Padgett Coventry Price v. Comm'r

T.C. Memo. 2004-103

UNITED STATES TAX COURT

PADGETT COVENTRY PRICE, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 7939-01. Filed April 22, 2004.

Padgett Coventry Price, pro se.

Louis B. Jack and Julie E. Vandersluis, for respondent.

Sherri Wilder (specially recognized), for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge: Respondent determined the following

deficiencies in, additions to, and penalties on petitioner’s

Federal income taxes:
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Additions to Tax Penalties
Sec. 6653 Sec. 6653 Sec. Sec.
Year Deficiency (a)(1) (b)(1) 6663 6662(a)

1988 $25,632 $749 $7,987 – --
1989 42,187 -- – $17,709 $2,622
1990 56,315 -- – 31,889 2,580
1991 23,063 -- – 3,650 3,319

Unless otherwise indicated, all section references are to the

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

Rule references are to the Tax Court Rules of Practice and

Procedure. All figures are rounded to the nearest dollar.

The primary issue for decision is whether petitioner is

liable for the addition to tax and penalties for fraud based on

unreported income from her law practice. Additional issues are

whether (1) petitioner is entitled to certain Schedule C, Profit

or Loss From Business, deductions; (2) petitioner is entitled to

certain Schedule E, Supplemental Income and Loss, losses; and (3)

petitioner is liable for additional self-employment tax.

FINDINGS OF FACT

As made absolute by the Court’s orders dated December 6,

2002, and February 3, 2003, some of the facts have been deemed

stipulated and are so found. The first stipulation of facts, the

second stipulation of facts, and the attached exhibits are

incorporated herein by this reference. At the time she filed the

petition, petitioner resided in Corona, California.

Petitioner’s Education and Legal Background

On June 15, 1971, petitioner received a bachelor of arts
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degree with honors from the University of California Riverside.

In December 1983, petitioner received a juris doctor degree from

Western State University College of Law. On June 13, 1984,

petitioner was admitted to the California bar.

Petitioner, Mr. Ludlow, and Ludlow & Price

From the early 1960s until 1985, Thomas H. Ludlow practiced

law as a sole practitioner. In September 1985, Mr. Ludlow began

practicing law with petitioner as “Ludlow & Price” (the law

firm). During the years in issue the law firm was located in

Corona, California, at either 212 or 812 East Grand Boulevard.

In January 1986, petitioner and Mr. Ludlow married. During

the years in issue, petitioner and Mr. Ludlow were married and

lived together at 1860 Kellogg Avenue, Corona, California.

During the years in issue, petitioner and Mr. Ludlow filed joint

Federal income tax returns, and they reported their law firm

income, expenses, and profits on a Schedule C.

Mr. Ludlow’s Health

Starting in 1982 or 1983, Mr. Ludlow began having heart

problems. In late 1985 or early 1986, Mr. Ludlow had a massive

heart attack. In 1993, Mr. Ludlow died.

Hiring of Mr. Reiter

In 1988, the law firm fired its bookkeeper/office manager

for alleged embezzlement. At this time, petitioner and Mr.

Ludlow consulted with Marvin Reiter, a C.P.A., who had assisted
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them in some cases for their clients. Petitioner and Mr. Ludlow

hired Mr. Reiter to do monthly accounting for the law firm and to

prepare their personal tax returns.

Although Mr. Reiter never prepared a formal engagement

letter for his work for the law firm, the limited scope of his

accounting responsibilities for the law firm was spelled out in

the cover letters he sent to the law firm each month. Mr. Reiter

performed “compilation” accounting for the law firm. In other

words, he relied on the law firm’s representations regarding its

income and expenses and did not perform an independent

verification of the information provided to him.

Mr. Reiter set up an accounting system for the law firm to

report its income and expenses. Mr. Reiter’s accounting system

for the law firm was as follows: The law firm would have two

business bank accounts--a general operating account and a client

trust account. During the years in issue, the law firm

maintained a general operating account at Bank of America

(general operating account). During the years in issue, the law

firm maintained a client trust account at Security Pacific

National Bank (client trust account). The bank records for the

general operating account and the client trust account were

mailed to the law firm’s address.

Proceeds of settlements and lawsuits, and funds belonging to

clients, were deposited into the client trust account. Funds
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deposited into the client trust account had not been earned by

the law firm. Funds in the client trust account did not affect

the law firm’s income or expenses, and had no tax significance,

as they were client funds held in trust.

All business income was to be deposited into, and all

business expenses were to be paid out of, the general operating

account. This allowed Mr. Reiter and his staff to “pick up” the

income and expenses of the law firm. This included distributions

from the client trust account to the law firm. As fees were

earned they were to be distributed to the law firm from the

client trust account and deposited in the general operating

account. Petitioner gave her employees instructions on how to

distribute funds from her cases and regarding the disbursement

sheet for the client trust account.

Petitioner or Mr. Ludlow had to sign checks for business

expenses. During the years in issue, only petitioner and Mr.

Ludlow had signatory authority on the general operating account

and the client trust account.

Under Mr. Reiter’s accounting system for the law firm,

income of the law firm not deposited into the general operating

account was not picked up as income. Mr. Reiter’s system was

explained to petitioner, Mr. Ludlow, and the employees of the law

firm. Mr. Reiter’s staff also knew how the accounting system

worked.
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Petitioner’s Control of the Law Firm

Petitioner and Mr. Ludlow were the only attorneys working at

the law firm during the years in issue. Petitioner practiced

mainly family law. Mr. Ludlow practiced family law, criminal

law, civil law, probate law, and personal injury law.

As Mr. Ludlow grew more ill, petitioner took over running

the law firm. By 1988, after firing the law firm’s

bookkeeper/office manager, petitioner had taken complete control

of the law firm’s financial operations. During the years in

issue, petitioner ran the law firm--she was in charge of its

business and financial aspects. Petitioner was a hands-on

manager.

Mr. Ludlow did not handle the financial aspects of the law

firm. Mr. Ludlow did not deal with checks that came to the law

firm. Mr. Ludlow did not get involved in deciding where checks

were deposited. The law firm’s employees did not talk to Mr.

Ludlow about where to deposit checks. Petitioner directed her

employees as to how and where to deposit the law firm’s earnings.

The law firm’s bills would be shown to petitioner, and

petitioner would approve them. The law firm’s employees then did

the billing and gave the billing statements to petitioner.

Petitioner was responsible for reviewing client and third

party checks that came to the law firm. Petitioner wrote,

signed, and approved most of the checks written on the general
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operating account and the client trust account. After the office

manager was fired, it was the law firm’s office procedure to give

client checks directly to petitioner.

Petitioner never informed her employees that checks made

payable to the law firm were deposited into accounts other than

the general operating account or the client trust account.

Employees of the law firm would not be aware of checks (income)

that were not deposited into the general operating account or

client trust account.

Records Sent to Mr. Reiter’s Office

Petitioner instructed her employees to contact Mr. Reiter to

learn what documents he wanted sent to him monthly. Mr. Reiter

made a list of items to be sent to his office monthly.

Petitioner knew what was on this list and that the client trust

account register was not sent to Mr. Reiter. Petitioner told her

employees what items to send to Mr. Reiter on a monthly basis.

During the years in issue, each month Mr. Reiter’s office

received a manilla envelope from the law firm containing the law

firm’s banking and bookkeeping records for the past month (the

monthly envelope). The records contained inside the monthly

envelopes ordinarily consisted of the following: (1) The monthly

statement, the check stubs, the canceled checks, and a

handwritten list (schedule) of all deposits for the month for the

general operating account; and (2) the monthly statement and the
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canceled checks, but no check register, no deposit slips, no

“pegboard register”, and no handwritten journal, for the client

trust account. The deposits into the general operating account

had been classified by the law firm’s employees as law firm

income, rental income, loan repayments, etc., and they noted

which deposits were not income to the law firm.

Mr. Reiter’s Bookkeeping and Accounting for the Law Firm

Mr. Reiter’s staff would use the schedule of deposits to

calculate the law firm’s monthly income. After Mr. Reiter’s

staff finished inputting the law firm’s monthly financial data,

the law firm’s records were stored at Mr. Reiter’s office for

later use in preparing petitioner’s tax returns.

Each month, Mr. Reiter or his staff reconciled the general

operating account. Mr. Reiter’s staff used the bank records

provided by the law firm to create a handwritten chart that

reflected the beginning balance, deposits, disbursements, any

outstanding checks, and any deposits in transit. Mr. Reiter and

his staff compiled the law firm’s business expenses on the basis

of the check stubs, and the description of the expense stated

therein, provided for the general operating account. The law

firm did not provide Mr. Reiter or his staff with receipts,

invoices, or other evidence of its expenses.

Each month, after completing the handwritten ledgers for the

general operating account and the client trust account, Mr.
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Reiter’s staff posted the information to a “standard entries”

ledger. Regarding the client trust account, only the beginning

and ending balances were posted to the standard entries ledger.

Mr. Reiter’s staff would then post this information into a

computer to generate a profit and loss statement and a balance

sheet for the law firm.

Mr. Reiter was not responsible for reconciling the client

trust account. For the client trust account, Mr. Reiter’s staff

took the starting balance, deposits, disbursements, and ending

balance directly off the monthly bank statements and entered the

information into a handwritten trust account ledger.

For each of the years in issue, Mr. Reiter determined the

law firm’s Schedule C income and expenses and prepared annual

income statements by totaling the monthly statements his staff

prepared based upon the information provided by the law firm.

Petitioner’s Merrill Lynch Account(s)

During the years in issue, petitioner maintained two “cash

management” accounts at Merrill, Lynch, Pierce, Fenner & Smith,

Inc. (Merrill Lynch). Petitioner was the only person with

signatory authority over these accounts. Petitioner’s Merrill

Lynch accounts were her personal accounts. Had Mr. Reiter

believed the Merrill Lynch accounts to be business accounts, he

would have requested the records for these accounts.

During the years in issue, several large deposits were made
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into one of petitioner’s Merrill Lynch accounts (Merrill Lynch

account). The deposits were checks for the following amounts:

Date Amount Year Total

11/08/88 $25,000 1988 $25,000
04/17/89 8,333
12,500
10,000
4,000 1989 34,833
01/16/90 42,831
06/29/90 21,587
09/17/90 21,972
3,750
5,000
12/06/90 7,945
825 1990 103,910
04/10/91 8,677 1991 8,667

Of the aforementioned checks, seven were distributions from the

client trust account for attorney’s fees earned by the law firm.

They were the checks for $8,333 and $12,500 in 1989; $42,831,

$21,587, $21,972, and $7,945 in 1990; and $8,677 in 1991 (the

seven checks). The seven checks were payable to the law firm.

Petitioner endorsed the seven checks.

The $25,000 November 8, 1988, deposit was a taxable referral

fee from attorney Bill Shernoff.

The $10,000 April 17, 1989, deposit was a taxable payment of

legal fees by a “Dr. Cole”.

The $4,000 April 17, 1989, deposit was part of a State

income tax refund. This amount had initially been deposited into

the general operating account and classified as a nonincome item

on the law firm’s April 1989 list of deposits. Accordingly, it
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was not reported as income. For the years related to the State

income tax refund, State income taxes had been deducted on the

relevant filed Federal income tax returns.

During the years in issue, petitioner used moneys from her

Merrill Lynch account to pay numerous personal expenses. This

included the purchase of a new 1990 Lincoln Town Car for $43,345

and a new 1990 Lincoln Continental for $34,317.

The law firm’s employees did not handle petitioner’s Merrill

Lynch account. The Merrill Lynch account’s monthly statements

were mailed to petitioner’s home address. Petitioner never gave

the law firm’s employees (1) monthly statements for petitioner’s

Merrill Lynch accounts or (2) memoranda from petitioner

discussing deposits into these accounts to include in the monthly

envelope. The Merrill Lynch statements were not on the list of

documents to be sent to Mr. Reiter monthly.

Neither Mr. Reiter nor his staff received monthly statements

for petitioner’s Merrill Lynch account or memoranda from

petitioner discussing deposits into her Merrill Lynch accounts.

No “sealed envelopes” addressed to Mr. Reiter were seen or placed

by the law firm’s employees into the monthly envelope. No

“sealed envelopes” addressed to Mr. Reiter were received by Mr.

Reiter’s office. Neither Mr. Reiter nor his staff was aware that

petitioner was distributing client fees from the client trust

account to one of her Merrill Lynch accounts.
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Preparation of Petitioner’s Tax Returns

Mr. Reiter’s office prepared petitioner’s tax returns for

the years in issue. This included preparing the Schedule C

related to the law firm. Mr. Reiter did not reconcile any

personal accounts of petitioner or Mr. Ludlow in order to prepare

these returns. Other than yearend statements showing the total

interest or dividend income earned during the year, Mr. Reiter

and his staff received no records regarding petitioner’s Merrill

Lynch accounts or any other personal accounts.

Unaware of the income petitioner diverted to her Merrill

Lynch account, Mr. Reiter and his staff did not include it in any

of the monthly financial statements, the annual income

statements, or the income tax returns that Mr. Reiter’s office

prepared for petitioner and the law firm.

Audit of Petitioner

In November or December 1991, Revenue Agent Francisco

Rangel began a civil audit of petitioner and Mr. Ludlow’s 1988

return. On December 11, 1991, Mr. Rangel conducted his initial

interview at the law firm. Pursuant to a power of attorney, Mr.

Reiter represented petitioner and Mr. Ludlow at the meeting. Mr.

Ludlow attended the meeting, but petitioner did not.

Mr. Rangel asked about the law firm’s business bank

accounts, and he was informed that the law firm had two accounts:

The general operating account and the client trust account.
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Petitioner’s Merrill Lynch account was not mentioned to Mr.

Rangel, and he was not provided records for petitioner’s Merrill

Lynch accounts.

In an Information Document Request (IDR) dated January 31,

1992, Mr. Rangel asked petitioner to provide, inter alia, all

bank statements, canceled checks, and stockbrokers’ statements

for 1988, 1989, and 1990. In an IDR dated July 2, 1992, Mr.

Rangel asked petitioner to provide all Merrill Lynch statements

for 1988, 1989, and 1990. Neither petitioner nor her

representatives produced any Merrill Lynch records in response to

the IDRs.

On April 10, 1992, Mr. Reiter and respondent executed a Form

872-A, Special Consent to Extend the Time to Assess Tax,

indefinitely extending the period of assessment for petitioner’s

1988 tax year.

On July 31, 1992, Mr. Rangel met with Mr. Reiter at Mr.

Reiter’s office. Mr. Rangel asked Mr. Reiter why he had not been

provided the Merrill Lynch records. Mr. Reiter stated that he

was not the problem. Mr. Reiter, on his own initiative, placed a

call to petitioner on his speakerphone. During this call,

petitioner told Mr. Reiter to do what he could, but that Mr.

Rangel was not going to get her Merrill Lynch records.

Petitioner was unaware that Mr. Rangel heard what she was saying

to Mr. Reiter.
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In August 1992, Jackie Anderson, C.P.A., telephoned Mr.

Rangel and advised him that she was representing petitioner.

Although she told Mr. Rangel that she would provide the documents

he had requested, Ms. Anderson did not.

On November 20, 1992, Mr. Rangel served a summons on Merrill

Lynch for petitioner’s records. Mr. Rangel sent a notice copy of

this summons to petitioner. Petitioner contacted Merrill Lynch,

spoke to Christopher Eng in the company’s compliance department,

and tried to dissuade him from complying with the IRS summons.

After speaking to petitioner, Mr. Eng contacted Mr. Rangel and

asked whether Merrill Lynch was required to comply with the

summons. Mr. Rangel advised Mr. Eng that the IRS would take

enforcement action against Merrill Lynch if it did not produce

the requested records. On or about December 22, 1992, Mr. Eng

forwarded petitioner’s Merrill Lynch statements to Mr. Rangel.

After receiving the Merrill Lynch statements, Mr. Rangel

discovered checks written to petitioner out of the client trust

account and deposited in her Merrill Lynch account. Mr. Rangel

asked petitioner or her representative about several deposits

made into her Merrill Lynch account during the years in issue,

including the $25,000 deposit made in 1988. Petitioner or her

representative told Mr. Rangel that the $25,000 deposit was an

inheritance from the estate of Mr. Ludlow’s mother, who died in

1984.
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Dawn Lucius was a staff accountant employed by Ms. Anderson.

Mr. Rangel and Ms. Lucius reconciled the income from the general

operating account to the tax returns for 1989 and 1990. Both

came to the conclusion that any deposits into petitioner’s

Merrill Lynch account were not reported on petitioner’s returns.

Ms. Lucius approached Ms. Anderson to advise her of the

situation. After advising Ms. Anderson, Ms. Lucius asked how to

proceed with Mr. Rangel. Ms. Anderson replied with an obscenity

that made it clear she was not to cooperate with Mr. Rangel.

During the civil audit, neither petitioner nor her

representatives provided Mr. Rangel with any alleged memoranda

from petitioner to Mr. Reiter about petitioner’s Merrill Lynch

account. Additionally, neither petitioner nor her

representatives mentioned the existence of such memoranda.

On January 12 and February 11, 1993, Mr. Rangel issued IDRs

for substantiation of numerous Schedule C expenses and for the

general ledger for 1988, 1989, and 1990. Copies of the IDRs were

sent to petitioner and her representatives. Mr. Rangel received

no reply to either of these IDRs.

Bank Deposit Analysis

By examining the deposits to the general operating account

and reconciling them with the tax returns, Mr. Rangel was able to

determine that none of the deposits to petitioner’s Merrill Lynch

account were included in income on petitioner’s returns.
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During the years in issue, all of the deposits to the

general operating account were reported as income of the law firm

on the Schedules C of petitioner’s returns. Any income deposited

into petitioner’s Merrill Lynch account was not reported on her

returns.

Criminal Referral and Prosecution

In mid to late 1993, Mr. Rangel referred petitioner’s case

for criminal investigation. Special Agent Leonard Ramos was

assigned to petitioner’s case.

On July 7, 1994, Mr. Ramos served a third-party record

keeper summons on Mr. Reiter seeking financial books and records

of the law firm. Pursuant to the summons, Mr. Ramos received

several boxes of records belonging to the law firm. These

records included disbursement journals, income statements, a

ledger sheet for the general operating account, and five monthly

envelopes containing check stubs and bank statements from the

general operating account. Mr. Ramos did not find any Merrill

Lynch statements or memoranda regarding Merrill Lynch in these

boxes.

During the criminal examination, neither petitioner nor her

representatives provided Mr. Ramos with any memoranda from

petitioner to Mr. Reiter about petitioner’s Merrill Lynch

account. Again, neither petitioner nor her representatives

mentioned the existence of such memoranda to Mr. Ramos. Mr.
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Ramos was unaware of alleged contemporaneous memoranda from

petitioner to Mr. Reiter when he finalized his special agent’s

report.

IRS District Counsel reviewed the Criminal Investigation

Division’s recommendation to prosecute petitioner. Allison

Rodgers Haft was assigned to review petitioner’s case. As part

of the review, petitioner was offered an opportunity to present

the IRS with defenses to the proposed criminal charges (criminal

conference). At the criminal conference, held on October 18,

1995, Ms. Haft explained the proposed charges and offered

petitioner the opportunity to present any defenses.

Kenneth Gordon, a former IRS District Counsel attorney,

represented petitioner during the criminal investigation and at

the criminal conference. After acknowledging that any statements

Mr. Gordon made could be used against petitioner in any

subsequent legal proceedings, Mr. Gordon made a presentation of

petitioner’s defenses. At the criminal conference, Mr. Gordon

did not assert that petitioner sent monthly memoranda to Mr.

Reiter regarding her Merrill Lynch account. Mr. Gordon stated

that petitioner had absolutely nothing to do with her Merrill

Lynch account, and that she avoided mathematics, numbers, and

accounting for the law firm’s money.

In February 1996, Mr. Gordon sent the U.S. Department of

Justice attorney reviewing petitioner’s case copies of what
 - 18 -

purported to be monthly memoranda for 1989, 1990, and 1991. The

memoranda made it appear as though petitioner had informed Mr.

Reiter of the deposits to her Merrill Lynch account and she had

provided him with monthly statements for the account. The

Department of Justice approved prosecution of petitioner and

referred the case to the local U.S. Attorney’s Office.

On April 19, 1996, Jerome Busch, an attorney representing

petitioner prior to her indictment, sent Assistant U.S. Attorney

Michael W. Emmick a package of documents purporting to be

memoranda from petitioner to Mr. Reiter regarding her Merrill

Lynch account. In response, the Government asked for the

original documents so they could be sent out for laboratory

analysis. Mr. Emmick was told that the original documents had

been stolen out of the trunk of George Pearson’s car. Mr.

Pearson was a friend of petitioner, and supposedly was

transporting the documents to Mr. Busch so that Mr. Busch could

deliver them to Mr. Emmick.

After the “disappearance” of the alleged original memoranda

and Merrill Lynch documents, the Government asked for the

computer and printer used by petitioner to prepare the memoranda

so that the Government could analyze the hard drive in order to

determine the date petitioner created the documents. Neither

petitioner nor her representatives provided the computer or the

printer.
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In 1995, Mae Roundy began working for petitioner. In 1995

or 1996, petitioner requested that Ms. Roundy pick up boxes of

law firm records for her to organize. Ms. Roundy’s husband

picked up 18 to 19 boxes of law firm records from petitioner and

took them to their home. Ms. Roundy organized documents, by

year, for the years in issue.

Petitioner later told Ms. Roundy that she needed Ms.

Roundy’s declaration for petitioner’s attorney in her criminal

tax case. Petitioner prepared a declaration and asked Ms. Roundy

to sign it. The declaration stated that while sorting the law

firm’s records Ms. Roundy found Merrill Lynch statements attached

to memoranda addressed to Mr. Reiter for 1989, 1990, and 1991.

Ms. Roundy did not find Merrill Lynch statements attached to

memoranda addressed to Mr. Reiter for 1989, 1990, and 1991. Ms.

Roundy signed the declaration prepared by petitioner without

reading it based on petitioner’s misrepresentations regarding

what the declaration stated and because she trusted petitioner.

Ms. Roundy would not have signed the declaration had she read it.

Ms. Roundy was sorry that she signed the declaration without

reading it.

In early 1996, petitioner contacted Veronica Wilson, a

former employee of the law firm, and asked her to sign a

declaration that petitioner prepared stating that Ms. Wilson had

copied Merrill Lynch statements to be sent to Mr. Reiter. Ms.
 - 20 -

Wilson signed the declaration after crossing out the portion that

referred to the Merrill Lynch account because she did not copy

Merrill Lynch statements and had nothing to do with petitioner’s

Merrill Lynch account. After receiving the redacted version of

the declaration, petitioner called Ms. Wilson and asked her why

she had crossed out portions of the declaration. Petitioner

stated that the crossed-out portions regarding her Merrill Lynch

account were the most important part of the declaration.

Petitioner attempted to convince Ms. Wilson that she had copied

the Merrill Lynch documents when she had in fact not copied them.

Petitioner’s Criminal Trial

Petitioner was the defendant in United States v. Ludlow,

Case No. CR-97-727. In the criminal case, petitioner was

indicted on three counts of subscribing false income tax returns

for 1989, 1990, and 1991 in violation of section 7206(1). After

being indicted, during trial, and at sentencing, petitioner was

represented by Deputy Federal Public Defender Victor B. Kenton.

Petitioner’s criminal trial lasted 8 days.

During the criminal proceedings, petitioner admitted that

the seven checks she deposited into her Merrill Lynch account

totaling $20,833 in 1989, $94,335 in 1990, and $8,677 in 1991

represented business income generated by the law firm which

should have been, but was not, reported on her 1989, 1990, and
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1991 tax returns. Petitioner also admitted that the $10,000

check deposited in 1989 was income in 1989.

The court instructed the jurors that petitioner contended

she was not guilty of the crimes charged because she acted in

good faith reliance on a certified public accountant after full

disclosure of tax-related information. The court further

instructed the jurors that the good faith defense alleged by

petitioner was a complete defense to the charges in the

indictment and that if the jury believed petitioner acted in good

faith they must acquit her. The jury rendered a verdict finding

petitioner guilty on all three counts in the indictment. On

January 28, 1999, judgment was entered in petitioner’s criminal

case.

Subsequent to her criminal conviction, petitioner was

disbarred.

Petitioner’s Disability Insurance

On June 9, 1997, petitioner applied to reinstate a

disability policy (disability policy) she held through the Paul

Revere Life Insurance Co. (PRLIC). The application asked whether

since the date of application for the policy(s) to be reinstated,

but within 5 years, she had been treated by a physician or

practitioner, been hospitalized or institutionalized, or been ill

or injured. Petitioner responded that she had been treated by a

physician for a sore throat approximately 6 months before June 9,
 - 22 -

1997--the date she signed the application. PRLIC reinstated her

disability policy.

On August 5, 1997, PRLIC received an anonymous phone call

from a medical doctor informing PRLIC that petitioner intended to

submit a fraudulent disability claim to PRLIC. Petitioner

offered this doctor money to certify a false psychiatric

diagnosis. Petitioner stated that she had a doctor’s stationery

and prescription pad and would write the medical reports herself

if necessary. The caller stated that petitioner was going to

attempt to increase her disability coverage.

On August 8, 1997, petitioner applied to increase the

benefit on her disability insurance. Petitioner stated in her

application to increase her benefit that she earned $136,483 per

year, approximately $11,374 per month (after business expenses),

from her law practice.

By May 19, 1998, PRLIC learned that petitioner visited Dr.

David Dixon on May 29, 1997, less than 2 weeks before the date

petitioner signed the reinstatement application, with complaints

of back pain and painful ambulation. PRLIC informed her that her

disability policy would not have been reinstated if petitioner

had answered the questions on the application truthfully and

disclosed the May 29, 1997, doctor’s visit.

PRLIC reported petitioner’s claim as a suspected insurance

fraud to the California Department of Insurance (CDI). CDI
 - 23 -

determined there was sufficient probable cause to investigate

petitioner. CDI was unable to investigate petitioner, however,

because of the volume of cases under investigation and a lack of

resources at the time.

Petitioner’s Alleged Indigence

On August 18, 1997, 10 days after submitting her application

to increase her benefit on her disability insurance and stating

in her application to PRLIC that her annual income was $136,483,

petitioner submitted a request for free legal representation from

the Public Defender’s Office on the grounds of inability to pay.

To establish her indigence, petitioner submitted a financial

affidavit to the U.S. District Court for the Central District of

California. On this affidavit, which petitioner signed under

penalty of perjury, petitioner claimed she earned $500 per month

from self-employment, $250 per month from rental income, and $200

per year in interest income.

OPINION

I. Unreported Income and Disallowed Deductions

The Commissioner’s determinations generally are presumed

correct, and the taxpayer bears the burden of proving that those

determinations are erroneous.1 Rule 142(a); Welch v. Helvering,

1
The examination in this case commenced prior to July 22,
1998. Accordingly, sec. 7491 is inapplicable. See Warbelow’s
Air Ventures, Inc. v. Commissioner, 118 T.C. 579, 582 n.8 (2002),
affd. 80 Fed. Appx. 16 (9th Cir. 2003).
 - 24 -

290 U.S. 111, 115 (1933); Durando v. United States, 70 F.3d 548,

550 (9th Cir. 1995). The U.S. Court of Appeals for the Ninth

Circuit, to which an appeal of this case would lie, has held that

in order for the presumption of correctness to attach to the

notice of deficiency in unreported income cases,2 the

Commissioner must establish “some evidentiary foundation” linking

the taxpayer to the income-producing activity, Weimerskirch v.

Commissioner, 596 F.2d 358, 361-362 (9th Cir. 1979), revg. 67

T.C. 672 (1977), or “demonstrating that the taxpayer received

unreported income”, Edwards v. Commissioner, 680 F.2d 1268, 1270

(9th Cir. 1982); see also Rapp v. Commissioner, 774 F.2d 932, 935

(9th Cir. 1985). Once there is evidence of actual receipt of

funds by the taxpayer, the taxpayer has the burden of proving

that all or part of those funds are not taxable. Tokarski v.

Commissioner, 87 T.C. 74 (1986).

There is ample evidence linking petitioner to an income-

producing activity (the law firm), and respondent has

demonstrated that petitioner received unreported income.

Respondent employed a combination of the specific items

method of proof and the bank deposits method of proof to

2
Although Weimerskirch v. Commissioner, 596 F.2d 358 (9th
Cir. 1979), revg. 67 T.C. 672 (1977), was an unreported income
case regarding illegal source income, the U.S. Court of Appeals
for the Ninth Circuit applies the Weimerskirch rule in all cases
involving the receipt of unreported income. See Edwards v.
Commissioner, 680 F.2d 1268, 1270-1271 (9th Cir. 1982); Petzoldt
v. Commissioner, 92 T.C. 661, 689 (1989).
 - 25 -

reconstruct petitioner’s gross receipts from the law firm. The

specific items method is a direct method of proof, and it has

been approved by this Court. See Schooler v. Commissioner, 68

T.C. 867 (1977); Schaaf v. Commissioner, T.C. Memo. 1991-530.

The bank deposits method of proof is well established. DiLeo v.

Commissioner, 96 T.C. 858, 867 (1991), affd. 959 F.2d 16 (2d Cir.

1992); Estate of Mason v. Commissioner, 64 T.C. 651, 656 (1975),

affd. 566 F.2d 2 (6th Cir. 1977).

Bank deposits are prima facie evidence of income. Tokarski

v. Commissioner, supra at 77; Estate of Mason v. Commissioner,

supra at 656-657. When using the bank deposits method, the

Commissioner is not required to show that each deposit or part

thereof constitutes income, Gemma v. Commissioner, 46 T.C. 821,

833 (1966), or prove a likely source, Clayton v. Commissioner,

102 T.C. 632, 645 (1994); Estate of Mason v. Commissioner,

supra at 657. Unless the nontaxable nature of deposits is

established, gross income includes deposits to bank accounts

where the taxpayer has dominion and control of the funds.

Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955);

Davis v. United States, 226 F.2d 331, 334-335 (6th Cir. 1955);

Manzoli v. Commissioner, T.C. Memo. 1988-299, affd. 904 F.2d 101

(1st Cir. 1990).

Respondent determined, via a bank deposit analysis, that the

amounts reported by petitioner as law firm income on her returns
 - 26 -

were identical to the amounts deposited into the general

operating account. Respondent then analyzed specific items

deposited into petitioner’s Merrill Lynch account during 1988,

1989, 1990, and 1991. These deposits included checks from the

client trust account which were gross receipts of the law firm.

Respondent prepared a schedule of omitted income for these items.

The schedule shows that petitioner did not report substantial

amounts of the law firm’s gross receipts.

A. Deposits Into the Merrill Lynch Account

Petitioner never sent Mr. Reiter any information about the

amounts deposited into petitioner’s Merrill Lynch account, Mr.

Reiter never received any records pertaining to petitioner’s

Merrill Lynch account, and in her criminal trial petitioner

admitted that unreported income of $20,833, $94,335, and

$8,677 was deposited into her Merrill Lynch account in 1989,

1990, and 1991, respectively (i.e., that she failed to report the

seven checks).

Petitioner also admitted that she knew the legal fees she

deposited into her Merrill Lynch account were taxable income.

Petitioner stipulated she endorsed the seven checks, they

were deposited into her Merrill Lynch account instead of the

general operating account, and that the checks represented

business income. Petitioner admitted that she received the

$25,000 check (in 1988), it was a taxable referral fee, it came
 - 27 -

from an attorney named Bill Shernoff, and it was petitioner and

Mr. Ludlow’s decision to deposit it in her Merrill Lynch account

instead of the general operating account.

Petitioner could not remember anything regarding the nature

of the $3,750 and $5,000 September 17, 1990, deposits or the $825

December 6, 1990, deposit. Respondent has proven a likely source

of these deposits, and petitioner has not established the

nontaxable nature of these deposits; accordingly, they are

included as gross income. Commissioner v. Glenshaw Glass Co.,

supra at 431; Davis v. United States, supra at 334-335; Manzoli

v. Commissioner, supra.

B. Schedule C Deductions

Deductions are a matter of legislative grace; petitioner has

the burden of showing that she is entitled to any deduction

claimed. Rule 142(a); New Colonial Ice Co. v. Helvering, 292

U.S. 435, 440 (1934). Taxpayers are required to maintain books

and records sufficient to establish the amount of their income

and deductions. Sec. 6001; DiLeo v. Commissioner, supra at 867.

Respondent disallowed Schedule C expenses petitioner claimed

relating to the law firm. Petitioner relies on her own testimony

to substantiate these deductions. The Court is not required to

accept petitioner’s unsubstantiated testimony. See Wood v.

Commissioner, 338 F.2d 602, 605 (9th Cir. 1964), affg. 41 T.C.

593 (1964). We found petitioner’s testimony to be general,
 - 28 -

vague, conclusory, and/or questionable in certain material

respects. Under the circumstances presented here, we are not

required to, and do not, rely on petitioner’s testimony to

sustain her burden of establishing error in respondent’s

determinations. See Lerch v. Commissioner, 877 F.2d 624, 631-632

(7th Cir. 1989), affg. T.C. Memo. 1987-295; Geiger v.

Commissioner, 440 F.2d 688, 689-690 (9th Cir. 1971), affg. per

curiam T.C. Memo. 1969-159; Tokarski v. Commissioner, 87 T.C. at

77.

Petitioner also presented the testimony of Don Monson. Mr.

Monson’s testimony related to petitioner’s alleged law library.

Mr. Monson testified that around 1980 he visited Mr. Ludlow’s

office and saw that he had an extensive law library. When a

taxpayer establishes that she has incurred deductible expenses

but is unable to substantiate the exact amounts, we can estimate

the deductible amount, but only if the taxpayer presents

sufficient evidence to establish a rational basis for making the

estimate. See Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d

Cir. 1930); Vanicek v. Commissioner, 85 T.C. 731, 742-743 (1985).

In estimating the amount allowable, we bear heavily upon the

taxpayer whose inexactitude is of her own making. See Cohan v.

Commissioner, supra at 544.

Petitioner has not provided sufficient evidence to establish

a rational basis for estimating the amount of her Schedule C
 - 29 -

expenses. Mr. Monson’s testimony related to 1980--a decade

before the years in issue and long before petitioner joined the

law firm--and Mr. Monson’s testimony was vague. Accordingly, we

sustain respondent’s determination on this issue.

C. Schedule E Loss

Respondent disallowed Schedule E losses petitioner claimed

relating to alleged rental real estate because petitioner failed

to substantiate the loss and petitioner’s son lived at the

property.

Taxpayers are required to maintain books and records

sufficient to establish the amount of their income and losses.

Sec. 6001; DiLeo v. Commissioner, 96 T.C. at 867. As we stated

supra, the Court is not required to accept petitioner’s

unsubstantiated testimony. See Wood v. Commissioner, supra at

605. We found petitioner’s testimony to be general, vague,

conclusory, and/or questionable in certain material respects.

Under the circumstances presented here, we are not required to,

and do not, rely on petitioner’s testimony to sustain her burden

of establishing error in respondent’s determinations. See Lerch

v. Commissioner, supra at 631-632; Geiger v. Commissioner, supra

at 689-690; Tokarski v. Commissioner, supra at 77. Accordingly,

we sustain respondent’s determination on this issue.

D. Alleged Embezzlement

Section 165(a) allows a deduction for any loss "sustained"
 - 30 -

during the taxable year and not compensated for by insurance or

otherwise, including losses arising from theft. Sec. 165(c)(3).

Petitioner has the burden of showing that a theft loss occurred.

Rule 142(a). A deduction for a theft loss can be sustained only

if a theft occurred under the applicable State law. Paine v.

Commissioner, 63 T.C. 736, 740 (1975), affd. without published

opinion 523 F.2d 1053 (5th Cir. 1975).

Petitioner did not introduce sufficient evidence at trial to

establish that there was an embezzlement from the law firm, what

the amount of the alleged embezzlement was, or precisely when the

embezzlement occurred or was discovered. Petitioner has failed

to establish that she is entitled to a theft loss for any of the

years in issue. See, e.g., Marr v. Commissioner, T.C. Memo.

1995-250.

E. Conclusion

Accordingly, we sustain respondent’s deficiency

determination.

II. Fraud

The addition to tax and penalty in the case of fraud is a

civil sanction provided primarily as a safeguard for the

protection of the revenue and to reimburse the Government for the

heavy expense of investigation and the loss resulting from a

taxpayer’s fraud. Helvering v. Mitchell, 303 U.S. 391, 401

(1938). Fraud is intentional wrongdoing on the part of the
 - 31 -

taxpayer with the specific purpose to evade a tax believed to be

owing. McGee v. Commissioner, 61 T.C. 249, 256 (1973), affd. 519

F.2d 1121 (5th Cir. 1975).

The Commissioner has the burden of proving fraud by clear

and convincing evidence. Sec. 7454(a); Rule 142(b). To satisfy

this burden, the Commissioner must show: (1) An underpayment

exists; and (2) the taxpayer intended to evade taxes known to be

owing by conduct intended to conceal, mislead, or otherwise

prevent the collection of taxes. Parks v. Commissioner, 94 T.C.

654, 660-661 (1990). The Commissioner must meet this burden

through affirmative evidence because fraud is never imputed or

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

A. Underpayment of Tax

The Commissioner has established by clear and convincing

evidence an underpayment of tax by petitioner for each of the

years in issue; namely, specific items of income deposited into

petitioner’s Merrill Lynch account that petitioner did not report

as income.

B. Fraudulent Intent

The Commissioner must prove that a portion of the

underpayment for each taxable year in issue was due to fraud.

Profl. Servs. v. Commissioner, 79 T.C. 888, 930 (1982). The

existence of fraud is a question of fact to be resolved from the

entire record. Gajewski v. Commissioner, 67 T.C. 181, 199
 - 32 -

(1976), affd. without published opinion 578 F.2d 1383 (8th Cir.

1978). Because direct proof of a taxpayer’s intent is rarely

available, fraud may be proven by circumstantial evidence, and

reasonable inferences may be drawn from the relevant facts.

Spies v. United States, 317 U.S. 492, 499 (1943); Stephenson v.

Commissioner, 79 T.C. 995, 1006 (1982), affd. 748 F.2d 331 (6th

Cir. 1984). Mere suspicion, however, does not prove fraud.

Cirillo v. Commissioner, 314 F.2d 478, 482 (3d Cir. 1963), affg.

in part and revg. in part T.C. Memo. 1961-192; Katz v.

Commissioner, 90 T.C. 1130, 1144 (1988); Shaw v. Commissioner, 27

T.C. 561, 569-570 (1956), affd. 252 F.2d 681 (6th Cir. 1958).

Over the years, courts have developed a nonexclusive list of

factors that demonstrate fraudulent intent. These badges of

fraud include: (1) Understating income, (2) maintaining

inadequate records, (3) implausible or inconsistent explanations

of behavior, (4) concealment of income or assets, (5) failing to

cooperate with tax authorities, (6) engaging in illegal

activities, (7) an intent to mislead which may be inferred from a

pattern of conduct, (8) lack of credibility of the taxpayer’s

testimony, (9) filing false documents, (10) failing to file tax

returns, and (11) dealing in cash. Spies v. United States,

supra at 499; Douge v. Commissioner, 899 F.2d 164, 168 (2d Cir.

1990); Bradford v. Commissioner, 796 F.2d 303, 307-308 (9th Cir.

1986), affg. T.C. Memo. 1984-601; Recklitis v. Commissioner, 91
 - 33 -

T.C. 874, 910 (1988). Although no single factor is necessarily

sufficient to establish fraud, the combination of a number of

factors constitutes persuasive evidence. Solomon v.

Commissioner, 732 F.2d 1459, 1461 (6th Cir. 1984), affg. per

curiam T.C. Memo. 1982-603.

The evidence establishing petitioner’s fraudulent intent is

overwhelming. First, petitioner was an attorney, and she took

one course in taxation during law school.

Second, petitioner consistently and substantially

understated her income. This is strong evidence of fraud when

coupled with other circumstances. Marcus v. Commissioner, 70

T.C. 562, 577 (1978), affd. without published opinion 621 F.2d

439 (5th Cir. 1980). A pattern of consistent underreporting of

income, when accompanied by other circumstances indicating an

intent to conceal income, may justify the inference of fraud.

Holland v. United States, 348 U.S. 121, 139 (1954).

Third, petitioner’s explanations were implausible and

inconsistent. She kept changing her story to fit the

circumstances she was faced with. As the agents, and the Court,

learned the truth, petitioner would change her story.

Fourth, petitioner attempted to conceal her true income by

depositing it into her Merrill Lynch account.

Fifth, petitioner failed to cooperate with tax authorities.

She attempted to prevent Merrill Lynch from complying with a
 - 34 -

summons. During the civil audit and criminal investigation,

petitioner repeatedly refused to claim certified letters sent to

her by the IRS. Petitioner explained that she refused the

letters because they were addressed to “Padgett Price Ludlow” and

not to “Padgett Price”. Petitioner’s name was listed on each of

her returns for the years in issue as “Padgett Price Ludlow”.

Petitioner also instructed her representatives to be

uncooperative. Petitioner lied to respondent’s agents and

attempted to persuade her employees to lie to the Government.

Sixth, petitioner’s pattern of conduct establishes an intent

to mislead. Apart from the conduct just previously mentioned,

petitioner apparently committed insurance fraud and a fraud on

the U.S. district court when she claimed to be indigent.

Petitioner also fabricated documents intended to be exculpatory.

Seventh, as stated supra, petitioner’s testimony totally

lacked credibility and is not worthy of belief.

Petitioner repeatedly denied ever signing a power of

attorney authorizing Mr. Gordon to represent her at the criminal

conference. After respondent obtained and submitted a copy of

this power of attorney, petitioner claimed that she forgot

signing it.

Petitioner introduced a document at trial referred to as the

“pegboard register”. This document was not produced at audit or

during discovery. The exhibit admitted was not the original, but
 - 35 -

a copy. We admitted this document in part based upon

petitioner’s assurance to the Court that she had the original.

Several days later, petitioner admitted that she had no idea

where the original of this document was. One of petitioner’s

employees testified that the pegboard register was not for the

client trust account ledger as petitioner alleged it to be and

that petitioner may have fabricated the pegboard register.

Another of petitioner’s employees did not recall seeing this

register. We conclude that the pegboard register admitted at

trial was fabricated by petitioner, and that petitioner’s

creation and submission of this document is further evidence of

fraud.

Last, although not dispositive, petitioner’s conviction

under section 7206(1) is probative evidence that she intended to

evade her taxes. See Wright v. Commissioner, 84 T.C. 636, 643-

644 (1985).

C. Petitioner’s Arguments

1. Mr. Reiter’s Credibility

Petitioner attacks the credibility of Mr. Reiter and

suggests we should not rely on his testimony. Mr. Reiter may

have engaged in some inappropriate conduct; however, in all

important respects, Mr. Reiter’s testimony was corroborated or

supported by two members of his staff, four employees of the law

firm, and/or respondent’s employees who testified at trial.
 - 36 -

Accordingly, we shall not disregard his testimony in reaching our

findings and conclusions.

2. Reliance on Return Preparer

According to petitioner, she placed statements and memoranda

regarding her Merrill Lynch account into sealed envelopes that

were sent to Mr. Reiter. We conclude that petitioner did not

send these memoranda or the Merrill Lynch statements to Mr.

Reiter. Rather, petitioner fabricated these memoranda long after

the fact.

If petitioner had told Mr. Reiter that she had distributed

taxable amounts directly to her personal accounts, he would have

relayed that information to his staff and made sure the

additional income was reported on petitioner’s tax return. The

evidence is clear that petitioner failed to inform Mr. Reiter of

the income she diverted to her Merrill Lynch account and she

failed to provide Mr. Reiter with her Merrill Lynch account

records.

The jury in her criminal trial convicted petitioner on all

three counts. Accordingly, they rejected her good faith reliance

on her return preparer defense, regarding 1989, 1990, and 1991,

as they were instructed they must acquit her if they believed

this defense.

The income was not reported on her returns not because Mr.

Reiter made a mistake, but because petitioner concealed the
 - 37 -

income and withheld information from her return preparer.

Accordingly, petitioner’s good faith reliance defense is without

merit. Bender v. Commissioner, 256 F.2d 771, 774-775 (7th Cir.

1958), affg. T.C. Memo. 1957-121; see Weis v. Commissioner, 94

T.C. 473, 487 (1990).

3. Petitioner’s Alleged Disease/Disability

Petitioner claims that since 1964 she has suffered from a

severe learning disability that made her incapable of “dealing

with the simplest of bookkeeping, banking, and/or financial

data.” Petitioner referred to her alleged disease as dyscalculia

and disnumeria. Dyscalculia is a disease that relates to

difficulty in performing simple mathematical problems. PDR

Medical Dictionary 550 (2d ed. 2000).

Petitioner introduced no expert testimony regarding her

alleged medical condition. Apart from her self-serving

testimony, which was not credible, one witness testified that

mathematics was not petitioner’s strong point and that the

witness observed petitioner use a calculator when she did

mathematics.

Petitioner’s records from the University of California

Riverside and Western State University College of Law contain no

record of petitioner’s suffering from any kind of learning

disability. As a practicing attorney, petitioner regularly

computed child support figures for clients. According to her
 - 38 -

employees and Mr. Reiter’s staff, although petitioner may have

had someone doublecheck her figures on occasion, she had no

difficulty with numbers. Furthermore, at trial, petitioner

lucidly discussed Mr. Rangel’s bank deposit analysis and

presented her own figures to state her position regarding the

amounts in issue.

We conclude that petitioner did not suffer from a learning

disability, and this is just another example of petitioner’s

repeated attempts to misconstrue the facts of this case and

mislead the Court.

D. Conclusion

After reviewing all of the facts and circumstances, we

conclude that respondent has clearly and convincingly proven

that a portion of the underpayment of tax resulting from

petitioner’s unreported law firm income for each of the years in

issue was due to fraud on the part of petitioner. Once the

Commissioner establishes that a portion of the underpayment is

attributable to fraud, the entire underpayment is treated as

attributable to fraud and subjected to a 75-percent penalty,

except with respect to any portion of the underpayment that the

taxpayer establishes is not attributable to fraud. Secs.

6653(b)(1) and (2), 6663(a) and (b).

At trial, and in his reply brief, respondent conceded that

the failure to report the $4,000 State tax refund deposited into
 - 39 -

her Merrill Lynch account was not due to fraud and was not

subject to the fraud penalty. Petitioner has not proven that any

other part of the underpayments is not attributable to fraud.

Therefore, the remainder of the underpayments for 1988, 1989,

1990, and 1991 are subject to the 75-percent penalty.

III. Self-Employment Tax

Respondent argues that petitioner had additional self-

employment income during the years in issue based on petitioner’s

unreported income from the law firm plus the disallowed

deductions.

Section 1401 imposes self-employment tax on self-employment

income. Section 1402 defines net earnings from self-employment

as the gross income derived by an individual from the carrying on

of any trade or business by such individual less allowable

deductions attributable to such trade or business.

Respondent argues that the law firm was a partnership, and

thus petitioner was subject to self-employment tax. Petitioner

counters that the law firm was a sole proprietorship. We need

not decide this issue because petitioner’s income from the law

firm is subject to self-employment tax regardless of whether the

law firm was a partnership or a sole proprietorship. Sec.

1402(a). We conclude that petitioner is liable for additional

self-employment tax in 1988, 1989, 1990, and 1991 in accordance

with section 1401 based upon petitioner’s additional self-
 - 40 -

employment income from her unreported income from the law firm

plus the disallowed deductions.

IV. Period of Limitations

Petitioner argues that respondent cannot assess the tax

liabilities petitioner reported on her tax returns due to the

expiration of the statutory period of limitations.

In the case of a false or fraudulent return with the intent

to evade tax, the tax may be assessed at any time. See sec.

6501(c)(1). If the return is fraudulent, it deprives the

taxpayer of the bar of the statutory period of limitations for

that year. See Badaracco v. Commissioner, 464 U.S. 386, 396

(1984); Lowy v. Commissioner, 288 F.2d 517, 520 (2d Cir. 1961),

affg. T.C. Memo. 1960-32; see also Colestock v. Commissioner, 102

T.C. 380, 385 (1994).

We found that petitioner filed fraudulent income tax returns

for 1988, 1989, 1990, and 1991; therefore, the periods of

limitation on assessment for all of these years remain open.

In reaching all of our holdings herein, we have considered

all arguments made by the parties, and to the extent not

mentioned above, we find them to be irrelevant or without merit.

To reflect the foregoing,

Decision will be entered

under Rule 155.