject notices

of deficiency.
 - 30 -

Fraud Penalty

The third issue for decision is whether petitioners

are liable for the fraud penalty under section 6663(a) for

each of the years in issue. Respondent determined that

petitioner Crabtree Investments fraudulently omitted income

from its 1992, 1993, and 1994 returns on which there are

underpayments of $245,051, $103,218, and $118,840,

respectively. Accordingly, respondent determined that

Crabtree Investments is liable for civil fraud penalties

under section 6663 of $183,788, $77,414, and $89,130.

Respondent determined that petitioner Jerry Crabtree

fraudulently omitted income from her 1992, 1993, and 1994

returns on which there are underpayments of $97,728,

$49,310, and $76,554, respectively. Accordingly,

respondent determined that Ms. Jerry Crabtree is liable

for civil fraud penalties under section 6663 of $73,296,

$36,983, and $57,416.

Respondent further determined that petitioner Eddie

Crabtree fraudulently omitted income from his 1992, 1993,

and 1994 returns on which there are underpayments of

$99,346, $50,523, and $95,103, respectively. Accordingly,

respondent determined that Mr. Eddie Crabtree is liable for

civil fraud penalties under section 6663 of $74,510,

$37,892, and $71,327.
 - 31 -

Section 6663(a) provides that, if any part of an

underpayment is due to fraud, there shall be added to the

tax an amount equal to 75 percent of the portion of the

underpayment which is attributable to fraud. The

Commissioner bears the burden of proving by clear and

convincing evidence that: (1) An underpayment exists;

and (2) some portion of the underpayment is attributable

to fraud. See sec. 7454(a); Rule 142(b); DiLeo v.

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

(2d Cir. 1992). The term “underpayment” is defined in

section 6664(a) as “the amount by which any tax imposed by

this title exceeds the excess of (1) the sum of (A) the

amount shown as the tax by the taxpayer on his return, plus

(B) amounts not so shown previously assessed (or collected

without assessment), over (2) the amount of rebates made.”

The Commissioner must establish that the taxpayer is guilty

of fraud with respect to his or her return for each taxable

year. E.g., Otsuki v. Commissioner, 53 T.C. 96, 105

(1969); AJF Transp. Consultants, Inc. v. Commissioner, T.C.

Memo. 1999-16. If the Commissioner establishes that any

portion of the underpayment is attributable to fraud, then

the entire underpayment is treated as attributable to

fraud, unless the taxpayer establishes by a preponderance
 - 32 -

of the evidence that it is not attributable to fraud. See

sec. 6663(b).

In a case like the present cases in which allegations

of fraud are intertwined with unreported and indirectly

reconstructed income, the Commissioner may prove the first

prong of the fraud test, that an underpayment exists, in

one of two ways: (1) By proving a likely source of the

unreported income; or (2) where the taxpayer alleges a

nontaxable source, by disproving the nontaxable source so

alleged. See Parks v. Commissioner, 94 T.C. 654, 661

(1990).

To prove the second prong of the fraud test,

fraudulent intent, the Commissioner must show that the

taxpayer intended to evade tax believed to be owing by

conduct intended to conceal, mislead, or otherwise prevent

the collection of such tax. See Recklitis v. Commissioner,

91 T.C. 874, 909 (1988); Rowlee v. Commissioner, 80 T.C.

1111, 1123 (1983). The existence of fraud is a question

of fact to be resolved upon consideration of the entire

record. See DiLeo v. Commissioner, supra at 874; Gajewski

v. Commissioner, 67 T.C. 181, 199 (1976), affd. without

published opinion 578 F.2d 1383 (8th Cir. 1978). Fraud

will never be imputed or presumed but must be affirmatively
 - 33 -

established by clear and convincing evidence. See Beaver

v. Commissioner, 55 T.C. 85, 92 (1970).

Because direct proof of a taxpayer’s fraudulent intent

is rarely available, fraud may be shown by circumstantial

evidence. See Stephenson v. Commissioner, 79 T.C. 995,

1005-1006 (1982), affd. per curiam 748 F.2d 331 (6th Cir.

1984). A taxpayer’s entire course of conduct may establish

the requisite fraudulent intent. See Stone v. Commis-

sioner, 56 T.C. 213, 224 (1971); Otsuki v. Commissioner,

supra at 105-106.

Over the years, courts have developed a nonexclusive

list of factors that demonstrate fraudulent intent. These

badges of fraud include: (1) Understating income, see

Holland v. United States, 348 U.S. at 137; Parks v.

Commissioner, 94 T.C. at 664; (2) inadequate books and

records, see Merritt v. Commissioner, 301 F.2d 484, 487

(5th Cir. 1962), affg. T.C. Memo. 1959-172; (3) false

entries on or alterations of documents, see Spies v.

Commissioner, 317 U.S. 492, 499 (1943); (4) failure to file

tax returns, see id.; (5) implausible or inconsistent

explanations of behavior, see Grosshandler v. Commissioner,

75 T.C. 1, 20 (1980); (6) concealment of income or assets,

see Bradford v. Commissioner, 796 F.2d 303, 307 (9th Cir.

1986), affg. T.C. Memo. 1984-601; (7) dealing in cash; and
 - 34 -

(8) failure to cooperate with tax authorities, see id. at

307-308.

A corporation can act only through its officers. See

Federbush v. Commissioner, 34 T.C. 740, 749 (1960), affd.

per curiam 325 F.2d 1 (2d Cir. 1963). “Corporate fraud

necessarily depends upon the fraudulent intent of the

corporate officer.” Id. (citing Auerbach Shoe Co. v.

Commissioner, 216 F.2d 693 (1st Cir. 1954), affg. 21 T.C.

191 (1953)). In these cases, the individual petitioners

each own 50 percent of the stock of Crabtree Investments.

They serve as the only two officers of the corporation.

On the basis of the entire record, we think the individual

petitioners exercised sufficient control over the affairs

of Crabtree Investments to justify imputing their actions

to Crabtree Investments. See Auerbach Shoe Co. v.

Commissioner, supra at 697.

As to the fraudulent intent prong of the fraud

analysis, respondent asserts that the following items of

circumstantial evidence indicate fraud: (1) Understatement

of income; (2) inadequate records; (3) implausible

explanations of the unreported income; (4) petitioners’

decision to rebuild the business after the fire destroyed

it; and (5) petitioners’ failure to report a robbery at

gunpoint due to their fear of an IRS audit.
 - 35 -

As discussed above, we found that Crabtree

Investments, Ms. Jerry Crabtree, and Mr. Eddie Crabtree

each understated income in 1992, 1993, and 1994. We agree

that a large understatement may, in an appropriate case,

suggest fraudulent intent. In cases such as those in

issue, in which deficiencies were determined using an

indirect method of proof and sustained on the basis of

petitioners’ failure to disprove such determinations,

the existence of underpayments, standing alone, is

insufficient to support a finding of fraud. See Kashat v.

Commissioner, 229 F.2d 282, 285 (6th Cir. 1956), revg. a

Memorandum Opinion of this Court dated March 29, 1954;

Drieborg v. Commissioner, 225 F.2d 216, 218 (6th Cir. 1955)

affg. in part and revg. in part a Memorandum Opinion of

this Court dated February 24, 1954); Otsuki v. Commis-

sioner, 53 T.C. 96 (1969); Christensen v. Commissioner,

T.C. Memo. 1982-672; cf. Mazzoni v. Commissioner, T.C.

Memo. 1970-37 (refusing to pile “inference upon inference”

by basing fraud exclusively on unreported income

established by the net worth method of reconstructing

income), affd. 451 F.2d 197 (3d Cir. 1971). This is

particularly true in cases such as these where there is

no evidence that the taxpayers actually received any of

the unreported income computed using an indirect method.
 - 36 -

As to the second badge of fraud asserted by

respondent, that petitioners maintained inadequate records,

we note that respondent has advanced this argument only

with respect to the records of Crabtree Investments.

Respondent has not introduced any evidence that petitioners

Jerry and Eddie Crabtree themselves maintained inadequate

records. As to the records of Crabtree Investments, we

cannot review their adequacy or inadequacy because all of

the records, except for the general ledgers, were destroyed

by fire. Therefore, we have no independent means from

which to evaluate the revenue agent’s conclusion that the

records were inadequate.

As to the third badge of fraud, respondent argues that

it is “patently unreasonable, particularly considering the

[cash] nature of his business” for the bar to earn income

“which just happened to equal the amount of checks received

for days upon end.” Petitioners claim that, during the

years in issue, some large manufacturing companies in the

area were renovating their plants and employed a number of

out-of-town workers. Petitioners testified that Justins

provided check-cashing services to these people to entice

them to spend their money at Justins.

Partly on the basis of the testimony of their

accountant, petitioners maintain that from time to time
 - 37 -

they would withdraw cash from their personal savings

account at AmSouth and would use the money at Justins to

cash customers’ payroll checks. Petitioners would deposit

the customers’ paychecks into Crabtree Investments’

business account at First Union, write a check for cash in

that amount, and start the process at Justins over again.

Eventually, they would redeposit the original amount of

money into their personal savings account at AmSouth.

As mentioned above, virtually all of Crabtree

Investments’ original records were destroyed by fire. As

a result, we cannot fully evaluate petitioners’ assertion

that they used cash from their personal accounts in the

bar. Our analysis of the statements from petitioners’

individual checking accounts tends to support petitioners’

explanation. Furthermore, the bank account statements

suggest that the individual petitioners were losing money

during the years in issue. In 1994, they deposited the

“surrender proceeds” from shares in “The Growth Fund” in

the aggregate amount of $41,584.87, and Mr. Eddie Crabtree

deposited a check for $25,790.65, apparently the proceeds

from the sale of real property. Nevertheless, during the

years in issue, the balance in the account went from

$82,284.35 to $9,274.19. Respondent does not assert that

the withdrawals from the joint bank accounts increased the
 - 38 -

net worth of the individual petitioners, such as through

the purchase of other assets. On the basis of the fact

that we have insufficient evidence by which to evaluate

respondent’s assertion and the fact that there is evidence

in the record that tends to support petitioners’ assertion,

we cannot accept respondent’s position that petitioners’

explanation of the lack of cash deposits is “patently

unreasonable”.

Respondent next asserts that petitioners’ decision to

rebuild the business after the fire supports respondent’s

determination of fraud. Respondent argues that petitioners

would not have rebuilt an uninsured building if the

business had been unprofitable. Petitioners maintain that

the business was losing money. Mr. Eddie Crabtree

testified that petitioners did not recover from the

insurance company because the insurance company filed for

bankruptcy during the same week that Justins burned.

Mr. Eddie Crabtree further testified that he consulted a

commercial real estate agent who recommended that it would

be easier to sell the property with a structure on it than

as bare land. We accept petitioners’ explanation for their

decision to rebuild after the fire. We do not agree with

respondent that it is an indication of fraud.
 - 39 -

Finally, respondent asserts that petitioners’

explanation of their refusal to report a robbery indicates

fraud on their part. Mr. Eddie Crabtree testified that his

brother was robbed at gunpoint of approximately $15,000.

Mr. Eddie Crabtree further testified that Mr. Morton,

petitioners’ accountant, “was afraid to report it because

the IRS would say--would throw up a yellow flag or red

flag.” Respondent argues on brief that “the evidence

indicates petitioners had every right to fear an audit

given the fraudulent nature of the returns in issue.” We

do not agree with respondent that petitioners’ failure to

report the alleged robbery, based upon the recommendation

of their accountant, supports a finding of petitioners’

fraud.

On the basis of the entire record, we find that

respondent has not met his burden of proving that any part

of the underpayment of tax in these cases is due to fraud.

Accordingly, we do not sustain respondent’s determination

that Crabtree Investments, Ms. Jerry Crabtree, and

Mr. Eddie Crabtree are liable for the fraud penalty under

section 6663(a).
 - 40 -

Penalty for Negligence or Disregard of Rules or Regulations

Because we find that petitioners are not liable for

the fraud penalty under section 6663(a), we must consider

whether they are liable for the accuracy-related penalty

under section 6662(a) for 1992, 1993, and 1994, which

respondent determined as an alternative to fraud. Section

6662 imposes a penalty equal to 20 percent of any portion

of an underpayment of tax that is attributable to

negligence or disregard of rules or regulations. See sec.

6662(a) and (b). The term “negligence” is defined as “any

failure to make a reasonable attempt to comply with the

provisions of [title 26 of the United States Code]”. Sec.

6662(c). This includes any failure to exercise due care or

to do what a reasonable and ordinarily prudent person would

do under the circumstances. See Rybak v. Commissioner, 91

T.C. 524, 565 (1988); Neely v. Commissioner, 85 T.C. 934,

947 (1985). The term “disregard” includes any careless,

reckless, or intentional disregard. Sec. 6662(c).

Petitioners bear the burden of proving that respondent’s

determination of negligence is erroneous. See Rule 142(a);

Luman v. Commissioner, 79 T.C. 846, 860-861 (1982).
 - 41 -

Petitioners contend that they maintained adequate and

accurate accounting records. Petitioners assert that

Crabtree Investments did not intentionally or unintention-

ally understate its income from sales during the audit

period. They also argue that “any understatement of tax as

a result of the adjustments made at trial is insubstantial

and not due to any negligence or intentional disregard of

rules or regulations.” On the basis of the entire record

of these cases, we find that petitioners have not met their

burden of proving that the underpayment of tax is not

attributable to negligence or disregard of rules or

regulations. Accordingly, we hereby sustain respondent’s

determination that petitioners are liable for the accuracy-

related penalty under section 6662(a) for the years in

issue.

To reflect the foregoing and concessions by the

parties,

Decisions will be entered

under Rule 155.