Bisceglia v. Comm'r

T.C. Memo. 2002-22

UNITED STATES TAX COURT

MONTY BISCEGLIA AND PATRICIA BISCEGLIA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 11328-99. Filed January 22, 2002.

Charles M. Torres, for petitioners.

Rebecca Dance Harris, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

THORNTON, Judge: Respondent determined the following

deficiencies and penalties with respect to petitioners’ Federal

income taxes:1

1
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.
 - 2 -

Penalties1
Year Deficiency sec. 6663(a)

1993 $40,980 $29,677
1994 452 –-
1995 46,543 34,824
1
The notice of deficiency states that in the
event it is held that all or part of the underpayment
in tax required to be shown on the 1993 and 1995
returns is not due to fraud, the sec. 6662(a) accuracy-
related penalty applies.

In his Answer to Amended Petition, respondent asserts that,

pursuant to section 6214(a), the proposed deficiency for 1993

should be increased to $42,836 and the penalty for that year

should be increased to $32,127. Respondent also concedes that

the deficiencies for 1995 should be reduced to $45,784 and that

the penalties for that year should be reduced to $34,338. On

brief, respondent concedes that petitioner Patricia Bisceglia

(Patricia), who filed joint Federal income tax returns with her

husband for the years in issue, is not liable for the section

6663(a) fraud penalty for taxable years 1993 and 1995 but

contends that she is liable for section 6662(a) accuracy-related

penalties for those years.

After concessions, the issues for decision are: (1) Whether

petitioners realized net income for taxable years 1993 and 1995

in excess of amounts reported on their returns; (2) whether

petitioner Monty Bisceglia (petitioner) is liable for the fraud

penalty under section 6663 for taxable years 1993 and 1995; and

(3) whether (in the alternative to the fraud penalty for
 - 3 -

petitioner) petitioners are liable for section 6662(a) accuracy-

related penalties for taxable years 1993 and 1995.2

FINDINGS OF FACT

The parties have stipulated some of the facts, which we

incorporate in our findings by this reference. When petitioners

filed their petition, they resided in Kingsport, Tennessee.

During 1992 and 1993, petitioner was a deputy sheriff in the

Sullivan County, Tennessee Sheriff’s Department. Petitioner was

also in business with his father, James E. Bisceglia (Jack), who

controlled the finances of their business activities. Petitioner

had no role in maintaining the business records. Petitioner did

not finish high school, although he subsequently acquired a

graduate equivalent diploma. Jack completed high school and

attended college for 3 weeks. Patricia did not work outside the

home.

2
The 1994 deficiency results from respondent’s
determination that petitioners’ taxable income for 1994 should be
increased by $3,000, owing to an improper carryover from 1993 of
long-term capital losses previously deducted. Petitioners
presented no evidence with regard to this issue and have not
addressed the issue on brief. We treat petitioners’ failure to
argue as, in effect, a concession of this issue. See Rule
151(e)(4) and (5); Sundstrand Corp. & Subs., Inc. v.
Commissioner, 96 T.C. 226, 344 (1991). As discussed below,
however, respondent’s net worth analysis also indicates that
petitioners had a 1994 net loss (without considering the $3,000
adjustment), which would appear to be available to offset the
$3,000 increase in taxable income. The parties have not
addressed this computational matter, which we expect to be taken
into consideration in the Rule 155 computations.
 - 4 -

In June 1992, petitioner and Patricia obtained a $135,000

mortgage loan from the Home Federal Bank (Home Federal), in

Kingsport, Tennessee. The mortgage was secured by their

residence at 1037 Parham Place, Kingsport, Tennessee. Late in

1992 or early in 1993, petitioner and Patricia borrowed

approximately $55,000 from NationsBank.

In December 1992, petitioner purchased the sole ownership

interest in Murphy’s Auto Sales (Murphy’s) for $10,000.

Petitioner and Jack operated Murphy’s throughout 1993, 1994, and

1995 at its location on 330 Lynn Garden, in Kingsport. Murphy’s

was a "buy here, pay here" operation. Its clientele consisted

principally of customers who could not obtain financing for their

automobile purchases elsewhere. Typically, a Murphy’s customer

would sign a sales agreement which indicated the sales price and

any unpaid balance, net of any trade-in and cash deposit. The

sales agreement also indicated an amount which exceeded the

unpaid balance, identified as a "time differential amount which

is amount owing if not paid by cash." This "time differential

amount" represented the total of the unpaid purchase price

balance and the finance charges that would be paid over the

scheduled term of the payments. Each month, Jack recorded the

car sales on manila envelopes. The sales income recorded

included the time differential amount. Once a customer paid off

his account, the records of that account were destroyed.
 - 5 -

During 1992 and 1993, petitioner and Jack operated a body

shop on property located at Netherland Inn Road in Kingsport,

Tennessee. The body shop purchased wrecked autos which it would

repair and resell through Murphy’s.

During the years in issue, petitioner and Jack also built

and sold condominiums.

On May 3, 1995, petitioner signed and gave a "Personal

Financial Statement" to NationsBank representing as "true and

complete" that he had a salary of $144,000 and a net worth of

$1,321,650.

Petitioners’ returns were prepared by an old school friend

of Jack’s who was an accountant in Florida. To prepare the tax

returns, the accountant used information from a one-page summary

that Jack supplied.

On their 1993, 1994, and 1995 returns, petitioners reported

adjusted gross income (loss) of ($11,652), $16,270, and $18,635,

respectively. Petitioners’ returns indicate that Murphy’s was on

a cash basis for 1993 and 1994 but on an accrual basis for 1995.

Respondent’s examination of petitioners’ 1993, 1994, and

1995 returns began in May 1996. Following an initial examination

of petitioners’ books, respondent’s agent reconstructed

petitioners’ income using the net worth method. To that end,

respondent’s agent identified petitioners’ assets, liabilities,

and expenses. Respondent’s agent then reconstructed petitioners’
 - 6 -

income by comparing changes in their net worth from 1 year to the

next for the 3 years in issue. Respondent’s net worth analysis

is as follows:3

Net Worth Expenditures Computation

Assets 12/31/92 12/31/93 12/31/94 12/31/95

Cash on hand $2,500 $2,500 $2,500 $2,500
Cash in banks 220 2,639 7,277 21,877
Notes receivable – 115,000 111,359 107,357
Inventory 20,477 18,514 12,000 18,221
Investments 821,000 654,000 889,621 762,000
Net accounts receivable 9,000 171,000 105,200 99,000
Total assets 853,197 963,653 1,127,957 1,010,955

Liabilities & Accum Depr

Notes & loans payable $409,938 $406,899 $653,369 $402,947
Accumulated depreciation –- – 1,873 3,746
Total liabilities & 409,938 406,899 655,242 406,693
Accum depr
Net worth 443,259 556,754 472,715 604,262
Less beginning net worth 443,259 556,754 472,715
Increase in net worth 113,495 (84,039) 131,547
Add: Personal expenses 29,148 58,972 26,628
Adjustments (capital loss (1,800) –- –
not deducted)
Corrected adjusted gross
income 140,843 (25,067) 158,175
Adjusted gross income (11,652) 16,270 18,635
reported
1
Unreported income 152,495 41,337 139,540
1
It appears that $41,337 should be a negative figure, rather than
positive unreported income as indicated on respondent’s net worth analysis.
Consistent with this conclusion, respondent has determined no 1994 deficiency
arising from any unreported income indicated by the net worth analysis.
Petitioners have not raised, and we do not reach, any issue as to whether any
part of any 1994 net loss should be deductible in 1993 or 1995 as a net
operating loss carryback or carryover. See sec. 172.

The following table, as set forth in respondent’s Answer to

Amended Petition, shows the particular assets and

3
This table, as set forth in respondent’s Answer to Amended
Petition, reflects certain adjustments to the net worth analysis
upon which the notice of deficiency was predicated, as discussed
in more detail, infra.
 - 7 -

liabilities that were used in computing petitioners’ asserted

unreported income.

Cash in Bank

Institution 12/31/92 12/31/93 12/31/94 12/31/95

Nations Bank 5140020-576-9 $220 $2,639 $7,277 $21,877
Total 220 2,639 7,277 21,877

Notes Receivable

Description 12/31/92 12/31/93 12/31/94 12/31/95

Blake Carter – $115,000 $111,359 $107,357
Total –- 115,000 111,359 107,357

Investments

Property 12/31/92 12/31/93 12/31/94 12/31/95

1008 Page Place $140,000 $140,000 – --
1148 Independence 58,000 –- –- --
2002 Netherland Inn Road 109,000 –- –- --
Porsche – –- $4,954 --
330 Lynn Garden 59,000 59,000 59,000 59,000
1011 Parham Place 265,000 265,000 265,000 265,000
1037 Parham Place 160,000 160,000 160,000 160,000
1
Lot 29 Rotherwood 20,000 20,000 20,000 410,000
2 Acres Rotherwood 10,000 10,000 10,000 10,000
Condo’s –- –- 310,667 248,000
2
Total 821,000 654,000 889,621 762,000
1
On the basis of the parties’ stipulations, it appears that this figure
should be $20,000, which is consistent with the $762,000 total indicated for
Dec. 31, 1995.
2
The sum should be $829,621. The discrepancy is not explained in the
record. Because respondent determined a decrease in petitioners’ net worth
for 1994, the apparent error does not operate to petitioners’ detriment.

OPINION

I. Unreported Income

A. The Net Worth Method

Respondent determined deficiencies in petitioners’ 1993 and

1995 income taxes by using the net worth method to reconstruct

their income. Petitioners bear the burden of overcoming the
 - 8 -

presumptive correctness of respondent’s determination. Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933); Conti v.

Commissioner, 39 F.3d 658, 663 (6th Cir. 1994), affg. and

remanding T.C. Memo. 1992-616; United States v. Walton, 909 F.2d

915, 918 (6th Cir. 1990).4 On the other hand, respondent has the

burden with respect to the $1,856 increase in the 1993 deficiency

as sought in his Answer to Amended Petition. Rule 142(a).

Because petitioners have not contested the items giving rise to

the asserted increase in deficiency, we conclude and hold that

respondent has met his burden of proof as to those items.5

4
In certain circumstances, if a taxpayer introduces
credible evidence with respect to any factual issue relevant to
ascertaining the taxpayer's liability for tax, sec. 7491 places
the burden of proof on the Commissioner. See sec. 7491(a)(1);
Rule 142(a)(2). Sec. 7491 is effective with respect to court
proceedings arising from examinations commenced after July 22,
1998. See Internal Revenue Service Restructuring and Reform Act
of 1998, Pub. L. 105-206, sec. 3001(c)(2), 112 Stat. 685, 726.
The parties have stipulated that respondent’s examination began
in May 1996. Accordingly, sec. 7491 is inapplicable.
5
The asserted increase in the 1993 deficiency arises from
two adjustments respondent made after issuing the notice of
deficiency. The first adjustment corrects the amount of cash in
banks utilized in petitioners’ 1993 opening net worth. The other
adjustment corrects the amount of the adjustment for capital
losses not deducted in that year (with correlative adjustments
being made for 1994 and 1995). Petitioners have stipulated the
corrected figures for cash in banks, and petitioners’ tax
returns, admitted as exhibits herein, show that the correction to
the capital loss amount is appropriate. Petitioners do not
contest these corrections.

Respondent’s Answer to Amended Petition also identifies two
other adjustments to the net worth computation that were made
(continued...)
 - 9 -

It is well settled that the Commissioner may use the net

worth method to reconstruct income, if only as a means of testing

the accuracy and trustworthiness of the taxpayer’s books and

records. See Holland v. United States, 348 U.S. 121, 131 (1954);

Conti v. Commissioner, supra; Foster v. Commissioner, 487 F.2d

902, 903 (6th Cir. 1973), affg. T.C. Memo. 1972-188; Gleis v.

Commissioner, 24 T.C. 941, 949 (1955), affd. 245 F.2d 237 (6th

Cir. 1957); Hurley v. Commissioner, 22 T.C. 1256, 1261 (1954),

affd. 233 F.2d 177 (6th Cir. 1956).

Petitioners contend that respondent was not entitled to use

the net worth method to reconstruct their income, because

respondent’s examining agent failed to review their business

records for 1994 and 1995. Citing Holland v. United States,

supra at 132, petitioners argue that the failure of respondent’s

agent to review and examine these records makes the net worth

analysis “arbitrary and without merit.” We disagree.

Respondent’s examining agent testified that she initially

reviewed petitioners’ 1993 records and found that the information

therein was fairly consistent with net income reported on

5
(...continued)
after the issuance of the notice of deficiency: (1) A reduction
of notes receivable for the period ending Dec. 31, 1995; and (2)
a reduction of petitioners’ personal living expenses for each
year in issue. The effect of these two adjustments is to
decrease petitioners’ indicated taxable incomes and thus the
deficiencies determined by respondent.
 - 10 -

petitioners’ tax returns. Respondent’s agent determined,

however, based on a review that ultimately entailed use of a net

worth analysis, that petitioners had understated their 1993 net

income by overstating cost of goods sold. Having determined that

the 1993 records were untrustworthy, respondent’s agent concluded

that there was no point in going through petitioners’ 1994 and

1995 records, because they were the same as the 1993 records.

Rather, the examining agent reconstructed petitioners’ 1994 and

1995 income using the net worth analysis.

Petitioners placed their financial records into evidence in

an incomprehensible state. The records consist, in the main, of

some 28 manila envelopes bearing handwritten notations on the

outside and stuffed with invoices, computer printouts, and such.

The records include a large and unsorted wad of receipts

(introduced as a single exhibit) and an undifferentiated stack of

more than 80 file folders (also introduced as a single exhibit)

putatively documenting bad debts and repossessions of used cars.

There appears to be no general ledger. After attempting,

unsuccessfully, to relate petitioners’ exhibits to the amounts

shown on their tax returns for the years in issue, we appreciate

the task faced by respondent’s agent in examining these records.

Even if we were to assume–-consistent with the conclusion of

respondent’s agent with respect to the 1993 taxable year--that

petitioners’ books and records are more or less consistent with
 - 11 -

the figures reported on their tax returns (a matter that we have

been unable independently to verify), such a circumstance would

not establish the accuracy of the business records or foreclose

respondent from using the net worth method to test their

trustworthiness. See Holland v. United States, supra at 132

(even if no false entries are detected, the taxpayer’s books may

be “more consistent than truthful”); Foster v. Commissioner,

supra at 903.

Petitioners rely on Talley v. Commissioner, 20 T.C. 715

(1953), for the proposition that, before utilizing the net worth

method, respondent must demonstrate that a taxpayer’s books and

records do not accurately reflect the taxpayer’s income.

Petitioners’ reliance on Talley is misplaced. Talley predates

Holland v. United States, supra, which rejected such a rule. See

Shelhorse v. Commissioner, T.C. Memo. 1980-98.

B. Petitioners’ Alleged “Leads” as to Nontaxable Sources

Petitioners contend that under Holland and its progeny,

respondent was required, in using the net worth method, to

exhaust all leads negating possible sources of nontaxable income.

Petitioners contend that they furnished respondent certain leads

that respondent failed to pursue, thus rendering his

determinations arbitrary.

In some cases, such as fraud and criminal cases, the

Commissioner may be expected to investigate leads of nontaxable
 - 12 -

sources of income that are reasonably susceptible of being

checked. We have held, however, that the Commissioner is not

required to investigate leads where the taxpayer bears the burden

of proof. See Tunnell v. Commissioner, 74 T.C. 44, 57-58 (1980),

affd. 663 F.2d 527 (5th Cir. 1981). As previously discussed,

petitioners bear the burden of proving that the amounts of

deficiencies determined by respondent were incorrect.

Even if we were to assume that the lead-check rule were

applicable here in determining the validity of respondent’s use

of the net worth method for purposes of determining petitioners’

deficiencies, the existence of likely sources of taxable income--

namely, petitioners’ automotive and construction-related

businesses–-would temper the need for respondent to pursue leads

as to other potential nontaxable sources of income. See King v.

Commissioner, T.C. Memo. 1978-351. In any event, as described

below, the quality of the “leads” that petitioners allegedly

offered respondent is insufficient to convince us that

respondent’s use of the net worth method was arbitrary or

invalid, or that respondent erroneously determined that

petitioners’ unreported income was from taxable sources.

1. The 1994 and 1995 Records “Lead”

On brief, petitioners contend that respondent improperly

failed to investigate the “lead” represented by their 1994 and

1995 business records. This contention is in essence a
 - 13 -

restatement of petitioners’ argument, previously considered and

rejected, that respondent was required to examine their 1994 and

1995 records before using the net worth method to reconstruct

their income. Petitioners do not identify exactly what items in

their 1994 and 1995 books and records might constitute a lead as

to potential nontaxable sources of income, and we have discovered

none.

2. The Private Expenditures “Lead”

On brief, petitioners contend that “the Government also

failed to make any investigation as to whether Petitioners 1994

and 1995 private expenditures exceeded available declared

resources.” It is not apparent how this contention is relevant

to establishing any potential nontaxable sources of income or

otherwise refuting the results of respondent’s net worth

analysis. Petitioners do not argue, for instance, that the

amounts of personal living expenses reflected in the net worth

analysis are incorrect. Rather, petitioners’ contention seems

directed more toward questioning respondent’s reasons for

undertaking a net worth analysis. Even if we were to assume, for

sake of argument, that petitioners’ “private expenditures” (by

which we understand petitioners to mean personal living expenses)

did not exceed their “available declared resources” (by which we

understand petitioners to mean the amounts of income they

reported on their tax returns), this circumstance would not tend
 - 14 -

to show error in respondent’s determination that unexplained

increases in petitioners’ net worth are attributable to

unreported taxable income. That is to say, respondent’s net

worth analysis is wholly compatible with (and partly predicated

on) an assumption that petitioners might have realized more

income than they consumed through “private expenditures.”

3. The Cash Hoard “Lead”

Finally, petitioners contend that respondent failed to make

a reasonable investigation of the “lead” that their 1993

beginning net worth, as reflected in respondent’s net worth

analysis, incorrectly omitted $125,000 in cash, which petitioners

allege they had in Jack’s safe as of January 1, 1993. There is

no evidence as to when petitioners may have provided respondent

this “lead”, which is predicated almost entirely on petitioner’s

and Jack’s testimony at trial. Hence, there is no basis to

conclude that respondent would have had reason to investigate

such a “lead” in the course of his examination.

In any event, petitioners have failed to show that the cash

hoard existed after 1992, or that, if it did exist, it was a

source of nontaxable income during the years in issue. On direct

examination, Jack testified that after petitioners obtained the

$135,000 Home Federal mortgage loan in June 1992, Monty signed

the check over to him, and that he (Jack) then cashed the check,

although he could not recall where he cashed it. Inconsistently,
 - 15 -

Jack testified on cross-examination that petitioner “cashed the

check and gave it to me.” Jack testified that he could not

recall what type of bills he received, although he “usually” got

$100 bills. He testified that he put the $135,000 cash in a safe

in his house and that to the best of his knowledge, $10,000 of

this cash was “used up” when petitioner purchased Murphy’s at the

end of 1992. Jack testified that he had been keeping cash in his

safe for 40 years and that he always paid cash for everything.

Petitioner’s testimony about these events was vague and

inconsistent. He initially testified that he did not recall the

amount of the check but in response to leading questions

testified that it was in the “range” of $130,000 to $135,000. He

initially testified that he was uncertain whether he had cashed

the check or not, but then testified that he knew that he had

signed the check and given it to Jack. On cross-examination, he

testified that “I suppose” that Jack cashed the check.

Petitioner testified that he did not remember whether he was

present when Jack cashed the check or whether he went with Jack

to put the money in Jack’s safe. He testified that as far as he

knew, the money was still in Jack’s safe as of the time of the

trial.6

6
On cross-examination, petitioner testified as follows:

Q. * * * you’re testifying that in December of ‘93-–
(continued...)
 - 16 -

Consistent with this testimony, petitioners’ arguments on

brief seem premised on an assumption that a $125,000 cash hoard

remained in Jack’s safe throughout the years in issue. If the

premise is valid, then the existence of a cash hoard is

immaterial: Respondent’s omission of such a cash hoard from

petitioners’ opening and closing net worth for each year in issue

would have no effect on the amount of unreported income

determined for each year and hence would not disturb the

presumption of the validity of respondent’s determination. See

Harp v. Commissioner, 263 F.2d 139, 142 (6th Cir. 1959), revg. on

other grounds T.C. Memo. 1957-105.

Petitioners have stipulated, however, that as of the end of

6
(...continued)
or December of ‘92-–excuse me-–he [Jack] had
$125,000 in cash that belonged to you in his safe.

A. Correct.

Q. Would he have had $125,000 in December of ‘94
-–or, excuse me-–December of ‘93?

A. I don’t know.

Q. Could he have?

A. Probably.

Q. What about December of ‘94?

A. Probably he could have.

Q. December of ‘95?

A. He still could up to today. I don’t know.
 - 17 -

each year in issue, they had cash on hand of $2,500. Assuming

that the stipulation is correct, any cash hoard in excess of this

amount obviously must have been depleted before December 31,

1993, in which case the omission of a cash hoard from the 1993

opening net worth could affect the results of the net worth

analysis, as 1993 expenditures from such a cash hoard would

represent a nontaxable source. Petitioners do not contend,

however, and the evidence does not show, that they expended the

$125,000 (or any specific amount thereof) during 1993.

Petitioners argue that since respondent’s analysis reflects

petitioners’ liability on the Home Federal mortgage loan (as a

liability owed to Home Federal’s successor in interest, First

Tennessee Bank), the net worth analysis must be adjusted to also

include the $125,000 cash proceeds. The fallacy of this argument

is that there is no proof that petitioners retained any cash

proceeds from the mortgage loan after 1992. Even if we were to

assume, for sake of argument, that petitioners at some point in

1992 had $125,000 cash on hand from the mortgage loan, the

evidence does not foreclose the possibility, among others, that

petitioners spent the $125,000 in 1992 on their residential

property at 1037 Parham Place, which was collateral for the

mortgage loan, or on one of their other properties which are

included in the net worth analysis.7

7
The 1037 Parham Place property is included in respondent’s
net worth analysis with a $160,000 value in the opening and
(continued...)
 - 18 -

Petitioners increased their borrowings by $55,000 in late

1992 or early 1993, when they claim to have had a cash hoard in

Jack’s safe. We believe that this circumstance also undermines

their contention of a cash hoard; absent any explanation to the

contrary, we find it unlikely that petitioners would incur an

additional $55,000 in debt if they had $125,000 cash in Jack’s

safe. Furthermore, we doubt that petitioner, being liable for a

$135,000 mortgage note, would have turned the proceeds over to

his father and yet have so little recollection of the

circumstances and so little regard for the ultimate disposition

of the funds. We also find it unlikely that Jack would be unable

to remember where he found a bank willing to accommodate his

desire to be paid $135,000 in $100 bills on a third-party check.

C. Other Attacks on Respondent’s Net Worth Analysis

1. Accounts Receivable

Petitioners argue alternatively that even if (as we have

held) respondent permissibly used the net worth method, its

component parts are, in a number of respects, incorrect. On

reply brief, petitioners argue that “Respondent’s net worth

[analysis] should not have included accounts receivables for

Petitioner’s car business since Petitioners are on a cash basis

accounting method as shown on all three tax returns in question.”

7
(...continued)
closing net worth balances for each year in issue. Thus, even if
the value of the 1037 Parham Place property were understated in
the net worth analysis, there would be no effect on the amount of
unreported income determined for each year.
 - 19 -

Contrary to this assertion, however, the Schedule C, Profit or

Loss From Business, attached to petitioners’ 1995 income tax

return indicates that their used car business was on an accrual

basis of accounting. Moreover, petitioners’ accountant explained

that petitioners’ accounting method was not, in fact, a cash

method but rather “a kind of a hybrid”. From the accountant’s

testimony, it appears that for all years in issue, petitioners

effectively reported income on an accrual basis, maintaining

accounts receivable. Such receivables properly represent assets

in a net worth analysis of a taxpayer who uses an accrual method

of accounting. Cf. United States v. Vardine, 305 F.2d 60, 64 (2d

Cir. 1962).

Petitioners contend that the accounts receivable figures

used in respondent’s net worth analysis are incorrect.

Petitioners have failed, however, to offer credible evidence as

to what the correct amount of their accounts receivable should

be. In light of Jack’s testimony that he discarded any documents

regarding accounts receivable once they were paid off, the dearth

of evidence is unsurprising. Jack testified in conclusory

fashion that petitioners’ net accounts receivable for 1993, 1994,

and 1995 were $100,578, $77,999, and $47,880, respectively. Jack

testified, without further explication, that these most recent

figures “were taken directly from the sales contracts.”
 - 20 -

Jack’s conclusory testimony does not credibly establish the

amount of petitioners’ accounts receivables. His credibility in

this regard is undermined by petitioners’ admission that Jack

gave respondent’s agent different accounts receivable figures

during the examination and only came up with the new figures

shortly before trial. Petitioners seem to invite us to rummage

through their boxes of records, calculator in hand, and replicate

Jack’s calculations. This we decline to attempt.

Even if we were to assume, for sake of argument, that Jack

has correctly tallied gross accounts receivable figures reflected

in petitioners’ records, we still would be unconvinced that his

figures accurately reflect petitioners’ net accounts receivable.

Petitioners contend, based solely on Jack’s testimony, that the

receivables should have been discounted by 60 percent to reflect

bad debts and repossessions. Apparently, Jack’s figures reflect

such a 60-percent discount. Petitioners have not substantiated

the reasonableness or appropriateness of such a discount.8

Although the record is unclear on this point, it appears

that the net accounts receivable figures used in respondent’s net

worth analysis were derived from information that Jack conveyed

8
We do not quite comprehend petitioners’ argument that
these accounts receivable should be reduced both for bad debts
and for repossessions. We understand the theoretical reduction
of those accounts to represent bad debts, and as petitioners
acknowledge, respondent has in fact made a minor reduction in the
figures used to reflect some uncollectibility. We do not
understand, however, why accounts receivable should be reduced
for repossessions without making a corresponding increase to
inventory.
 - 21 -

to the examining agent. Although their clouded paternity does

not inspire confidence that they are correct to the penny, the

figures do not seem unreasonable. Petitioners propose as a

finding of fact that respondent gave them a 10-percent discount

on accounts receivable for 1993, 1994, and 1995. If we accept

petitioners’ proposed finding, and if (as it appears) Jack’s

figures reflect a 60-percent discount, then for each year in

issue respondent’s implied gross receivables figures were less

than Jack’s implied gross receivables figures.9 Moreover, our

examination of Murphy’s records indicates that many, if not most,

of its autos were sold for a modest downpayment (and often a

trade-in), with most of the sales price being financed over a

period of several months. It follows that, at the end of any

given year, accounts receivable should represent a substantial

part of petitioners’ gross sales. On the Schedules C attached to

their tax returns for the years in issue, petitioners reported

that Murphy’s had gross receipts of $448,870 for 1993, $371,278

for 1994, and $286,532 for 1995. The yearend accounts receivable

figures used by respondent were $171,000, $105,200, and $99,000

9
Specifically, if respondent’s net accounts receivable
figures reflect a 10-percent discount, the implied gross
receivables figures for yearend 1993, 1994, and 1995 are $190,000
($171,000/.9), $116,889 ($105,200/.9), and $110,000 ($99,000/.9),
respectively. Similarly, if Jack’s net receivables figures
reflect a 60-percent discount, the implied gross receivables
figures for these same periods are $251,445 ($100,578/.4),
$194,998 ($77,999/.4), and $119,700 ($47,880/.4), respectively.
 - 22 -

for the corresponding years. These numbers indicate that

accounts receivable were 38 percent of gross sales at the end of

1993, 28 percent of gross sales at the end of 1994, and 35

percent of gross sales at the end of 1995. In the absence of

more convincing evidence, we believe that respondent’s accounts

receivable figures are reasonable.

Petitioners contend that respondent never asked Jack about

1992 accounts receivable and that respondent’s inclusion of

$9,000 accounts receivable in their 1993 opening net worth is

therefore arbitrary and without basis, thereby rendering the net

worth analysis invalid. Respondent’s inclusion of accounts

receivable in petitioners’ 1993 opening net worth operates to

their detriment only insofar as respondent has understated the

amount. Petitioners do not argue, and the evidence does not

indicate, that petitioners had any amount of accounts receivable

at the end of 1992. Hence, petitioners have not established that

the $9,000 accounts receivable that respondent has included in

their 1993 opening net worth is understated. Indeed, given that

petitioner acquired Murphy’s in December 1992, it seems likely

that accounts receivable as of December 31, 1992, would be small

in amount.
 - 23 -

2. Accounts Payable

Petitioners contend that if their net worth is increased by

accounts receivable, it should also be reduced by accounts

payable. Petitioners contend that total liabilities as of year-

end 1995 should be increased by a number of accounts payable that

were outstanding on December 31, 1995. Petitioners offered

documentary evidence of construction costs incurred in 1995 but

not paid until 1996. On brief, respondent does not dispute that

his net worth analysis omits these amounts from accounts payable

but attacks the probative value of petitioners’ evidence. On the

basis of our detailed review of the evidence, we conclude and

hold that $30,786.54 of such accounts payable should be included

in petitioners’ net liabilities as of year-end 1995 for purposes

of the net worth analysis.

3. Value of Netherland Inn Road Property

In his net worth analysis, respondent included in

petitioners’ 1993 opening net worth $109,000 as the value of

petitioners’ property on Netherland Inn Road. Petitioners

contend that the value should be increased to $127,000, based on

Jack’s testimony that petitioner added an improvement to the

property “at a cost of approximately $18,000.” The only other

evidence on this point consists of the hearsay testimony of

petitioner’s out-of-State accountant. On the Schedule D, Capital

Gains and Losses, attached to their 1993 return, petitioners
 - 24 -

reported that they had acquired the Netherland Inn Road property

in March 1991, that they had a “Cost or other basis” in the

property of $109,000, and that they sold it in December 1993 for

$115,000. From the evidence in the record, it is unclear that

the $109,000 does not include the cost of the alleged improvement

on the property. Petitioners have not explained why, if the

property were worth $127,000 on January 1, 1993, as they allege,

it would have been sold in December 1993 for $115,000, as they

have reported. In sum, petitioners have failed to show that the

$109,000 value used by respondent should be increased.

4. Alleged Undeposited Check

Petitioners also argue that a check to petitioner for

$5,800, which was received in 1992 but not deposited until

January 1993, should have been included in petitioners’ 1993

opening net worth. In support of this contention, petitioners

rely upon an exhibit incorporating the uncashed check.

Petitioners failed, however, to offer this exhibit into evidence,

and we lack an evidentiary basis for making the finding

petitioners seek.

II. Fraud

Section 6663(a) imposes a 75-percent penalty on any part of

a tax underpayment due to fraud. The two elements of civil fraud

under section 6663 are the existence of an underpayment and

fraudulent intent. Conti v. Commissioner, 39 F.3d 658, 664-665
 - 25 -

(6th Cir. 1994), affg. T.C. Memo. 1992-616. Section 7454(a)

provides that, in any case involving the issue of fraud with

intent to evade tax, the burden of proof in respect of that issue

is on respondent. Respondent’s burden of proof with respect to

the issue of fraud is to be carried by clear and convincing

evidence. Rule 142(b). Fraud is not to be presumed or based

upon circumstantial evidence which creates merely a suspicion of

fraud. Wainwright v. Commissioner, T.C. Memo. 1993-302 (citing

Carter v. Campbell, 264 F.2d 930, 935 (5th Cir. 1959)).

To support a finding of tax fraud, respondent must show that

the taxpayer engaged in conduct with the intent to evade taxes

that he knew or believed to be owing. United States v. Walton,

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

often unavailable and unnecessary; the courts may infer

fraudulent intent from strong circumstantial evidence. Id.

In fraud cases, it may happen that, although the taxpayer

fails to overcome the presumption of correctness as to the

asserted deficiencies in tax, the Commissioner will also fail to

establish that the same deficiencies were the result of fraud.

"Both parties to a proceeding may fail through inadequate proof

on the several issues." Kashat v. Commissioner, 229 F.2d 282,

285 (6th Cir. 1956), affg. in part and revg. in part a Memorandum

Opinion of this Court dated March 29, 1954. "That this differing

burden of proof in the Tax Court can have an important
 - 26 -

dispositive effect has been pointed out by this court * * *. As

was made clear * * *, the taxpayer’s failure to overcome the

presumptive correctness of deficiencies in reported income even

over a period of consecutive years does not of itself create a

presumption of fraud." Hawkins v. Commissioner, 234 F.2d 359,

360 (6th Cir. 1956), affg. in part, revg. in part, and remanding

T.C. Memo. 1955-110.

Respondent asserts that the fraud penalty is properly

imposed on petitioner based upon circumstantial evidence in the

form of several generally accepted indices, or "badges", of

fraud. Respondent first urges that the asserted understatements

of income of $152,495 in 1993 and $139,540 in 1995 justify an

inference of fraud.10 Although systematic understatements of

income over an extended time can be persuasive evidence of fraud,

see, e.g., Solomon v. Commissioner, 732 F.2d 1459, 1461 (6th Cir.

1984), affg. T.C. Memo. 1982-603, such understatements may also

be consistent with negligence or a even a mistaken view of the

law. See Carr v. Commissioner, T.C. Memo. 1978-408.

Respondent urges that petitioner’s bookkeeping practices are

evidence of fraudulent intent. We strongly suspect that

petitioner’s hybrid-pooling method of tracking income falls short

of generally accepted accounting principles. Petitioner,

10
According to respondent’s analysis, petitioners actually
overstated their 1994 income-–a circumstance inconsistent with
fraud.
 - 27 -

however, did not finish high school, and Jack attended only 3

weeks of college. Neither has any training in business record

keeping. Respondent has failed to show clearly that petitioners’

unsatisfactory bookkeeping practices were the result of

fraudulent intent.

Respondent also criticizes petitioner’s practice of

submitting a one-page summary of receipts and expenditures to

Jack’s accountant, an old friend from Florida, as a basis for

preparing petitioners’ tax returns. The accountant testified

credibly, however, that after respondent’s examination commenced,

he reviewed certain of petitioners’ records and was able to tie

business expenses reported on petitioners’ returns to invoices

contained in the records. We also have taken into account

testimony of respondent’s agent that the 1993 used-car dealership

records she examined closely substantiated the income reported on

petitioners’ 1993 return and that the construction business

yielded little income. We further note that respondent’s agent

did not examine the records for 1994 and 1995.

Respondent contends that petitioner’s records do not

necessarily reflect off-the-books income that is reflected in the

net worth analysis. Respondent, however, has not demonstrated

any specific instances wherein any such income was omitted or

wherein the records were otherwise falsified. Respondent’s

examining agent testified that she believed the unreported income

indicated by the net worth analysis was attributable to
 - 28 -

petitioners’ overstatement of cost of goods sold. Respondent has

not demonstrated that any such overstatements were fraudulent,

rather than the result of negligence or a misunderstanding of the

law.

Respondent also accuses petitioner of concealing one of his

bank accounts from respondent’s agent, thus indicating a

fraudulent intent to conceal income. This bank account,

NationsBank Account No. 5500026-201-8, was excluded from the net

worth analysis attached to respondent’s Answer to Amended

Petition but was included on the net worth analysis attached to

respondent’s brief. There is no direct evidence that petitioner

attempted to conceal this account. Respondent’s agent conceded

at trial that petitioner signed a release permitting her to

examine his records at NationsBank. The agent also testified

that she did not review petitioner’s records for 1994 and 1995.

The evidence shows that Account No. 55000026-201-8 was not opened

until 1994. We conclude that the evidence does not support a

finding that petitioner deliberately failed to disclose this

account.

Nor has respondent convinced us that petitioner’s extensive

use of cash is evidence of fraud. We believe it likely that the

clientele of Murphy’s, most of whom were expected to make

payments on their own paydays, themselves dealt extensively in
 - 29 -

cash. We also find credible Jack’s explanation that many of his

contractors, who worked until after the banks had closed,

preferred that he pay them in cash.

Accordingly, while we have suspicions that petitioner’s

activities may have been fraudulent, we conclude that respondent

has failed to adduce evidence to prove fraud clearly and

convincingly. Because respondent has not proved fraud, we turn

to his alternative argument as to imposing accuracy-related

penalties.

III. Accuracy-Related Penalties

Respondent has proposed the section 6662(a) accuracy-related

penalty against petitioners for each of the years in issue.

Section 6662(a) authorizes respondent to impose a penalty in an

amount equal to 20 percent of the portion of the underpayments

that is attributable to the items set forth in section 6662(b).

Section 6662(b)(1) includes any underpayment attributable to

negligence or disregard of rules or regulations. Negligence is

defined as "any failure to make a reasonable attempt to comply

with the provisions of * * * [the Internal Revenue Code]". Sec.

6662(c); see also Neely v. Commissioner, 85 T.C. 934, 947 (1985)

(negligence is lack of due care or failure to do what a

reasonable and prudent person would do under the circumstances).

Negligence also includes any failure by the taxpayer to keep
 - 30 -

adequate books and records or to substantiate items properly.

See sec. 1.6662-3(b)(1), Income Tax Regs.

Petitioners bear the burden of proving that respondent's

determinations of these accuracy-related penalties are erroneous.

See Rule 142(a); ASAT, Inc. v. Commissioner, 108 T.C. 147, 175

(1997).11 Taxpayers are not liable for accuracy-related

penalties if they show that they had reasonable cause for the

underpayment and that they acted in good faith. See sec.

6664(c).

Petitioners failed to maintain adequate records to

substantiate the deductions claimed on their tax returns for the

years in issue. See sec. 6001; sec. 1.6001-1(a), Income Tax

Regs. Petitioners’ records were substandard and, when presented

to the Court, chaotic. Petitioners’ claims that they accurately

reported their income for the years in issue are not aided by

their submitting obviously indecipherable records into evidence.

Petitioners blame respondent’s agents for the jumbled nature of

the records, but they must also concede that they, or Jack, or

their representatives, had some hand in presenting the records as

they now exist. Having examined the records closely, we believe

11
Sec. 7491(c) places the burden of production on the
Commissioner with respect to the liability of any individual for
any penalty, addition to tax, or additional amount, in court
proceedings arising in connection with examinations commencing
after July 22, 1998. The petition in the instant case was filed
in 1996. Accordingly, sec. 7491(c) is inapplicable.
 - 31 -

that, with some assiduous efforts, petitioners could have re-

sorted the records at least into their original state.

We are unmoved by petitioner’s explanation that he trusted

his father and signed anything that Jack put in front of him.

Although petitioner lacks higher education, we believe that he

was aware of his responsibility to report his income accurately.

He did not do so.

Accordingly, we conclude that petitioners’ underpayments are

attributable to negligence or disregard of rules or regulations.

Thus, we hold that petitioners are liable for accuracy-related

penalties under section 6662(a) for 1993 and 1995, based on the

amount of their underpayments for those years, to be determined

in the Rule 155 computations.

To reflect the foregoing and the parties’ concessions,

Decision will be entered

under Rule 155.