YANG-WU v. COMMISSIONER

T.C. Memo. 2002-68

UNITED STATES TAX COURT

YU-YANG WU, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 19108-99. Filed March 22, 2002.

Yu-Yang Wu, pro se.

Dale A. Zusi, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

BEGHE, Judge: Respondent determined the following

deficiencies and fraud addition to tax and penalties with respect

to petitioner’s Federal income taxes:
 - 2 -

Addition to Tax Penalty
Year Deficiency Sec. 6653(b) Sec. 6663

1988 $35,523 $26,642 ---
1989 17,502 --- $13,127
1990 29,203 --- 21,902

Unless otherwise indicated, all section references are to

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

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

Procedure.

The deficiencies were based on respondent’s determinations

that petitioner failed to report income of $93,374 in 1988,

$52,543 in 1989, and $78,253 in 1990. At trial, respondent

conceded that petitioner’s unreported income should be reduced by

$10,997 in 1990 to reflect items that respondent inadvertently

double counted. We sustain respondent’s deficiency

determinations, as adjusted, and the fraud addition to tax and

penalties applicable thereto.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulation of facts and the related exhibits are

incorporated by this reference.

Petitioner, who is also known as David Wu, resided in Palo

Alto, California, when he filed his petition.

During the years at issue, petitioner owned at least 30

percent of Palo Alto Computer, doing business as Palo Alto

Microsystems (PAC), a subchapter C corporation. The record does
 - 3 -

not disclose who, if anyone, owned the remaining interests in

PAC. PAC was in the business of selling and repairing personal

computers and computer parts.

Petitioner was in charge of PAC. He made the day-to-day

business decisions for PAC, signed its corporate income tax

returns, had sole signature authority for PAC’s business checking

account, hired and supervised PAC’s bookkeepers and return

preparers, and dealt with customers daily by making sales and

receiving payments.

Petitioner understood that all revenue receipts from the

sale of computer equipment and from repairs performed by PAC

should be deposited in PAC’s business account. Petitioner also

understood that PAC’s accountant was preparing PAC’s income tax

returns on the basis of information regarding sales, purchases,

and expenses that petitioner provided to him from PAC’s books and

records. PAC’s books and records were maintained under

petitioner’s supervision and control. Petitioner understood that

if he failed to record sales revenues in PAC’s books and records,

those revenues would not be reported on PAC’s income tax returns.

Petitioner instructed many of PAC’s customers to pay for

their purchases or repairs in cash, to leave the payee lines of

their checks blank, or to write petitioner’s name on the payee

lines of their checks. Petitioner also wrote, or asked PAC’s

customers to write, on the memo lines of their checks to
 - 4 -

petitioner that the payments were on account of loans even though

he knew that the payments were on account of computer sales or

services.

Petitioner deposited or caused to be deposited in his

personal bank account substantial amounts of money representing

revenues belonging to PAC’s business. Petitioner deposited or

caused to be deposited into his personal bank account at least

$58,798.44 in 1988, $36,091.69 in 1989, and $50,837.89 in 1990 of

income belonging to PAC that was not reported on either PAC’s or

petitioner’s income tax returns.1

1
As discussed infra pp. 16-21, respondent’s determinations
were based on an extremely conservative analysis. During the 3
years before the Court, petitioner deposited $769,612 in his bank
account from sources who failed to respond to respondent’s
requests for information. Respondent treated the deposits from
these unexplained sources as not taxable to petitioner. We
believe that many of these deposits were taxable income that
petitioner diverted from PAC and failed to report. Petitioner
had an additional $695,910 in unidentified deposits. Respondent
also treated these unidentified deposits as nontaxable to
petitioner. Again, we believe that some portion of these
unidentified deposits represented taxable income to petitioner.
Finally, approximately $80,000 of deposits in petitioner’s bank
account represented amounts that were reported by either
petitioner or PAC. Respondent took the position that any amounts
deposited into petitioner’s bank account that were reported as
income by PAC were not taxable to petitioner. Because PAC was a
C corporation, amounts paid by PAC to petitioner would likely
constitute income to petitioner in the form of constructive
dividends. Nevertheless, respondent treated these amounts as
nontaxable to petitioner. Respondent identified as taxable to
petitioner only amounts that respondent could verify were
revenues of PAC that had not been reported on either PAC’s or
petitioner’s Federal income tax returns.
 - 5 -

Petitioner hired different accountants to prepare PAC’s and

his personal income tax returns and provided them with only

limited financial information in aid of his efforts to avoid

detection of his unreported income.

On his Forms 1040, U.S. Individual Income Tax Return, for

1988, 1989, and 1990, petitioner reported wage income from PAC of

only $9,000, $9,000, and $10,000, respectively. For 1988, 1989,

and 1990, petitioner reported gross income of $62,655, $30,254,

and $62,457, respectively, and paid taxes of $7,750, zero, and

$14,720, respectively.

Despite showing only relatively modest amounts of income on

his tax returns, petitioner purchased during the years in issue

and the following year (1988, 1989 and 1991) four parcels of

improved real property for $1,925,000 and made total downpayments

of $755,037.57.2

In support of his applications for loans to finance these

purchases, petitioner made numerous representations concerning

his income that were inconsistent with the positions he took on

2
In 1988, petitioner purchased property located at 3340 Ross
Road, Palo Alto, California 94303 for $395,000, paying
$152,226.35 down (of which $11,850 was paid from a PAC business
account) and property located at 3616 South Court, Palo Alto,
California 94306 for $310,000, with a downpayment of $74,832.83.
In 1989, petitioner purchased property located at 65 Park Avenue,
Atherton, California 94025 for $560,000, with a downpayment of
$147,255.15. In 1991, petitioner purchased property located at
3636 El Camino Real, Palo Alto, California, for $660,000, with a
downpayment of $380,723.84.
 - 6 -

his income tax returns. Petitioner claimed in a 1988 loan

application to receive $8,000 per month in wages from PAC, while

reporting only $9,000 for the entire year on his 1988 Federal

income tax return. In a 1989 loan application, petitioner

claimed to receive $6,000 per month salary and $4,000 per month

in rental income, while reporting on his tax return only $9,000

in wages and $20,560 in rental income for the entire year.

Petitioner understood his legal obligation to report all

his income on his Federal income tax returns. Petitioner was

advised repeatedly by his and PAC’s accountants of the need to

report all his income. Petitioner knowingly and intentionally

structured transactions to avoid detection of his schemes to

underreport income.

On June 6, 1995, petitioner was indicted on eight counts of

Federal income tax evasion and filing false Federal income tax

returns for the years 1988 through 1991. As part of a plea

bargain, petitioner pled guilty to one count of tax evasion for

1988 in return for the dismissal of the remaining counts. In the

final judgment, petitioner was sentenced to 2 years of probation,

was fined $8,050, and was required to participate in home

detention with electronic monitoring for 6 months.

On December 12, 2000, respondent served on petitioner

requests for admission, a first request for production of

documents, and a first set of interrogatories. Petitioner did
 - 7 -

not respond to respondent’s admissions and discovery requests.

By order dated January 30, 2001, this Court granted respondent’s

motion to compel responses, ordering petitioner to respond to

respondent’s interrogatories and document requests by February

12, 2001. In our order, we advised petitioner that “in the event

petitioner does not fully comply with the provisions of this

order, this Court will be inclined to impose sanctions pursuant

to Tax Court Rule 104.” By order dated February 21, 2001, we

held that the matters set forth in respondent’s request for

admissions were deemed admitted pursuant to Rule 90(e) by reason

of petitioner’s failure to respond thereto.

At trial, the Court granted respondent’s motion for

discovery sanctions, which was grounded upon petitioner’s

inadequate responses to respondent’s discovery requests: the

Court ruled that any documents covered by respondent’s requests

that petitioner failed to provide to respondent before trial

would not be admitted into evidence at trial. The Court also

refused petitioner’s request at trial that we hold the record

open to allow him to supplement the factual record after trial

with additional evidence allegedly held by his former attorney.

OPINION

Issue 1. Petitioner’s Liability for Deficiencies

In Judy v. Commissioner, T.C. Memo. 1997-232, we stated:

Every taxpayer is required to maintain sufficient
records to enable the Commissioner to establish the
 - 8 -

amount of his taxable income. Sec. 6001; sec.
1.6001-1(a) and (b), Income Tax Regs. If such records
are lacking, the Commissioner may reconstruct the
taxpayer's income by any indirect method that is
reasonable under the circumstances. Cebollero v.
Commissioner, 967 F.2d 986, 989 (4th Cir. 1992), affg.
T.C. Memo. 1990-618; Petzoldt v. Commissioner, 92 T.C.
661, 687 (1989); Schellenbarg v. Commissioner, 31 T.C.
1269, 1277 (1959), affd. in part and revd. and remanded
in part on another issue 283 F.2d 871 (6th Cir. 1960).

In order to prove that petitioner received income and did

not report it on his income tax returns, respondent called seven

witnesses: Barry Sharrow, Richard Eberli, Dexter Duncan, Dale

Rutz, Tim Earle, Gordon Anderson, and Gerald Latter. Each of

these witnesses credibly testified to purchasing computers or

computer parts from petitioner and to paying for them either with

cash or with checks not made payable to PAC. Those who paid by

check credibly testified that petitioner told them either to

leave the payee line blank or to enter petitioner’s name on the

payee line. Respondent established that the payments made by

these customers were not reported on petitioner’s or PAC’s income

tax returns.

Having established the existence of unreported income (and

the inaccuracy of petitioner’s books and records), respondent is

given substantial latitude in choosing an appropriate method to

reconstruct petitioner’s income. One reconstruction method we

have repeatedly accepted is the bank deposits method. As we

recognized in Zuckerman v. Commissioner, T.C. Memo. 1997-21:
 - 9 -

Use of the bank deposits method for reconstructing
income is well established. DiLeo v. Commissioner, 96
T.C. 858, 867 (1991), affd. 959 F.2d 16 (2d Cir. 1992);
Estate of Mason v. Commissioner, 64 T.C. 651, 656
(1975), affd. 566 F.2d 2 (6th Cir. 1977). Under the
bank deposits method there is a rebuttable presumption
that all funds deposited to a taxpayer's bank account
constitute taxable income. Price v. United States, 335
F.2d 671, 677 (5th Cir. 1964); Hague Estate v.
Commissioner, 132 F.2d 775, 777-778 (2d Cir. 1943),
affg. 45 B.T.A. 104 (1941); DiLeo v. Commissioner,
supra at 868. The Commissioner must take into account
any nontaxable sources of deposits of which she is
aware in determining the portion of the deposits that
represent taxable income, but she is not required to
trace deposits to their source. Petzoldt v.
Commissioner, supra 695-696; Estate of Mason v.
Commissioner, supra at 657.

In the case at hand, respondent used the bank deposits

method to reconstruct petitioner’s income, doing so in very

conservative fashion. In connection with the criminal case

against petitioner, Special Agent Bricker had obtained copies of

petitioner’s bank records. Agent Bricker sent letters to each of

the drawers on the checks deposited to petitioner’s bank account

requesting information regarding (1) the nature of the payment,

and (2) whether the drawers had any records of their dealings

with petitioner. Agent Bricker sent out 685 letters to the

drawers of more than $900,000 in identifiable checks deposited to

petitioner’s bank account in 1988, 1989, and 1990. Agent Bricker

received 322 responses to his letters (a response rate of

approximately 47 percent), 266 of which (approximately 82 percent

of the responses) identified their checks as payments made for

the purchase of computers or computer-related devices.
 - 10 -

Revenue Agent Oertel compared the data obtained by Agent

Bricker against petitioner’s and PAC’s bank records to determine

whether the sales had been reported as income on either

petitioner’s or PAC’s Federal income tax returns. Agent Oertel

prepared a detailed line-item analysis of petitioner’s bank

records. Respondent’s analysis of the evidence left no doubt

that petitioner had received substantial amounts of income that

were not reported on his income tax returns. Petitioner offered

no credible explanation for the omitted income.

Respondent took a very conservative approach to the

determination of petitioner’s omitted income. Unless Agent

Oertel could tell from specific information contained on the

check (such as a reference to the purchase of computer products

written on the check itself), Agent Oertel treated all the

deposits for which Agent Bricker did not receive a response

(totaling $769,6123) as nontaxable to petitioner. In addition,

petitioner had $695,9104 in deposits to his checking account that

neither Agent Bricker nor Agent Oertel could identify, either

because the bank did not provide sufficient information, because

the information provided was not legible, or because the check

did not indicate the name and address of the drawer. Agent

3
This consists of $459,677.02 for 1988, $150,338.50 for
1989, and $159,596.09 for 1990.
4
This consists of $352,975.57 in 1988, $137,509.13 in 1989,
and $205,425.77 for 1990.
 - 11 -

Oertel treated all these unidentified deposits as nontaxable to

petitioner. Agent Oertel also cross-checked against PAC’s

corporate books all items treated as taxable to petitioner.

Agent Oertel treated as nontaxable any items deposited to

petitioner’s account that had been included in PAC’s income.5

Using this very conservative approach, Agent Oertel

determined that petitioner deposited to his bank account during

the years in issue $122,599 in funds6 from the sale of computer

equipment, none of which was recognized on petitioner’s or PAC’s

income tax returns.

In addition to the taxable income determined from responses

to Agent Bricker’s letters, respondent treated a total of

$23,1297 deposited into petitioner’s bank account as taxable

because Agent Oertel could tell from references on the checks

that the payments were on account of computer equipment

purchases. Respondent introduced into evidence copies of the

documents showing the references upon which Agent Oertel relied.

As determined by respondent, the references specifically relate

5
Respondent did not analyze whether amounts included in
PAC’s income that had been paid to petitioner would be taxable to
petitioner as, for example, constructive dividends.
6
This consists of $48,956.84 in 1988, $30,586.19 in 1989,
and $43,055.89 in 1990.
7
This consists of $9,841.60 in 1988, $5,505.50 in 1989, and
$7,782.00 in 1990.
 - 12 -

to computer purchases. Petitioner offered no evidence to put in

doubt the correctness of respondent’s determinations.

Finally, respondent established that petitioner received

additional unreported income that was not deposited to

petitioner’s or PAC’s bank accounts. A number of PAC’s

customers, in response to Agent Bricker’s mailing, provided

evidence of additional computer purchases from PAC, the income

from which was not recognized on PAC’s or petitioner’s tax

returns and was not traceable to petitioner’s or PAC’s bank

accounts. Many of these were cash sales. Petitioner received

additional unreported income of $37,733.38 for 1988, $20,319.27

for 1989, and $16,417.87 in 1990 on account of these unrecorded

sales.

In sum, Agent Oertel established that petitioner received

and failed to report income of $220,198.54 for the 3 years in

issue, consisting of $96,531.828 in 1988, $56,410.969 in 1989,

8
This consists of $48,956.84 identified using the deposit
method from responses to Agent Bricker’s mailing, $9,841.60
identified using the deposit method from indicia on the checks,
and $37,733.38 identified from the specific evidence provided by
PAC customers in response to Agent Bricker’s mailing.
9
This consists of $30,586.19 identified using the deposit
method from responses to Agent Bricker’s mailing, $5,505.50
identified using the deposit method from indicia on the checks,
and $20,319.27 identified from the specific evidence provided by
PAC customers in response to Agent Bricker’s mailing.
 - 13 -

and $67,255.7610 in 1990. Agent Oertel’s testimony and analysis

leave no doubt that petitioner omitted from income the full

amounts identified as taxable to him by respondent for the years

in issue, as adjusted by respondent’s concession for 1990, as

described below.

Once the Commissioner makes a prima facie case of unreported

income using the bank deposits and specific identification

methods, and has made a determination in the notice of

deficiency, the taxpayer bears the burden of proving that the

deposits identified by the Commissioner as unreported income do

not in fact represent unreported income. See DiLeo v.

Commissioner, 96 T.C. 858, 869 (1991) (“petitioners, not the

Government, bear the burden of proving that respondent's

determination of underreported income, computed using the bank

deposits method of reconstructing income, is incorrect”), affd.

959 F.2d 16 (2d Cir. 1992).

At no time during the trial did petitioner attempt to

introduce any evidence to show: (1) That the unreported income

identified by respondent had in fact never been received by him,

(2) that the unreported income identified by respondent had in

10
This consists of $43,055.89 identified using the deposit
method from responses to Agent Bricker’s mailing, $7,782
identified using the deposit method from indicia on the checks,
and $16,417.87 identified from the specific evidence provided by
PAC customers in response to Agent Bricker’s mailing.
 - 14 -

fact been reported, or (3) that the unreported income identified

by respondent was somehow tax exempt.11

Agent Oertel obtained additional information of unreported

income for 1988 and 1989 after the notice of deficiency was

mailed. With respect to 1988 and 1989, respondent established

that petitioner had unreported income of $96,531.82 and

$56,410.96, respectively, but had only determined in the notice

of deficiency unreported income of $93,374 and $52,543,

respectively. Respondent does not seek to increase the amount

11
Instead of addressing the unreported income issues
identified by respondent, petitioner attempted (unsuccessfully)
to elicit testimony from the computer equipment purchasers that
the purchased equipment may have belonged to a Mr. Hu, rather
than to petitioner or PAC. According to the testimony, Mr. Hu
was a former employee of PAC who spoke little English and
assisted petitioner in assembling and repairing computers. The
witnesses all testified that they bought the equipment from PAC’s
store, received a PAC receipt, and dealt only with petitioner.
Petitioner offered no evidence that Mr. Hu owned the equipment,
and he failed to explain how Mr. Hu’s alleged ownership of the
equipment would be relevant; after all, the purchase price ended
up in petitioner’s bank account.

Petitioner also attempted to introduce into evidence an
affidavit allegedly signed by Mr. Hu, in which Mr. Hu allegedly
took responsibility for the deposit of PAC’s money into
petitioner’s bank account. We sustained respondent’s objection
to the admission of the affidavit into evidence as hearsay. We
also fail to see how the affidavit would be relevant. Even if
Mr. Hu made the deposits to petitioner’s bank account, the
testimony of the witnesses left no doubt that petitioner was in
charge, that petitioner orchestrated the scheme to avoid
detection of his unreported income--by requesting cash payments,
by requesting that checks be made out in his name or with the
payee left blank so that he could insert his name, and by falsely
causing indications on the check to reflect loans rather than
computer sales--and was fully aware of both the deposits and his
failure to report the income.
 - 15 -

determined in the notice of deficiency to reflect the proof of

additional amounts introduced into evidence at trial: “To the

extent that Revenue Agent Oertel’s analysis exceeds the amounts

asserted in the Statutory Notice of Deficiency for 1988 and 1989,

respondent will not seek an increased deficiency.” In addition,

Agent Oertel identified several items that were double counted in

the notice of deficiency for 1990. For 1990, Agent Oertel’s

analysis shows a lower deficiency of $67,255 than was set forth

in the statutory notice of deficiency of $78,253. In his trial

brief and at trial, respondent conceded the excess: “For 1990,

inasmuch as Revenue Agent Oertel’s analysis shows less unreported

income than the Statutory Notice of Deficiency, respondent has

conceded the excess.” We accept respondent’s concession for

1990.

Respondent’s deficiency determinations excluded substantial

additional amounts of unreported income that are apparent from

the record. Respondent determined the deficiencies using only

the amounts concretely proved to be unreported income on the

basis of his single information request. The evidence suggests

that petitioner received substantial additional amounts of

unreported income. Respondent identified deposits of $769,612

made to petitioner’s bank account for which the drawers of the

checks did not respond to Agent Bricker’s mailing, and an

additional $695,910 in deposits made to petitioner’s bank account
 - 16 -

by payors who respondent could not identify from the information

provided by petitioner’s bank.

Given the percentage of responses to Agent Bricker’s letter

that showed unreported income from the sale of computer products

and services (82 percent of those who responded stated that their

payment was for PAC computer equipment and services, and none of

this revenue was reported on petitioner’s or PAC’s Federal income

tax returns), there is a high probability, amounting to more than

mere suspicion, that a substantial proportion of the unidentified

or unproven deposits also represent unreported taxable income.

Petitioner offered no credible evidence (and maintained no

credible records) as to the source or nature of those deposits.

Although it’s not our job to tell respondent how to do his

job, see United States v. Payner, 447 U.S. 727, 731, 737 (1980)

(Burger, C.J., concurring), we observe that respondent

established substantial amounts of unexplained deposits that were

not included in the deficiency notice.12

We have affirmed determinations of unreported income under

the bank deposits method where the Commissioner has offered no

evidence as to the source of the deposits, requiring the

Commissioner to show only that unexplained deposits were made to

12
Our concerns are aggravated by the evidence in the record
that during 2 of the taxable years in issue and the year
following, petitioner purchased four parcels of real property for
$1.925 million, making aggregate downpayments of $755,038. See
supra note 2.
 - 17 -

the taxpayer’s bank account. In Parks v. Commissioner, 94 T.C.

654, 658 (1990), we held:

Contrary to petitioner’s belief, the burden is
upon petitioner to prove that respondent's
determination of unreported income, computed using the
cash deposits and expenditures method of reconstructing
income, is incorrect. * * * [Citations omitted.]

Again, id. at 660, we held:

Where a taxpayer provides respondent with no leads as
to source, respondent is not required to negate every
possible source of nontaxable income, a matter
peculiarly within the knowledge of the taxpayer.
Moreover, where a taxpayer admits receipt of cash,
respondent need not prove a likely source of resulting
cash deposits or expenditures. [Citations omitted.]

Accord Hardy v. Commissioner, 181 F.3d 1002, 1004-1005 (9th Cir.

1999) (“If the Commissioner introduces some evidence that the

taxpayer received unreported income, the burden shifts to the

taxpayer to show by a preponderance of the evidence that the

deficiency was arbitrary or erroneous.”), affg. T.C. Memo.

1997-97; Clayton v. Commissioner, 102 T.C. 632 (1994); Kling v.

Commissioner, T.C. Memo. 2001-78 (“Absent some explanation, a

taxpayer's bank deposits represent taxable income. * * * The

taxpayer has the burden of proving that the bank deposits came

from a nontaxable source”); Beck v. Commissioner, T.C. Memo.

2001-270 (“Bank deposits are prima facie evidence of income”);

Kudo v. Commissioner, T.C. Memo. 1998-404 (Commissioner not

required to show link between deposits and taxable source of

income), affd. 11 Fed. Appx. 864 (9th Cir. 2001). These rules
 - 18 -

recognize that the taxpayer is responsible for maintaining

adequate books and records to explain the sources of his bank

deposits.

If the taxpayer offers a possible nontaxable source for the

deposits, the Commissioner must either negate the potential

nontaxable source or connect the deposits with a likely source of

taxable income. Kramer v. Commissioner, 389 F. 2d 236, 239 (7th

Cir. 1968) (Commissioner not required to provide likely source if

he proves that deposit was not from “cash hoard”), affg. T.C.

Memo. 1966-234; Price v. Commissioner, T.C. Memo. 2001-307 (“If

the taxpayer suggests a nontaxable source, the Commissioner must

either connect the bank deposits to a likely source of taxable

income or negate the nontaxable source alleged by the

taxpayer.”); Estate of Johnson v. Commissioner, T.C. Memo.

2001-182.

In cases such as the case at hand, governed by precedent

from the Court of Appeals for the Ninth Circuit, if the

Commissioner fails to prove that the taxpayer actually received

income (such as, in the case at hand, by showing unexplained bank

deposits), the Commissioner has the burden of proving a likely

source of the allegedly unreported and reconstructed income. In

Weimerskirch v. Commissioner, 596 F.2d 358 (9th Cir. 1979), revg.

67 T.C. 672 (1977), the Court of Appeals ruled that no

presumption of correctness would attach to a reconstruction of
 - 19 -

hypothetical drug-dealing income where the Commissioner offered

no proof either of income or of drug dealing. However, if the

Commissioner either establishes the identity of the specific

income or proves the source of unreported income, the taxpayer

has the burden of proving the Commissioner’s determination

incorrect. See, e.g., Hardy v. Commissioner, supra at 1004-1005

(showing of unexplained bank deposits sufficient to shift burden

to taxpayer); Palmer v. United States, 116 F.3d 1309 (9th Cir.

1997) (showing that expenditures exceeded reported income

sufficient to shift burden); Roat v. Commissioner, 847 F.2d 1379

(9th Cir. 1988) (presumption of correctness applies where

taxpayer admitted receiving income); Delaney v. Commissioner, 743

F.2d 670 (9th Cir. 1984) (presumption of correctness applies

against taxpayer who admits owning asset allegedly purchased with

unreported income), affg. T.C. Memo. 1982-666; United States v.

Stonehill, 702 F.2d 1288 (9th Cir. 1983).

In the case at hand, respondent has shown through

petitioner’s bank records both the receipt of specific items of

unreported income (the bank deposits) and their likely source

(receipts from sales and repairs of computer equipment).13 In

13
As explained supra p. 12, responses to Agent Bricker’s
mailing showed that petitioner received additional unreported
income of $74,470.52 from cash sales during the years in issue.
Respondent did not attempt to use statistical methods to estimate
the amount of unreported cash sales that petitioner received from
sources who did not respond to Agent Bricker’s mailing. For a
(continued...)
 - 20 -

13
(...continued)
discussion of the use of statistical methods in legal cases to
extrapolate estimates from known samples, see United States v.
Shonubi, 895 F. Supp. 460 (E.D. N.Y. 1995) (approving use of
statistical methods to determine, based on a sample of four of
the 103 balloons swallowed by defendant, that all 103 balloons
contained heroin), revd. on other grounds 103 F.3d 1085 (2d Cir.
1997).

In the tax context, the Court of Appeals for the Ninth
Circuit rejected the use of statistical methods to assess
deficiencies against a restaurant for failing to withhold and pay
sufficient employment taxes on its employees’ tip income. Fior
D’Italia, Inc. v. United States, 242 F.3d 844 (9th Cir. 2001),
cert. granted 122 S. Ct. 865 (2002). However, the Court of
Appeals distinguished the case before it from the presumption
that would apply to the use of statistical methods to estimate
the unreported tip income received by the employees themselves.
The Court of Appeals cited with approval and distinguished the
Tax Court’s opinion in McQuatters v. Commissioner, T.C. Memo.
1973-240, which upheld the use of statistical methods to recreate
the tip income received by waiters who failed to keep proper
records:

Because the employees should have maintained records of
their income but failed to do so, it was deemed
entirely appropriate to put the burden on them to prove
that the IRS’s estimate overstated their taxable
income. * * *

* * * the taxpayer in our case did not fail to satisfy
a legal duty imposed on it by the Internal Revenue
Code, and thus did not give the IRS just cause for
resorting to an estimate in constructing its
assessment. [Fior D’Italia, Inc. v. United States,
supra at 848.]

In view of the complexity of using statistical methods to
estimate unreported cash income that cannot be traced, we
understand respondent’s decision to focus on traceable deposits.
However, respondent might well have required petitioner to
explain the source of the remaining bank deposits, inasmuch as
respondent would have been required to do no more than include
the unexplained deposits in his determination, on the ground that
the deposits were unexplained and similar to the other taxable
(continued...)
 - 21 -

these circumstances, respondent might well have included in the

deficiency determination14 all the unexplained deposits and

imposed on petitioner the burden of showing that the deposits

were not unreported income.15

In view of the conservative approach taken by respondent, we

have no hesitation in sustaining respondent’s deficiency

determinations, as adjusted to reflect respondent’s concession

for 1990.

Issue 2. Petitioner’s Liability for Fraud Addition to Tax and
Penalties

For 1988, the civil fraud addition was set forth in section

6653(b). It was moved in 1989, with some minor clarifying

13
(...continued)
deposits.
14
If the Commissioner does not include unexplained deposits
as unreported income in his deficiency determination, he may
still raise the issue by answer, or with leave of court by
amendment to answer. The Commissioner initially bears the burden
of proof in respect of new matters asserted in the answer, Rule
142(a)(1), but that burden is satisfied if the Commissioner
establishes the existence of bank deposits and a potential
taxable source, and the taxpayer fails to offer credible evidence
of a nontaxable source, see Hardy v. Commissioner, 181 F.3d 1002
(9th Cir. 1999), affg. T.C. Memo. 1997-97.
15
Petitioner stated in his pretrial memorandum: “my CPA and
attorney told me that I am very unlucky”. Although petitioner
might consider himself unlucky because his returns were selected
for examination in the “audit lottery”, petitioner is very
fortunate that respondent did not include in his deficiency
determination, or in his answer: (1) The remaining unexplained
deposits, (2) estimates, using statistical methods, of other
unreported cash receipts, or (3) amounts paid by the corporation
to petitioner, as constructive dividends.
 - 22 -

changes in language, to section 6663 and termed a “penalty”.

Omnibus Budget Reconciliation Act of 1989, Pub. L. 101-239, sec.

7721(a), (d), 103 Stat. 2395, 2400 (“effective for returns the

due date for which (determined without regard to extensions) is

after 12/31/89”).

Under both these provisions, respondent must prove by clear

and convincing evidence that some portion of the underpayment in

petitioner’s tax for each of the years in issue was due to fraud.

Respondent is not required to prove the precise amount of the

underpayment resulting from fraud, but only that some part of the

underpayment is attributable thereto. See Otsuki v.

Commissioner, 53 T.C. 96, 105 (1969). The burden then shifts to

petitioner to show any portion of the underpayment that was not

due to fraud. Sec. 6653(b)(2) (1988); sec. 6663(b).

For the purposes of the civil tax statutes, fraud is an

intentional wrongdoing on the part of the taxpayer with the

specific purpose of evading tax believed to be owed. See Powell

v. Granquist, 252 F.2d 56 (9th Cir. 1958); Mitchell v.

Commissioner, 118 F.2d 308, 310 (5th Cir. 1941), revg. and

remanding 40 B.T.A. 424 (1939). Negligence of a taxpayer,

whether slight or gross, is not sufficient to prove fraud. See

Mitchell v. Commissioner, supra at 310. To prove fraud, the

Commissioner must show that the taxpayer intended to evade taxes

believed to be owing by conduct intended to conceal, mislead, or
 - 23 -

otherwise prevent the collection of taxes. See Parks v.

Commissioner, 94 T.C. at 661.

The presence of fraud is a question of fact to be resolved

upon consideration of the entire record. See Recklitis v.

Commissioner, 91 T.C. 874, 909 (1988). Because direct proof of

the taxpayer's intent is rarely available, fraud may be proven by

circumstantial evidence. See Spies v. United States, 317 U.S.

492 (1943); Recklitis v. Commissioner, supra at 910.

A taxpayer convicted of criminal tax evasion is collaterally

estopped from denying liability for the civil fraud penalty.

Moore v. United States, 360 F.2d 353 (4th Cir. 1965); Zamzam v.

Commissioner, T.C. Memo. 2000-371. Therefore, petitioner, having

been convicted of criminal tax evasion for 1988, is liable as a

matter of law for the fraud addition for 1988. Respondent must

prove fraud by clear and convincing evidence for 1989 and 1990.

Courts have developed a nonexclusive list of items of

circumstantial evidence--often referred to as “badges of

fraud”--that will support a finding of fraudulent intent. In

Bradford v. Commissioner, 796 F.2d 303, 307 (9th Cir. 1986),

affg. T.C. Memo. 1984-601, the Court of Appeals for the Ninth

Circuit--to which an appeal of this case would lie--set forth the

following indicia or “badges” of fraud: (1) Understatement of

income; (2) maintenance of inadequate records; (3) failure to

file tax returns; (4) implausible or inconsistent explanations of
 - 24 -

behavior; (5) concealment of assets; and (6) failure to cooperate

with tax authorities. The Court of Appeals also stated that the

existence of the following facts additionally supports a finding

of fraudulent intent: (1) Dealing in cash to avoid scrutiny of

finances, and (2) failing to make estimated tax payments. See

id. at 308.

We affirm respondent’s determination of the fraud addition

to tax and penalties. Petitioner’s conduct displays many of the

“badges” of fraud.

As described in detail above, petitioner significantly

understated income and maintained inadequate records to explain

the nature and sources of his deposits.

Petitioner also provided implausible and inconsistent

explanations of his deposits. He lied to Agent Bricker during

the criminal investigation, stating that not more than one or two

checks for the purchase of computer equipment had been deposited

into his personal account, and that any such checks deposited to

his account would have been the result of a bank error. In fact,

as petitioner knew full well, hundreds of such checks had been

deposited to his account. Petitioner also lied when he testified

that he did not tell customers to leave the payee lines blank, to

make PAC checks payable to him, or to pay in cash. Barry

Sharrow, Richard Eberli, Dexter Duncan, Dale Rutz, and Tim Earle

all testified that petitioner told them to leave the payee line
 - 25 -

blank or to make their checks payable to petitioner. Mrs. Rutz

and Messrs. Eberli and Latter testified that petitioner told them

to pay in cash.

Petitioner also attempted to blame his fraud on his former

employee, Mr. Hu, suggesting that it was Mr. Hu who deposited all

those checks into petitioner’s bank account. Petitioner also

suggested to the customer/witnesses that they may have been

buying computer products belonging to Mr. Hu rather than

belonging to him or PAC. Petitioner’s explanations were

implausible and were an unsuccessful attempt to confuse the Court

and to divert attention from his own fraudulent conduct.

Petitioner concealed computer sales by making sure that the

sales were not reflected on PAC’s books, by having the payments

made in cash or by check made out to him personally, by

indicating that the deposits related to loan repayments when he

knew that they were for computer sales, and by carefully

concealing the facts from his accountants.

Petitioner failed to cooperate with respondent’s

investigation; he refused to answer questions during the

investigation, and he failed to respond to respondent’s formal

discovery requests in any meaningful way, even after being

ordered by the Court to respond. Petitioner’s conduct was not

innocent. He fully understood his obligation to report sales on

PAC’s books and records. Petitioner’s conduct evidences a course
 - 26 -

of action consciously undertaken both to avoid taxation and to

avoid detection.

Respondent has met his burden of showing by clear and

convincing evidence that petitioner’s understatements of income

were due to fraud. Petitioner offered no credible evidence to

show that any portion of the understatements was not due to

fraud. We sustain respondent’s determinations that petitioner is

liable for the civil fraud addition to tax for 1988 and fraud

penalties for 1989 and 1990.

To reflect the foregoing and respondent’s concessions,

Decision will be entered

under Rule 155.