BARNARD v. COMMISSIONER

T.C. Memo. 2001-242

UNITED STATES TAX COURT

MICHAEL L. AND SUSAN BARNARD, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 11118-99. Filed September 17, 2001.

Carolyn J. Jackson and Richard Craig Krause, for

petitioners.

Alexandra E. Nicholaides and Timothy S. Murphy, for

respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge: Petitioners petitioned the Court to

redetermine respondent’s determination of deficiencies in their

1987, 1988, and 1989 Federal income taxes, additions to their

1987 and 1988 taxes for fraud, and a penalty for fraud as to
 - 2 -

1989. Respondent determined deficiencies of $11,253, $15,996,

and $14,689 for the respective years. Respondent also determined

that petitioners were liable for an $8,440 addition to their 1987

tax under section 6653(b)(1)(A), an $11,997 addition to their

1988 tax under section 6653(b)(1), and an $11,017 penalty for

fraud as to 1989. Respondent also determined that petitioners

were liable for a time-sensitive addition to their 1987 tax under

section 6653(b)(1)(B).

We must decide whether petitioners are liable for the

deficiencies, additions to tax, and penalty. We hold they are

liable for the deficiencies to the extent stated herein and that

they are not liable for any of the additions to tax or the

penalty. Unless otherwise indicated, section references are to

the Internal Revenue Code applicable to the relevant years. Rule

references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some facts have been stipulated. We incorporate herein by

this reference the parties’ stipulation of facts and the exhibits

submitted therewith. We find the stipulated facts accordingly.

Petitioners resided in Charlevoix, Michigan (Charlevoix), when

their petition was filed. They filed joint 1987, 1988, and 1989

Federal income tax returns.

Michael Barnard (Mr. Barnard) grew up in East Jordan,

Michigan. Upon graduating from high school, he attended the
 - 3 -

General Motors (GM) Institute and received a degree in mechanical

engineering in 1966. During the next 15 years, he worked as an

engineer for GM Corp. He married Susan Barnard (Ms. Barnard) on

February 14, 1981. Ms. Barnard is a registered nurse.

Petitioners owned property in Charlevoix on which they

constructed a facility that included a restaurant and bar

(collectively, the restaurant) and a 12-room motel (motel).

Petitioners began operating the restaurant and the motel in late

1982 as unincorporated businesses and incorporated those

businesses in the middle of 1986 under the name Nanny's, Inc.

(Nanny's).1 For the remainder of 1986 throughout the end of

1988, Nanny’s operated as a C corporation that reported its

income and expenses for Federal income tax purposes on the basis

of the calendar year. Nanny's elected to be treated as an S

corporation effective with its taxable year beginning on January

1, 1989.

Ms. Barnard oversaw Nanny’s daily operation. Nanny’s

received most of its income in cash, and petitioners deposited

Nanny’s receipts into a cash register. Each morning, Ms. Barnard

reconciled the cash in the register to the cash register tape of

Nanny’s business for the previous day. Afterwards, petitioners

left some of the cash in the register for the current day's

1
Petitioners’ basis in their Nanny’s stock was $10,000 upon
incorporation and at all relevant times thereafter (except to the
extent that their basis is reduced pursuant to this report).
 - 4 -

business (including the payment of vendors) and either deposited

the remaining cash into Nanny’s checking account (business

account) or secured it for safekeeping at the restaurant or at

their home. Petitioners deposited into the business account only

the portion of Nanny’s gross receipts necessary to cover its

anticipated expenses which would be paid by check. When Nanny’s

did not have enough funds in the business account to pay business

expenses, petitioners usually paid the expenses directly with the

secured cash or transferred the cash to the business account and

paid the expenses by check. On many occasions, petitioners used

their own funds to pay Nanny’s business expenses and used Nanny’s

funds to pay their personal expenses. Petitioners generally

operated Nanny’s business in the same manner after its

incorporation as they did before its incorporation; i.e., as an

alter ego of themselves.

Following Ms. Barnard’s reconciliation of the cash in the

register to the cash register tapes, petitioners recorded the

gross receipts onto daily sheets and discarded the cash register

tapes. They also discarded the daily sheets after Mr. Barnard

used them to prepare monthly summaries of Nanny’s income and

expenses which he gave to his longtime accountant, Hugh Mason

(Mr. Mason), to prepare the required tax returns (e.g., sales

tax, income tax) and financial statements. Petitioners kept no

written record of the amount of Nanny’s gross receipts that was
 - 5 -

not deposited into the business account. Nor did they keep any

detailed records as to the amount of their personal funds which

they used in Nanny’s business or as to the amount of Nanny’s

funds which they used personally. For both Federal income tax

and financial accounting purposes, Mr. Mason calculated at the

end of each year the balance of any loan that he considered to

exist between Nanny’s and petitioners on account of Nanny’s use

of petitioners’ funds and vice versa.

Petitioners also owned a mobile home park called Lake

Michigan Heights Mobile Home Park (Lake Michigan Heights) and a

building with office and retail space called Bridge Street Centre

(Bridge Street). All payments to Lake Michigan Heights and

Bridge Street were made by check, and petitioners deposited all

of these checks into the separate bank accounts of Lake Michigan

Heights and Bridge Street. Petitioners operated Lake Michigan

Heights and Bridge Street as unincorporated businesses. For the

respective years from 1987 through 1989, petitioners reported on

their income tax returns, as initially filed, that they had

received rent of $27,893, $28,375, and $37,871 as to Lake

Michigan Heights and $81,305, $87,503, and $94,394 as to Bridge

Street.

Nanny's Old Place is petitioners’ unincorporated business

that rents to Nanny’s the real estate petitioners owned in

Charlevoix. Petitioners received rent checks from Nanny’s
 - 6 -

totaling $60,000 in 1987, $60,000 in 1988, and $60,000 in 1989.

Petitioners deposited all of these checks into the Bridge Street

account.

Petitioners sometimes bought items or paid expenses using

cashier's checks which they purchased with cash or using the

proceeds of cashier’s checks which they purchased with cash and

which were payable to Mr. Bernard.2 In September 1988, they

bought a boat (the Tollycraft) for $196,620. They paid part of

the Tollycraft’s purchase price with the proceeds of three $9,000

cashier's checks which they had purchased with cash on July 25

and 26, 1998, and August 11, 1998, respectively, and which were

payable to Mr. Bernard.3 They paid another $150,025 of the

Tollycraft’s purchase price with the proceeds of a loan. They

reported for State sales tax purchases that the purchase price of

the Tollycraft was $161,021, and they remitted to the State of

Michigan a $6,585.84 cashier’s check (payable to the State of

Michigan) in payment of the sales tax. In 1989, Ms. Barnard paid

her childcare expenses using cashier’s checks in the amounts of

2
Petitioners also bought items and paid expenses using
other than cashier’s checks. Many of these items and expenses
exceeded $10,000 in amount.
3
Each of these cashier’s checks listed on its face that Mr.
Barnard was the purchaser of the check. Mr. Barnard signed these
checks and presented them to the Tollycraft’s seller in partial
payment of the boat.
 - 7 -

$256.15, $705.40, and $1,076.90. She also purchased a $1,083.04

cashier's check payable to a seller of furniture.

In 1988 and 1989, the Charlevoix County State Bank (the

Bank) delivered to respondent various "Suspicious Transaction

Reports" (STRs) as to petitioners. These STRs reported the

following transactions made by petitioners:

Date Transaction

July 1, 1988 $3,647 cash payment on a $330,000 loan
(the first loan) dated December 15, 1986

July 5, 1988 $3,647 cash payment on the first loan

July 18, 1988 $9,000 cash purchase of a cashier's
check payable to American Marine
Electronics for unidentified goods
or services

July 22, 1988 $9,000 cash purchase of cashier's
check payable to Mr. Barnard

July 25, 1988 $9,000 cash purchase of a cashier's
check payable to Mr. Barnard

July 26, 1988 $9,000 cash purchase of a cashier's
check payable to Mr. Barnard

Aug. 11, 1988 $9,000 cash purchase of a cashier's
check payable to Mr. Barnard

Aug. 24, 1988 $6,565.84 cash purchase of a
cashier's check payable to the
State of Michigan for the sales tax
on the Tollycraft

Oct. 13, 1988 $8,000 cash payment on a second
loan

Jan. 23, 1989 $5,000 cash purchase of a cashier's
check payable to a contractor in
partial payment for services that
 - 8 -

it performed at Lake Michigan
Heights

Feb. 15, 1989 $3,647 cash payment on the first
loan

Feb. 20, 1989 $4,545.30 cash purchase of a
cashier's check payable to a
contractor in full payment for
unidentified goods or services

June 29, 1989 $3,647 cash payment on the first
loan

July 21, 1989 $3,647 cash payment on the first
loan; $1,200.56 cash payment on a
third loan

Sept. 11, 1989 $9,000 cash purchase of a cashier's
check payable to a contractor as
first of four payments on $32,940
of services that it performed at
Lake Michigan Heights

Sept. 18, 1989 $1,200 cash payment on the third
loan; $9,000 cash purchase of a
cashier's check payable to a
contractor as second of four
payments on $32,940 of services
that it performed at Lake Michigan
Heights

Oct. 3, 1989 $9,000 cash purchase of a cashier's
check payable to a contractor as
third of four payments on $32,940
of services that it performed at
Lake Michigan Heights

Oct. 20, 1989 $3,647.82 cash payment on the first
loan; $5,940 cash purchase of a
cashier's check payable to a
contractor as final payment on
$32,940 of services that it
performed at Lake Michigan Heights

Nov. 9, 1989 $3,647.82 cash payment on the first
loan
 - 9 -

The STRs stated specifically that a financial institution

reporting a suspicious transaction must “Give brief summary of

the suspected violation, explaining what is unusual or irregular

about the transaction.” The STRs issued by the Bank as to

petitioners did not explain why the Bank considered the

transactions either unusual or irregular. The Bank’s practice

was that it would prepare: (1) The currency transaction

reporting form required by 31 U.S.C. sec. 5313 and 31 C.F.R. sec.

103.22 (2000), as to any nonexempt customer who in a single day

transacted business at the Bank involving cash totaling more than

$10,000 and (2) an STR as to any other nonexempt customer who the

Bank perceived was engaging in a “suspicious activity”. The Bank

generally considered exempt customers to be those retail

businesses that dealt with cash in the normal course of business.

The Bank did not consider either petitioners or Nanny’s to be an

exempt customer.

Respondent notified petitioners on April 3, 1990, that he

would be auditing Nanny's 1988 taxable year.4 Two months later,

respondent began auditing petitioners' 1987 through 1989 years.

Immediately before respondent notified petitioners that their

personal returns would be audited, Mr. Barnard reviewed his

records for Bridge Street and Lake Michigan Heights and

4
Respondent’s audit of that year concluded that Nanny’s
income and expenses were reported correctly on its Federal income
tax return.
 - 10 -

discovered that he had underreported his income from those

activities; petitioners had originally estimated the income from

these activities for Federal income tax purposes by way of rough

calculations. When respondent notified petitioners that he would

be auditing their personal returns, Mr. Barnard notified

respondent that petitioners had just amended (but not yet filed)

their 1987, 1988, and 1989 personal income tax returns to report

additional rental income. Mr. Barnard gave those amended returns

to Revenue Agent Bruce Smith (Revenue Agent Smith) pursuant to

his request. The 1987 amended return reported additional income

of $16,030 and $1,860 from Bridge Street and Lake Michigan

Heights, respectively. The 1988 amended return reported

additional income from those respective rentals of $20,963 and

$1,850. The 1989 amended return reported additional income of

$24,840 from Bridge Street and a reduction of income of $3,959

from Lake Michigan Heights. Because respondent never processed

any of these amended returns, the deficiencies shown in the

notice of deficiency include the underpayments reflected on those

returns.

On February 12, 1991, Revenue Agent Smith referred

petitioners' 1987, 1988, and 1989 returns to respondent’s

Criminal Investigation Division. The assigned agent, Special

Agent Robert Keller, concluded that he could ascertain

petitioners’ taxable income only through an indirect method of
 - 11 -

income calculation. Mr. Keller’s conclusion was based on his

determination that: (1) Petitioners maintained inadequate

records as to their income and expenses, (2) petitioners appeared

to be living a lifestyle that did not comport with their reported

income, and (3) respondent had received the STRs as to

petitioners.

For purposes of the notice of deficiency, respondent

determined petitioners’ income using the net worth method (the

same method used by Mr. Keller). Respondent’s notice of

deficiency lists that petitioners’ net worth, increase in net

worth, total net worth, and personal living expenses were as

follows for the related years:
 - 12 -

12/31/86 12/31/87 12/31/88 12/31/89

Bank accounts $19,422 $3,369 $5,256 $1,707
Investments 113,330 111,401 109,249 115,814
Boats and automobiles 115,345 95,149 250,089 250,089
Real estate 39,700 45,450 45,450 45,450
Rental properties 884,009 933,581 998,066 1,206,032
Total assets 1,171,806 1,188,950 1,408,110 1,619,092

Total liabilities (877,013) (839,854)(1,000,991)(1,122,085)
Net worth 294,793 349,096 407,119 497,007

Prior year’s net worth (294,793) (349,096) (407,119)

Increase in net worth 54,303 58,023 89,888

Personal living expenses 24,319 45,392 20,396
Personal losses 10,196
88,818 103,415 110,284

Nontaxable items (3,380) (2,546) (462)

Corrected adjusted gross income 85,438 100,869 109,822

Adjusted gross income per return (38,335) (37,386) (51,229)

Understated adjusted gross income 47,103 63,483 58,593

The understated adjusted gross income amounts led to the subject

deficiencies. As to the understated amounts, the parties agree

that $17,890, $22,813, and $20,881 for 1987, 1988, and 1989,

respectively, are attributable to Lake Michigan Heights and

Bridge Street, and only those amounts are understatements

attributable to those properties. Respondent asserts that the

remaining understatements of $29,213, $40,670, and $37,712,

respectively, are attributable to Nanny’s. As we understand

respondent’s position as to the unreported income attributable to
 - 13 -

Nanny’s, all of those amounts are taxable to petitioners as

constructive dividends.

Nanny’s realized taxable income in 1986, 1987, and 1988 of

$2,436, $18,659, and $31,529, respectively, and recognized all of

these amounts on its Federal income tax returns. Its retained

earnings at the ends of those years were $2,070, $18,077, and

$32,306, respectively. Its retained earnings at the end of 1988

were net of a $12,500 dividend that it paid to petitioners during

that year. Nanny’s realized ordinary income of $48,006 in 1989,

all of which petitioners recognized for that year.

OPINION

We decide first whether petitioners are liable for the

deficiencies determined by respondent. Respondent used the net

worth method to determine petitioners’ income for the subject

years. When a taxpayer fails to keep adequate books and records,

section 446(b) authorizes the Commissioner to compute the

taxpayer's income by any method that clearly reflects income.

Meneguzzo v. Commissioner, 43 T.C. 824, 831 (1965). The net

worth method has been accepted by the Courts as satisfying this

legislative mandate. E.g., Holland v. United States, 348 U.S.

121 (1954). The Commissioner's determination of tax liability,

when calculated under the net worth method, is presumptively

correct and places upon the taxpayer the burden of proving it

wrong. Helvering v. Taylor, 293 U.S. 507 (1935); Kearns v.
 - 14 -

Commissioner, 979 F.2d 1176, 1178 (6th Cir. 1992), affg. T.C.

Memo. 1991-320; Traficant v. Commissioner, 884 F.2d 258, 263 (6th

Cir. 1989), affg. 89 T.C. 501 (1987); Calderone v. United States,

799 F.2d 254, 258 (6th Cir. 1986). A taxpayer must generally

prove by a preponderance of the evidence that respondent’s

determination is erroneous. Helvering v. Taylor, supra at 515;

Traficant v. Commissioner, supra at 263; Calderone v. United

States, supra at 258.

Income is computed under the net worth method by determining

a taxpayer's net worth at the beginning and end of a taxable

year. The difference between those two amounts is the increase

in the taxpayer’s net worth. This difference is increased by

adding nondeductible expenditures, e.g., living expenses, and by

subtracting gifts, inheritances, loans, and other nontaxable

receipts. Holland v. United States, supra at 125; United States

v. Giacalone, 574 F.2d 328, 330-331 (6th Cir. 1978). An increase

in a taxpayer's net worth, plus his or her nondeductible

expenditures, less nontaxable receipts, may be considered taxable

income. Holland v. United States, supra.

Petitioners argue primarily that respondent's use of the net

worth method was inappropriate because, they assert, they

maintained sufficient records as to their income. We disagree.

First, as a point of fact, petitioners did not maintain

sufficient records from which respondent could accurately compute
 - 15 -

their personal income tax liability. Second, respondent applied

the net worth calculation to each year only after respondent

audited Nanny’s 1988 taxable year and determined that some of

Nanny’s cash receipts had been commingled with petitioners’

personal funds and that Nanny’s records did not allow for a

proper accounting of the commingled funds. The bare summaries

which petitioners maintained as to Nanny’s income did not allow

respondent to determine with any precision or certainty the

amount of the commingled funds which were attributable to Nanny’s

but which Nanny’s no longer retained (i.e., were spent by

petitioners on personal items). Whereas Mr. Mason performed a

calculation under which he was assured as to the amount of any

loan between petitioners and Nanny’s on account of the commingled

funds, we do not have the same level of assurance in that

calculation to hold respondent to it. Third, respondent

performed the net worth calculations only after analyzing

petitioners’ lifestyle and determining that their lifestyle did

not appear to comport with their reported income. In this

regard, respondent had received the STRs which the Bank had

issued as to petitioners reporting that they had entered into

various “suspicious” cash transactions. Under the facts herein,

we conclude that respondent was entitled to use the net worth

method to compute petitioners’ income for each subject year.
 - 16 -

Petitioners argue alternatively that respondent’s net worth

analysis was unreliable. They assert that respondent failed to

determine accurately their net worth on December 31, 1986,

because, they claim, respondent incorrectly determined that they

had no cash on hand on that date. They also assert that

respondent’s net worth analysis failed to reflect properly

certain incidental items.

We disagree with petitioners’ claim that respondent’s net

worth analysis is unreliable. We have set forth that analysis in

our findings of fact. On the basis of our review of it in light

of the record, we are unpersuaded that respondent’s calculation

as to petitioners’ cash on hand on December 31, 1986, is

inaccurate. The record contains no reliable evidence from which

we can conclude that petitioners, in their personal capacity, had

any cash on that date.5 Petitioners’ position as to their cash

on hand rests almost entirely on their trial testimony. We find

that testimony unpersuasive in that it is uncorroborated,

inconsistent, and self-serving. See Roberts v. Commissioner,

T.C. Memo. 1987-182. Nor can we conclude that respondent did not

properly take into account various other incidental items for

5
Petitioners focus on a $63,000 loan that petitioners
received on Aug. 22, 1986, and assert that $21,000 of those
proceeds was on hand on Dec. 31, 1986. The record does not
support this assertion.
 - 17 -

which petitioners claim error in connection with the net worth

analysis.

Respondent determined that all of the underpayments

attributable to Nanny’s were includable in petitioners’ gross

income as constructive dividends. We disagree. Absent a

provision to the contrary, funds which a shareholder diverts from

a corporation are generally includable in the shareholder’s gross

income under section 61(a) to the extent that the shareholder has

dominion and control over them. See also Commissioner v.

Glenshaw Glass Co., 348 U.S. 426, 431 (1955). One example of a

contrary provision is section 301, where Congress has provided

that funds (or any other property) distributed by a corporation

to a shareholder over which the shareholder has dominion and

control are to be taxed under the provisions of section 301(c).

Under section 301(c), a constructive distribution is taxable to

the shareholder as a dividend only to the extent of the

corporation’s earnings and profits. Any excess is a nontaxable

return of capital to the extent of the shareholder’s basis in the

corporation, and any remaining amount is taxable to the

shareholder as a long-term capital gain. Sec. 301(c)(2) and (3);

Truesdell v. Commissioner, 89 T.C. 1280, 1295-1298 (1987). See

also FDIC v. First Heights Bank, FSB, 229 F.3d 528, 540 (6th Cir.

2000), wherein the Court of Appeals for the Sixth Circuit, the

court to which this case is appealable, stated:
 - 18 -

The amount of the constructive dividend given by *
* * [a corporation] must be controlled by the
well-known rule that dividends cannot exceed retained
earnings and profits. In Hagaman, 958 F.2d at 694, we
stated that "[b]ecause dividends can only be
distributed to the extent of a corporation's earnings
and profits under IRC § 316, a court can only find a
constructive dividend to be taxable as ordinary income
to the extent of the corporation's earnings and
profits." Another opinion recognizes that
"[o]therwise, a distribution to the stockholder is
merely a recovery from his basis in his shares to the
extent that he has such a basis; to the extent that the
payments exceed the basis, the payments amount to a
[taxable capital] gain." Estate of DeNiro v.
Commissioner, 746 F.2d 327, 332 (6th Cir. 1984). * * *

See generally Action on Decision on Truesdell v. Commissioner,

supra, CC-1988-025 (Sept. 12, 1988), wherein the Commissioner

stated:

Funds diverted to the shareholder of a wholly owned
corporation should be regarded as constructive
distributions, unless the funds were additional salary
or otherwise were received in a nonshareholder
capacity. The funds should be included in the income
of the corporation and taxed to the shareholder in
accordance with I.R.C. section 301(c). When such funds
are received in a shareholder capacity, we will no
longer argue they are ordinary income regardless of
earnings and profits.

Here, we find that Nanny’s was incorporated in 1986 and that

it realized taxable income in 1986, 1987, 1988, and 1989 of

$2,436, $18,659, $31,529, and $48,006, respectively. We also

find that its retained earnings at the end of each of the first 3

respective years (before consideration of this report) were

$2,070, $18,077, and $32,306. Although a corporation’s retained

earnings are not always the same as its earnings and profits, we
 - 19 -

are comfortable in treating the two as the same for purposes of

the instant case. See Jones v. Commissioner, T.C. Memo. 1997-

400, affd. without published opinion 177 F.3d 983 (11th Cir.

1999).

Respondent asserts that petitioners’ understatements for the

subject years are attributable to Nanny’s to the extent of

$29,213, $40,670, and $37,712, respectively. We agree. We

disagree with respondent, however, that all of these amounts are

constructive dividends which are includable in petitioners’ gross

income as ordinary income. As to 1987, we conclude and hold that

$18,659 (i.e., Nanny’s 1987 income) of the $29,213 is includable

in petitioners’ gross income as a dividend, that $10,000 is

excludable from their gross income as a return of capital, and

that $554 is includable in their gross income as a long-term

capital gain.6 Sec. 301(c). As to 1988, we conclude and hold

that $31,529 (i.e., Nanny’s 1988 income) of the $40,670 is

includable in their gross income as a dividend and that the

remainder of $9,141 is includable in their gross income as a

long-term capital gain. Id. As to 1989, we conclude and hold

6
After considering our opinion herein, we find that at the
end of Nanny’s 1987 taxable year: (1) Nanny’s had a $582 deficit
in earnings and profit (the $18,077 less the constructive
dividend of $18,659) and (2) petitioners had a zero basis in
their Nanny’s stock (their original $10,000 basis less the
$10,000 return of capital).
 - 20 -

that the entire $37,712 is includable in their gross income as a

capital gain. Sec. 1368(b).

Turning to respondent’s other determination, namely, that

petitioners are liable for fraud, respondent must prove this

determination by clear and convincing evidence. Sec. 7454(a);

Rule 142(b); Rowlee v. Commissioner, 80 T.C. 1111, 1113 (1983).

Fraud requires a showing that the taxpayer intended to evade a

tax known or believed to be owing by conduct intended to conceal,

mislead, or otherwise prevent the collection of tax. Stoltzfus

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

must prove that: (1) Petitioners underpaid their taxes for the

relevant years, and (2) some part of each underpayment was due to

fraud. Because respondent bears the burden of proving fraud, we

may not and shall not bootstrap any part of our fraud

determination upon petitioners’ failure to prove respondent's

deficiency determination erroneous. Parks v. Commissioner,

94 T.C. 654, 660-661 (1990).

On the basis of on our review of the record, we conclude

that respondent has proven the first prong of the two-part test.

Petitioners amended their personal income tax returns for each of

the subject years to report additional income. Petitioners’

amended returns are admissions of Federal income tax

underpayments. Badaracco v. Commissioner, 464 U.S. 386, 399
 - 21 -

(1984). Thus, respondent has proven that petitioners underpaid

their Federal income taxes for each of the subject years.

As to the second prong of the test; i.e., the presence of

fraud, the existence of fraud is a question of fact. Gajewski v.

Commissioner, 67 T.C. 181, 199 (1976), affd. 578 F.2d 1383 (8th

Cir. 1978). Fraud is never presumed or imputed; it must be

established by independent evidence that establishes a fraudulent

intent on the taxpayer's part. Otsuki v. Commissioner, 53 T.C.

96 (1969). Because direct proof of a taxpayer's intent is rarely

available, fraud may be proven by circumstantial evidence and

reasonable inferences may be drawn from the relevant facts.

Spies v. United States, 317 U.S. 492 (1943); Stephenson v.

Commissioner, 79 T.C. 995 (1982), affd. 748 F.2d 331 (6th Cir.

1984). Where fraud is determined for multiple years, as is the

case here, respondent must establish the requisite fraudulent

intent for each of those years in order to prevail as to all of

those years. The Court may sustain respondent’s determination of

fraud only as to those years for which the fraudulent intent is

established clearly and convincingly.

We often rely on certain indicia of fraud in deciding the

existence of fraud. The presence of several indicia is

persuasive circumstantial evidence of fraud. Beaver v.

Commissioner, 55 T.C. 85, 93 (1970). The "badges of fraud"

include: (1) Filing of false documents, (2) understatement of
 - 22 -

income, (2) maintenance of inadequate records, (3) implausible or

inconsistent explanations of behavior, (4) concealment of assets,

(5) failure to cooperate with tax authorities, (6) engaging in an

illegal activity, (7) attempting to conceal the illegal activity,

and (8) dealing in cash. Bradford v. Commissioner, 796 F.2d 303,

307 (9th Cir. 1986), affg. T.C. Memo. 1984-601; Petzoldt v.

Commissioner, 92 T.C. 661, 700 (1989).

Respondent’s determination rests primarily on the fact that

the Bank issued to him the STRs as to petitioners, that

petitioners used cashier’s checks to pay for personal expenses,

and that petitioners structured their affairs to avoid the

reporting requirements as to cash transactions over $10,000. See

31 U.S.C. sec. 5313; 31 C.F.R. sec. 103.22 (2000). Respondent

also finds a fraudulent intent on the part of petitioners in the

fact that they underreported their income for each subject year,

that Nanny’s kept inadequate records, and that Nanny’s did not

deposit all of its cash receipts into the business account.

On the basis of our review of the record, we conclude that

respondent has not proven this prong of the two-part test for any

of the subject years. First, we give little weight to the mere

fact that petitioners’ income was understated for each year. As

we view the record, bearing in mind the fact that respondent must

prove fraud by clear and convincing evidence, we conclude that

petitioners’ understatements were more properly attributable to
 - 23 -

negligence (i.e., an unreasonable failure to comply with the

provisions of the Code or a careless, reckless, or intentional

disregard of rules or regulations) rather than to fraud (i.e., an

intent to evade a tax known or believed to be owing).7 To be

sure, petitioners deposited into their bank accounts all of the

unreported income attributable to their rental properties and

never attempted to hide their receipt of that income. Moreover,

as even respondent acknowledges, petitioners’ failure to report

all of their rental income on their original returns was due to

the fact that they estimated that income rather than attempted

earnestly to ascertain it by reference to the bank statements.

As to the fact that petitioners commingled their personal

funds with the funds of Nanny’s, we do not view this fact in

light of the record as a whole as establishing the requisite

fraudulent intent. Petitioners’ commingling of the funds was

simply a continuance of that practice from the immediate prior 4

years in which they operated Nanny’s as a sole-proprietorship,

rather than as a blatant attempt to avoid Federal income taxes.

Moreover, at the end of the relevant years, Mr. Mason, their

longtime accountant who was knowledgeable as to both Nanny’s

7
We stop short of opining on whether petitioners’
underpayment is actually attributable to negligence for purposes
of the additions to tax under sec. 6653(a). Respondent has
neither determined nor pleaded as an alternative to the fraud
determination that petitioners are liable for those additions for
any of the subject years.
 - 24 -

business and petitioners’ commingling of the funds, calculated

for Federal income tax purposes the amount of any loan that he

believed existed between petitioners and Nanny’s by virtue of

their use of its funds and vice versa. We are unable to conclude

on the basis of the record at hand that petitioners knew when

they filed their tax returns that Mr. Mason’s calculation may

have reflected inaccurately their use of Nanny’s funds. Nor do

we believe that the mere fact that petitioners commingled their

personal funds with the funds of Nanny’s, and knew that they did

so, means ipso facto that petitioners possessed the requisite

fraudulent intent when they filed their income tax returns.

Our conclusion is unchanged by the fact that the Bank issued

the STRs as to petitioners. As we view the transactions

underlying the STRs, we are unable to conclude that those

transactions, which occurred in only the last 2 years in issue,

lead to a finding that petitioners possessed the requisite

fraudulent intent in any of the years. Ten of the reported

transactions involved payments on loans which presumably included

the Social Security number of one or both petitioners. The

remaining transactions concerned petitioners’ purchase of

cashier’s checks, no two of which were on the same day and each

of which was somewhat spread out from another. Although all of

the cashier’s checks were in amounts less than $10,000, none of

those checks, but for three of the $9,000 checks payable to Mr.
 - 25 -

Bernard and the four checks payable to the contractor for its

$32,940 of services, covered an expense greater than $10,000.8

Under the facts herein, petitioners’ use of the cashier’s checks

does not convince us that they used those checks with the

requisite intent to evade Federal income tax. To be sure, an

individual’s use of cashier’s checks to pay personal expenses

does not necessarily mean that the individual did so to evade the

payment of Federal income tax. Such is especially true here

where petitioners regularly used cashier’s checks to pay personal

expenses during years before the subject years.

Respondent also finds a fraudulent intent on the part of

petitioners in the fact that Nanny’s kept imperfect records and

that Nanny’s did not deposit all of its cash receipts into the

business account. We do not do likewise. Nanny’s is an entity

separate from petitioners, and we do not consider it appropriate

under the facts herein to impute Nanny’s actions to petitioners.

See, e.g., Estate of Feinsmith v. Commissioner, T.C. Memo. 2001-

194. In fact, respondent’s only exception is to the fact that

Nanny’s failed to deposit all of its gross receipts into its

business account, acknowledging explicitly that petitioners did

deposit in their bank accounts all of the income that they

8
We also bear in mind that petitioners, on Sept. 18, 1989,
knowingly subjected themselves to the Bank’s practice of
reporting cash transactions totaling more than $10,000 when they
purchased one of the checks payable to the contractor and made
their cash payment on the third loan.
 - 26 -

received from their rental properties. Moreover, as to Nanny’s’

1988 taxable year, respondent determined that Nanny’s accurately

reported all of its income for that year. Such a determination

obviously undercuts respondent’s position in this case that

petitioners: (1) Skimmed $40,670 of Nanny’s 1988 receipts for

their personal use without reporting those receipts for Federal

income tax purposes and (2) tried to conceal Nanny’s earning of

those receipts by dealing in cash and destroying the cash

register tapes. Respondent tries to downplay the fact that the

audit of Nanny’s 1988 taxable year concluded that Nanny’s income

was reported correctly on its Federal income tax return. As we

understand respondent’s position as to this fact, Revenue Agent

Smith reached this conclusion only because Nanny’s did not supply

him with any document that would disprove the reported amount.

We are unpersuaded that this is so. In addition to the fact that

Revenue Agent Smith testified to the contrary, we find it

unlikely given the facts herein that respondent would have

conceded that Nanny’s income was reported correctly simply

because Nanny’s kept in its records no documentation that showed

otherwise.

Nor do we reach a finding of fraud on the basis of our

review of the remaining badges of fraud. Petitioners did not

attempt to conceal any assets. They did not engage in an illegal

activity. They did not attempt to conceal an illegal activity.
 - 27 -

They did not deal primarily in cash in their personal capacity;

e.g., all of the rent that they received was paid by check. They

cooperated with respondent as to their audit; e.g., they promptly

gave Revenue Agent Smith their amended returns reporting

additional income for those years and expeditiously transferred

to respondent all of the records which they maintained as to

themselves individually. Although we agree with respondent that

petitioners were less than upfront with the State of Michigan in

1988 as to the purchase price of the Tollycraft, and in this

regard filed a false document with the State, this fact does not

convince us clearly that petitioners possessed the requisite

fraudulent intent for that year as to their Federal income tax

liability.9

All of the parties’ arguments have been considered, and we

have rejected those arguments not discussed herein as meritless.

Accordingly,

Decision will be entered

under Rule 155.

9
Nor do we believe that some of petitioners’ explanations
as to their behavior, explanations which we find implausible or
inconsistent, dictate a finding of fraud in any of the years.