Parsons v. Commissioner

T.C. Memo. 2000-205

UNITED STATES TAX COURT

PHILIP E. PARSONS AND KAREN PARSONS, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 9303-97. Filed July 5, 2000.

J. Timothy Bender and J. Scott Broome, for petitioners.

Christopher A. Fisher, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GALE, Judge: Respondent determined deficiencies in

petitioners’ Federal income taxes and additions to tax as

follows:
 - 2 -

Additions to Tax
Sec. Sec. Sec. Sec.
Year Deficiency 6653(b)(1) 6653(b)(1)(A) 6653(b)(1)(B) 6661(a)
1
1987 $18,652 N/A $13,989 $4,663
1988 10,100 $7,575 N/A N/A 2,525
1
50 percent of the interest due on $18,652.00 for tax year 1987.

Unless otherwise noted, all section references are to the

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

Rule references are to the Tax Court Rules of Practice and

Procedure.

After concessions,1 we must decide the following issues:

(1) Whether petitioners are liable for additions to tax for

fraud under section 6653(b) for 1987 and 1988.2 We hold they

are.

(2) Whether petitioners are liable for additions to tax for

substantial understatement of tax for 1987 and 1988. We hold

they are.

1
Petitioners have conceded the deficiencies in each year
at issue.
2
Petitioners have also averred that the sec. 6501(a) 3-
year period of limitations on assessment has expired with respect
to the years in issue. Because we conclude that petitioners
filed fraudulent returns for each of these years, the period for
assessment remains open. See sec. 6501(c)(1); Murphy v.
Commissioner, T.C. Memo. 1995-76; Sisson v. Commissioner, T.C.
Memo. 1994-545 (“The definition of fraud for purposes of section
6653 is the same as the definition of fraud for the purpose of
extending the period of limitations under section 6501(c).”),
affd. without published opinion 108 F.3d 339 (9th Cir. 1996).
 - 3 -

FINDINGS OF FACT

At the time they filed their petition, petitioners resided

in Pepper Pike, Ohio. Petitioners were married and filed joint

returns for the years in issue.

During the years in issue, petitioner Philip E. Parsons was

a licensed pharmacist and the president and sole shareholder of

Cedar Hill Drug Company, Inc. (Cedar Hill), which operated a

pharmacy in Cleveland Heights, Ohio, and, beginning in November

1988, a second pharmacy in Solon, Ohio. Mr. Parsons formed Cedar

Hill in 1975 and incorporated it in the State of Ohio in 1981.

In addition to filling prescriptions, Cedar Hill sold milk,

tobacco, beer, wine, and other merchandise. Mr. Parsons was an

employee of Cedar Hill and was issued Forms W-2, Wage and Tax

Statement, for the years in issue. Mr. Parsons, as the

pharmacist, did not ring up sales on the register, which was

operated by other employees. Mrs. Parsons, also a licensed

pharmacist, worked at an unrelated pharmacy, and although not an

employee of Cedar Hill, she occasionally filled in for Mr.

Parsons at Cedar Hill.

During the years at issue, petitioners retained the

accounting firm Skoda, Minotti, Reeves & Co. (SMR) to perform

bookkeeping and tax consultation services for Cedar Hill, as well

as to prepare Cedar Hill’s corporate income tax returns and

petitioners’ personal income tax returns. Joseph F. Skoda was
 - 4 -

the SMR partner responsible for petitioners’ and Cedar Hill’s

accounts.

SMR supplied petitioners with forms for the purpose of

recording cash transactions in Cedar Hill’s operations. These

forms were titled “Daily Sales and Cash Report” and were referred

to as “pink sheets”. The pink sheets provided a means of

recording different categories of cash receipts and disbursements

so that petitioners and SMR could account for Cedar Hill’s cash.

The cash disbursement categories included a line denoted

“Personal Drawing” for recording cash withdrawn by Mr. Parsons

for personal use. The pink sheets also had a line for recording

the amount of cash deposited into Cedar Hill’s bank account. Mr.

Parsons understood the “Personal Drawing” line to be a place for

recording money taken out of the register during the course of

the day for personal use.

At the end of each business day, Mr. Parsons brought home

the register tapes, cash, and receipts from the cash registers at

Cedar Hill and gave them to Mrs. Parsons, who then completed the

pink sheet record for that day. By comparing the cash and the

register tapes from each cash register and shift, it could be

determined whether each cashier was properly accounting for his

or her cash receipts. Each morning, Mr. Parsons would take the

cash that Mrs. Parsons had counted in preparing the pink sheets

the previous evening, so he could deposit it in Cedar Hill’s bank
 - 5 -

account. At some point during the business day, he would deposit

cash into Cedar Hill’s bank account.

Mr. Parsons did not receive regularly scheduled, pro rata

installments of his salary from Cedar Hill. Instead, either Mr.

or Mrs. Parsons would take cash from Cedar Hill’s proceeds as

needed for living expenses. On occasion, Mr. Parsons would

remove cash from the Cedar Hill registers during the business

day, and either he or Mrs. Parsons would record the withdrawal on

the pink sheets on the personal drawing line. In the evening,

Mrs. Parsons would sometimes remove cash that had been brought

home from Cedar Hill and use it for the Parsonses' personal use.

Mrs. Parsons recorded these withdrawals on the pink sheets as

personal draws. The withdrawals of cash that were recorded as

personal draws on the pink sheets and the value of any business

checks written for personal expenditures were tallied at yearend

by SMR and offset against the salary due Mr. Parsons. Cedar Hill

would then issue a check to Mr. Parsons for any remaining salary

due him.

However, not all cash taken by Mr. Parsons from Cedar Hill’s

proceeds was recorded on the pink sheets. On many occasions, Mr.

Parsons would remove cash from the previous day’s proceeds that

had been counted by Mrs. Parsons the previous evening, had been

recorded on the pink sheets as deposited, and was awaiting
 - 6 -

deposit into Cedar Hill’s bank account.3 These withdrawals of

cash by Mr. Parsons were not noted as personal draws or otherwise

recorded on the pink sheets. As a result, the pink sheets

reflected the cash on hand at the end of each business day but

often did not reflect the subsequent cash withdrawals made by Mr.

Parsons before making deposits into Cedar Hill’s bank account.

The total cash withdrawn by Mr. Parsons but not recorded on the

pink sheets equaled $57,106 in 1987 and $35,957 in 1988. Some,

but not all, of this money was deposited into Mrs. Parsons’

personal bank account.

After the close of each month, Mr. Parsons forwarded that

month’s pink sheets to SMR. He also provided handwritten

summaries of that month’s sales and accounts receivable (the

white sheets). Using the pink sheets, the white sheets, and

other records of check transactions, SMR prepared monthly balance

sheets, income statements, and general ledger sheets for Cedar

Hill.

Mr. Skoda noticed that the amounts recorded for Cedar Hill’s

accounts receivable could not be reconciled with the cash in

Cedar Hill’s bank account, nor did the “Cash Deposited” amounts

Mrs. Parsons had recorded on the pink sheets match the actual

3
Often, Mr. Parsons would make such withdrawals at the
request of Mrs. Parsons, who would call him at Cedar Hill and
request that he deposit additional funds in her personal checking
account to cover checks she was writing.
 - 7 -

amounts deposited. Mr. Skoda attributed these discrepancies to

the large volume of workmen’s compensation prescriptions filled

by Cedar Hill, wherein the nominal amounts billed for such

prescriptions were greater than the actual amounts reimbursed to

Cedar Hill for such prescriptions. Mr. and Mrs. Parsons did not

mention to Mr. Skoda that they had withdrawn for personal use

some of the amounts listed as deposits on the pink sheets, and

Mr. Skoda did not review the Parsonses’ personal bank accounts

during the years at issue.

At various times, Mr. Parsons advanced funds to Cedar Hill,

and as of January 31, 1987, Cedar Hill’s books recorded debt owed

to Mr. Parsons of $54,891.68. In February 1987, in an effort to

avoid Mr. Parsons’ having imputed interest income from Cedar

Hill, SMR recharacterized on Cedar Hill’s books $52,000 of the

indebtedness to Mr. Parsons as Mr. Parsons’ paid-in capital. As

a result of SMR’s action, by February 28, 1987, Cedar Hill’s

indebtedness to Mr. Parsons was recorded as only $3,066.68, and

by April 30, 1987, the indebtedness had been eliminated from

Cedar Hill’s books.

In April or May of 1989, Donald Paskert, a revenue agent for

respondent, began a Taxpayer Compliance Measurement Program audit

of Cedar Hill. At that time, Mr. Paskert asked for and received

all of Cedar Hill’s books and records. During his audit of Cedar

Hill, Mr. Paskert was unable to reconcile the deposit amounts
 - 8 -

listed on the pink sheets with the bank deposits recorded on the

bank statements for Cedar Hill’s account. He was also unable to

match the figures from Cedar Hill’s white sheets with those from

the pink sheets. To resolve these discrepancies, Mr. Paskert

expanded his investigation to the personal tax returns of

petitioners. He requested and received petitioners’ personal

bank records in the fall of 1989, which indicated that

petitioners had made deposits that far exceeded the income

reported on their returns. In a subsequent telephone interview

with Mr. Paskert, when asked about these excess deposits, Mr.

Parsons admitted that all the funds in petitioners’ bank account

consisted of either Mrs. Parsons’ wages or money removed from

Cedar Hill. At a second meeting in December 1989, Mr. Parsons

admitted to Mr. Paskert that the pink sheets did not reflect all

of the cash withdrawn from Cedar Hill by petitioners.

Mr. and Mrs. Parsons were subsequently indicted and, after a

jury trial, convicted of two violations of section 7206(1) with

respect to their 1987 and 1988 returns, for subscribing to false

income tax returns. Specifically, the indictments charged

petitioners with reporting on each return total income which they

knew to be false.

Petitioners reported gross income of $49,660 and $54,379 in

1987 and 1988, respectively, which included salary income of Mr.

Parsons from Cedar Hill of $25,000 and $30,000, respectively.
 - 9 -

For the same respective years, respondent determined, using the

bank deposits and cash expenditures method, that petitioners had

unreported income of $57,106 and $35,957. Petitioners now

concede they had unreported income in these amounts, the source

of which was cash proceeds from Cedar Hill’s operations not

deposited into Cedar Hill’s bank accounts but instead retained by

petitioners. Thus, petitioners received from Cedar Hill a total

of $82,106 and $65,957 during 1987 and 1988, respectively, while

reporting as income only $25,000 and $30,000, respectively, from

that source.

Respondent determined in addition that the underpayments

resulting from the unreported income in each year at issue were

due to fraud and that there was a substantial understatement of

tax in each year within the meaning of section 6661(a).

Petitioners dispute these determinations.

OPINION

1. Fraud

The existence of fraud is a question of fact. See Hagaman

v. Commissioner, 958 F.2d 684, 696 (6th Cir. 1992), affg. and

remanding on other grounds T.C. Memo. 1987-549. Respondent has

the burden of proving fraud by clear and convincing evidence.

See sec. 7454(a); Rule 142(b). If respondent establishes that

any portion of an underpayment is attributable to fraud, the

entire underpayment shall be treated as attributable to fraud,
 - 10 -

except to the extent petitioners establish otherwise. See sec.

6653(b)(2). To establish fraud, respondent must show that

petitioners "engaged in conduct with the intent to evade taxes

that * * * [they] knew or believed to be owing." United States

v. Walton, 909 F.2d 915, 926 (6th Cir. 1990). Direct evidence of

fraud is seldom available. See Petzoldt v. Commissioner, 92 T.C.

661, 699 (1989); Rowlee v. Commissioner, 80 T.C. 1111, 1123

(1983). Consequently, we may rely on circumstantial evidence to

establish fraud. See United States v. Walton, supra; see also

Hagaman v. Commissioner, supra at 696. Fraud may be inferred

from "any conduct, the likely effect of which would be to mislead

or to conceal." Spies v. United States, 317 U.S. 492, 499

(1943). The taxpayer’s background, including his sophistication,

experience and education, and the context of the events in

question may be considered circumstantial evidence of fraud. See

Solomon v. Commissioner, 732 F.2d 1459, 1461-1462 (6th Cir.

1984), affg. per curiam T.C. Memo. 1982-603; Plunkett v.

Commissioner, 465 F.2d 299, 303 (7th Cir. 1972), affg. T.C. Memo.

1970-274; Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).

The courts have established several indicia or "badges" of

fraud which include: (1) Understating income; (2) maintaining

inadequate records; (3) giving implausible or inconsistent

explanations of behavior, (4) concealment of income or assets,

(5) failing to cooperate with tax authorities, (6) engaging in
 - 11 -

illegal activities, (7) an intent to mislead which may be

inferred from a pattern of conduct, (8) lack of credibility of

the taxpayer’s testimony, (9) filing false documents, (10)

failing to file tax returns, and (11) dealing in cash. Spies v.

United States, supra at 499; Conti v. Commissioner, 39 F.3d 658,

662 (6th Cir. 1994), affg. and remanding on other grounds T.C.

Memo. 1992-616; Douge v. Commissioner, 899 F.2d 164, 168 (2d Cir.

1990); Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir.

1986), affg. T.C. Memo. 1984-601; Recklitis v. Commissioner, 91

T.C. 874, 910 (1988). Although no single factor is necessarily

sufficient to establish fraud, the existence of several indicia

constitutes persuasive circumstantial evidence of fraud. See

Bradford v. Commissioner, supra at 307; Petzoldt v. Commissioner,

supra at 700. Finally, although not dispositive, a conviction

for filing false Federal income tax returns under section 7206(1)

is evidence of fraudulent intent. See Wright v. Commissioner, 84

T.C. 636, 643-644 (1985); Miller v. Commissioner, T.C. Memo.

1989-461.

Petitioners concede they had unreported income resulting in

the deficiencies as determined by respondent for 1987 and 1988,

which establishes an underpayment for each year. However, they

contend that the underpayments were not due to fraud.

Petitioners mount a number of arguments to show that they lacked

the requisite fraudulent intent.
 - 12 -

First, to rebut the adverse inferences that might be drawn

from the fact that Mr. Parsons often took cash from Cedar Hill’s

proceeds without recording it on the pink sheets as a personal

draw, petitioners contend that they understood the pink sheets to

function merely as a “snapshot” of the day’s business activity,

so that cash removed after the business day need not be reflected

on the pink sheets. Thus, the argument goes, Mr. Parsons

recorded cash he withdrew for personal use from the registers

during business hours but did not believe it was necessary to

record cash taken on the following day before Cedar Hill’s

proceeds were deposited into its bank account. Besides finding

it implausible that a college-educated, successful businessman

could believe this, we note that petitioners’ own actions are

inconsistent with this explanation. Mrs. Parsons testified that

she would on occasion remove cash for petitioners’ personal use

in the evenings at home when she was performing her bookkeeping

tasks for Cedar Hill, and that these withdrawals were recorded as

personal draws on the pink sheets. If petitioners believed the

pink sheets were to function only as a “snapshot” of the business

day, Mrs. Parsons’ after-hours withdrawals would not need to be

recorded.4

4
Petitioners’ “snapshot” theory is also different from the
explanation initially provided by petitioners’ accountant to
respondent’s revenue agent in the course of the audit. As
(continued...)
 - 13 -

Apparently recognizing that if, as they professed to

believe, it was not necessary to record on the pink sheets all

withdrawn cash, then there would have to be some means by which

SMR could trace withdrawn cash not so recorded, petitioners claim

they believed SMR would compile the unrecorded cash by examining

the records of Mrs. Parsons’ personal checking account, into

which petitioners claim all such cash was deposited. Petitioners

concede that the records of Mrs. Parsons’ account were never

given to SMR but claim this failure resulted from a

miscommunication between them. Mr. Parsons testified that he

instructed his wife to provide her checking account records to

their accountant; Mrs. Parsons testified that she misunderstood

this instruction. Thus, Mr. Parsons claims, he believed his

accountant was taking account of all the cash Mr. Parsons removed

from Cedar Hill’s proceeds because he could track it through the

cash deposits made into Mrs. Parsons’ checking account.

Petitioners’ efforts to account for the failure to provide

Mrs. Parsons’ personal checking account records to their

accountant-–which records, in their version of events, were

crucial to the accountant’s correctly compiling their income-–are

4
(...continued)
petitioners’ authorized representative, the accountant advised
the agent that Mr. Parsons’ explanation was that the pink sheets
had already been completed and were at home when, on the
following morning, he would remove some of the cash awaiting
deposit to Cedar Hill’s bank account.
 - 14 -

based entirely on their self-serving testimony and are

unconvincing. Moreover, this failure purportedly caused by

miscommunication occurred 2 years in a row. The amounts reported

on petitioners’ returns as Mr. Parsons’ salary or “draw” from

Cedar Hill were $25,000 and $30,000 in 1987 and 1988,

respectively. Petitioners have conceded that the actual amounts

they received from Cedar Hill in those years were $82,106 and

$65,957, respectively. We do not believe that petitioners could

continue to believe that their accountant was successfully

tracking all the cash they were taking from Cedar Hill, via Mrs.

Parsons’ checking account records, which were never furnished to

the accountant, or otherwise, in light of the size of the

discrepancies in the figures reported on the return and the

amounts actually taken in each year. Finally, respondent has

reconstructed personal expenditures in each year (which

petitioners have conceded) that substantially exceed the net

balance plus deposits into Mrs. Parsons’ checking account,

creating the clear inference that significant amounts of cash

taken from Cedar Hill by Mr. Parsons were not deposited into the

account, as petitioners contend, but spent directly on personal

expenditures. Accordingly, even if SMR had been provided with

Mrs. Parsons’ checking account records, it would not have been

able to reconstruct all of Mr. Parsons’ diversions from Cedar

Hill.
 - 15 -

Petitioners further contend that they lacked fraudulent

intent because they believed any cash they received from Cedar

Hill in excess of Mr. Parsons’ reported salary constituted

repayment of loans owed to Mr. Parsons by the corporation.

Although on January 31, 1987, Cedar Hill owed Mr. Parsons

$54,892, by February 28, 1987, the value of the loans had been

reduced to $3,067. This reduction resulted from SMR’s decision

to recharacterize amounts recorded as debt as paid-in capital in

order to preclude petitioners’ having imputed interest income in

respect of these amounts. Petitioners assert that they were

never informed of the elimination of this indebtedness.

We do not find petitioners’ “loan repayment” rationale

convincing. Regardless of whether petitioners had been advised

of their accountant’s recharacterization of the loan amounts as

paid-in capital, their rationale that the cash Mr. Parsons took

constituted loan repayments fails because there was no way for

their accountant to keep track of the purported “repayments” by

Cedar Hill. Only if one accepts that Mrs. Parsons’ checking

account was intended to provide a means for SMR to compile Mr.

Parsons’ removals of cash-–which, for the reasons previously

stated, we do not-–could SMR have any conceivable way of keeping

track of Cedar Hill’s outstanding indebtedness to Mr. Parsons as

he “paid himself back” with diverted cash.
 - 16 -

A final argument by petitioners deserves brief

consideration. Petitioners contend that if they were attempting

to evade taxes, they would not have left such a clear “paper

trail”. Specifically, petitioners argue that a lack of

fraudulent intent should be inferred from the fact that all of

the diverted cash was deposited into Mrs. Parsons’ checking

account, creating a clear record of the diversions which they

would have avoided if their intent were to evade. As discussed

previously, the record in this case refutes petitioners’ claim

that all their cash withdrawals from Cedar Hill were deposited

into Mrs. Parsons’ checking account. A second “paper trail” that

petitioners contend they created, which rebuts fraudulent intent,

concerns the accurate recording of all of Cedar Hill’s cash sales

on the pink sheets. According to this argument, it would have

been “very simple” for Mr. Parsons to avoid ringing up cash sales

on the register or to record a lower figure for cash sales on the

pink sheets if he intended to evade taxes. We find this argument

unpersuasive. First, the record in this case does not establish

that the pink sheets accurately recorded Cedar Hill’s

transactions in cash. Respondent reconstructed unreported income

using the bank deposit and cash expenditures method, not by

reference to data on the pink sheets. As to the suggestion that

Mr. Parsons could have simply avoided ringing up sales on the

register if he wished to divert cash surreptitiously, we note
 - 17 -

that Mr. Parsons testified that, as pharmacist, he did not

operate the cash register at Cedar Hill; this task was performed

by other employees. Thus, Mr. Parsons could not have readily

avoided ringing up cash sales without involving his employees in

this scheme.

In summary, we find that in removing cash from Cedar Hill’s

proceeds and failing to record or report such removal to their

accountant, petitioners engaged in “conduct * * * likely * * * to

mislead or to conceal.” Spies v. United States, 317 U.S. at 499.

The amounts petitioners diverted to personal use that were not

reported on their returns for 2 years in a row were substantial

in relation to their reported income, rebutting inferences of

mere mistake or inadvertence. The explanations offered by

petitioners to cast these events in a more innocent light are

implausible and unpersuasive. Moreover, petitioners were both

convicted of violations of section 7206(1) for filing returns for

each year in issue reporting an amount of income which they knew

to be false. While the convictions under section 7206(1) do not

estop petitioners from denying fraud for these years, they are

evidence of fraud. Absent some credible evidence that knowingly

filing a false return should not be considered indicative of

fraud, a section 7206(1) conviction is highly persuasive of

fraud. See Biaggi v. Commissioner, T.C. Memo. 2000-48; Wilson v.
 - 18 -

Commissioner, T.C. Memo. 1994-454; Avery v. Commissioner, T.C.

Memo. 1993-344; Williamson v. Commissioner, T.C. Memo. 1993-246.

On the basis of the foregoing, we hold that respondent has

shown by clear and convincing evidence that the underpayments in

1987 and 1988 are due to fraud on the part of both petitioners.

Under section 6653(b)(3), the fraud of one joint-filing spouse

cannot be attributed to the other; respondent must show that each

spouse engaged in fraud. Although on the basis of petitioners’

testimony it appears that all or most of the cash diversions from

Cedar Hill may have been the result of Mr. Parsons’ taking cash

without recording it as a personal draw, Mrs. Parsons’

involvement in and awareness of the diversions is clear.

According to petitioners’ testimony, the cash withdrawals that

were not recorded on the pink sheets typically occurred when Mrs.

Parsons would call Mr. Parsons at work to request that he make a

deposit into her account to cover checks she was writing. Mrs.

Parsons’ testimony that she had “no idea” where Mr. Parsons got

the money to make these deposits is, in the circumstances, not

credible. Because she performed daily bookkeeping duties for

Cedar Hill, Mrs. Parsons had knowledge of the business’ finances

and the extent of petitioners’ use of Cedar Hill proceeds.
 - 19 -

2. Substantial Understatements

Section 6661 provides for a 25-percent addition to tax on

any substantial understatement. A substantial understatement is

one that exceeds the greater of 10 percent of the tax required to

be shown on the return or $5,000. See sec. 6661(b)(1). The

amount of the understatement, for purposes of section 6661, is to

be reduced by the portion attributable to any item for which

there was substantial authority or any item that was adequately

disclosed. See sec. 6661(b)(2)(B). In addition, the

Commissioner may waive all or part of a section 6661 addition to

tax upon a showing by the taxpayer that there was reasonable

cause for the understatement and that the taxpayer acted in good

faith. See sec. 6661(c).

Petitioners have not claimed substantial authority or

adequate disclosure. Rather, petitioners argue they had

reasonable cause and acted in good faith and that respondent

abused his discretion in denying them relief. To show reasonable

cause and good faith, petitioners rely upon the same arguments

and explanations they employed in an effort to show that they

lacked fraudulent intent. These arguments are no more persuasive

here, nor do we see how petitioners can reconcile their

convictions under section 7206(1) with a showing of reasonable

cause or good faith. For the foregoing reasons we do not find

that respondent acted “arbitrarily, capriciously, or without
 - 20 -

sound basis in fact” in not waiving the additions to tax in this

case. Mailman v. Commissioner, 91 T.C. 1079, 1084 (1988); see

also Rao v. Commissioner, T.C. Memo. 1996-500.

To reflect the foregoing,

Decision will be entered

for respondent.