PAPPAS v. COMMISSIONER

T.C. Memo. 2002-127

UNITED STATES TAX COURT

ZABETTI A. PAPPAS, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 24593-95. Filed May 23, 2002.

Zabetti A. Pappas, pro se.

Lyle B. Press and David A. Williams, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

GALE, Judge: Respondent determined deficiencies and

additions to tax in petitioner’s Federal income taxes as follows:
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Additions to Tax
Year Deficiency Sec. 6651(f)1 Sec. 6654(a)

1989 $21,867 $16,400 $1,478
1990 19,575 14,681 1,287
1991 3,873 2,905 224
1992 4,017 3,013 175

After concessions,2 the issues for decision are as follows:

(1) Whether amounts paid to or received by Real Services, Inc.,

during 1989 and 1990 are properly treated as petitioner’s taxable

income; (2) whether petitioner failed to report income received

in connection with an “escort” business during 1989 and 1990; (3)

whether petitioner failed to report income she received through

embezzlement and/or fraudulent loan transactions during 1989 and

1
Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect for the taxable years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
2
In connection with the pretrial proceedings in this case,
respondent was deemed to have conceded his determinations that
petitioner had unreported income of $4,640 in 1990 as a result of
a transaction with an individual identified as Harvey K. and
unreported income of $1,500 as a result of a transaction with one
Dennis T. Additionally, on brief, respondent has conceded his
determination that petitioner had unreported income of $1,030 as
a result of a transaction with an individual identified as
Ricardo S.

The determinations in the deficiency notice included amounts
of self-employment taxes for the years in issue. Petitioner has
not specifically contested the applicability of these taxes, and
we deem that she has conceded this issue. The amount of self-
employment taxes, and the commensurate deductions for those
taxes, are to be determined in accordance with our conclusions
herein regarding petitioner’s unreported income.
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1990; (4) whether petitioner failed to report sales and rental

income she received during 1989 and 1990; (5) whether petitioner

may deduct business expenses in excess of those allowed by

respondent for 1989 and 1990; (6) whether respondent properly

reconstructed petitioner’s 1991 and 1992 taxable income through

the use of Bureau of Labor Statistics data; (7) whether

petitioner is liable for the additions to tax under section

6651(f) or, in the alternative, for the additions to tax under

section 6651(a) for the years at issue; and (8) whether

petitioner is liable for the additions to tax under section

6654(a) for the years at issue.

FINDINGS OF FACT

Petitioner Zabetti A. Pappas was a resident of New York, New

York, at the time the petition herein was filed. She did not

file Federal income tax returns for the taxable years at issue,

nor did she make estimated tax payments for those years.

1. Petitioner and Real Services, Inc.

Petitioner attended Vassar College from 1976 through

approximately 1978. Thereafter, she held a variety of jobs,

including operating a business known as “Disco Queen”. She was

known to her associates and clientele in New York as “Z” or

“Betty” or “Angel”. Petitioner was actively involved in a number

of income-producing activities. She operated a prostitution

business, in which she arranged for other women or herself to
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engage in sexual activities with individuals who paid her for

such services. The parties have referred to such arrangements as

the provision of “escort” services, and we shall do so in this

opinion. Petitioner also sold electronic equipment, lighting

equipment, theater tickets, and music tapes. She earned money

for designing apartment interiors and installing entertainment

systems; she also engaged in obtaining loans; and she dabbled in

her family’s real estate activities in Hawaii and Ohio.

Petitioner formed Real Services, Inc. (Real Services), in

New York State on September 29, 1988. Petitioner was its

president and sole shareholder. She signed a preprinted

document, filling in the blanks, which indicated that she was an

employee of Real Services. Her associate and companion, Laura

C., agreed to serve as vice president of Real Services but

performed no meaningful activities in that role. Ms. C. was

elected vice president of Real Services several months after

using that title to attest to petitioner’s employment contract.

Two individuals named Ted P. and Michael S. were business

associates of petitioner but were not actively involved in the

operation of the corporation. Real Services did not file Federal

corporation income tax returns, Federal payroll tax returns, or

New York State tax returns covering any of the years at issue.

Petitioner maintained sketchy and incomplete records for

Real Services. She did, however, have signature authority over a
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checking account at Chemical Bank in the name of Real Services.

At the request of Chemical Bank, her lawyer obtained an employer

identification number (EIN) for Real Services.

Petitioner gave the name “Real Services” for use on the

sales slips she received when she purchased electronic equipment

for resale. Instead of giving an identifying number for Real

Services, however, petitioner used her own Social Security number

when requesting exemptions from State sales tax for these

purchases.

Petitioner made deposits into the Real Services’ checking

account totaling $46,242.81 in 1989 and $73,351.08 in 1990. In

October 1989, petitioner wrote a check on this account for $500

to her brother and another for $250 to her sister as birthday

presents. The next month petitioner wrote a check on this

account for $900 to pay private school tuition for the daughter

of her companion, Laura C., and another check to pay for Ms. C.’s

contact lenses. In 1990, petitioner paid $100 for an exercise

class with a check drawn on the same account. The account was

closed in December 1990.

Petitioner also maintained two accounts at Chemical Bank in

her own name. She deposited $2,500.00 and $2,452.61 into one

such account in 1989 and 1990, respectively. Into the other

personal account, she deposited $12,711.48 in 1989 and $12,373.85

in 1990.
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During the years in issue, petitioner’s principal residence

was an apartment at 500 E. 77th Street in New York. She took

over the lease of that apartment in the early 1980s from an

individual named Joy C. but continued to use Ms. C.’s name on

documents regarding that lease. She did not use her own name or

that of Real Services. Petitioner shared the apartment with

Laura C., who occasionally used Joy C.’s name instead of her own.

After 1986, Laura C.’s infant daughter also lived in the E. 77th

Street apartment.

In July 1989, petitioner arranged to take over an apartment,

located at 320 E. 65th Street in New York, rented by another

individual named Jane M. Ms. M. was allowed to live at the E.

77th Street apartment while the apartment on E. 65th Street was

renovated. Ms. M.’s name remained on the lease for the E. 65th

Street apartment; Real Services was not identified on the lease

document.

2. Unreported Income

For petitioner’s 1989 and 1990 taxable years, respondent

determined unreported income in a number of categories. For

convenience, we discuss the issues presented in each of these

categories in the order they were presented in the deficiency

notice.
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A. Escort Income

Petitioner arranged for the provision of escort services

during 1989 and 1990 out of the two apartments noted above, as

well as an apartment on W. 58th Street in New York during the

latter year. She received cash and checks in payment for those

services. At her request, many of the checks were drawn to the

order of Real Services.

Dennis T. engaged escort services at least six times at

petitioner’s E. 77th Street apartment. Mr. T. received escort

services from Laura C. In terms of his direct dealings with

petitioner, however, he engaged only in legitimate business

activities. These included a loan to petitioner for $4,000,

which she repaid with a mixture of checks from the Real Services’

account and from her personal accounts.

A business associate of petitioner, Michael S., paid for

escort services received at either petitioner’s E. 77th or E.

65th Street apartment, approximately six times during 1989

through 1990. However, the arrangements were made by, and the

money was paid to, Laura C.

Paul G. paid petitioner $1,500 in 1989 and $500 in 1990 for

arranging escort services for him with other women. Mr. G. also

provided investment advisory services for one of the women

providing escort services to him pursuant to petitioner’s
 - 8 -

arrangement, but none of the amounts he paid petitioner

constituted a fee for introducing him to that woman.

Over a 10-year period that included 1989 and 1990, Jeffrey

F. paid between $5,000 and $15,000 to petitioner for procuring

escort services for his business clients. He wrote a $200 check

to cash in September 1989 that petitioner deposited into the Real

Services’ checking account. Mr. F. dealt with at least one other

escort service in addition to petitioner’s during this period.

He paid $1,500 to petitioner for escort services in 1989 and

$1,500 in 1990.

Alexander K. issued a check for $1,200 that was made out to

Real Services and dated October 12, 1989. Petitioner deposited

this check in the Real Services’ checking account. Petitioner

had in her possession Alexander K.’s business card.

Between 1989 and 1992, an individual named Richard S.

availed himself of petitioner’s escort services “maybe once a

month but not necessarily for all that period of time.” He paid

$200 per visit. Petitioner received $2,700 in 1989 and $2,700 in

1990 from Mr. S. for escort services. Mr. S. abused alcohol

during the period that he used petitioner’s escort services.

Meyer S. wrote 10 checks to cash during the first half of

1990 as payment to petitioner for escort services she arranged.

Petitioner deposited the checks into the Real Services’ checking

account. The 10 checks totaled $1,450. However, these 10 checks
 - 9 -

included checks totaling $460 that were dishonored, as well as

checks totaling $460 that were provided as replacements for the

dishonored checks.

A check for $200, dated June 23, 1989, was made payable to

cash by Eric K. and endorsed by Jane M. for Real Services. Jane

M. was one of the women who provided escort services to customers

pursuant to petitioner’s arrangements. The check was deposited

into the Real Services’ account.

Ronald K. paid petitioner approximately $125 per session for

escort services she arranged on 12 to 15 occasions during the

years 1989 through 1990. Additionally, in 1990, he lent

petitioner $5,000, which she repaid without interest. On two or

three occasions, however, she provided him with the escort

services of other women in appreciation for his having lent her

the money.

In the summer of 1990, Michael L. lent petitioner $4,000 in

the form of a check made out to Real Services. Two months later,

petitioner issued him a check in repayment for $4,800. The check

was dishonored, and petitioner then repaid Mr. L. by providing

escort services.

Harvey K. paid petitioner for escort services provided by

herself and by other women during 1990. He visited between three

to four times and paid petitioner $180 per visit.
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A check issued by Crihil I. for $1,300, made payable to

Jennifer R. “and/or cash” and dated November 10, 1990, was

endorsed by Jennifer R. to Real Services. On November 15, 1990,

petitioner deposited the check into one of her personal accounts

at Chemical Bank. Jennifer R. was one of the women who provided

escort services to customers pursuant to petitioner’s

arrangements.

Near the end of 1989, petitioner deposited a check for $400,

dated December 15, 1989, made payable to Real Services from

Douglas B. During 1990, petitioner deposited into her Chemical

Bank accounts two checks to cash totaling $225 from Jerrold M., a

check to cash for $200 from William C., and two checks payable to

cash totaling $140 from Takero O. These six checks were received

by petitioner as payments for escort services.

In connection with providing the escort services, petitioner

was required to pay the women who performed services for her

clientele.

On November 10, 1990, petitioner endorsed and deposited into

her account a check for $500 made payable to Real Services by Raj

International. This check constituted part of a loan to

petitioner from Parvin S. She repaid the loan later that year

with checks drawn on Real Services’ account and on her personal

account.
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B. Embezzlement Income

Michael S., who received escort services at petitioner’s

apartments during 1989 and 1990, also engaged in certain

legitimate transactions with petitioner in 1989. Petitioner

talked him into lending her $12,000 on October 10, 1989. She

explained that the loan would finance the furnishing of the

apartment on E. 65th Street. Mr. S. reviewed the expenses of

furnishing the apartment and visited the apartment to verify that

it had been furnished.

As security for the $12,000 loan, petitioner gave Mr. S. a

letter promising him a share of a commission she would earn on

the sale of some family property, known as Haiku Plantation,

located in Hawaii. Mr. S. looked at some documents describing

the property and discussed its value with petitioner’s sister,

who, he understood, had the majority ownership in the property.

Petitioner partially repaid Mr. S. with a series of checks

totaling $3,640 written during first half of 1990.

Mr. S. also purchased a large supply of magnetic tapes from

petitioner for $10,000, which he then donated to a school. Mr.

S. obtained these materials from petitioner because he could get

a “better rate” than elsewhere. One of his checks given in

payment to petitioner for this purchase, for $3,000, was returned

unpaid.
 - 12 -

Howard S. lived in the same apartment building as

petitioner. He became friendly with petitioner and, in 1989,

lent her $5,000. On August 1, 1989, she agreed to repay that

amount within 60 days. By the first quarter of 1991, petitioner

had repaid Mr. S. $1,300, which he acknowledged by initialing an

invoice to that effect. Mr. S.’s loan was made to petitioner

individually, but the repayment came in the form of Real Services

checks. On August 12, 1991, Mr. S. sued petitioner in both her

capacities; i.e., as “Zabetti Pappas, d/b/a/ Real Services

* * *”, with respect to the loan. He alleged, among other

things, that he had lent petitioner $3,750 and that “to date no

monies have been paid back”.

John K. was a friend of petitioner’s from their college days

at Vassar. Mr. K. believed petitioner possessed business acumen

and trusted her on the basis of their friendship. He sought

petitioner out in 1990, seeking a profitable return on money he

wished to invest. In March 1990, Mr. K. gave petitioner $10,000

to invest in real estate projects that she described. In August

1990, petitioner advised Mr. K. that she had an investment

opportunity that would return a profit in 30 days. On the basis

of this representation, he gave her an additional $5,000 to

invest. She returned to him only $1,750, in the form of a check

for $1,250, dated September 19, 1990, and the payment of $500 in

cash. Petitioner’s other checks to him were dishonored.
 - 13 -

Petitioner offered various excuses to Mr. K. for her failure to

return his money, either the $10,000 or the balance of the

$5,000, which he did not believe.

Mr. K.’s investments with petitioner were made in the form

of checks made out to Real Services, but when repayments fell

short, petitioner wrote to him, “I can start paying even more

next month * * *. I am really trying--its [sic] just that my

finances are jumbled.” Her letter made no mention of Real

Services.

On or about July 24, 1990, petitioner received $5,000 from

Jennifer R., one of the women who provided escort services to

customers pursuant to petitioner’s arrangements. Petitioner

executed a letter memorandum to record the $5,000 payment, which

stated that the money “shall be used for investment purposes” and

provided for a “guaranteed minimum return” of 25 percent

“interest” in 1 year, on July 24, 1991. On or about November 7,

1990, petitioner received an additional $10,000 from Jennifer R.

under similar circumstances. Petitioner executed another letter

memorandum, which recorded her receipt of $10,000 that was to be

used “for investment purposes” and provided for a “guaranteed

return” of 25-percent “interest”, payable within 45 days, or by

December 21, 1990. Jennifer R. died before the trial in this

case.
 - 14 -

C. Electronics, Introduction Fees, Theater Tickets, and
Music Tape Income

During 1989, petitioner received $10,800 from the sale of

electronics to, as well as the payment of introduction fees by,

Ted and Brian P. Petitioner also received $7,800 from the sale

of electronics to Howard S. (in addition to the $5,000 loan from

Mr. S. noted earlier). Petitioner’s cost of goods sold to Ted

and Brian P. and to Howard S. in 1989 was $5,371.

In August 1989, petitioner received $300 in the form of a

check written to her individually by David M. The check was for

the purchase of tickets to the Broadway show “Phantom of the

Opera”. Petitioner, as “Zabetti Pappas - REAL SERVICES”, had

paid $300 for these tickets. She also received $250 for tickets

to the Broadway show “M. Butterfly” for which she paid the same

amount.

On September 18, 1989, Paul H. wrote a check to Real

Services in the amount of $110, in payment for prerecorded music

tapes that had cost petitioner $12. Petitioner deposited this

check into Real Services’s checking account.

In 1990, petitioner received $3,000 for additional

electronic equipment sold to Ted and Brian P. This equipment

included some security devices for a warehouse rented by Ted P.

Petitioner’s cost for the electronic equipment totaled $2,628.

In the same year, Howard S. paid her $2,775 for additional

electronic equipment. The items petitioner sold him included a
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52-inch rear-projection television and two answering machines.

The rear-projection television cost her $2,902, including taxes

and shipping, while the answering machines cost her $210.

During 1990, petitioner also received $1,400 in cash from

Kenny T. for the sale of a video cassette recorder for $200 and a

40-inch rear-projection television for $1,200. She paid $1,400

for those items. The television was returned to the business

from which petitioner purchased it for a credit of $1,200. She

accordingly neither made nor lost money on the transactions with

Kenny T.

D. Rental Income

Petitioner arranged a lease and sublease in her own name for

the apartment on W. 58th Street. In 1990, petitioner received

$2,800 from an individual named Terri D. representing 4 months’

rent for that apartment.

3. Petitioner’s Business Expenses

During 1989, petitioner incurred rental expenses of $7,763

and an electricity expense of $302 with respect to the apartment

on E. 65th Street at which she conducted some of her escort

business.

During 1989, petitioner lived in the apartment on E. 77th

Street. She had a room in that apartment in which she conducted

office business and in which escort services were occasionally

provided.
 - 16 -

During 1989, petitioner incurred additional business

expenses of $825 for office expenses, printing expenses, and

travel, plus $600 for business-related telephone service. She

also incurred printing costs of $24 and miscellaneous costs paid

to contractors of $132.

During 1989, petitioner also paid a total of $3,000 in legal

and professional fees to the law firm of Saltzman & Holloran and

to Prentice-Hall Financial Services relating to the incorporation

of Real Services. She incurred additional legal expenses of

$1,000 in defense of charges that she was using the apartment on

E. 77th Street for an illegal purpose.

During 1989, petitioner, in the name of Real Services,

executed a brokerage agreement in which she undertook to sell an

estate in Hawaii. The sellers were petitioner’s sister and

another individual. Petitioner spent considerable sums in

improving and marketing the property. The property had been

recorded as belonging to their deceased father and another

individual. The efforts to sell the property were unsuccessful,

and it was foreclosed upon in 1991.

Petitioner incurred rental expenses of $3,600 and utility

expenses of $223 in 1990 for the apartment on W. 58th Street

which, in that year, was used in her escort business and was also

subleased for 4 months.
 - 17 -

Petitioner continued to rent the apartment on E. 65th Street

for business purposes during 1990. She incurred rental expenses

of $13,983 and a utility charge of $790 in that year with respect

to that apartment.

During 1990, petitioner continued to live in the apartment

on E. 77th Street.

Petitioner incurred $100 for messenger expenses in 1990 and

$126.60 in shipping and mailing expenses. She incurred business

expenses of $600 for telephone service in that year. She also

paid monthly services charges totaling $220 during 1990 on the

Real Services’ checking account. In the same year she paid legal

fees of $1,650 in defending against charges that she was using

the apartment on E. 77th Street for an illegal purpose. She paid

an additional $400 to an attorney in connection with obtaining a

lease.

In 1990, petitioner also paid $150 to her brother for

appraisal fees concerning some property inherited from their

father.

4. Petitioner’s Interest Expenses

Petitioner frequently borrowed money. In addition to the

instances already cited, Tammy M., one of the women who provided

escort services to customers pursuant to petitioner’s

arrangements, lent petitioner $6,000 in 1990. Petitioner wrote

checks in repayment totaling at least $6,070. Many of
 - 18 -

petitioner’s repayment checks bounced, however, or were

reinvested, on the basis of petitioner’s representation that she

would invest this money in real estate on behalf of Tammy M.

Tammy M. recovered the amount of her loan to petitioner, but she

received no more than that.

In another transaction in early 1990, petitioner received

$2,500 from Vania W. Petitioner executed a letter memorandum

dated February 3, 1990, acknowledging her receipt of $2,500 from

Vania W., which she promised to invest and to repay in 30 days

with $1,000 interest. Petitioner subsequently wrote two checks

in March 1990 totaling $2,650 on a Real Services’ account, made

payable to herself or to cash. Although the memorandum line on

the checks indicated that they were executed as a “return” or

“replacement” for Ms. W., each check was endorsed only by

petitioner herself.

In the summer of 1990, petitioner borrowed $2,500 from a

tennis-playing partner named Phillip B.; he charged her no

interest on the loan. She made substantial repayments a few

months later.

5. Petitioner’s 1991 and 1992 Taxable Years

For the last two years in issue, 1991 and 1992, respondent

determined petitioner’s unreported income by applying cost-of-

living survey information published by the Bureau of Labor

Statistics (BLS). Respondent used BLS tables that classify the
 - 19 -

cost of living for specific years according to such factors as

age, size of consumer unit, occupation and location in the

greater New York area to determine that petitioner had a cost of

living-–and, hence, net income-–of $16,766 for 1991 and $17,461

for 1992.

OPINION

The Commissioner’s determinations in the notice of

deficiency are presumed correct, and petitioner bears the burden

of proving that the determinations are in error.3 See Rule

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

We note at the outset that petitioner has no credibility

with respect to the matters on which she testified. Her

testimony was shown on repeated occasions to be false, indicating

to us that she did not consider herself under any particular

obligation to testify truthfully in these proceedings. For

example, she denied absolutely that she, either in a personal or

corporate capacity, received any money for providing escort

services, although many of the 17 individuals identified in

respondent’s notice of deficiency testified credibly that they

paid her for such services. Also, petitioner first denied any

detailed knowledge regarding an eviction proceeding for an

3
Sec. 7491 does not apply to this case because the
examination commenced prior to July 22, 1998, the effective date
of that section. See Internal Revenue Service Restructuring and
Reform Act of 1998, Pub. L. 105-206, sec. 3001(c)(1), 112 Stat.
726.
 - 20 -

apartment she had rented, and then revealed a familiarity with

minute details regarding the proceeding when cross-examining

witnesses. In addition, on at least one occasion petitioner

sought to have a document admitted into evidence that she had

falsified. A witness testified credibly that petitioner provided

him with a written statement that contained a material

misstatement. He corrected the document and then signed it.

Petitioner then substituted a page of that document which failed

to reflect his correction before she submitted the document to

this Court. We accordingly give credence to petitioner’s

testimony and proffered documentary evidence only where we are

convinced by independent corroborating evidence of their veracity

or authenticity.

I. Whether Amounts Paid to or Received by Real Services Are
Properly Treated as Petitioner’s Taxable Income

The first issue to be addressed concerns the identity of the

taxpayer. Petitioner contends that she, individually, is not

liable for the taxes at issue; instead, she argues, the

corporation Real Services is liable for any taxes that may be

owing, because Real Services received the unreported income that

respondent has attributed to petitioner in his determination.

Taxpayers have the right to shape business transactions in a

manner that minimizes the incidence of taxation. Gregory v.

Helvering, 293 U.S. 465, 469 (1935). In this regard, a corporate

entity is deemed to exist as a separate taxpayer if it is
 - 21 -

organized to carry on a business activity or if, in fact, it has

carried on such activity. Moline Props., Inc. v. Commissioner,

319 U.S. 436 (1943). However, “in matters relating to the

revenue, the corporate form may be disregarded where it is a sham

or unreal. In such situations, the form is a bald and

mischievous fiction.” Id. at 439. In the latter situation, the

Government may not be required to acquiesce in the taxpayer’s

election of that form for doing business which is most

advantageous to him. The Government may look at actualities and

upon determination that the form employed for doing business or

carrying out the challenged tax event is unreal or a sham may

sustain or disregard the effect of the fiction as best serves the

purposes of the tax statute. See Higgins v. Smith, 308 U.S. 473,

477 (1940).

Here, if Real Services operated merely as a sham or the

alter ego of petitioner, its incorporation would have no impact

on her Federal income tax liabilities. See G.M. Leasing Corp. v.

United States, 429 U.S. 338, 350-351 (1977). The question before

us, then, is whether Real Services “conducted the kind and amount

of business activities to be a taxable entity.” Kimbrell v.

Commissioner, 371 F.2d 897, 902 (5th Cir. 1967), affg. T.C. Memo.

1965-115.

In this case, “Adopting a reasonable meaning of the Moline

Properties’ guiding phrase,” id., we hold that Real Services did
 - 22 -

not conduct sufficient business activities to be recognized for

Federal income tax purposes.

Petitioner’s activities with respect to Real Services reveal

many characteristics of an alter ego, such as:

“the intermingling of corporate and personal funds,
undercapitalization of the corporation, failure to
observe corporate formalities such as the maintenance
of separate books and records, failure to pay
dividends, insolvency at the time of a transaction,
siphoning off of funds by the dominant shareholder, and
the inactivity of other officers and directors.”
[LiButti v. United States, 107 F.3d 110, 119 (2d Cir.
1997) (quoting Bridgestone/Firestone, Inc. v. Recovery
Credit Servs., Inc., 98 F.3d 13, 18 (2d Cir. 1996)).]

Petitioner observed no meaningful distinction between her

personal funds and those of her corporation. Although petitioner

opened bank accounts in the name of Real Services, she siphoned

funds from that account for personal expenses and gifts. On the

other hand, petitioner wrote checks in her own name for

transactions that she now alleges were those of Real Services.

The record also reveals a number of checks made out to Real

Services from petitioner’s escort service clients, but the

evidence suggests that, in naming the payee, the clientele were

only following petitioner’s wishes.

There is no indication that Real Services was ever properly

capitalized; to the contrary, it often appeared to be insolvent.

Individuals such as John K. and Tammy M., who had made loans to

petitioner operating as Real Services, reported that checks they

received in repayment often were dishonored.
 - 23 -

Petitioner consistently ignored corporate formalities.

After the organizational meeting for Real Services, there is no

indication of another meeting of a board of directors. Real

Services maintained no office separate from petitioner’s personal

address, and petitioner was its only purported employee. There

is no evidence that Real Services furnished to outside parties

any papers relating to petitioner’s employment, such as tax

withholding forms or other payroll records. There are no

meaningful corporate records; petitioner produced only three

handwritten documents as records of the corporation–-one

indicating the costs of furnishing the E. 65th Street apartment

and the other two listing startup costs. Even petitioner’s

employment contract is suspect; it is a fill-in-the-blanks form

that contains many blanks and was executed several months before

the date that the hiring officer, petitioner’s companion Laura

C., allegedly assumed office. We reject petitioner’s contention

that other corporate records were stolen; we find it much more

likely that such records never existed. There is no history of

the declaration or payment of dividends.

No other individuals were active as officers or directors of

Real Services. Petitioner exaggerated the roles played by two

individuals named Ted P. and Michael S. in the operation of the

corporation. Petitioner, in fact, altered a document in which

Mr. P.’s son Brian had indicated to her that his father was not
 - 24 -

an officer of Real Services. Moreover, Mr. S. testified that he

was not involved in the directorship or management of Real

Services. Although Laura C. provided some testimonial support to

petitioner’s claims of corporate meetings and elections, we

believe that her testimony was coached and does not accurately

represent actual events.

There is no evidence of any business extending credit to

Real Services; for example, its name did not appear on any of the

documents used for its alleged leasing of real properties.

Indeed, the contrary appears to be true: on the E. 65th Street

apartment, the name of the lessee was Jane M., not Real Services,

and on the E. 77th Street apartment, the name was that of Joy C.,

not Real Services. Similarly, the lease for the W. 58th Street

apartment does not indicate that the lessor-sublessee was Real

Services.

Real Services’ alleged dealings in the Hawaii real property

are similarly suspect. These arrangements were made with

petitioner’s family members. Once again, many of the documents

executed in these transactions bear only petitioner’s name, and

not that of Real Services.

In sum, there is no evidence that Real Services engaged in

business as a separate entity. Petitioner cites clauses

typically used in preprinted forms for incorporating business

entities. The use of such clauses for Real Services, however,
 - 25 -

falls short of showing actual business activity by the

corporation. Nor is such activity reflected in petitioner’s

practice of having salespeople and customers use the name “Real

Services” when they executed sales slips and checks to

petitioner. The fact remains that no one who dealt with

petitioner did so with any reliance upon the business probity or

solvency of Real Services. To the extent that anyone acquiesced

in petitioner’s employment of the name “Real Services”, they did

so with the understanding that they were doing business with her,

and not with a corporation.4

We conclude that Real Services functioned merely as an alter

ego of petitioner and is therefore a sham corporation. As a

result, we disregard the existence of Real Services for purposes

of Federal taxation; the income at issue is properly taxed to

petitioner individually.

II. Whether Petitioner Had Unreported Income From an Escort
Business in 1989 and 1990

Petitioner operated an escort business as previously

described during 1989 and 1990. Although she denies involvement

with the escort business, and with the receipt of income from

4
In this regard, petitioner argues that the dealings of
Real Services involved making payments to a puppeteer. In
support she cites an exhibit that was not introduced into
evidence. She has made similar citations throughout her briefs.
These documents are not part of the record and have not been
considered in making our decision herein. Rule 143; see
Eickmeyer v. Commissioner, 66 T.C. 109, 110 n.3 (1976).
 - 26 -

that business, the evidence to the contrary provided by her

clientele is overwhelming. That evidence nonetheless falls short

of providing us with a firm basis upon which to calculate her

income from those activities. Perhaps unsurprisingly, few of the

witnesses have been entirely forthcoming, leaving us with an

unsatisfactory record.

Respondent has used the specific item method of

reconstructing petitioner’s income for 1989 and 1990. This

method depends upon proof of specific items of income that were

omitted from the taxpayer’s return. In Estate of Beck v.

Commissioner, 56 T.C. 297, 353 (1971), the Court stated: “the

‘specific item’ method of proof * * * simply consists of evidence

of particular or specific amounts of taxable income received by

the taxpayer during a particular tax period, with evidence that

the taxpayer did not include such amounts in his tax return”.

See also United States v. Merrick, 464 F.2d 1087, 1092 (10th Cir.

1972). In most instances, petitioner has presented evidence

disputing the specific amounts or taxability of the items in

question. We have used our best judgment on the basis of the

record before us to arrive at the amounts of income involved.

Respondent determined that petitioner had unreported escort

income of $3,600 in 1989 and $3,600 in 1990 from an individual

named Dennis T. Dennis T. testified, however, that he had only

legitimate business dealings with petitioner. He conceded that
 - 27 -

he engaged escort services at least six times at petitioner’s E.

77th Street apartment. The services were provided by women other

than petitioner. Dennis T. recalled the name used by

petitioner’s companion Laura C. and conceded receiving escort

services from her. There are no checks or other documentary

evidence connecting petitioner to any amounts Dennis T. may have

paid for escort services received at the E. 77th Street

apartment, where Ms. C. also resided. Although the evidence

demonstrates a business relationship between petitioner and

Dennis T., it fails to connect her with any of the money he paid

for escort services. We accordingly do not sustain the

determination.

Respondent determined that petitioner had unreported escort

income of $945 in 1989 and $945 in 1990 from an individual named

Michael S. Although Michael S. was a business associate of

petitioner’s and admitted paying for escort services at one of

petitioner’s apartments, the arrangements were made by, and the

money was paid to, Laura C., not to petitioner. The payments for

escort services by Michael S. have not been connected to

petitioner, and we accordingly do not sustain the determination.

Respondent determined that petitioner had unreported escort

income of $1,500 in 1989 and $750 in 1990 from an individual

named Paul G. Mr. G. testified that he paid between $1,500 and

$2,000 to petitioner for escort services during the period of
 - 28 -

their relationship, which he estimated to be approximately 2

years. His testimony and the documentary evidence support the

conclusion that he paid most of this amount in 1989, but that the

relationship continued into 1990. On the basis of his testimony,

we find that petitioner received $1,500 from Mr. G. in 1989 and

another $500 in 1990. We accordingly sustain all of respondent’s

determination except to the extent of $250 in 1990.

Respondent determined that petitioner had unreported escort

income of $10,500 in 1989 and $3,900 in 1990 from an individual

named Jeffrey F. The evidence adduced in connection with this

determination conflicts to some extent with the specific items of

income determined by respondent. Mr. F. recognized the name Real

Services as the payee of checks he used to acquire escort

services for his clients. The record contains one check from him

for $200 that petitioner deposited. Mr. F. also testified that

he paid between $5,000 and $15,000 to a woman named “Angel”, one

of petitioner’s nicknames, for escort services for his clients.

However, Mr. F. testified that these payments took place over a

10-year period during which he also used at least one other

escort service for his clients. Mr. F. was unable to identify

petitioner at trial, or to recall the amount he paid petitioner

during the years at issue. We conclude that the evidence

establishes that Mr. F. paid petitioner $1,500 in 1989 and $1,500
 - 29 -

in 1990. We accordingly sustain respondent’s determination to

that extent.

Respondent determined that petitioner had unreported escort

income of $1,400 in 1989 and $200 in 1990 from an individual

named Alexander K. The evidence with respect to these specific

items consists of Mr. K.’s check for $1,200 made out to Real

Services, dated October 12, 1989, which petitioner deposited into

the Real Services’ account; petitioner’s possession of Mr. K.’s

business card; Mr. K.’s testimony that he did not purchase escort

services from petitioner in 1989 or 1990, but that he entered

only the amount on the check and signed it; and petitioner’s

claim that the check was in payment for space for an office

party. Petitioner’s claim is uncorroborated; the amount is

improbable for the use of residential apartment space for a

party; and she is otherwise not credible. Given the other proof

of petitioner’s extensive dealings in providing escort services

in 1989, we find that the $1,200 payment in October 1989 was for

escort services. There is no other evidence that petitioner had

the specific items of income determined by respondent or which

connects petitioner to any payments from Mr. K. for any goods or

services. We accordingly sustain respondent’s determination only

to the extent that petitioner had unreported escort income of

$1,200 in 1989.
 - 30 -

Respondent determined that petitioner had unreported escort

income of $2,700 in 1989 and $2,700 in 1990 from an individual

named Richard S. Mr. S. testified that, between 1989 and 1992,

he utilized petitioner’s services “maybe once a month but not

necessarily for all that period of time” and paid $200 per visit.

Petitioner has failed to provide sufficient credible evidence

that Mr. S. paid her less than the amounts determined for the

years in issue. We accordingly sustain respondent’s

determination.

Respondent determined that petitioner had unreported escort

income of $2,350 in 1990 from an individual named Meyer S. Mr.

S. wrote 10 checks to cash during the first half of 1990 for

escort services arranged by petitioner.5 Petitioner deposited

the checks into the Real Services’ account. The 10 checks

totaled $1,450. The $1,450 in Meyer S.’s checks in the record

included $460 in checks that were dishonored, as well as $460 in

checks that replaced the dishonored checks. Thus, the documented

amount that Mr. S. paid petitioner for escort services in 1990 is

$990 ($1,450 less $460). We therefore hold that petitioner

received $990 as payment for the escort services she arranged for

5
Although Mr. S. testified that the checks were payment for
the use of petitioner’s apartment to work on clothing designs,
his testimony was highly implausible in the circumstances and not
worthy of belief. We find that Mr. S. testified falsely in view
of an obvious motive to avoid admitting to the purchase of escort
services.
 - 31 -

Mr. S. in 1990, and sustain respondent’s determination only to

that extent.

Respondent determined that petitioner had unreported escort

income of $200 in 1989 from an individual named Eric K. A check

in the amount of $200, dated June 23, 1989, was made payable to

cash, written by Eric K., and endorsed by Jane M., who provided

escort services to customers pursuant to petitioner’s

arrangements. In these circumstances, and because the check was

deposited into the Real Services’ account controlled by

petitioner, we sustain respondent’s determination.

Respondent determined that petitioner had unreported escort

income of $875 in 1989 and $875 in 1990 from Ronald K.

Respondent’s figures reflect seven escort sessions per year at

$125 per session. Mr. K. testified on cross-examination,

consistently with respondent’s determination, that he received

escort services arranged by petitioner on 12 to 15 occasions

during the 2-year period 1989 through 1990. He also testified

that he paid approximately $125 per occasion. Petitioner’s

contention that she paid $875 of this amount in 1990 to furnish

mud wrestlers at an event sponsored by Mr. K. was contradicted by

him, and we do not accept it. Accordingly, we sustain

respondent’s determination.

Respondent determined that petitioner had unreported escort

income of $6,000 in 1989 and $6,000 in 1990 from an individual
 - 32 -

named Michael L. Mr. L. testified to paying substantial sums for

escort services in 1989 and 1990 that were provided in

petitioner’s E. 77th Street apartment. He could not, however,

identify petitioner in person, and he was uncertain whether a

person he knew as “Angel” was the person depicted in a photograph

of petitioner taken close to the years in issue. He described

the “Angel” with whom he had dealings as a person who bears

little resemblance to petitioner. The record before us fails to

provide an adequate basis for finding that petitioner, rather

than some of her associates, received unreported income in the

form of direct payment for escort services from Mr. L. during the

years at issue. The evidence nevertheless supports a finding

that petitioner received $4,000 in escort income from Mr. L., and

that she received this amount in 1990. In the summer of 1990,

Mr. L. lent $4,000 to “Real Services Corp.” Two months later,

petitioner signed and issued a check, presumably in repayment,

for $4,800. The check was dishonored, and Mr. L. acknowledged

that his loan was “most probably” repaid in the form of escort

services. Although Mr. L. did not pay petitioner directly for

escort services, petitioner’s signature on the invalid check

nevertheless connects her to the receipt of $4,000 in 1990 in

exchange for which Mr. L. received such services. We accordingly

sustain respondent’s determination only to the extent of $4,000

of unreported escort income in 1990.
 - 33 -

Respondent determined that petitioner had unreported escort

income of $540 in 1990 from an individual named Harvey K. Mr.

K.’s testimony supports the determination in full, in that he

recalled paying petitioner for escort services on three or four

occasions in 1990, estimated the cost at between $100 and $200,

and acknowledged a check paid in one instance in 1990 for $180.

Respondent’s determination of $540 is three times this figure.

We do not accept petitioner’s contention that she and Mr. K. were

having an affair and that any escort-related activities involved

were independent of his giving her money. We accordingly sustain

respondent’s determination.

Respondent determined that petitioner had unreported escort

income of $1,300 in 1990 from an individual named Crihil I. A

check for $1,300 issued by Mr. I. on November 10, 1990 to

Jennifer R. and/or cash was endorsed by Jennifer R. to Real

Services and deposited by petitioner into one of her personal

bank accounts on November 15, 1990. Mr. I. did not testify and

Ms. R. is deceased.

Jennifer R. was one of the women who provided escort

services to customers pursuant to petitioner’s arrangements

during the years in issue. In these circumstances, and in light

of the other proof that petitioner was regularly engaged in the

provision of escort services in 1990, we conclude that this check

was for escort services arranged by petitioner. We reject
 - 34 -

petitioner’s contention that this $1,300 was a loan to her (or

Real Services) from Jennifer R. On the basis of the record in

this case as a whole, we do not believe that all of this money

belonged to Jennifer R. so that she could “lend” it to

petitioner. The credible testimony of other witnesses

establishes that single payments of this magnitude were sometimes

made for escort services arranged by petitioner when the occasion

was a “party” involving several customers. We infer that this

$1,300 payment was for escort services in addition to those

provided by Jennifer R. personally. In addition, the record as a

whole also establishes that when petitioner arranged for other

women to provide escort services, she did not do so for free.

Therefore, we believe that the check signed over to petitioner by

Jennifer R. included petitioner’s “brokerage” fee for the

transaction she had arranged. In sum, we are satisfied that the

evidence supports, and petitioner has demonstrated no error in,

respondent’s determination. We accordingly sustain it.

Respondent determined that petitioner had unreported escort

income of $1,200 in 1989 and $1,200 in 1990 from an individual

named Douglas B.; $1,440 in 1989 and $1,680 in 1990 from an

individual named Jerrold M.; $1,050 in 1989 and $1,050 in 1990

from an individual named William C.; and $400 in 1989 and $600 in

1990 from an individual named Takero O.
 - 35 -

In 1989, petitioner deposited a check payable to Real

Services from Douglas B. for $400. During 1990, petitioner

deposited into her Chemical Bank accounts two checks to cash

totaling $225 from Jerrold M., a check to cash for $200 from

William C., and two checks payable to cash totaling $140 from

Takero O. Petitioner claims that the $400 check from Douglas B.

represents repayment of a loan. She argues that she got two

checks from Jerrold M. for helping him to find his girlfriend.

She claims not to know William C. and that she got his $200 check

from a third party for room rental. She says the two checks

totaling $140 from Takero O., plus $10 cash, were payment for

tickets to a Broadway show. We do not accept her self-serving

testimony. See Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

To the contrary, in light of the other substantial evidence that

petitioner was in the business of providing escort services for

compensation during 1989 and 1990, her deposit of checks made out

to Real Services or to cash from Douglas B., Jerrold M., William

C., and Takero O. is sufficient, we conclude, to support the

finding that these six checks were payments to her for the

provision of escort services. On the other hand, these

individuals did not testify, and there is no evidence in the

record that petitioner had any specific items of income from

these individuals beyond the amounts evidenced by the checks. We

accordingly hold that petitioner had unreported escort income in
 - 36 -

1989 of $400 from Douglas B.; and in 1990 of $225 from Jerrold

M., $200 from William C., and $140 from Takero O., but we do not

otherwise sustain respondent’s determinations with respect to

these individuals.

Respondent determined that petitioner had unreported escort

income of $500 from Raj International in 1990. Although

petitioner endorsed and deposited into her account a $500 check

in November 1990 made payable to Real Services by Raj

International, we have found that this amount was a loan to

petitioner which she repaid later that year with funds drawn on

Real Services’ and her personal accounts. Accordingly,

respondent’s determination with respect to Raj International is

not sustained.

III. Whether Petitioner Had Unreported Income From Fraudulent
Loan and Investment Transactions

Respondent determined that petitioner received embezzlement

income in several instances during 1989 and 1990 by taking money,

as “investments” or “loans”, from friends and associates without

any intention of repayment. See, e.g., James v. United States,

366 U.S. 213, 219 (1961) (“wrongful appropriations” constitute

income if acquired with no intent to repay); United States v.

Rochelle, 384 F.2d 748, 751-752 (5th Cir. 1967) (fraudulent loans

are “wrongful appropriations” within the meaning of James v.

United States, supra). We consider each determination

separately.
 - 37 -

Respondent determined that petitioner received embezzlement

income of $18,500 from Michael S. in 1989. In pretrial

pleadings, respondent asserted that the $18,500 determination

consisted of: (i) $12,000 from petitioner’s sale to Michael S. of

a fictitious interest in certain real property in Hawaii; and

(ii) $10,000 from a fraudulent loan transaction involving Michael

S., of which petitioner had repaid $3,500.

Respondent now concedes that the $12,000 fictitious sale of

property was in fact a loan of $12,000 by Mr. S. to petitioner,

secured by an interest in any commission that petitioner might

receive on the sale of the Hawaii property.6 The evidence

adduced at trial establishes that petitioner partially repaid

this loan in a series of checks totaling $3,640 that were given

to Mr. S. during the first half of 1990.

On brief, respondent argues that the $12,000 loan was income

to petitioner in 1989, the year of its receipt, because she did

not intend to repay this amount to Michael S. Petitioner,

however, repaid $3,640 of the loan in 1990. We conclude that

this repayment evidences an intent to repay at the time she

obtained the loan, and that this intent continued at least

through some portion of 1990. Although respondent has modified

his theory to some extent in response to the evidence at trial,

6
Respondent seeks findings of fact to that effect in his
posttrial brief.
 - 38 -

he has not asserted in the alternative that petitioner received

income in 1990 as a result of this loan transaction. On this

record, we are persuaded that petitioner has shown error in

respondent’s determination that she had $12,000 in income in 1989

as a result of the payment from Michael S. in that amount.

Accordingly, the determination is not sustained.

With respect to the second element of respondent’s original

$18,500 determination, namely, the $10,000 fraudulent loan

transaction, petitioner claims that this amount represents the

proceeds from a sale of magnetic tapes from which she realized no

gain. At trial, Mr. S. corroborated petitioner’s claim by

testifying that he paid her $10,000 for magnetic tapes which he

then donated to a school.

On brief, respondent now argues that the $10,000, even if

paid for tapes provided by petitioner, was nevertheless income to

petitioner. Respondent’s propounding of the theory that the

$10,000 from Mr. S. was sales income, and not income from a

fraudulent loan transaction, is, at a minimum, “new matter”

within the meaning of Rule 142(a). Respondent’s adoption of this

theory (without making an allowance for cost of goods sold) is a

new theory which, if we considered it, would prejudice

petitioner. Its tardy assertion would deprive petitioner of an

adequate opportunity to acquire the requisite evidence of her

cost of goods sold. See Sundstrand Corp. v. Commissioner, 96
 - 39 -

T.C. 226, 347 (1991). Moreover, under Rule 142(a), respondent

would bear the burden of proof as to the issue whether the

$10,000 is sales income. Even if we permitted respondent to

raise this new theory, he would not prevail upon it because he

cannot carry his burden. The record shows that Mr. S. ordered

tapes from petitioner because he could get a “better rate” than

elsewhere. He wrote her checks totaling $10,000. One of those

checks, for $3,000, was returned unpaid. We believe that, if

petitioner provided a better rate than other sellers, her loss of

$3,000 on the sale likely prevented her from earning any profit

on the transactions. In any event, respondent has not shown

otherwise. We accordingly do not sustain any portion of

respondent’s determination that petitioner had $18,500 in

unreported income from Mr. S. in 1989.

Respondent determined that petitioner had unreported income

of $5,000 in 1989 from a loan transaction with an individual

named Howard S. On brief, respondent argues that this was a

“fraudulent” loan transaction in that petitioner had no intention

of repaying, making the original loan amount income to her in

1989.

We have found that Howard S. lent petitioner $5,000 in 1989

and that by the first quarter of 1991 she had repaid him $1,300.

Mr. S. acknowledged as much in early 1991 in an invoice that he

admits initialing. He subsequently sued petitioner in August
 - 40 -

1991 with respect to the loan, seeking $3,750, which further

confirms that significant repayment had been made.7 Respondent

makes no effort on brief to explain how petitioner lacked intent

to repay this loan when she in fact repaid approximately 25

percent. His determination is not sustained.

Respondent determined that petitioner had unreported

embezzlement income of $5,000 in 1989 from an individual named

Jane M. Although the evidence establishes that Jane M. was an

associate of petitioner’s, petitioner has denied receiving this

amount from Jane M. Respondent has not introduced evidence to

rebut this assertion, nor has he contested petitioner’s denial on

brief. We conclude that respondent has abandoned this issue, see

Julicher v. Commissioner, T.C. Memo. 2002-55; Zidar v.

Commissioner, T.C. Memo. 2001-200 (citing Bradley v.

Commissioner, 100 T.C. 367, 370 (1993)), and the determination is

accordingly not sustained.

Respondent determined that petitioner had unreported

embezzlement income of $13,250 from an individual named John K.

Respondent clarified in his answer that the determination was

7
Mr. S. subsequently made at least two statements to the
IRS in connection with these proceedings that were inconsistent
with these findings (and with each other), to the general effect
that none of the $5,000 had been repaid. We are convinced,
however, that Mr. S. would not have sued in 1991 for less than he
thought he was owed. Further, when confronted at trial with the
invoice documenting partial repayment, Mr. S. acknowledged his
initials on the document.
 - 41 -

based upon petitioner’s having received $15,000 from John K. in

1990 to invest on his behalf and having only repaid him $1,750.

John K. was a college friend of petitioner’s. Mr. K.

testified credibly that he turned over $10,000 to petitioner in

March 1990, based upon petitioner’s representation that she could

earn him a 25 percent return in 1 year. He believed that

petitioner was a savvy businesswoman and trusted her on the basis

of their friendship; he accordingly did not investigate her

claims or plans with any rigor, although he recalled that she

represented that the money would be invested in a real estate

project in the Midwest. Several months later, in August 1990,

petitioner advised Mr. K. that she had an investment opportunity

that would give him a profit in 30 days. Mr. K. gave petitioner

an additional $5,000 on her representation of a 30-day turnaround

for that investment. According to his testimony, when the $5,000

was not returned as promised, Mr. K. first suspected that

petitioner had taken advantage of their friendship and

“hoodwinked” him; he became convinced of that fact when neither

the $10,000 nor $5,000 was returned, and petitioner made excuses

that he did not believe.

Petitioner contends that these amounts are not income to her

because she genuinely tried and intended to repay Mr. K. These

amounts were not bona fide loans, however; the money was given on

the representation that it would be invested on Mr. K.’s behalf.
 - 42 -

Petitioner’s explanations of how the money was invested are

vague, uncorroborated, and/or contradicted by Mr. K.’s credible

testimony. On the basis of the evidence in the record, we are

convinced that petitioner exploited Mr. K.’s trust in her to

obtain the funds in issue, and then did not invest them as she

had represented. As a result, she exercised sufficient dominion

and control over the $13,250 she did not repay to render that

amount taxable to her in 1990. See James v. United States, 366

U.S. at 219 (proceeds over which taxpayer wrongly assumes “actual

command” taxable to him); United States v. Rochelle, 384 F.2d 748

(5th Cir. 1967); O’Sheeran v. Commissioner, T.C. Memo. 1983-702;

see also United States v. Rosenthal, 454 F.2d 1252, 1254 (2d Cir.

1972). We accordingly sustain respondent’s determination.

Respondent determined that petitioner had unreported

embezzlement income of $15,000 in 1990 from an individual named

Jennifer R. Respondent now asserts that petitioner had $17,700

of such income in that year.

Jennifer R. was one of the women who provided escort

services to customers pursuant to petitioner’s arrangements. Ms.

R. died before trial, and the evidence that has been offered with

respect to this item consists of the notes of one of respondent’s

agents concerning an interview he conducted with Ms. R. before

her death, two letter memoranda documenting payments from Ms. R.

to petitioner, and petitioner’s testimony.
 - 43 -

We turn first to the interview notes. Although respondent’s

original determination in the deficiency notice was that

petitioner had 1990 embezzlement income from Ms. R. of $15,000,

respondent now contends on brief that the amount is $20,000, less

a repayment of $2,300, or $17,700.8 Respondent bases his

assertion of an increased amount and the partial repayment on the

agent’s notes. We pass over the question whether the increased

deficiency respondent asserts has been properly raised in this

case, because we agree with petitioner that the agent’s notes,

which are the only basis for asserting the increased deficiency,

are inadmissible hearsay.

Respondent argues that the notes qualify for the exception

to the hearsay rule provided in Federal Rules of Evidence

804(b)(3). Respondent maintains that the notes embody a

statement against Ms. R.’s penal interest, because they reflect

Ms. R.’s statement that she earned money as a prostitute.

Respondent, however, does not seek the admission of the notes as

proof of Ms. R.’s illegal profession; respondent seeks their

admission to prove petitioner’s receipt of a net $17,700 in

embezzlement income from her. It is settled that a statement

against interest will not operate as an exception to the hearsay

8
Although respondent on brief repeatedly states the balance
of $20,000 less $2,300 as $17,800, we deem respondent to have
taken the position that petitioner had unreported embezzlement
income from Jennifer R. of $17,700.
 - 44 -

rule when the statement sought to be introduced is only

collateral to the statement against the declarant’s interest.

Williamson v. United States, 512 U.S. 594, 599-600 (1994). Such

is the case with the statement respondent seeks to introduce. We

accordingly decline to consider respondent’s allegation that

petitioner had embezzlement income in an increased amount of

$17,700 from Ms. R. The sole basis for the allegation is

inadmissible hearsay.9

With respect to respondent’s original determination that

petitioner had embezzlement income of $15,000 from Ms. R. in

1990, the two letter memoranda executed by petitioner establish

to our satisfaction that petitioner received $5,000 and $10,000

from Jennifer R. in July and November 1990, respectively. In

these memoranda, petitioner acknowledges receipt of the foregoing

amounts, promises to invest the money, and guarantees a “minimum

return” or “return” of 25 percent in 1 year (in one instance) or

45 days (in the other). We are struck by the similarity of these

arrangements with those that petitioner foisted upon John K.

That is, in the same year, with respect to both John K. and

Jennifer R., petitioner first obtained a substantial sum

9
Respondent also concedes on brief that the revenue agent’s
notes provide the sole basis for his determination that
petitioner had unreported income of $2,600 in 1990 from the sale
of electronics to Jennifer R. Because the notes are likewise
inadmissible hearsay with respect to this transaction, there is
no competent evidence that petitioner had this specific item of
income, and we accordingly do not sustain the determination.
 - 45 -

promising to return it in 1 year with a guaranteed return, and

then went back to each individual several months later and

persuaded him or her to part with another substantial sum by

promising a quick return in 30 or 45 days. We draw the inference

that petitioner engineered a scheme with Jennifer R. that was

similar to the scheme to which John K. testified.

Unlike the situation with John K., Jennifer R. was deceased

at the time of trial and unable to give testimony from which we

might determine whether her payments to petitioner were loans or

entrustments of funds to invest. Regardless of which

characterization is more accurate, we are satisfied that

petitioner is taxable on the amounts Ms. R. turned over to her in

1990. We decline to accept petitioner’s self-serving testimony

regarding her dealings with Ms. R. Absent petitioner’s

testimony, there is no evidence that petitioner repaid the

amounts at issue when due or ever,10 and Ms. R. is now deceased.

10
To support her claim that she made repayment to Jennifer
R., petitioner offered into evidence two deposit slips dated in
January 1991 evidencing deposits totaling $2,771 into an account
in the name of Jennson Co. The exhibits were not admitted
because their relevance to Jennifer R. was not established. As
part of her posttrial brief, petitioner submitted a copy of a
business certificate indicating that Jennifer R. was conducting
business under the name Jennson Co. Even if the foregoing
exhibits were admitted, however, they would not establish
repayment because there is no proof that petitioner made the
deposits or, even if petitioner made them, that the deposits
represented repayments with respect to the $15,000 in issue-–as
opposed to, e.g., payments to Jennifer R. for rendering escort
services pursuant to petitioner’s arrangements.
 - 46 -

There is likewise no evidence that the funds were invested as

petitioner represented to Ms. R. in the letter memoranda. Based

on the record as a whole, we are satisfied that petitioner has

failed to demonstrate error in respondent’s determination that

she had $15,000 in unreported income in 1990 as a result of

payments to her from Jennifer R. in that amount; we accordingly

sustain the determination. See James v. United States, 366 U.S.

213 (1961); United States v. Rosenthal, 454 F.2d 1252 (2d Cir.

1972); United States v. Rochelle, 384 F.2d 748 (5th Cir. 1967).

IV. Whether Petitioner Had Unreported Income From Sales and
Rentals During 1989 and 1990

Respondent determined, also using the specific item method,

that petitioner had unreported income from certain sales and

rental activity during 1989 and 1990.

A. 1989 Sales of Electronics, Theater Tickets, and Music
Tapes

Respondent determined that petitioner had unreported income

from the sale of electronics of $10,500 from individuals named

Brian and Ted P. and $8,200 from an individual named Howard S.

Petitioner does not dispute receipt of these amounts,11 except

for $400 of the $8,200 received from Howard S. We agree with

11
Although respondent originally determined that petitioner
had unreported income in 1989 of $10,500 from electronics sales
to Brian P., the parties subsequently stipulated that the amount
received from Brian (and Ted) P. from the sale of electronics and
certain introductory fees was $10,800 in 1989.
 - 47 -

petitioner regarding this $400 and do not sustain that portion of

respondent’s determination.12

Respondent conceded at trial that petitioner is entitled to

a cost-of-goods-sold allowance with respect to the foregoing

sales of $1,360.13 We conclude that petitioner has produced

documentary evidence and testimony which establish that she may

increase her cost-of-goods-sold allowance by an additional

$4,011, for a total of $5,371, with respect to goods sold to

those individuals.

The difference between the $18,300 petitioner demonstrably

received from the P.’s and from Mr. S. in exchange for

electronics merchandise provided to them and the $5,371 we have

concluded petitioner paid for those goods is surprisingly large

and reflects substantial unreported income. In making our

allowance for the cost of goods sold to the P.’s and to Mr. S.,

we have resolved doubts in favor of petitioner, even to the

12
Petitioner objected to respondent’s “specific item”
evidence for $400 of the amount received from Howard S. because
the check documenting this amount states clearly that it is for a
“ticket purchase”, whereas respondent’s determination, answer,
and pretrial memorandum all took the position that the foregoing
amount was for electronics. We advised respondent’s counsel
prior to trial that if the $400 check was intended to prove
receipt of income by petitioner from the sale of tickets,
respondent would be required to amend his pleadings. Respondent
sought no leave to amend, and we accordingly treat the $400
specific item of income from Howard S. as abandoned.
13
Although respondent contends on brief that the total
conceded is $890, he clearly conceded an additional $470 at trial
with respect to Howard S., for a total of $1,360.
 - 48 -

extent of accepting her reasonably based estimated cost of a

speaker system and a receiver. She has claimed no larger costs

than we have found, and, in any event, the record does not

support our allowing her more. Although we suspect that the

actual cost of goods sold was higher, we cannot make that

estimate absent a demonstration “that at least the amount allowed

in the estimate was in fact spent or incurred for the stated

purpose. Until the trier [of fact] has that assurance from the

record, relief to the taxpayer would be unguided largesse.”

Williams v. United States, 245 F.2d 559, 560 (5th Cir. 1957); see

Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930).

Based on the foregoing, we hold that petitioner had

unreported sales income from Brian and Ted P. and Howard S. in

1989 of $12,929 (i.e., $18,300 gross receipts less $5,371 in

costs of goods sold).

Respondent determined that petitioner had unreported income

of $300 in 1989 from the sale of tickets and tapes to an

individual named David M. In August of 1989, David M. wrote a

check to petitioner individually for $300 for the purchase of

tickets to the Broadway show “Phantom of the Opera”. Petitioner,

however, has provided a receipt showing that she paid $300 for

those tickets. She accordingly has no unreported income from the
 - 49 -

transaction with Mr. M., and respondent’s determination is not

sustained.14

Respondent determined that petitioner had unreported income

of $110 in 1989 from the sale of tickets and tapes to an

individual named Paul H. In September of 1989, Paul H. wrote a

check to Real Services in the amount of $110, in payment for

prerecorded music tapes. Petitioner deposited this check into

Real Services’ checking account. Respondent concedes that

petitioner is entitled to a cost-of-goods-sold allowance of $12

with respect to these tapes. We accordingly find that petitioner

had unreported income of $98 in 1989 from this transaction and

sustain respondent’s determination to that extent.

B. 1990 Sales of Electronics and Rental Income

Respondent determined that petitioner had unreported income

of $3,000 in 1990 from the sale of additional electronic

equipment to Ted and Brian P. Brian P. confirmed this amount at

trial. From numerous receipts, petitioner has identified the

items that she purchased and resold to Ted and Brian P. The

receipts indicate that her cost for this electronic equipment

14
Petitioner claims an additional $250 exclusion from
income, relying upon documentary evidence that she paid that
amount for tickets to the Broadway show “M. Butterfly”. The case
of Mr. M. indicates, however, that petitioner charged her
customers what she paid for Broadway tickets. There is no basis
to assume otherwise in the case of the tickets for “M.
Butterfly”. Absent some proof to the contrary, we believe that
petitioner received full payment for those tickets, offsetting
the amount she used to buy them. There is thus no taxable event.
 - 50 -

totaled $2,628.15 Accordingly, we conclude that petitioner is

entitled to a cost-of-goods-sold allowance of $2,628 with respect

to the $3,000 in sales to Ted and Brian P. and sustain

respondent’s determination only to the extent of $372.

Respondent determined that petitioner had unreported income

of $2,775 in 1990 from the sale of additional electronic

equipment to Howard S. Howard S. paid petitioner $2,775 for

electronic equipment in that year. Petitioner sold him a 52-inch

rear-projection television and two answering machines. The rear-

projection television cost $2,902, including taxes and shipping,

while the answering machines cost her $210.16 As petitioner has

shown that she had product costs for goods transferred to Mr. S.

in 1990 that exceed the amount that respondent determined was

paid to her by Mr. S., we conclude that petitioner has

demonstrated error in respondent’s determination and do not

sustain it.

15
Petitioner’s brief overstates by $100 the cost of
equipment purchased on Feb. 22, 1990, and resold to Ted and Brian
P.
16
Mr. S.’s complaint in his previously noted lawsuit
against petitioner states that he never received the projection
television set. His later affidavit states, however, that he
received the set, but that it was in defective condition and he
never received a replacement. Petitioner has submitted evidence
of the purchase of the set, its delivery to Mr. S., and two
service calls to repair the set. On this record, we conclude
that Howard S. paid for and received a 52-inch rear-projection
television.
 - 51 -

Respondent determined that petitioner had unreported income

of $1,400 in 1990 from the sale of electronics to an individual

named Kenny T. We find, however, that she neither made nor lost

money on these sales. She sold Mr. T. a video cassette recorder

and a television for the same amount she was required to pay her

supplier for these items. Although the television was returned

to the supplier for a credit equal to what petitioner (and Mr.

T.) had paid, there is no evidence or suggestion that petitioner

retained the $1,200 that Mr. T. had paid her. We accordingly do

not sustain the determination.

Petitioner also paid $1,147 for items that she asserts she

provided to Jennifer R. in repayment of a loan in 1990. Although

petitioner has presented receipts showing her purchases in these

amounts, we have only her self-serving testimony that these items

were delivered to Ms. R., and Ms. R. is deceased.

Respondent determined that petitioner had unreported income

of $2,800 in 1990 from the rental of an apartment to an

individual named Terri D. Petitioner concedes receiving $2,800

in 1990 for the short-term rental of the apartment on W. 58th

Street but asserts that it was paid to Real Services and is not

income to her individually. Because we have elsewhere concluded

that Real Services should be disregarded for tax purposes, we

hold that the $2,800 is taxable income to petitioner and sustain

respondent’s determination.
 - 52 -

V. Whether Petitioner May Deduct Business Expenses in Excess of
Those Allowed by Respondent

A. Business Expenses in 1989

Petitioner maintains that, if we find that she was engaged

in providing escort services, respondent has failed to allow her

a sufficient deduction for the amounts she was required to pay to

the women she arranged to engage in those services. Petitioner

strenuously denies that she was engaged in providing escort

services. Nevertheless, she argues in the alternative that if we

find she was engaged in such a business, we should allow her to

deduct 50 to 60 percent of the gross receipts in recognition of

the fact that she was required to pay the women who actually

rendered the services.

Under certain circumstances, where a taxpayer establishes

his entitlement to a deduction, but does not establish the amount

of the deduction, we are permitted to estimate the amount

allowable. Cohan v. Commissioner, supra. In so doing, we bear

heavily against the taxpayer, who is responsible for the

uncertainty. Id. at 543-544. In this case, respondent has

allowed a deduction equal to 31.64 percent of the amount

determined as escort income in 1989 as specific expenses of

petitioner’s escort business. Petitioner has failed to establish

that she is entitled to larger deductions than those allowed by

respondent. We therefore hold that she may deduct, as business
 - 53 -

expenses, 31.64 percent of the amounts that we have held were

unreported escort income for 1989.

Petitioner asserts and respondent concedes that during 1989

petitioner incurred rental expenses of $7,763 and an electricity

expense of $302 with respect to the apartment on E. 65th Street,

at which petitioner’s escort business was conducted. We hold

that she is entitled to deduct these amounts as business expenses

in 1989.

During 1989, petitioner lived in the apartment at E. 77th

Street. She had a room in that apartment in which she conducted

office business and in which, to some extent, escort services

were provided. She now claims one-third of the rentals paid for

that apartment during 1989 as a home office deduction.

In general, a taxpayer is not entitled to deduct any

expenses related to the use of a dwelling unit used by the

taxpayer as a residence during the taxable year. See sec. 280A.

The statute provides an exception to this general rule, however,

if the expenses are allocable to a portion of the dwelling which

is used exclusively on a regular basis as the principal place of

business for the taxpayer’s trade or business. Petitioner’s

claims that the room was used exclusively for business purposes

and that it was her principal place of business rest entirely on

her own testimony which, as we have concluded elsewhere, should
 - 54 -

not be given any credence. Accordingly, we hold that she is not

entitled to the claimed home office deduction for 1989.17

Respondent has conceded that during 1989 petitioner incurred

deductible business expenses of $825 for office expenses, bank

charges, printing expenses, and travel. Petitioner has claimed

that she is entitled to deduct other expenses in addition to

those conceded by respondent. She has borne her burden of

proving that she is entitled to deduct additional printing costs

of $24 and miscellaneous costs paid to contractors of $132.

Petitioner further claims a deduction of $5,220 in 1989 for

telephone service. She claims that she maintained one personal

telephone line and two business lines, located in two of her

apartments, and seeks deductions with respect to the claimed

business lines.18 She has offered as proof cancelled checks and

receipts from the telephone company. We are not convinced that

she made payments in the amounts claimed. The records proffered

for each of the claimed business telephone lines contain

cancelled checks that are duplicates of those submitted in

17
Petitioner also claims a deduction of 3 months’ rent in
the summer of 1989 when she allegedly provided a home to Jane M.
in order to move Ms. M. out of the apartment on E. 65th Street.
Petitioner has not established that this was legitimately a trade
or business expense, and accordingly we do not allow the claimed
deduction.
18
Sec. 262(b) provides that, in the case of individuals,
charges for basic local telephone service with respect to the
first telephone line provided to a residence are nondeductible
personal expenses.
 - 55 -

support of deductions for the other line. Moreover, the records

do not distinguish whether the telephone charges were for local

or long distance service.

The magnitude of the telephone expenses petitioner seeks to

deduct suggests to us that significant long-distance charges are

included in the figure. The documentation proferred by

petitioner generally does not indicate what portion of the

charges was for long-distance, nor has she proven a business

purpose for significant long-distance charges. However, we are

persuaded that petitioner’s escort business almost certainly

involved the use of local telephone service to arrange

appointments. In these circumstances, we allow a deduction of

$600 for local telephone expenses at the locations where she

conducted her escort business during 1989. See Cohan v.

Commissioner, supra.

The deduction of other claimed expenses for 1989 requires

closer examination. The allowance of travel and entertainment

business deductions described in section 274 are subject to

strict rules of substantiation. Section 274(d) provides that,

unless the taxpayer complies with these rules, no deductions

shall be allowed with respect to “any traveling expense

(including meals and lodging away from home),” or “for any item

with respect to an activity which is of a type generally

considered to constitute entertainment”. The rules require the
 - 56 -

taxpayer to substantiate by adequate records or by sufficient

evidence to corroborate the taxpayer’s own testimony: (a) The

amount of the expenditure, (b) the time and place of the

expenditure, (c) the business purpose of the expenditure, and (d)

the business relationship to the taxpayer of the person being

entertained.

For 1989, petitioner claims a business expense deduction of

$180 for the cost of meals billed through the Vassar Club.

Inconsistencies between the handwritten and printed receipts from

the Vassar Club, however, prevent us from finding that she has

adequately substantiated the business meal deductions claimed.

Nor has she adequately demonstrated the business purposes of

claimed travel expenses totaling $343 for separate trips in 1989

to Florida and to Washington, D.C.

Petitioner also claims deductions in 1989 for $3,000 in

legal and professional fees paid to the law firm of Saltzman &

Holloran and to the Prentice-Hall Financial Service relating to

the incorporation of Real Services. She also seeks to deduct the

filing fees charged for such incorporation. Assuming arguendo

that the claimed expenses of incorporating a corporation found to

be a sham for tax purposes have a business purpose, these

expenses would nevertheless not be deductible in 1989;19 these

19
Organizational expenses incurred and paid by a
corporation can be amortized at its election over a 60-month
(continued...)
 - 57 -

costs, which petitioner incurred in connection with the

acquisition of a capital asset-–that is, the stock of Real

Services--are capital in nature and not currently deductible.

See Woodward v. Commissioner, 397 U.S. 572, 575 (1970);

Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775, 781 (2d

Cir. 1973), revg. on other grounds and remanding T.C. Memo. 1972-

43; Lychuk v. Commissioner, 116 T.C. 374, 389 (2001).

The situation is different, however, with respect to the

other $1,000 in legal fees claimed by petitioner. Those fees,

incurred by petitioner against charges that she was using the

apartment on E. 77th Street for an illegal purpose, were incurred

in connection with the preservation of the income-producing

activities associated with her escort business and are

deductible. See Johnson v. Commissioner, 72 T.C. 340, 348

(1979).

Petitioner also maintains that she entered into a real

estate brokerage agreement with her sister and another

individual, who were owners of some valuable real estate in

Hawaii. She argues that this arrangement resulted in her making

deductible expenditures during either 1989 or 1990.20 Even if we

accept petitioner’s contention that she had a valid broker’s

19
(...continued)
period beginning when its business commences. Sec. 248.
20
Although petitioner contends that the expenditures were
incurred in 1989, she claims deductions for them in 1990.
 - 58 -

agreement to sell the property, and, further, that she spent

substantial sums in preparing the property for sale, she has

failed to demonstrate that she is entitled to deduct any of the

claimed expenditures in either 1989 or 1990. Deductions are a

matter of legislative grace, and a taxpayer claiming a deduction

bears the burden of clearly showing that the terms of the

applicable statute have been satisfied. INDOPCO, Inc. v.

Commissioner, 503 U.S. 79, 84 (1992); Holmes v. United States, 85

F.3d 956 (2d Cir. 1996); Stark v. Commissioner, T.C. Memo.

1999-1.

Petitioner initially claims that she may deduct these

expenditures as business expenses under section 162 or as

expenses for the production of income under section 212. Here,

however, the details concerning the property in Hawaii and its

disposition are too vague and contradictory to support such

deductions. For example, there is evidence that, in May of 1990,

petitioner’s sister in Hawaii sent petitioner $1500 in the form

of credit from a bank in Hawaii. On brief, petitioner maintains

that she received this $1,500 "back in regard to expenses paid."

This suggests that the amounts petitioner expended upon the

property in 1989 were loans or advances to her sister, rather

than expenses of her own. She has not demonstrated otherwise,

and we hold that she is not entitled to deduct the claimed

expenditures under either section 162 or 212 in 1989 or 1990.
 - 59 -

Petitioner alternatively claims a deductible loss in 1990

based upon her ultimate failure to recover these expenditures.

She explains that when the property did not sell, it was

foreclosed upon. Section 165(a) allows a deduction for "any loss

sustained during the taxable year and not compensated for by

insurance or otherwise." To be claimed as a deduction, a loss

must be evidenced by a closed or completed transaction. United

States v. S.S. White Dental Manufacturing Co., 274 U.S. 398, 401

(1927); Ramsay Scarlett & Co. v. Commissioner, 61 T.C. 795, 807

(1974), affd. 521 F.2d 786 (4th Cir. 1975); sec. 1.165-1(b),

Income Tax Regs. If the taxpayer has a claim for reimbursement

of a loss and there is a reasonable prospect of recovery, the

loss is not deductible until it can be ascertained with

reasonable certainty whether or not the reimbursement will be

received. Ramsay Scarlett & Co. v. Commissioner, supra; Julicher

v. Commissioner, T.C. Memo. 2002-55; sec. 1.165-1(d)(2)(i) and

(3), Income Tax Regs. The evidence before us, although far from

clear, indicates petitioner was being repaid some amounts of

these expenditures in 1990, the year for which she claims the

loss, and, further, that the foreclosure did not take place until

1991, 1 year later than the year for which she claims the loss.

The return of $1,500 of her expenditures in 1990 suggests that

she had a reasonable prospect of recovery for the claimed loss in

the year for which the deduction is claimed; petitioner has not
 - 60 -

proven otherwise. Alternatively, the fact that foreclosure did

not occur until 1991 indicates that there was no closed or

completed transaction in 1990. Accordingly, we hold that

petitioner has failed to demonstrate that she is entitled to

deductions from income tax with respect to the property in

Hawaii.

B. Business Expenses in 1990

Petitioner also claims a deduction in 1990 for the amounts

she was required to pay the women who provided escort services

pursuant to her arrangements, equal to 50 to 60 percent of gross

receipts. Respondent has allowed a deduction equal to 27.04

percent of the amount determined as escort income in 1990 as

specific expenses of petitioner’s escort business. On the same

basis as our conclusions for 1989, we find that petitioner has

failed to establish that she is entitled to larger deductions

than those allowed by respondent. We therefore hold that

petitioner may deduct 27.04 percent of the amounts we have held

were unreported escort income for 1990.

Petitioner also claims as deductions $220 allegedly paid to

third-party contractors in 1990. The record, however, fails to

provide sufficient substantiation for us to permit this

deduction.

Petitioner asserts, and respondent concedes, that petitioner

is entitled to a deduction for rent of $3,600 and utility
 - 61 -

expenses of $223 in 1990 with respect to the apartment on W. 58th

Street.

Petitioner continued to rent the apartment on E. 65th Street

for business purposes during 1990. She asserts, and respondent

concedes, that she is entitled to a deduction for rent of $13,983

and utility expenses of $790 in 1990 with respect to the

apartment on E. 65th Street.

In 1990, petitioner continued to live in the apartment on E.

77th Street. As was the case for 1989, however, we do not accept

her uncorroborated testimony regarding exclusive business use of

the furniture or any portion of the space. She has thus failed

to demonstrate that she is entitled to any business-related

deductions for 1990 rental costs of this property. Petitioner

has also failed to prove to our satisfaction that $857 of

furniture she claims to have purchased in 1990 was used in her

trade or business and thus could be deducted as a business

expense or in the form of depreciation deductions. See secs.

162(a), 167(a).

Respondent has allowed petitioner $100 for messenger

expenses in 1990 and an additional $114 in shipping and mailing

expenses. Petitioner has satisfied us that she is entitled to

claim an additional $12.60 in mailing expenses, but she has not

provided substantiation for an additional claimed $114.75 for

such expenses.
 - 62 -

Respondent has also conceded that petitioner may claim, as

business expenses, monthly bank service charges totaling $220 in

1990 on Real Services’ checking account. She claims that she

should be allowed to deduct additional service charges imposed on

her personal account, but she has failed to substantiate to our

satisfaction either the amount of these claimed expenses or their

business purpose. Petitioner has also failed to meet the

substantiation requirements of section 274 with respect to a

claimed traveling expense deduction in 1990 of $92.

Petitioner further claims a deduction of $4,064.10 for

telephone service in 1990. As was the case for 1989, her

documentary evidence is duplicative and unclear, and there is

generally no basis to distinguish between local and long-distance

charges. We are persuaded, however, that local telephone service

was utilized by petitioner to conduct her escort business. Again

exercising our discretion under the Cohan rule, we hold that she

may deduct $600 in 1990 for local telephone expenses at the

locations where she conducted her escort business in that year.

Petitioner may deduct additional legal fees of $1,650,

incurred in 1990 by her in defense against charges that she was

using the apartment on E. 77th Street for an illegal purpose,

because they were incurred in connection with the preservation of

her income-producing activities and are deductible. See Johnson

v. Commissioner, 72 T.C. at 348. Similarly, she has demonstrated
 - 63 -

that the amount of $400, paid to an attorney in connection with

obtaining a lease for the W. 58th Street apartment, is properly

deductible, because, as we have found above, she used that

apartment for income-producing purposes.

Petitioner’s testimony and the introduction of a cancelled

check indicates that she paid her brother $150 in 1990 for

appraisal fees concerning some property in Ohio that was

inherited from their father. Petitioner argues that she, as Real

Services, might have been interested in selling the property at a

profit and is therefore entitled to deduct this $150. As was the

case with the 1989 Hawaiian property expenditures, however,

petitioner has failed to show that the $150 qualifies as a

deduction. She testified that, when the property was sold, “Real

Services was returned $175 in regard to this loan”. It thus

appears that her check for $150, rather than being a deductible

expense, was a loan or advance to her brother.

C. Interest Deductions in 1990

Petitioner borrowed money from a number of people in 1990

and now claims that she should be allowed to deduct the interest

she paid to her lenders. Petitioner, however, has failed to

establish that she actually paid such interest. As noted above,

she borrowed $4,000 from Michael L. and, a few months later,

wrote him a check in repayment of $4,800. But the repayment

check was dishonored, and Mr. L. acknowledged that his loan was
 - 64 -

“most probably” repaid in the form of escort services. We held

that petitioner derived $4,000 in escort income from this

transaction. This evidence does not demonstrate that petitioner

is entitled to an interest deduction.

Petitioner also claims a deduction for interest paid to

Vania W., as a result of a $2,500 “loan” made to her by Ms. W.

“for investment purposes” in February 1990. However, the

documents petitioner offered in support of the claimed interest

payments are not competent evidence for this purpose,21 and Ms.

W. did not testify. Petitioner has failed to prove the amount of

any repayment to Ms. W. that may have occurred, or the amount of

principal repayment versus interest.

Petitioner claims a $200 interest deduction with respect to

a loan from Phillip B., but undercuts that claim with other

testimony to the effect that this loan was to be one with “no

interest”. She additionally claims that, if we find that she was

in the escort business, she is entitled to an interest deduction

of $875 for escort services provided to Ronald K. His testimony,

however, is that she provided the services (less frequently than

she now claims) only as a favor. Once again, this testimony

fails to support a finding that petitioner incurred a deductible

21
Ms. W.’s written statements regarding repayment were
excluded as hearsay, and the checks that petitioner claims
reflect repayment to Ms. W. were made out to petitioner herself
or cash.
 - 65 -

interest expense. Finally, the testimony of Tammy M., one of the

women who provided escort services to customers pursuant to

petitioner’s arrangements, fails to establish that petitioner

paid interest with respect to any loan from Ms. M. Ms. M. lent

petitioner $6,000, and respondent concedes that petitioner wrote

checks in repayment totaling at least $6,070. Ms. M. testified,

however, that many of petitioner’s repayment checks were

dishonored. She also testified that, while she may have

recovered the amount of her loan to petitioner, she received no

more than that. We thus cannot find that petitioner has

established her entitlement to a deduction for interest from her

dealings with Ms. M.22

VI. Whether Petitioner Has Unreported Income in 1991 and 1992

For the last 2 years in issue, 1991 and 1992, respondent

determined that petitioner had unreported income by

reconstructing her income using cost-of-living survey information

published by the Bureau of Labor Statistics (BLS). Respondent

employed this data to determine that petitioner had a cost of

22
In addition to claiming deductions for interest,
petitioner also claims deductions for the repayment of principal
in various instances. There is no legal basis for her to deduct
repayments of principal per se. Our findings of unreported
income to petitioner from embezzlement, however, have excluded
amounts she repaid. Petitioner has thus received the benefit of
her repayments for tax purposes where appropriate. See Collins
v. Commissioner, 3 F.3d 625 (2d Cir. 1993), affg. T.C. Memo.
1992-478.
 - 66 -

living-–and, hence, net income-–of $16,766 for 1991 and $17,461

for 1992.

We have approved the Commissioner’s use of cost of living

statistics, such as BLS survey statistics, to reconstruct the

amount of a taxpayer’s income. We explained in Giddio v.

Commissioner, 54 T.C. 1530, 1533 (1970):

Where * * * there is evidence of taxable income but no
information can be acquired to ascertain the amount of
such income, we do not think it is arbitrary for the
Commissioner to determine that the taxpayer had income
at least equal to the normal cost of supporting his
family. [Citation omitted.]

As noted earlier, respondent’s determinations are

presumptively correct. Rule 142(a). In cases involving the

Commissioner’s determination of unreported income, however, the

presumption of correctness may not attach if the notice of

deficiency is unsupported by any evidence. Schaffer v.

Commissioner, 779 F.2d 849, 858 (2d Cir. 1985), affg. in part and

remanding in part Mandina v. Commissioner, T.C. Memo. 1982-34.

Thus, in unreported income cases, imposition of the burden of

proof upon the petitioner requires that the “record must at least

link the taxpayer with some tax-generating acts”. Llorente v.

Commissioner, 649 F.2d 152, 156 (2d Cir. 1981), affg. in part and

revg. and remanding in part 74 T.C. 260 (1980). In the absence

of evidence linking the taxpayer with such acts, a notice of

deficiency will be found arbitrary, insofar as it covers periods

for which there is no evidence of direct involvement. Id.
 - 67 -

In this case, petitioner disputes respondent’s determination

of unreported income for 1991 and 1992, claiming that there is no

reliable evidence that she earned taxable income in those years.

To the contrary, she maintains, after 1990 she abandoned her

business activities and moved in with family members who

supported her.

Evidence linking petitioner to taxable income for 1991 and

1992 is no more than tenuous. Revenue Agent Schnorbus, who

examined petitioner’s tax liability for the years in issue,

testified that the majority of the parties he interviewed told

him that they did not have dealings with petitioner in 1991 or

1992. Agent Schnorbus was not aware of any bank accounts which

reflected that petitioner earned income or had a business in 1991

or 1992.

Agent Schnorbus indicated that he believed that two of

petitioner’s associates, Jeffrey F. and Richard S., had told him

that they had engaged in business activities with petitioner

during 1991 and 1992. Agent Schnorbus conceded, however, that

neither had provided canceled checks nor other documents showing

that there were any such dealings in those 2 years. Moreover,

although respondent introduced notes of an interview that Agent

Schnorbus had conducted with Mr. F., those notes make no

reference to petitioner’s receipt of income for 1991 or 1992.

Finally, Agent Schnorbus stated that although he had made notes
 - 68 -

of the interview with Mr. S., those notes had been lost before trial.

Both Mr. F. and Mr. S. testified at trial. Mr. F. stated

that he referred business clients to an “Angel” for escort

services “probably sometime between–-sometime between ‘82 and

‘92.” He later added, “somewhere in around there.” He did

business with the escort service for “6 or 7 years.” At trial,

however, Mr. F. failed to identify petitioner as the “Angel” to

whom he sent his clients. On cross-examination, petitioner asked

Mr. F. if he could have stopped using the escort services prior

to 1989. He replied: “It’s possible. I don’t think so, but

it’s possible.”

Similarly, at trial, respondent’s counsel asked Mr. S.:

“Did you engage in any business transactions with Ms. Pappas

during the years 1989 through 1992, sir?” Mr. S. replied: “Yes,

I did.” He identified the nature of those business transactions

as “sexual favors”. When asked specifically about 1989, however,

Mr. S. replied: “I can’t guarantee that it was 1989. I just

* * * don’t remember back that far.” On cross-examination,

petitioner asked Mr. S. whether the events in his narration to

the IRS could have occurred prior to 1989. He replied: “It’s

possible.” She also asked “So in fact all of this activity could

have occurred prior to 1989?” Mr. S. replied: “Could have.”
 - 69 -

Mr. S.’s testimony also establishes that he abused alcohol during

the periods in which he engaged in transactions with petitioner.

In the final analysis, the record in this case shows that

the examining agent believed that two individuals had informed

him of business dealings with petitioner in 1991 and 1992,

although the majority of his contacts did not support that

contention. There are no checks or other contemporaneous

documentation in the record connecting petitioner to the receipt

of taxable income in those years. The two individuals who

provided the basis for respondent’s assertion of income in those

years both conceded at trial that it is possible that their

business with petitioner had taken place at other times. The

evidence thus only shows that petitioner possibly engaged in an

income-generating activity in 1991 and 1992, not that she

actually did so. The notice of deficiency therefore lacks the

evidentiary support needed to sustain the determination of income

based upon BLS data for 1991 and 1992. Respondent’s

determinations for those 2 years are therefore not sustained.

VII. Whether Petitioner Is Liable for the Addition to Tax Under
Section 6651(f) or, in the Alternative, for the Addition to Tax
Under Section 6651(a), for the Years in Issue

Sections 6011 and 6012 require every individual who has

gross income in excess of certain amounts for a taxable year to

file an income tax return. Section 6651(a)(1) provides for an

addition to tax for failure to file a timely return. The
 - 70 -

addition to tax is equal to 5 percent of the amount required to

be shown as tax on the return, with an additional 5 percent for

each additional month or fraction thereof during which such

failure continues, not exceeding 25 percent in the aggregate.

If, however, the failure to file any return is fraudulent, then

the addition to tax is equal to 15 percent of the amount required

to be shown as tax on the return, with an additional 15 percent

for each additional month or fraction thereof during which such

failure continues, not exceeding 75 percent in the aggregate.

Sec. 6651(f). Respondent has determined that petitioner’s

failure to file for the years in issue was fraudulent.

The Commissioner must prove fraud by clear and convincing

evidence. See sec. 7454(a); Rule 142(b); Clayton v.

Commissioner, 102 T.C. 632, 646 (1994). In determining whether

petitioner’s failure to file was fraudulent within the meaning of

section 6651(f), we consider the same elements that are relevant

in imposing the penalty for underpayment of tax due to fraud

under section 6663. Clayton v. Commissioner, supra at 653.

Establishing fraud requires proof that the taxpayer “acted

with an intent to evade paying taxes” and may be proved by

circumstantial evidence. Douge v. Commissioner, 899 F.2d 164,

168 (2d Cir. 1990), affg. in part and revg. in part and remanding

an order of this Court dated June 6, 1988. “Such evidence may

include (1) consistent and substantial understatement of income,
 - 71 -

(2) failure to maintain adequate records, (3) failure to

cooperate with an IRS investigation, (4) inconsistent or

implausible explanations of behavior and (5) awareness of the

obligation to file returns, report income and pay taxes.” Id.

An application of these criteria to petitioner’s situation

demonstrates convincingly that in failing to file tax returns for

1989 and 1990 she intended to evade paying taxes and therefore

committed fraud. We have found that she received, and knew she

had received, gross income sufficient to require filing returns

for 1989 and 1990. Petitioner has consistently and substantially

understated her income. Part of her defense in this case has

been her claim that Real Services, rather than herself, was the

recipient of the income at issue. However, no corporate income

tax returns were filed on behalf of Real Services. She had not

maintained adequate records; the three pages of handwritten notes

and a cluster of receipts are inadequate under any definition.

Petitioner has contended that most of her business records were

stolen, but we do not believe her. She has not cooperated with

the Internal Revenue Service investigation; instead, petitioner

has manifested a persistent pattern of obstruction,

confrontation, and inattention with respect to respondent’s

attempts to determine the correct amount of her taxable income

for the years in issue. She has been equally persistent in

advancing implausible explanations for her failure to report her
 - 72 -

income and to pay taxes thereon. Her excuses include the

improbable contention that her now-deceased attorney informed her

that she was not required to file personal or corporate tax

returns, her tales of theft of records, and her steadfast denials

that she earned any income from an escort business. She also

altered a document in a material respect that she sought to

introduce as evidence in this case. These dubious claims and

actions are the kinds of implausible or deceitful representations

that serve as circumstantial evidence of fraud. Finally,

petitioner’s actions in these proceedings reveal that she is

intelligent, shrewd, and experienced in financial matters. Her

efforts to interpose a sham corporate entity between herself and

her tax obligations confirm this view. We conclude that she was

aware of her obligation to file tax returns and pay tax for 1989

and 1990, and that her failure to do so was a willful attempt to

evade those responsibilities, which is fraudulent within the

meaning of section 6651(f).23

For the taxable years 1991 and 1992, however, it has not

been established that petitioner had sufficient gross income to

require the filing of income tax returns. It follows that she is

not liable for any addition to tax under section 6651 for those

years.

23
Because we conclude that petitioner’s failure to file in
1989 and 1990 was fraudulent, we need not address respondent’s
alternative determinations under sec. 6651(a).
 - 73 -

VIII. Whether Petitioner Is Liable for the Addition to Tax Under
Section 6654(a) for the Years at Issue

Respondent also determined additions to tax for 1989 through

1992 under section 6654 arising from an underpayment of estimated

taxes. This addition to tax is mandatory absent a showing by

petitioner that one of the specified statutory exceptions

applies. See Clayton v. Commissioner, supra (citing Grosshandler

v. Commissioner, 75 T.C. 1, 20-21 (1980)). Petitioner has made

no such showing for her 1989 and 1990 taxable years, and we

therefore sustain the additions to tax provided in section 6654

for those years. Section 6654(e) provides, however, that no

addition to tax for underpaid estimated taxes shall be imposed if

the tax “is less than $500.” We have found that petitioner is

not liable for income tax for the years 1991 and 1992.

Accordingly, the determination of additions to tax under section

6654 for those 2 years is not sustained.

In view of the foregoing,

Decision will be entered

under Rule 155.