T.C. Memo. 2006-160
UNITED STATES TAX COURT
PAUL BI-YANG CHEN AND CHIU-MEI CHEN, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 15579-04. Filed August 8, 2006.
John Gigounas, Edward Simpson, and Gerald Holmes, for
petitioners.
Huong T. Duong, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
HOLMES, Judge: Paul Chen and his wife, Chui-Mei, were both
officers of a closely held business, PCTI. PCTI was a successful
wholesaler of computer components for a few years, but it began
having a cashflow problem in 1998. Mr. Chen tried to solve the
problem by committing insurance fraud. The fraud unraveled, and
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both Chens pleaded guilty to a variety of crimes. Neither PCTI
nor the Chens reported the proceeds of the fraud as income. The
Chens contest the resulting deficiency and fraud penalty. Mrs.
Chen seeks innocent spouse relief.
Background
The Chens came to the United States in 1985 from Taiwan,
where Mr. Chen had graduated from college and earned master’s
degrees in civil engineering and architecture. He had taught
high school for 20 years in Taiwan, but after immigrating he
switched fields and worked for his brother’s computer business.
In 1991, he started up his own firm and began wholesaling
computer parts under the name PC Team. Within two years, he
incorporated that business as PCTI. He was PCTI’s sole
shareholder and its president, and he named Mrs. Chen vice
president and administrator. She worked at PCTI full time,
managing the company’s inventory and running the business when
Mr. Chen was away. She had full authority to sign checks and tax
returns on behalf of PCTI, though the parties stipulated that she
does not read, write, or speak English.
PCTI made a valid S corporation election in 1995 and was
still an S corporation in 1998, the tax year at issue. Its
accounting system was not complex--Mr. Chen simply dictated the
company’s financial transactions to Bo Hua He, PCTI’s in-house
accountant. Ms. He also prepared many of the checks for the
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Chens to sign. These checks were drawn on accounts that PCTI
kept at several banks. Mr. Chen kept signature authority over
them all, giving Mrs. Chen cosigning authority over only one.
In September 1998, PCTI contracted with Beam Technology, a
Singapore company, to buy computer processor chips. The chips
were shipped, but then lost in transit. Mr. Chen spotted the
opportunity: He submitted a claim to his carrier, Chubb
Insurance, stating that PCTI had paid $292,000 for the shipment.
This was a lie--PCTI had paid nothing at all. Chubb, relying on
Mr. Chen’s representation, sent a $287,000 check to PCTI to cover
the alleged loss, less a $5,000 deductible. Mr. Chen then
directed Mrs. Chen to open a new bank account in the name of Beam
Technology. No one ever told Beam that the account existed, and
only the Chens had signature authority. Once the account was
opened, Mr. Chen signed a check from PCTI labeled “refund
prepaid” for $287,000, which Mrs. Chen deposited. We
specifically find that the Chens’ purpose in opening the account
was to make it seem that the insurance proceeds were being used
to pay off PCTI’s debt to Beam, while allowing them unfettered
access to the money.
After the check cleared, Mr. Chen transferred $154,409.28
back to PCTI. He directed Ms. He to record the money on PCTI’s
books as payment on an outstanding account receivable from
Citirom, one of PCTI’s customers--one that had several
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outstanding invoices in 1998, and was having trouble making
payments to PCTI. He then transferred another $130,000 from the
Beam account into Mrs. Chen’s personal account. She in turn
signed checks totaling $80,000 from her account to PCTI, only to
receive the money back from PCTI a few days later. She gave the
other $50,000 to Mr. Chen to cover some of his gambling losses.
(The Chens credibly testified that Mr. Chen had a severe gambling
compulsion.)
The Chens used an accounting firm, Chang Accountancy Corp.,
to prepare both their own and PCTI’s 1998 tax returns. Mr. Chen
did not disclose PCTI’s receipt of the Chubb insurance proceeds
to Chang, so the $287,000 in proceeds was not reported on PCTI’s
return and did not flow through to the Chens’ own joint return.
Chubb grew suspicious and began an investigation, eventually
referring the matter to law enforcement. In March 2001, Mr. Chen
pleaded guilty to money laundering and filing a false tax return;
likewise, Mrs. Chen pleaded guilty to wire fraud, aiding and
abetting Mr. Chen’s crime, and filing a false tax return. In
their plea agreements, the Chens agreed to pay $287,000
restitution to Beam Technology, and they paid $40,000 of the
deficiency owed to the IRS. The Commissioner determined a
deficiency based on the Chens’ failure to include the proceeds of
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the fraud in their reported income. He also determined a fraud
penalty under section 6663.1
The Chens contest both the deficiency and the penalty. Mrs.
Chen also asserts as a defense that she is an innocent spouse, on
the grounds that she could not communicate in English; had
nothing to do with the 1998 tax return other than signing the
return; wrote checks only at Mr. Chen’s direction; and did not
benefit from the additional income. The Commissioner denied her
request as inconsistent with her signed plea agreement, in which
she had admitted participating in her husband’s fraudulent
scheme. Mrs. Chen believes the Commissioner abused his
discretion in denying her request for innocent spouse relief.
Both Chens also assert a statute-of-limitations defense.
The Commissioner admits that he sent the notice of deficiency
more than three years after they filed their 1998 tax return, but
argues that the Chens’ fraud makes the notice of deficiency
valid.
The Chens also argue that even if they did commit fraud, the
amount of their understatement is exaggerated by the IRS. They
argue that PCTI was already taxed on a portion of the proceeds,
and argue as well that if the fraudulently obtained proceeds are
no longer applied to the Citirom account receivable, that account
1
Section references are to the Internal Revenue Code; Rule
references are to the Tax Court Rules of Practice and Procedure.
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should be considered a bad debt and give rise to an offsetting
deduction from PCTI’s income.
Trial was held in San Francisco, and the Chens were
California residents when they filed their petition.
Discussion
I. Fraud
We first consider whether the Commissioner has proven that
the Chens committed fraud, because this will resolve the
threshold question of the statute-of-limitations defense. A
fraud penalty under section 6663(a) requires proof that there is
an underpayment of tax required to be shown on a return that the
underpayment is due to fraud. Miller v. Commissioner, T.C. Memo.
1989-461. The Commissioner has the burden of proving fraud by
clear and convincing evidence. Sec. 7454(a); Rule 142(b).
The Commissioner shoulders the first part of his burden with
a stipulation--the parties agree that the Chens underpaid their
1998 taxes: “The $287,000 [of insurance proceeds] * * * was not
reported as income on Petitioners’ 1998 Form 1040.” The second
part of the Commissioner’s burden is to show that the Chens’
underpayment was due to fraud. We define fraud as the “willful
attempt to evade tax”, and look at the entire record of a case to
see if it exists. Beaver v. Commissioner, 55 T.C. 85, 92 (1970).
The indicia of fraud are numerous and varied, and can include
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such circumstantial evidence as: (1) understatement of income;
(2) inadequate records; (3) failure to file tax returns;
(4) implausible or inconsistent explanations of behavior;
(5) concealing assets; and (6) failure to cooperate with tax
authorities. Spies v. United States, 317 U.S. 492, 499 (1943);
Bradford v. Commissioner, 796 F.2d 303, 307 (9th Cir. 1986),
affg. T.C. Memo. 1984-601.
But we begin with what we think is the most important bit of
evidence in support of the Commissioner’s position: In their
criminal plea agreements, Mr. Chen admitted that he conspired to
commit fraud and Mrs. Chen admitted to “act[ing] with a specific
intent to commit fraud.” They also both pleaded guilty under
section 7206(1) to willfully filing their 1998 income tax return
knowing it was false because it did not include the proceeds of
their fraud. (We specifically note, with regard to Mrs. Chen,
that the plea agreement has a certificate of accurate translation
and that Mrs. Chen did not attack her consent to the plea
agreement.)
It is true that this is not enough for the Commissioner to
win on this issue through collateral estoppel--the fraud penalty
requires proof of an intent to evade taxes, and we held in Wright
v. Commissioner, 84 T.C. 636, 643 (1985), that a conviction under
section 7206(1) establishes as a matter of law only an intent to
falsify a tax return. But a conviction for willful falsification
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under section 7206(1) is certainly one of the facts to be
considered in deciding whether the Chens committed tax fraud.
See id. at 643-644; see also Welker v. Commissioner, T.C. Memo.
1997-472. And the Chens’ specific acknowledgment of fraud in the
plea agreements certainly weighs against their claims of
innocence now.
But even without the acknowledgment of fraud and the guilty
plea, the badges of fraud in this case are plain:
! Mr. Chen intentionally submitted a false claim of loss
to Chubb Insurance;
! he concealed receipt of the resulting fraud proceeds
from his tax preparer;
! the Chens’ testimony is replete with contradictory
claims, ranging from Mr. Chen’s claim to know nothing
about the financial aspect of the business--“I really
[am] not too much concern[ed] about the finance[s], you
know, I [am] just a super-sales[man] only”, while later
claiming the opposite--“I am like a dictator in the
company;” to saying that he “never touch[ed] the money
flow and accounting issues * * * [or paid] too much
attention in this issue”, only to testify in answer to
the question “[D]id you tell the accountant what to
do?”, “Yes”; to Mrs. Chen’s testimony both that she
herself deposited the $287,000 into the fake Beam
account and that Ms. He did;2
! implausible explanations--to take one example, Mr. Chen
said he intended to split the insurance proceeds with
Beam’s owner. Yet Mr. Chen never gave him any money,
2
Such inconsistency cannot be chalked up to bad memory or
simple misunderstanding, as the Chens argue. The flip-flops are
too numerous to discount, and the Court made sure that transla-
tors were available at trial to guarantee that the Chens under-
stood the questions being asked.
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arguing at one point that he kept the whole $287,000 to
cover a gambling loan of only $7,000; and
! concealment of assets--when Mr. Chen received the
reimbursement check from Chubb, he directed his wife to
open a fake account for Beam, into which he deposited
the proceeds.
The Chens’ counterargument is that despite these telltale
signs of fraud, they should be spared the penalty because they
cooperated with the IRS, kept company records, filed their tax
returns, etc. However, these actions are not enough to overcome
the substantial evidence of fraudulent intent to evade tax on the
ill-gotten insurance proceeds. Nor is the Court able to rely on
PCTI’s records in the face of credible evidence that those
records were created to cover up the Chens’ fraud by making it
seem to be a payment on an account receivable. We conclude that
the Commissioner has met his burden of proving fraud by clear and
convincing evidence.
There is no statute-of-limitations problem in this case.
See sec. 6501(c)(3).
II. Innocent Spouse Relief
The Chens eloquently argued at trial that Mr. Chen was the
more guilty party--and the Court does find that he was the
architect of the fraud at issue. It was also his gambling
compulsion that motivated Mrs. Chen to help him move the stolen
money in and out of her account. The Chens argue from this
lesser culpability that Mrs. Chen should be relieved from joint
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liability for the deficiency. Section 6015 allows relief from
joint and several liability on three grounds: subsection (b)
lets a spouse seek relief if she can show that she neither knew,
nor had reason to know, of an understatement on the return;
subsection (c) lets divorced or separated spouses split their tax
liability; and subsection (f) allows relief where “it is
inequitable to hold the individual liable for any unpaid tax or
any deficiency (or any portion thereof).”
Mrs. Chen’s first problem is section 1.6015-1(d), Income Tax
Regs., applicable to all these subsections. It provides:
If the Secretary establishes that a spouse
transferred assets to the other spouse as
part of a fraudulent scheme, relief is not
available under section 6015 * * *. For
purposes of this section, a fraudulent scheme
includes a scheme to defraud the Service or
another third party * * *
We hold that this section alone supports the Commissioner’s
refusal to grant Mrs. Chen innocent spouse relief under any
subsection of section 6015--Mrs. Chen admitted, after all, to
helping to defraud Chubb, “another third party.”
As alternative grounds, however, we discuss each of the two
subsections that Mrs. Chen relies on.
A. Section 6015(b) Relief
Section 6015(b) requires, among other elements, the spouse
asking for relief to prove that “in signing the return, * * *
[she] did not know, and had no reason to know, that there was
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such an understatement.” Sec. 6015(b)(1)(C). Mrs. Chen’s claim
for relief under subsection (b) turns on whether she can prove
this.3 She argues that, despite her status as an officer of
PCTI, hers was only a clerical position giving her no
comprehension of what was happening when she signed corporate
checks and documents. She says that she just signed whatever Mr.
Chen or Ms. He gave her without asking questions. Mrs. Chen’s
limited English skill is a fact that would seem to support her
position.
But the regulations interpreting subsection (b) direct us to
look at “all of the facts and circumstances.” Sec. 1.6015-2(c),
Income Tax Regs. And there are other facts weighing against
relief. Perhaps most damning is Mrs. Chen’s admission of guilt
in committing wire fraud, filing a false tax return, and aiding
and abetting her husband to launder money. Mrs. Chen’s plea
agreement, which she signed, specifically indicated that she
“acted with a specific intent to commit fraud.” Even though Mrs.
Chen is not as well educated as her husband, she was too deeply
involved to be characterized as playing an unsuspecting dupe in
his fraud. We also do not give much weight to Mrs. Chen’s
inability to communicate in English. PCTI’s office was staffed
3
Petitioners have the burden of proof under section
6015(b), but need only persuade us by a preponderance of the
evidence rather than that the Commissioner abused his discretion.
See Haltom v. Commissioner, T.C. Memo. 2005-209.
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with Chinese speakers, and we infer from the evidence and
observation during trial that the Chens simply worked together in
Chinese. We find that Mrs. Chen knew exactly what she was doing
when she wrote Mr. Chen a $50,000 check to cover some of his
gambling debts. The regulations direct us to look, not at
whether a spouse requesting relief knows specifically of the
understatement (as the Chens argue), but at whether “the
requesting spouse had actual knowledge of an erroneous item.”
Sec. 1.6015-3(c)(2)(i), Income Tax Regs., incorporated by sec.
1.6015-2(c), Income Tax Regs. The regulation specifically
directs us to look at whether the spouses “jointly owned the
property that resulted in the erroneous item,” sec. 1.6015-
3(c)(2)(iv), Income Tax Regs., and the situation here is even
more egregious since Mrs. Chen had sole power and control of the
fake Beam account.
We therefore conclude, after considering all these facts and
circumstances, that Mrs. Chen knew of Mr. Chen’s fraud when she
signed the joint tax return for 1998. She is not entitled to
relief under subsection (b).
B. Section 6015(f) Relief
Mrs. Chen also argues for relief under subsection (f),
arguing that it would be inequitable to hold her liable for the
unpaid tax.4 Rev. Proc. 2003-61, 2003-2 C.B. 296,5 sets out
4
Our jurisdiction to review Mrs. Chen’s claim for
(continued...)
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general conditions a requesting spouse must meet in order to be
eligible for subsection (f) relief. One of these is the absence
of fraudulent transfers of assets between the spouses. As we
have already found, the Chens transferred assets back and forth
between Mrs. Chen, Mr. Chen, and PCTI in order to hide the trail
of fraud, and this enabled Mrs. Chen to give $50,000 to Mr. Chen
to cover some of his gambling losses. Moreover, Mrs. Chen
admitted that she acted with fraudulent intent. This means that
the Commissioner did not abuse his discretion in concluding that
she did not qualify for (f) relief.6
III. Amount of Deficiency
The only remaining issue is the amount of the deficiency,
which the Chens argue should not reflect the full amount of the
4
(...continued)
subsection (f) relief stems from the existence of an assertion of
a deficiency in this case. Compare Commissioner v. Ewing, 439
F.3d 1009 (9th Cir. 2006) (no Tax Court jurisdiction when no
deficiency involved), revg. 122 T.C. 32 (2004) with Butler v.
Commissioner, 114 T.C. 276, 288 (2000) (Tax Court does have
jurisdiction when 6015(f) relief is sought as defense to
deficiency).
5
This new revenue procedure replaced Revenue Procedure
2000-15, 2000-1 C.B. 447, and became effective on November 1,
2003, for all pending or subsequently filed requests for relief.
The principal change in the new IRS guidance is revision of the
weight given to the knowledge factor. See Baumann v.
Commissioner, T.C. Memo. 2005-31.
6
The standard of review we apply differs between section
6015(b) and (f) cases. In section 6015(f) cases, we review the
Commissioner’s denial of relief for abuse of discretion. Butler
v. Commissioner, 114 T.C. 276, 292 (2000).
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stolen insurance money. The Chens are certainly right about part
of this. Of the $287,000 deposited into the Beam account,
$154,409 was transferred to PCTI, with $140,372 applied to a
Citirom receivable. The Commissioner concedes that $14,037 of
the proceeds was reported by PCTI, and thus flowed through to the
Chens in 1998, leaving $272,963 in unreported income.7 The Chens
argue, however, that the $154,409 that they transferred to PCTI
after a short detour through the fake Beam account should be
regarded as PCTI’s income, not their own.
The problem with this argument is that PCTI was an S
corporation, and an S corporation’s income is generally taxable
to its owners, not to the corporation itself, sec. 1363(a); and
whether or not the income is distributed, sec. 1366(a). In any
event, the Chens never identified any exception to the general
rules making PCTI’s income taxable to them. The $140,372 is
therefore income to the Chens in 1998, and the IRS is right that
the total amount of unreported income is $272,963.
The Chens also argue that if the insurance proceeds had not
been misapplied by PCTI’s accountant to wipe out one of Citirom’s
outstanding accounts receivable, PCTI would have been entitled to
a bad debt deduction for $140,372 on its 1998 return. The
Citirom receivable was held by PCTI and so flowed through to the
7
The Commissioner’s concession is derived by subtracting
the total transferred back to PCTI from the amount applied to the
Citirom account ($154,409 - $140,372 = $14,037).
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Chens; this meets the Code’s requirement of a debt relating to a
business activity. Because the debt is a business one, the Chens
could deduct it if they proved the other elements of a bad debt
deduction: (1) a valid debtor-creditor relationship; (2) the
amount of the debt; (3) its worthlessness; and (4) the year it
became worthless. See Davis v. Commissioner, 88 T.C. 122, 142
(1987), affd. 866 F.2d 852 (6th Cir. 1989).
We have no reason to doubt that Citirom and PCTI had a valid
debtor-creditor relationship. The Chens also proved the amount
of the receivable through PCTI’s business records. So far, so
good. However, they stumble over the last two hurdles:
worthlessness, and worthlessness in 1998. Mr. Chen did credibly
testify that PCTI had trouble collecting from Citirom in 1998,
but though Citirom was a slow payer, it did continue to make
payments throughout the year on a number of other outstanding
invoices. A taxpayer’s “mere belief” that a debt is worthless
won’t support a deduction. Fox v. Commissioner, 50 T.C. 813,
822-823 (1968), affd. per curiam 25 AFTR 2d 70-891, 70-1 USTC
par. 9373 (9th Cir. 1970); sec. 1.166-2, Income Tax Regs. We
look instead for facts that establish reasonable grounds for
abandoning any hope of recovery--proof of the customer’s
insolvency, a description of action taken to recover the debt, or
an explanation of why no action was taken. Fincher v.
Commissioner, 105 T.C. 126, 137-138 (1995); Crown v.
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Commissioner, 77 T.C. 582, 598 (1981). The Chens did not do this
and so cannot offset their 1998 gross income with a business bad
debt deduction.
Conclusion
We reject each of the Chens’ arguments. Because of the
fraud involved, the IRS has no time limit for assessing the
unpaid tax, so the statute of limitations had not passed.
Unreported income of $272,963 was omitted from the Chens’ 1998
return. The Chens are liable for the fraud penalty due to their
intentional failure to report the insurance proceeds. And
finally, Mrs. Chen does not qualify for innocent spouse relief.
To reflect the Commissioner’s concession, however,
Decision will be entered under
Rule 155.