T.C. Memo. 2000-22
UNITED STATES TAX COURT
JOSEPH J. HOUSE, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
JOSEPH J. HOUSE INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 8664-98, 8665-98. Filed January 19, 2000.
P is a former revenue agent with the Internal
Revenue Service and has been a return preparer for over
28 years. P set up J-Co., a wholly owned corporation,
purportedly to conduct his accounting business. P also
set up C-Co. to hide his assets from the Internal
Revenue Service and X-Co. for his wife’s arts and
crafts business. P conducted his accounting business
at his personal residence. P’s clients hired him
individually to prepare their returns. P was not an
employee of J-Co. and was not acting on J-Co.’s behalf
when servicing clients. J-Co. did not engage in a
substantive business activity. Neither P nor his
family members maintained personal checking accounts.
P deposited all his gross receipts into J-Co.’s account
and paid all his business and personal expenses from
this account without maintaining adequate records to
differentiate between business and personal items. P
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also transferred funds from this account to the
accounts of C-Co. and X-Co. to allow other family
members to use the funds for personal purposes. P
reported all receipts from his accounting services on
J-Co.’s return, then deducted all business and personal
items therefrom, disguising most of the items as “cost
of goods sold”. J-Co. paid no tax. P did not report
any income from J-Co. on his return for 1994, nor did
he report income from the payment of personal expenses.
Held: J-Co. is a sham, and we disregard it for tax
purposes. Petitioner’s gross receipts, less allowable
business expenses, are includable in his income. Held,
further: P is liable for the fraud penalty under sec.
6663, I.R.C.
Joseph J. House, pro se.
John J. Comeau, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
LARO, Judge: These cases are before the Court consolidated
for purposes of trial, briefing, and opinion. Joseph J. House
(petitioner) and Joseph J. House, Inc. (JJH) separately
petitioned the Court to redetermine respondent’s determinations
of the following deficiencies in Federal income tax, addition to
tax, and accuracy-related penalties:
Joseph J. House, docket No. 8664-98
Accuracy-related penalty
Year Deficiency Sec. 6662(a)
1994 $32,921 $6,584
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Joseph J. House Inc., docket No. 8665-98
Year ended Addition to tax Accuracy-related penalty
June 30 Deficiency Sec. 6651(a)(1) Sec. 6662(a)
1994 $39,723 $9,931 $7,945
By amendment to answer in docket No. 8664-98, respondent
affirmatively asserted that petitioner was liable for an
increased deficiency in tax and that petitioner was liable for
the fraud penalty.1 On brief, respondent conceded the deficiency
in tax, addition to tax, and accuracy-related penalty in docket
No. 8665-98. Following concessions of the parties, we decide the
following issues:
1. Whether petitioner had unreported income for 1994
related to his accounting business. We hold he did to the extent
set forth herein.
2. Whether petitioner is liable for the fraud penalty. We
hold he is.
Unless otherwise indicated, section references are to
applicable provisions of the Internal Revenue Code, Rule
references are to the Tax Court Rules of Practice and Procedure,
and dollar amounts are rounded.
1
Respondent asserted in his amendment to answer that
petitioner failed to report $156,197 in gross receipts instead of
$77,550 as determined in the notice of deficiency, and he
asserted that the entire deficiency resulting therefrom was
attributable to fraud. Respondent did not set forth a specific
dollar amount for the increased deficiency or the fraud penalty,
stating that the amounts were computational.
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FINDINGS OF FACT
Some of the facts have been stipulated and are so found.
The stipulated facts and exhibits submitted therewith are
incorporated herein by this reference. Petitioner resided in
Lockport, Illinois, when he petitioned the Court.
Petitioner has been an accountant and tax return preparer
for over 28 years, and he has a bachelor’s degree in accounting
from Lewis College in Lockport, Illinois. Petitioner worked as a
revenue agent for the Internal Revenue Service (the Service) for
5 years in the 1970's. While he was at the Service, his duties
included auditing Federal income tax returns of individuals and
corporations. Petitioner has prepared thousands of Federal
income tax returns in his career, and he is knowledgeable about
the Federal income tax laws. Petitioner has also set up hundreds
of corporations for various individuals, and he serves as
registered agent for at least 163 of these corporations.
Petitioner is married to Charlene House (Charlene), and they
have two sons, Craig House (Craig) and Tim House (Tim). Craig
was a construction worker in 1994, and he built at least two
homes during 1992 through 1994. Tim was a college student at the
University of Central Florida in 1994. During all relevant
times, petitioner, Charlene, and Craig lived at 210 Muehl,
Lockport, Illinois (Muehl residence). The Muehl residence was
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owned by Lewis Simmons (Simmons), who rented the residence to
petitioner.
Petitioner incorporated JJH in 1985 purportedly to conduct
his tax return preparation business. At all relevant times,
JJH’s address and business location were at the Muehl residence.
The Muehl residence has three levels: A basement, a main floor,
and an upstairs floor where the bedrooms are located. Petitioner
conducted his return preparation business in the basement, and he
saw clients at his office in the basement.
Tim has been collecting Walt Disney toys and characters
since he was very young, and his collection today includes
numerous figurines and other collectible items of a variety of
sizes and types (Disney collection). Petitioner is similarly
intrigued with Mickey Mouse, Donald Duck, and the Walt Disney
fantasy, and he enjoys sharing his affinity for these characters
with others.2 When Tim left home for college, he left behind his
Disney collection, and petitioner displays the Disney collection
throughout the basement where he meets tax and accounting
clients.
During all relevant periods, petitioner was the beneficial
owner of all JJH’s stock. Petitioner did not have an employment
contract with JJH, and he was not an employee of JJH. JJH had no
2
For example, petitioner submitted his brief to the Court on
a diskette bearing Mickey Mouse’s image.
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employees and no officers or directors. When clients obtained
petitioner’s services, they did not execute an engagement
contract with JJH, and the clients did not recognize JJH as the
service provider. JJH did not have a rental agreement for its
office space from Simmons; Simmons had a verbal agreement with
petitioner to rent the entire house to petitioner. JJH did not
engage in a business activity.
Charlene made fabric and wood country crafts that she sold
to craft malls. Petitioner and Charlene incorporated Char’s
Country Accents, Inc. (CCA), in 1986 to operate this business.
Charlene and Craig were the owners and officers. CCA’s address
and location were at the Muehl residence.
In 1987, petitioner incorporated an entity he called Coastal
Leasing (Coastal) to conceal his assets from the Service.
Coastal’s address was the Muehl residence. Coastal did not
conduct any business activity, and petitioner used Coastal to
circulate funds among and between his other entities and his
family members. By 1994, petitioner allowed Craig to operate his
construction activities under the Coastal name to give the
appearance that Craig was a mature individual with his own
construction company.
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The Bank Accounts
Neither petitioner, Charlene, nor Craig maintained any
personal checking accounts of any kind. Petitioner transferred
funds freely among JJH, CCA, and Coastal, as he saw fit.
1. JJH Account—Petitioner opened an account in the name of
JJH in 1985 (JJH account) over which he had signature authority,
and this account remained open throughout 1994. Petitioner used
the JJH account as his personal and business account, and he paid
all business and personal expenses from this account. Charlene
also had access to the account and used it to pay some of her
personal expenses. Petitioner deposited all income generated from
his return preparation business into the JJH account. Petitioner
did not designate what amounts in the account, if any, were salary
or other income to him, and he did not document whether expenses
paid from the account were business or personal. Petitioner
commingled his personal income and expenses with his business
income and expenses without limitation.
As relevant herein, petitioner wrote a total of $150,208 in
checks from the JJH account. Of the total, $47,105 related to
expenses of operating petitioner’s return preparation business, and
the $103,103 balance related to personal living expenses of
petitioner and his family.
For 1994, total deposits to the JJH account were $176,547,
comprising $144,812 in gross receipts and $31,735 in transfers
from CCA’s and Coastal’s accounts. Petitioner withdrew virtually
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all of those deposits by either check or withdrawal, leaving a 1994
ending balance of $853. The following is a summary of the checks
drawn on the JJH account during 1994:
PAYEE/CATEGORY AMOUNT PERSONAL BUSINESS
Petitioner $4,680 $4,680 -0-
Charlene 7,725 7,725 -0-
Coastal 18,525 18,525 -0-
CCA 8,375 8,375 -0-
Craig 1,950 1,950 -0-
Tim 14,454 14,454 -0-
Walt Disney World 4,869 4,869 -0-
Utilities1 6,768 4,125 $2,643
Lewis Simmons2 8,780 5,853 2,927
Internal Revenue Service 4,570 4,570 -0-
Other3 63,514 21,979 41,535
Total 144,210 97,105 47,105
1
The total electric, gas, and water bills of the Muehl
residence were $3,948. We allocate one-third to business use and
two-thirds to personal use as there are no separate meters for
the basement of the residence, and petitioner has provided no
credible evidence that this allocation, which was proffered by
respondent, is improper. The balance of the utilities expense
comprises telephone expenses allocated $1,362 to personal use and
$1,458 to business use.
2
This represents rent for the Muehl residence, allocated
one-third to business and two-thirds to personal.
3
We allocate the following payment categories 100 percent to
personal: River Park Apts, $1,360; insurance, $8,631; medical,
$2,130; misc. expenses petitioner admits are personal, $3,621.
We allocate the following payment categories 100 percent to
business: Charles Losa, $5,276; Tax Court, $300; Dir. of Labor,
$39; misc. payments, $10,581; Office Max, $598; S.W. Financial,
$1,818; various individuals, $3,677; Cindy Manzzi, $4,485;
Postmaster, $2,526. On the basis of a reasonable estimation and
lack of exact substantiation in the record, we allocate the
following payment categories 50 percent to business and 50
percent to personal (amount stated is the total expense): Credit
cards, $6,468; Hintze Auctions, $4,360; cable, $953; automotive
related, $12,690.
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None of the above personal expenses were ordinary and necessary
business expenses of JJH or petitioner. The checks to
petitioner, Charlene, Coastal, CCA, and Craig were for the
personal use of petitioner and his family. The checks to Tim and
the University of Central Florida were for Tim’s tuition, room
and board, and other college expenses. The automotive expenses
included petitioner’s monthly car payments, payments for gas, and
car maintenance expenses. The payments to the IRS were payments
for petitioner’s and Craig’s Federal income tax obligations.
2. CCA’s Account—CCA had a checking account over which
petitioner and Charlene had signatory authority. Charlene used
this account as her personal checking account. The deposits to
this account during 1994 included $16,100 in checks from JJH
written to Charlene and CCA and $9,000 in checks from Coastal.
Charlene also deposited receipts from her craft business into
this account, but she did not know what portion of the deposits
these receipts were. During 1994, Charlene wrote approximately
$30,569 in checks from this account, including $9,400 in checks
to JJH, $7,700 in checks to Charlene or Coastal, and other
miscellaneous checks to cover personal living expenses.
3. Coastal’s Account—Coastal had a checking account over
which Charlene and Craig had signatory authority, but petitioner
was in control of the account, and Charlene and Craig obtained
petitioner’s approval before using the funds. The Coastal
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account served primarily as a “clearing account” through which
petitioner circulated funds for the purpose of paying Craig’s
personal and construction expenses, and other personal expenses
of petitioner’s family. During 1994, the deposits into Coastal’s
checking account consisted of primarily checks written from JJH
and also included checks from CCA and a small amount of
unidentified deposits. The transfers from JJH’s account were not
loans, and the transfers were not related to petitioner’s
accounting business.3 Craig used the funds in the Coastal
account to pay some of his personal living and construction
expenses and to funnel money to other family members. During
1994, Craig wrote a total of $39,863 in checks from this account,
including $22,335 in checks to JJH and $11,920 in checks to
petitioner, Charlene, CCA, and Craig.
Tax Reporting
Petitioner—Petitioner filed a 1994 income tax return
claiming married filing separate status. Charlene did not file a
return for 1994. On his 1994 return, petitioner reported no
salary, wages, dividends, or other compensation from JJH. He
reported total income of $31,500, comprising $1,000 Schedule C
income, $10,000 rent income, $3,000 capital gain income, and
$17,500 as income from a covenant not to compete. On the
3
Petitioner admitted these transfers were made “on the basis
of an affinity, of a relationship” between him and his family.
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Schedule C attached to his return, petitioner stated that he was
an “accountant”, and that his business name was “House
Accountant”. Petitioner failed to provide a complete business
address but stated his office was in Lockport, Illinois.
JJH—Petitioner prepared and filed returns for JJH for the
fiscal years ending June 30, 1994 and 1995, reporting that the
business activity of JJH was “sales” and the product or service
was “process”. For these years, petitioner reported the gross
receipts from his accounting business on JJH’s returns, reporting
gross receipts of $156,197 and $152,340, respectively. These
gross receipts equaled the total deposits into the JJH account
for both years.4 In reporting the total bank deposits as gross
receipts, petitioner was aware he was including transfers from
CCA’s and Coastal’s accounts. In each year, petitioner claimed
on JJH’s return deductions and cost of goods sold in excess of
the gross receipts, and JJH paid no tax in either year. The
claimed deductions and cost of goods sold included the checks
drawn for business and personal items of $150,208 as set forth
above for calendar year 1994.
CCA’s Returns—Petitioner prepared and filed a return on
behalf of CCA for 1994, reporting gross receipts of $66,994,
expenses and cost of goods sold of $68,358, and no taxable
4
For the calendar year 1994, the reported gross receipts
equal the $176,547 in deposits identified above.
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income. Charlene had no idea what these figures comprised or
whether the reported gross receipts, expenses, and cost of goods
sold were accurate. Most of the $68,358 claimed on CCA’s return
was listed as cost of goods sold, and a large portion of the cost
of goods sold figure represented personal living expenses of
petitioner and Charlene.5
Coastal’s Return—Petitioner prepared and filed Coastal’s
returns for fiscal years ended June 30, 1994 and 1995, reporting
as gross receipts $23,056 and $94,952, respectively. In both
years, the reported expenses exceeded the reported gross
receipts, and Coastal reported no taxable income and paid no tax.
Craig signed the returns but had no idea where the reported
income came from or whether it was accurate. The reported gross
receipts comprised primarily checks and transfers from JJH’s
account to Coastal.
The Audit
Revenue Agent Ruby Townsend (Townsend) conducted the audits
of petitioner’s and JJH’s returns at issue. Petitioner was
uncooperative with Townsend. Townsend repeatedly requested to
meet with petitioner and requested that petitioner provide
documents to substantiate the items on his return and JJH’s
5
Charlene admitted that she used the funds in the CCA
account for personal purposes, and there is insufficient evidence
in this record to determine what items, if any, were business
related.
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return. After refusing several times to meet with Townsend,
petitioner reluctantly appeared for a meeting wherein he provided
no documents.
Respondent’s Determination
Respondent determined petitioner had unreported income in
1994 of $81,879, computed as follows:
Deposits to JJH’s account $176,547
Less: Transfers from CCA (9,400)
Less: Transfers from Coastal (22,335)
Total gross receipts 144,812
Less: Business expenses (31,433)
Taxable income 113,379
Less: Reported income (31,500)
1
Unreported Income 81,879
1
This figure is respondent’s revised determination set forth
on brief and is less than the amount he set forth by amendment to
answer.
Respondent determined that JJH is a sham and should be
disregarded for tax purposes, or, alternatively, that petitioner
improperly assigned his income to JJH.
OPINION
Economic Reality of JJH
Petitioner was a knowledgeable former Internal Revenue
Service agent who devised a deceitful plan to divert and disguise
his income and used his insight and skill in an attempt to avoid
detection.
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We first decide whether JJH should be disregarded for tax
purposes. According to respondent, it should because it lacked
economic substance and is a sham. We agree. The burden of proof
is split in this case. Petitioner has the burden of proof as to
the $77,550 in unreported income respondent determined in the
notice of deficiency. See Rule 142(a). Respondent has the
burden of proof as to the $4,328 increase in unreported income6
and as to fraud. See Rule 142(a) and (b).
There is no dispute that JJH was properly organized under
Illinois law. However, even though a corporation is organized
under the laws of a State, we may disregard it for Federal tax
purposes if it is no more than a vehicle for tax avoidance and
void of a legitimate business purpose. See Gregory v. Helvering,
293 U.S. 465 (1935); American Sav. Bank v. Commissioner, 56 T.C.
828, 838 (1971); Aldon Homes, Inc. v. Commissioner, 33 T.C. 582
(1959). While a taxpayer is free to adopt the corporate form of
doing business, a corporation must engage in some meaningful
business activity to be recognized as a separate entity for tax
purposes. See Moline Properties, Inc. v. Commissioner, 319 U.S.
436 (1943); Achiro v. Commissioner, 77 T.C. 881 (1981). Avoiding
taxation is not a business activity. See National Carbide Corp.
6
On brief, respondent maintains that petitioner’s unreported
income was $81,879, leaving respondent with the burden of proof
on $4,328, the excess over the $77,550 determined in the notice
of deficiency.
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v. Commissioner, 336 U.S. 422, 437 n.20 (1949); Higgins v. Smith,
308 U.S. 473 (1940); Gregory v. Helvering, supra. On this
record, we find that JJH lacked economic substance and was merely
a paper entity that engaged in no meaningful business activity.
The purported purpose of JJH was to render accounting
services, yet it had no employees to carry out this purpose.7
Petitioner admits he was not an employee of JJH, testifying at
trial: "As Joseph J. House, the individual, I was not an
employee. I did not consider myself an employee of Joseph J.
House, Inc. I considered myself an independent contractor”. To
the extent petitioner suggests he was acting on behalf of JJH as
an independent contractor, we are not persuaded. Petitioner was
acting on behalf of himself individually when he rendered
services to clients. There was no employment or agency contract
between petitioner and JJH. There is no credible evidence that
there was a relationship between JJH and petitioner’s clients or
that the clients recognized JJH as the service provider. The
relationship was directly between petitioner and his clients.
Petitioner’s clients paid petitioner directly. JJH did not pay
petitioner compensation for his services and did not issue him a
Form 1099 or W-2. To embrace petitioner’s argument, we would
7
Petitioner reported a negligible amount of wages paid on
JJH’s returns but does not argue these wages were paid to him,
and the record does not disclose who purportedly earned them.
Petitioner has not suggested that JJH’s payment of personal
expenses constitutes compensation.
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have to find that he worked for JJH without compensation. We
decline to do so.
Petitioner did not respect the separateness of JJH, and he
commingled his income and expenses with JJH’s. Petitioner
maintained no personal checking accounts, and he treated JJH’s
account as his own. Petitioner had dominion and control over the
account, and he readily admits that he used it as his own,
boasting at trial: “my home, my style of living, is paid for by
Joseph J. House, Inc.”, and that "personal checkbooks are not a
good thing". See Denali Dental Services v. Commissioner, T.C.
Memo. 1989-482 (corporation a sham where its checking account was
used as a “pocketbook” for payment of shareholder’s personal
expenses). JJH did not keep separate books and records of the
deposits, checks, transfers, or withdrawals from JJH’s account to
differentiate between business and personal income and expenses.
Instead, petitioner treated his affairs as one and the same with
JJH’s.
JJH had no management other than petitioner, and petitioner
acknowledged that he was in complete control of JJH.
Petitioner’s contention that Charlene and Craig were officers of
JJH does not stand up in the face of the evidence, which shows
that they had nothing to do with its activities. In discussing
the use of the family corporations, petitioner admitted that
"This whole operation, this whole function, is my responsibility
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* * *. These people [Charlene and Craig] don't understand what's
going on. They're part of it, they benefit from it, and they
don't understand”. Charlene’s testimony corroborates
petitioner’s admission as she was obviously unfamiliar with JJH.
Charlene did not know what JJH’s assets were, and she had no idea
whether it operated at a profit or loss. What Charlene did know
about JJH was that it had a checking account from which she could
withdraw funds. Her knowledge about JJH’s affairs stopped there.
Craig knew even less about JJH, admitting that he does not recall
how or why he became an officer and that petitioner just said
“this is what we’ll do”. Petitioner’s attempt to lend legitimacy
to the arrangement by naming his family members as officers of
JJH is unavailing.
JJH did not contract with Simmons for rental of the Muehl
residence; petitioner did, and Simmons believed the rent checks
were personal payments from petitioner. Petitioner prepared
Simmons’ tax returns, and Simmons considered petitioner
individually his “tax person”. JJH did not have services or
utilities (e.g., telephone and electric) billed in its name, and
there is no other credible evidence that it contracted with third
parties or held itself out to the public as a business. The only
activity in which JJH engaged was receiving, spending, and
circulating the funds earned by petitioner. JJH was essentially
a conduit through which petitioner moved funds. Petitioner
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admitted JJH “repetitively and continuously, in the normal course
of its business, transfers money to account of Coastal Leasing;
it transfers money to the account of Char’s Country Accents;
transfers money to and from Joseph Craig House, the individual”.
We find no business purpose for this circular flow of funds.
In substance, there really was no JJH; there was only
petitioner. Petitioner recognized JJH once a year, at tax time,
and the fact that petitioner so recognized it and filed returns
on its behalf fails to legitimize its existence. As outlined
above, JJH was little more than a clearing account through which
petitioner moved funds, and the returns were the vehicle through
which petitioner improperly reported the flow of funds and
payment of personal expenses to avoid taxes. Petitioner did not
respect the separateness of JJH, nor do we. We disregard JJH for
tax purposes, and we hold that petitioner had unreported income
in the amount of $66,207 determined as follows:
Deposits to JJH’s account $176,547
Less: Transfers from CCA (9,400)
Less: Transfers from Coastal (22,335)
Total gross receipts 144,812
Less: Business expenses (47,105)
Taxable income 97,707
Less: Reported income (31,500)
1
Unreported income 66,207
1
This figure is less than the unreported income figure of
$81,879 advanced by respondent on brief because of our finding
petitioner is entitled to additional business expenses.
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We sustain respondent’s determination of unreported income to the
extent of $66,207.
Petitioner maintains that buried somewhere in JJH’s large
cost of goods sold figure are several other business expenses
which are deductible, in addition to the expenses of $47,105
allowed above. We have carefully reviewed all arguments made by
petitioner as to his expenses, and we are unpersuaded that he had
business expenses greater than the amounts decided herein. For
example, petitioner argues that in 1990, JJH obtained a covenant
not to compete from petitioner for $105,000 to be paid over a 6-
year period, and that $17,500 of the cost of goods sold
represents a payment under the covenant. Purportedly, petitioner
sold his stock in JJH to a friend, Charles Losa (Losa), in
exchange for $1,000 and a covenant not to compete.8 We are
unpersuaded and find petitioner’s testimony and documentary
evidence on this point not credible. We have already found that
petitioner remained the beneficial owner of the JJH stock at all
times, and petitioner’s contention that he transferred anything
other than nominal title to the stock is not credible. Losa
admitted that he was a shareholder in “name only” and that the
transfer was effected to get assets out of petitioner’s name
8
The purported covenant provides that petitioner will not
compete with JJH for 6 years within a 50-mile radius of the Muehl
residence. Petitioner is precluded from engaging in the
following activities: “Accounting Work, Bookkeeping, Financial
Consulting, Tax Preparation & Advice, Consulting, Service”.
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because of his tax problems. Further, the purported covenant is
an unsigned document with no effective date, and it does not
identify to whom the covenant is granted. Most telling,
petitioner’s conduct belies the existence of the covenant. He
engaged in an accounting and tax business within the prohibited
territory during the entire prohibited period. Petitioner’s
contentions as to the covenant are meritless.
Petitioner attempts to legitimize the payments made by JJH
to Tim and the University of Central Florida by arguing the
payments were attributable to a lease between JJH and Tim for the
use of Tim’s Disney collection. Petitioner asserts that JJH made
payments for the lease of Mickey Mouse, Donald Duck, Goofy, and
other colorful Disney characters in his basement office as bona
fide business expenses. Petitioner’s story is as fantastic as
the Disney characters themselves. Petitioner did not know the
value of the collection or how many items were in the collection,
and there is no evidence the Disney collection furthered any
advertising goal. Charlene’s testimony that she engaged in bona
fide negotiations with Tim with respect to a lease price on New
Year’s Day in 1993 is not credible. The lease document is
concocted and back dated, and the stated rent of $1,000 per month
bears no relation to the actual payments made to Tim or to the
University of Central Florida.
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Petitioner argues that the payments by JJH to CCA, Coastal,
and Craig were deductible because JJH transferred funds to these
entities “in the normal course of its business”. We disagree.
Petitioner has put forth no credible evidence that these payments
by JJH to these entities or to Craig are deductible. To the
contrary, petitioner’s own statements support our finding that
the funds were circulated without a business purpose to fund
petitioner’s personal expenses. We reject petitioner’s argument
that the amounts paid to Simmons are deductible interest
payments. Simmons admitted he rented the Muehl residence to
petitioner, and the fact that Simmons reported the payments from
petitioner as “interest” on his return is unpersuasive since it
was petitioner who prepared this return. Finally, petitioner
argues generally that all amounts paid by JJH are deductible
because “Personal living expenses, when provided by an employer,
are not income to the person who receives it”. Petitioner’s
argument is without merit, and, on the basis of his knowledge and
experience, petitioner knows it. We find all other testimony and
evidence not discussed herein in favor of additional deductions
to be unpersuasive or incredible.
Fraud Penalty Under Section 6663
We turn now to the fraud penalty. Respondent bears the
burden of proving by clear and convincing evidence that
petitioners are liable for the penalty for fraud. See sec.
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7454(a); Rule 142(b); Toussaint v. Commissioner, 743 F.2d 309,
312 (5th Cir. 1984), affg. T.C. Memo. 1984-25; Wright v.
Commissioner, 84 T.C. 636, 639 (1985). Respondent must meet this
burden through affirmative evidence because fraud is never
imputed or presumed. See Toussaint v. Commissioner, supra at
312; Beaver v. Commissioner, 55 T.C. 85, 92 (1970). The
existence of fraud is a question of fact to be resolved from the
entire record. See Gajewski v. Commissioner, 67 T.C. 181, 199
(1976), affd. without published opinion 578 F.2d 1383 (8th Cir.
1978). Petitioners’ entire course of conduct can be indicative
of fraud. See Stone v. Commissioner, 56 T.C. 213, 224 (1971);
Otsuki v. Commissioner, 53 T.C. 96, 105-106 (1969).
To satisfy his burden of proof, respondent must show two
things. First, respondent must prove that an underpayment
exists. Respondent may not rely on petitioner’s failure to
disprove a deficiency determination to satisfy this element. See
Drieborg v. Commissioner, 225 F.2d 216, 218 (6th Cir. 1955),
affg. in part a Memorandum Opinion of this Court; Parks v.
Commissioner, 94 T.C. 654, 660-661 (1990); Petzoldt v.
Commissioner, 92 T.C. 661, 700 (1989). Second, respondent must
show that petitioners intended to evade taxes known to be owing
by conduct intended to conceal, mislead, or otherwise prevent the
collection of taxes. See Stoltzfus v. United States, 398 F.2d
1002, 1004 (3d Cir. 1968); DiLeo v. Commissioner, 96 T.C. 858,
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874 (1991), affd. 959 F.2d 16 (2d Cir. 1992); Rowlee v.
Commissioner, 80 T.C. 1111, 1123 (1983).
To satisfy the first prong, there must be clear and
convincing evidence to support respondent’s determination of an
underpayment; i.e., clear and convincing evidence that JJH was a
sham and that the income generated from petitioner’s accounting
services belonged to him. This prong must be satisfied with
affirmative proof, and a taxpayer’s failure to meet his or her
burden of proof alone will not suffice. We find such clear and
convincing evidence here. Much of this evidence came directly
from petitioner’s own testimony, including petitioner’s
admissions that: He was not an employee of JJH; he paid his
personal expenses from JJH’s account; the purported officers of
JJH, Charlene and Craig, knew nothing about JJH; he moved funds
in a circular manner among the accounts of JJH, CCA, and Coastal;
and he fabricated the numbers and categories on his 1994 return
(see discussion of fraud below). These admissions together with
the other evidence detailed under our discussion of the
deficiency are clear and convincing affirmative evidence that
petitioner underpaid his 1994 taxes.
With respect to the second prong of the fraud test; i.e.,
that petitioner had the requisite fraudulent intent, fraud may be
proven by circumstantial evidence because fraud can rarely be
established by direct proof of the taxpayer’s intention. See
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Rowlee v. Commissioner, supra at 1123. Courts have developed
various factors or “badges” which tend to establish fraud. Some
of the “badges of fraud” are: (1) Understating income, (2)
maintaining inadequate records, (3) failing to file tax returns,
(4) giving implausible or inconsistent explanations of behavior,
(5) concealing assets, (6) failing to cooperate with tax
authorities, (7) engaging in illegal activities, (8) attempting
to conceal activities, (9) dealing in cash, and (10) failing to
make estimated tax payments. See Bradford v. Commissioner, 796
F.2d 303, 307-308 (9th Cir. 1986), affg. T.C. Memo. 1984-601;
Clayton v. Commissioner, 102 T.C. 632, 647 (1994). We consider
this list nonexclusive, and we take into account all the unique
facts and circumstances of every case in determining whether
fraudulent intent exists.
After examination of some of the applicable factors above as
well as other factors in this case, we conclude respondent has
satisfied his burden of proving fraud. Petitioner is a former
Internal Revenue Service agent, which gives him insight into
audit techniques and the Service’s means of detecting inaccurate
returns. He has practiced as a return preparer and accountant
for over 20 years, and he is knowledgeable about tax law.
Petitioner put his knowledge and insight to use and tried to
disguise his income to underpay his taxes, and he tried to
circumvent detection of his deceit by the Service. In filing his
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return for 1994, petitioner knew he was not reporting his income
from his accounting business or the income attributable to JJH’s
payment of his personal expenses, and he knew this was contrary
to the tax law. See Taxpayers Assistance Corp. v. Commissioner,
T.C. Memo. 1988-343 (taxpayer’s background and experience taken
into account as evidence of fraud).
Petitioner used JJH, CCA, and Coastal to conceal his income
and personal expenses. The corporations were a critical part of
his scheme. Petitioner frequently circulated funds among JJH,
Coastal, and CCA for no business purpose and then used the funds
in these accounts to pay personal expenses. JJH’s and Coastal’s
bank accounts were petitioner’s and Charlene’s personal
pocketbook. CCA’s bank account was also Charlene’s personal
pocketbook, and petitioner funneled money from JJH and Coastal to
this account to fund Charlene’s expenditures. The use of a
corporation to disguise the personal nature of income and
expenses is evidence of fraud. See Truesdell v. Commissioner, 89
T.C. 1280, 1302-1303 (1987); Benes v. Commissioner, 42 T.C. 358,
383 (1964), affd. 355 F.2d 929 (6th Cir. 1966).
Petitioner claimed the living expenses detailed in our
findings of fact as business expenses on JJH's return, concealing
them as cost of goods sold. Petitioner deliberately
mischaracterized JJH’s business activity on its returns to create
the appearance JJH was a merchandise business rather than a
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service business, stating that JJH’s business activity was
“sales”, and that the product or service was “process”. In so
mischaracterizing, petitioner intended that a large portion of
the personal expenses be buried in cost of goods sold, minimizing
the possibility that the personal nature of the expenses would be
detected.9 These claims were false and petitioner knew it.10
Petitioner’s testimony that “any personal expenses that are paid
by the corporation are not deducted by the corporation" is not
credible. Finally, petitioner’s failure to include in his income
JJH’s payment of his personal expenses resulted in a large
understatement of his income.
Petitioner failed to maintain adequate records of his income
and expenses. Petitioner maintained three corporate checking
accounts from which he paid all business and personal expenses,
and he maintained no records to determine which expenses were
business or personal. The records petitioner did keep were
inadequate. Petitioner purportedly maintained a ledger for his
“draw account” from JJH. This ledger recorded negligible amounts
as “drawn” by petitioner, did not include JJH’s payment of the
9
Petitioner was aware that the largest expense of a
merchandising business is generally cost of goods sold, and he
knew a large cost of goods sold was less likely to “red flag” his
return than larger expenses elsewhere on the return.
10
As just one example, petitioner admitted that the
insurance paid by JJH to Prudential was a personal expense, and
that he deducted it anyway, stating: “It’s not probably
technically, in the truest accounting sense a good thing to do”.
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personal expenses, and did not correlate with the numbers on
petitioner’s return.
Petitioner admits he engaged in a pattern of concealing
assets from the Service, and he was not reluctant to acknowledge
his disdain for paying taxes, bragging at trial that he formed
Coastal to hide his assets from the Service.
Petitioner failed to cooperate during the audit, and his
claim that the flood of the Muehl residence prevented him from so
doing is not credible. The flood did not destroy relevant
documents requested by respondent, such as bank statements,
canceled checks, or deposit slips, as evidenced by the fact
petitioner was able to produce these documents close to trial.
Petitioner precisely included in the income of JJH all
amounts deposited into its bank account, notwithstanding the fact
that he knew he was including transfers between accounts and
double counting income.11 Petitioner points to this as evidence
there was no intent to deceive. To the contrary, this was part
of the deception plan. Petitioner admitted that he knew a tax
auditor would always compare bank statements with reported
receipts. Petitioner’s ensuring that the numbers matched was his
attempt to deceive the Service into believing his return and
11
Petitioner testified: “Now, the problem with that income
is that it includes transfers and/or loans and/or exchanges of
money between those corporations of Joseph House, Coastal Leasing
and Char’s”.
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JJH’s return were accurate. This double counting of income was
of no consequence to petitioner since he managed to manipulate
the numbers on all returns to the point where there was little to
no taxable income.
Petitioner intentionally mischaracterized items of income on
his 1994 return. He reported total income of $31,500, comprising
$1,000 Schedule C income, $10,000 rent income, $3,000 capital
gain income and $17,500 as income from a covenant not to compete.
At trial, he admitted these categories were all concocted,
stating: “I don't mind giving you [IRS] the elbow, but I'm not
going to lie to him [the Court]”. Petitioner mischaracterized
his income to avoid self-employment tax and to deter the Service
from discovering unreported income related to JJH. Petitioner’s
lack of candor was prevalent throughout the discovery process and
trial.12
Petitioner filed a separate return to avoid payment of taxes
on the unreported income in the event he got caught.13
12
By interrogatory, respondent asked why JJH paid the
University of Central Florida, and petitioner stated the payments
were for “equipment rental”. When questioned on cross-
examination about why JJH paid petitioner’s personal living
expenses, petitioner stated: “I've got to live somewhere".
13
Charlene did not file and testified that she bought her
husband out of JJH and took his name off everything including the
CCA signature card because of the IRS collection activity. In
avoiding the joint and several liability of a joint return,
petitioner hoped to remain free to transfer assets and income to
Charlene to frustrate the Service’s collection activities.
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Petitioner’s attempt to legitimize JJH’s payment of personal
expenses with his fabricated Disney collection lease story and
the covenant not to compete story is further evidence of
petitioner’s fraudulent intent. These concocted stories show
petitioner does not hesitate to manufacture facts and events to
further his interests.14
Petitioner’s fraudulent scheme was not just a family affair,
and he recommended it to others. He set up 163 corporations for
other taxpayers. In at least one such case where the Service
challenged the personal expenses paid by the corporation and
deducted as cost of goods sold, petitioner advised his clients to
settle, stating: “Hey, we got away with it for ten years, it's
time”. At trial, petitioner proudly stood by his prior
statement, bragging: “it was good advice then and I stand by it
now”.
We conclude on this record that “it’s time” for petitioner
also. Respondent has proven by clear and convincing evidence
that petitioner underreported his income in 1994 with the
fraudulent intent of evading taxes. We sustain respondent’s
determination as to fraud.
14
Petitioner similarly disliked having to pay out-of-State
tuition for Tim at the University of Central Florida, so he
perpetuated the Disney collection lease scheme to create the
appearance that Tim was self-sufficient and had fixed income.
This allowed Tim to obtain residency status for tuition purposes.
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We have considered all other arguments advanced by
petitioner for a contrary result and, to the extent not discussed
herein, find them to be irrelevant or without merit.
Decision will be entered under
Rule 155 in docket No. 8664-98;
decision will be entered for
petitioner in docket No. 8665-98.