Delvecchio v. Comm'r

T.C. Memo. 2001-130

UNITED STATES TAX COURT

JOSEPH A. AND CAROL DELVECCHIO, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 6533-94. Filed June 6, 2001.

Petitioner H was the sole proprietor of a
business, A. Ps, H and W, filed original joint returns
and, subsequently, amended tax returns for the tax
years 1987 and 1988. R determined deficiencies and
additions to tax against Ps based on Ps’ failure to
report on the original returns all gross income from A
and all capital gain from the sale of real property.
1. Held: Each of Ps’ amended returns is an
admission of a tax underpayment.
2. Held, further, P-H is liable under sec.
6653(b)(1)(A), I.R.C., for 1987 and sec. 6653(b)(1),
I.R.C., for 1988 for the addition to tax for fraud on
the portion of the underpayment attributable to the
failure to report all gross income from A.
3. Held, further, to the extent we have
determined there to be an underpayment of tax
attributable to fraud, the addition to tax under sec.
6653(b)(1)(B), I.R.C., shall apply for 1987.
4. Held, further, Ps are liable for the addition
to tax for substantial understatement under sec. 6661,
I.R.C., for 1987 and 1988.
 - 2 -

Joseph A. DelVecchio and Carol DelVecchio, pro se.

Leonard T. Provenzale, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HALPERN, Judge: By notice of deficiency dated January 20,

1994, respondent determined deficiencies in, and additions to,

petitioners’ 1987 and 1988 Federal income taxes as follows:

Joseph DelVecchio:

Additions to Tax
Sec. Sec. Sec. Sec.
Year Deficiency 6653(b)(1)(A) 6653(b)(1) 6653(b)(1)(B) 6661
1
1987 $29,400 $22,050 -- $7,350
1988 16,699 -- $12,524 -- 4,175
1
50% of the interest payable under sec. 6601.

Carol DelVecchio:

Additions to Tax
Sec. Sec. Sec. Sec.
Year Deficiency 6653(a)(1)(A) 6653(a)(1)(B) 6653(a)(1) 6661
1
1987 $29,400 $1,470 -- $7,350
1988 16,699 –- -- $835 4,175
1
50% of the interest payable under sec. 6601.

Following the trial in this case, respondent moved to amend

the answer to conform the pleadings to the proof, to take account

of amended tax returns received into evidence (which show items

of income in excess of respondent’s previous adjustments). We

granted that motion and, as amended, the answer now avers

deficiencies in, and additions to, petitioners’ Federal income

taxes for 1987 and 1988 as follows:
 - 3 -

Joseph DelVecchio:
Additions to Tax
Sec. Sec. Sec. Sec.
Year Deficiency 6653(b)(1)(A) 6653(b)(1) 6653(b)(1)(B) 6661
1
1987 $30,789 $23,092 -- $7,697
1988 29,282 -- $21,961 -- 7,321
1
50% of the interest payable under sec. 6601.

Carol DelVecchio:

Additions to Tax
Sec. Sec. Sec. Sec.
Year Deficiency 6653(a)(1)(A) 6653(a)(1)(B) 6653(a)(1) 6661
1
1987 $30,789 $1,539 -- $7,697
1988 29,282 –- -- $1,464 7,321
1
50% of the interest payable under sec. 6601.

Unless otherwise indicated, all section references are to

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

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

Procedure.

The principal issues remaining for decision are petitioners’

claims that they are entitled to net operating loss deductions

for the years in issue and the additions to tax.

FINDINGS OF FACT

Residence

Petitioners resided in Stuart, Florida, at the time the

petition was filed.

Monterey Glass and Mirror Distributors

Petitioner Joseph DelVecchio (Joseph) is a glazier. During

the years in issue, Joseph sold glass to both wholesale and

retail customers. Joseph carried on his business as a
 - 4 -

proprietorship, under the name “Monterey Glass and Mirror

Distributors” (Monterey). Joseph (Monterey, when referring to

the business) had a shop and employed two or three secretaries

and two drivers.

Joseph was familiar with all aspects of Monterey’s business.

Deliveries to customers were made from Monterey’s shop, and, when

Monterey’s drivers returned to the shop, Joseph reviewed all sale

documents and received any checks collected by the drivers.

Joseph opened Monterey’s mail and removed any checks. He

examined all invoices from vendors and the checks drawn to pay

such invoices.

Bookkeeping

During the years in issue, a central feature of Monterey’s

system of bookkeeping was a financial register, referred to by

the parties as the “peg board ledger system” (the peg board).

The peg board consists of sheets of paper, on one side of which

is a check register (the check register) and on the other side of

which are columns to keep a running bank balance, showing checks

drawn, deposits made, and the resulting balance. The check

register consists of numerous columns. The first 5 columns have

preprinted headings, as follows: “REMARKS”, “PAID TO”, “DATE”,

“CHECK NO.”, and “AMOUNT OF CHECK”. Blank checks overlay the

first 5 columns, and, as the check is written, carbon is

deposited onto a line of the ledger and records the information
 - 5 -

for columns 2 through 5. Columns 6 through 23 have no preprinted

headings. The headings may be filled in, or “extended”, to

identify information entered in the underlying column with

respect to any check.

Generally, during the years in issue, checks to pay

Monterey’s expenses were written by secretaries. All checks were

recorded in the check register. Joseph signed those checks. As

the checks were written, entries were automatically made in

columns 2 through 5. Columns 6 through 23 (and the headings of

those columns) of the original pegboard remained blank until

1990, at which time, after the commencement of respondent’s

examination of the years in question, Joseph filled in the

headings to identify various categories of expenses, e.g.,

insurance, phone, and truck repairs, and made entries in the

appropriate column based on the check information on each line.

At that time, entries were made footing each column.

During the years in issue, secretaries made entries on the

reverse side of each sheet, to show checks written, deposits

made, and the resulting bank balance. Secretaries would collect

checks received by Monterey, total them, enter the total as a

deposit in the peg board, and deposit the checks in the bank.

Joseph reviewed all invoices to customers and checks received.

Monterey also kept vendor ledger cards, files of sales

invoices, and bank statements.
 - 6 -

Joseph was familiar with the peg board and other aspects of

Monterey’s bookkeeping system.

Sales and Bank Deposits

Generally, Monterey received payments for glass by check.

Information as to all receipts was entered on the peg board, and

the receipts were deposited into Monterey’s account at First

National Bank and Trust Company (the Monterey account). Monterey

deposited $994,058.25 and $926,963.35 into the Monterey account

during 1987 and 1988, respectively.

Withdrawals

Monthly, during 1987 and 1988, Joseph examined statements

showing the balance of the Monterey bank account and withdrew

funds in excess of the amount needed to operate the business. He

deposited such excess funds, in the amounts of $111,200 and

$74,880, during 1987 and 1988, respectively, into interest

bearing accounts in his own name.

Original Tax Returns

Petitioners timely filed Forms 1040, U.S. Individual Income

Tax Return, for 1987 and 1988 (the Forms 1040). Attached to the

Forms 1040 were Schedules C, Profit or (Loss) From Business or

Profession, which relate to Monterey (the Schedules C). Joseph

prepared the Forms 1040 (including the Schedules C). In

preparing the Schedules C, as source documents, Joseph had

available the peg board, vendor ledger cards, sales invoices, and
 - 7 -

Monterey’s bank statements. At least for 1988, Joseph used an

adding machine to prepare adding machine tapes (the adding

machine tapes) totaling various periodic expenses, such as

expenses for repairs and telephone, which were deducted on the

Schedule C for 1988. Entries on the adding machine tapes

correspond to the totals of such expenditures on pages of the peg

board. For example, on the Schedule C for 1988 there is a

deduction for repairs in the amount of $3,991. There is an

adding machine tape headed “repairs”, with 17 items, totaling

$3,991.28. Column 21 on the check register pages of the peg

board is headed “utilities”. The footed amounts for column 21

match, on an item by item basis, all of the items on the adding

machine tape.

Examination and Investigation

In January 1990, respondent began an examination of the

Forms 1040. In July 1990, that examination was terminated, so

that respondent could commence a criminal investigation of Joseph

(the criminal investigation) with respect to his income tax

liability for 1987 and 1988. The criminal investigation resulted

in charges and a trial, at which, on, August 5, 1997, Joseph was

acquitted of all charges.

Administrative Summons

On January 25, 1991, in connection with the criminal

investigation, Special Agent Richard McLaughlin served an
 - 8 -

administrative summons (the administrative summons) on

petitioners’ accountant, Nancy Crowder, who, in response thereto,

turned over various business and personal records of petitioners.

The records included bank statements, invoices, canceled checks,

and a cash disbursements ledger. Respondent has returned some,

if not all, of the documents obtained pursuant to the

administrative summons.

Amended Returns

On April 13 and 14, 1993, petitioners filed Forms 1040X,

Amended U.S. Individual Income Tax Return, for 1987 and 1988,

respectively (the Forms 1040X). The Forms 1040X were prepared by

accountants retained by Joseph. On the Forms 1040X, petitioners

reported increases in Schedule C net income of $80,214 and

$54,778, for 1987 and 1988, respectively, a capital gain of

$27,944 for 1988, net operating loss deductions of $74,749 and

$85,000 for 1987 and 1988, respectively, and decreases in

interest income of $747 and $288, for 1987 and 1988,

respectively. Following is a comparison of various Schedule C

entries, with respect to Monterey, from the Schedules C attached

to the Forms 1040 and Forms 1040X (the amended Schedules C).

1987

Form 1040 Form 1040X
Income
Gross receipts or sales $442,171 $982,437
Less: Returns and allowances 4,530 --
Less: Cost of goods sold 301,892 644,154
Balance (gross income) 135,749 338,283
 - 9 -

Deductions
Advertising $1,015 --
Bad debts 3,150 --
Bank service charges 240 226
Car & truck expenses 8,733 7,675
Depreciation -- 17,669
Insurance 5,032 10,526
Office expense 3,758 3,284
Repairs 2,117 955
Supplies -- 4,707
Taxes -- 8,248
Utilities and telephone 3,674 6,866
Wages 92,761 92,761
Trash pickup -- --
Other expenses 660 14,443
Nonemployee compensation -- 76,100
Total deductions $121,140 $243,460

Net profit $14,609 $94,823

1988
Form 1040 Form 1040X
Income
Gross receipts or sales $506,362 $900,342
Less: Returns and allowances 8,137 18
Less: Cost of goods sold $356,363 $638,202
Balance (gross income) $141,862 $262,122

Deductions
Advertising $1,957 $506
Bad debts 2,217 0
Bank service charges 348 343
Car & truck expenses 9,451 3,455
Depreciation 0 10,410
Insurance 9,032 23,550
Office expenses 4,452 2,887
Repairs 3,991 0

Supplies 0 4,854
Taxes 0 10,435
Utilities and telephone 4,724 7,020
Wages 90,226 90,226
Trash pickup 0 0
Other expenses 848 39,042
Nonemployee compensation 0 0
Total deductions $127,246 $192,728

Net profit $14,616 $69,394
 - 10 -

Sales Tax Deficiencies

Monterey was subject to an examination by the State of

Florida Department of Revenue (the Department) for sales tax

liabilities for 1987, 1988, and other years. The Department

found that Monterey had collected more sales taxes than reported

to the Department. For 1987 and 1988, Monterey reported to the

Department gross receipts of $288,276 and $124,763, respectively.

OPINION

I. Deficiencies in Tax

Respondent determined deficiencies in petitioners’ income

taxes for 1987 and 1988 principally on account of respondent’s

determination that petitioners underreported their Schedule C

income from Monterey by $75,859 and $44,347, for 1987 and 1988,

respectively.1 On the Forms 1040X, petitioners reported

increased Schedule C net income for Monterey of $80,214 and

$54,778, for 1987 and 1988, respectively, a capital gain of

$27,944 for 1988, net operating loss deductions of $74,749 and

$85,000 for 1987 and 1988, respectively, and decreases in

interest income of $747 and $288, for 1987 and 1988,

1
Respondent also determined increased self-employment
taxes under sec. 1401. Petitioners have not separately
challenged those determinations, which, we assume, are derivative
of respondent’s principal adjustments. We do not further discuss
the self-employment tax adjustments.
 - 11 -

respectively. Respondent accepts the foregoing changes reported

on the Forms 1040X except for the net operating loss deductions.

Based on the Forms 1040X, we find that petitioners underreported

their Schedule C net income from Monterey by $80,214 and $54,778,

for 1987 and 1988, respectively, and failed to report a capital

gain of $27,944 for 1988. Based on respondent’s acceptance of

the decreases in interest income shown on the Forms 1040X, we

find that petitioners over reported their interest income in such

amounts. Petitioners have failed to prove their entitlement to

the net operating loss deductions claimed on the Forms 1040X, and

we allow no deductions therefor.

II. Additions to Tax for Fraud

A. Introduction

Respondent has determined additions to tax for fraud against

Joseph for both 1987 and 1988. For 1987, section 6653(b)(1)(A)

imposes an addition to tax equal to 75 percent of any

underpayment in tax if any part of the underpayment is due to

fraud; section 6653(b)(1)(B) imposes a separate addition to tax,

equal to 50 percent of the interest payable under section 6601,

determined on the portion of the underpayment attributable to

fraud. For 1988, section 6653(b)(1) imposes an addition to tax

equal to 75 percent of any underpayment in tax if any part of the

underpayment is due to fraud; the time-sensitive interest

addition previously found in section 6653(b)(1)(B) is eliminated.
 - 12 -

For both years, if the Secretary establishes that any portion of

an underpayment is attributable to fraud, the entire underpayment

is attributable to fraud, except with respect to any portion of

the underpayment that the taxpayer establishes is not

attributable to fraud. See sec. 6653(b)(2). Respondent has the

burden of proving fraud by clear and convincing evidence. Sec.

7454(a); Rule 142(b). To prove that a taxpayer fraudulently

underpaid a dollar of tax, respondent must prove both the fact of

the underpayment and fraudulent intent with respect thereto.

See, e.g., Recklitis v. Commissioner, 91 T.C. 874, 909 (1988).

B. Existence of an Underpayment

The first inquiry is whether any underpayment exists. As

relevant to this case, section 6653(c)(1) defines an

“underpayment” for purposes of section 6653 as a “deficiency”

defined under section 6211. Petitioners filed amended returns

for 1987 and 1988, the Forms 1040X, showing additional taxes due.

Each of petitioners’ amended returns is an admission of a tax

underpayment. See Badaracco v. Commissioner, 464 U.S. 386, 399

(1984). Respondent has satisfied the first prong of the test.

C. Fraudulent Intent

1. Introduction

The second inquiry concerns the taxpayer’s state of mind.

The existence of a fraudulent state of mind is a question
 - 13 -

of fact to be determined from the entire record. See Recklitis

v. Commissioner, supra at 909; Meier v. Commissioner, 91 T.C.

273, 297 (1988). Respondent must show that petitioner intended

to evade taxes known to be owing by conduct intended to conceal,

mislead, or otherwise prevent the collection of taxes. Stoltzfus

v. United States, 398 F.2d 1002, 1004 (3d Cir. 1968); Parks v.

Commissioner, 94 T.C. 654, 660-661 (1990). Fraud will never be

presumed, Beaver v. Commissioner, 55 T.C. 85, 92 (1970), but may,

however, be proved by circumstantial evidence because direct

proof of the taxpayer’s intent is rarely available. Recklitis v.

Commissioner, supra at 910; Meier v. Commissioner, supra. The

taxpayer’s entire course of conduct may be examined to establish

the requisite fraudulent

intent. Recklitis v. Commissioner, supra; Meier v. Commissioner,

supra.

Having considered all of the evidence before us, we conclude

that respondent clearly and convincingly has shown fraud with

respect to at least the underpayments in tax attributable to

Monterey for both 1987 and 1988. We do so based on the following

factors, which, together, convince us that Joseph had fraudulent

intent with respect to his underreporting of income from

Monterey.
 - 14 -

2. Consistent and Substantial Understatements of
Income

On the Forms 1040X, petitioners reported increased net

profit from Monterey of $80,214 and $54,778 for 1987 and 1988,

respectively. The amended Schedules C show that, originally,

petitioners underreported Monterey’s gross sales by $540,266 and

$393,980 for 1987 and 1988, respectively. Those are large

amounts compared to the amounts originally reported. A

consistent pattern of underreporting large amounts of income is

evidence of fraud. See Holland v. United States, 348 U.S. 121,

137 (1954). Two years of substantial understatement may support

a finding of fraud. See Kelley v. Commissioner, T.C. Memo. 1991-

324 (1991), affd. 988 F.2d 1218 (11th Cir. 1993).

3. Control of Books and Records

Joseph prepared the Schedules C, on which Monterey’s income

was understated. Monterey’s system of bookkeeping centered

around the peg board, in which was recorded all checks written

with respect to Monterey’s business and all deposits of moneys

received with respect to that business. Together with the vendor

ledger cards, sales invoices, and bank statements, the peg board

provided sufficient information to prepare accurately the

Schedules C. Entries on adding machine tapes used by Joseph to

prepare the Schedule C for 1988 convince us that Joseph did use

the peg board to prepare the Schedule C for 1988. Also, Joseph

testified that he looked at statements for Monterey’s bank
 - 15 -

account to determine bank charges deducted on the Schedules C.

Joseph had in his possession, and used, source documents that, we

assume, accurately recorded Monterey’s income and expenses. The

gross discrepancies between entries on the Schedules C and the

amended Schedules C convince us that Joseph did not make

inadvertent mistakes in completing the Schedules C. We infer

from the ready availability to Joseph of accurate information,

which he failed to use, a willful attempt by him to avoid his

obligation correctly to state his net income from Monterey.

4. Withdrawals of Funds From Monterey

On the amended Schedules C, petitioners reported net profits

from Monterey of $94,823 and $69,394 for 1987 and 1988,

respectively. When the noncash expense of depreciation shown on

the amended Schedules C is added to such net profits, the

resulting amounts are $112,492 and $79,804, for 1987 and 1988,

respectively. Those amounts coincide with the yearly totals of

amounts withdrawn monthly by Joseph from Monterey’s bank account

and deposited into interest bearing accounts in his own name. We

consider such transfers to be some evidence that Joseph attempted

to conceal Monterey’s income, albeit, ineptly. More importantly,

we consider such transfers evidence that Joseph knew very well,

not only on a yearly, but on a monthly, basis what Monterey’s

profits were. Moreover, on the Schedules C, Joseph reported net

profits from Monterey of $14,609 and $14,616, for 1987 and 1988,
 - 16 -

respectively. Joseph has failed to explain how he could deposit

into his personal bank account each year substantially more money

from Monterey than he reported as Monterey’s net profit and

disregard that fact when figuring such net profit.

5. Joseph’s Lack of Credibility

Joseph was not a credible witness.

Some of Joseph’s testimony was as follows: He was not

involved in the financial operations of his business, and he had

no idea how much money Monterey earned in 1987 and 1988. He did

not see the incoming checks, but, rather, the drivers turned in

all checks received from customers directly to the secretaries,

and the secretaries opened the mail and removed any checks before

turning the mail over to Joseph. He had no knowledge as to the

bookkeeping method the secretaries used to record the checks. He

signed the checks that were sent out to pay bills, but he did not

keep track of total expenditures.

Shirley Saunier (Ms. Saunier) was employed as a secretary at

Monterey from approximately January or February 1987 until

shortly before Thanksgiving of 1987. Ms. Saunier testified as

follows: Joseph maintained strict control over Monterey’s

finances. Joseph received all incoming checks from the drivers

directly and opened all the mail and removed the incoming checks.

Joseph scrutinized all outgoing checks and accompanying invoices

and frequently questioned the secretaries regarding these
 - 17 -

transactions. Although the secretaries entered the deposits and

disbursements onto the peg board, Joseph reviewed all the

entries. We found Ms. Saunier’s testimony as to Joseph’s

extensive involvement with and awareness of Monterey’s finances

to be consistent and credible.

Joseph testified that he never balanced or reviewed

Monterey’s bank statements (except when preparing the Schedules C

and then only to determine the amount of bank charges) and,

therefore, was unaware of how much money had been deposited into

the Monterey account. That testimony is contradicted by

petitioners’ statements on brief: (1) “Mr. DelVecchio each month

reviewed his bank statements, and when balances in the business

account exceeded the amounts needed to operate the business,

Petitioner transferred some of the excess funds to his other

account”, and (2) “Although Mr. DelVecchio was obviously aware

that he was receiving more gross receipts than previous years, it

is obvious with his lack of accounting experience that he

operated primarily based on his bank balances each month when he

received his bank statements.”

Joseph testified that he did not use the peg board to

prepare the Schedules C. That testimony is false, as shown by

our analysis supra section II.C.3.

Joseph’s lack of credibility is evidence of his fraudulent

intent.
 - 18 -

6. Joseph’s Defense

Joseph claims that he once possessed computer sheets that

would demonstrate how he mistakenly understated both his gross

receipts and expenses. He contends that such computer sheets are

among the records obtained by respondent’s agent pursuant to the

administrative summons. He further contends that he did not

receive back from respondent many of those records, including the

computer sheets he needs to defend himself.

In fact, such computer sheets are the only document Joseph

has identified as missing. He does not contend that he needs the

computer sheets to calculate his gross income and deductions, but

rather, that they would serve as proof that he had a reasonable,

albeit erroneous, basis for the gross receipts and cost of goods

sold he reported on the Schedules C. Joseph did not offer any

testimony as to the creation or maintenance of those computer

sheets, nor did he produce any witnesses to authenticate their

existence. Indeed, he did not explain (1) what information the

computer sheets would contain that differed from that appearing

on the peg board, (2) the purpose for also running adding machine

tapes against the peg board, nor (3) why he would have gone to

the effort of maintaining two bookkeeping systems–-a manual peg

board system and an automated computer system. We do not believe

that the claimed computer sheets ever existed.
 - 19 -

7. Conclusion

Joseph methodically understated gross receipts and cost of

goods sold in order to conceal the amount of net profit that

Monterey earned; he did that 2 years in a row. According to his

own testimony, which, in many respects, was incredible, he had

kept what amounted to a second set of books, the computer sheets,

which purportedly are missing. Joseph had no explanation for why

he maintained two separate sets of books. He moved funds from

Monterey’s bank account to his personal account. That is the

clear evidence that convinces us that Joseph fraudulently

intended to understate his income with respect to Monterey for

1987 and 1988.

D. Portion of Underpayments Attributable to Fraud

Petitioners have failed to rebut the presumption that the

entire underpayments in tax for 1987 and 1988 are due to fraud.

See sec. 6653(b)(2). We find accordingly.

E. Additions to Tax For Fraud

We sustain respondent’s additions to tax for fraud against

Joseph under section 6653(b)(1)(A) and (B) for 1987 and under

section 6653(b)(1) for 1988.

III. Addition to Tax for Negligence

Having found that the entire underpayments for 1987 and 1988

are attributable to fraud, and that Joseph is subject to

additions to tax on account thereof, we need not address the
 - 20 -

addition to tax for negligence that respondent determined against

petitioner Carol DelVecchio. See sec. 6653(a)(2).

IV. Substantial Understatement of Income Tax Liability

For returns due before January 1, 1990, section 6661

provides for an addition to tax equal to 25 percent of the amount

of any underpayment attributable to a substantial understatement.

An understatement is “substantial” when the understatement for

the taxable year exceeds the greater of (1) 10 percent of the tax

required to be shown or (2) $5,000. The understatement is

reduced to the extent that the taxpayer has (1) adequately

disclosed his or her position, or (2) has substantial authority

for the tax treatment of an item. See sec. 6661; sec.

1.6661-6(a), Income Tax Regs.

Petitioners’ understatements for 1987 and 1988 exceed

10 percent of the tax required to be shown. They are, therefore,

substantial under section 6661.

Petitioners have cited no authority for their failure to

report the understatements of income for 1987 or 1988, nor did

they disclose any facts pertaining to such income on their

returns or in a statement attached to the returns. Therefore,

petitioners are liable for the section 6661 addition to tax.

Decision will be entered

under Rule 155.