Wright v. Comm'r

T.C. Memo. 2007-50

UNITED STATES TAX COURT

MARK N. WRIGHT AND ERICA Y. WRIGHT, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 3276-05. Filed March 5, 2007.

Ps established offshore entities, and an offshore
bank account and credit card, that they used to conceal
unreported income. Ps also understated their S
corporation’s income and failed to include in their
income distributions from the S corporation that
exceeded their basis.

R determined deficiencies for 1999, 2000, and
2001, and additions to tax pursuant to sec. 6651(a)(1),
I.R.C., for 1999 and 2000. R determined civil fraud
penalties for P-H pursuant to sec. 6663, I.R.C., for
1999, 2000, and 2001. In the alternative to liability
for sec. 6663, I.R.C., R determined accuracy-related
penalties for Ps pursuant to sec. 6662, I.R.C., for
1999, 2000, and 2001.

Held: R’s deficiency determinations for 1999,
2000, and 2001, are sustained.
 - 2 -

Held, further, Ps are liable for the additions to
tax pursuant to sec. 6651(a)(1), I.R.C., for 1999 and 2000.

Held, further, P-H is liable for the civil fraud
penalty pursuant to sec. 6663, I.R.C., for 1999, 2000,
and 2001.

Mark and Erica Wright, pro sese.1

Stephen R. Takeuchi, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

WHERRY, Judge: This case is before the Court on a petition

for judicial review of a notice of deficiency issued November 23,

2004, to both petitioners for their 1999, 2000, and 2001 taxable

years. Respondent determined the following Federal income tax

deficiencies, additions to tax, and penalties for petitioner Mark

N. Wright’s (Mr. Wright) 1999, 2000, and 2001 taxable years:2

Addition to Tax Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6663
1999 $34,194.00 $8,528.25 $25,645.50
2000 4,183.00 416.00 3,137.25
2001 10,495.00 -- 7,870.95

1
Petitioners were represented by William Randolph Klein at
trial, on briefing, and until his death on Nov. 27, 2006.
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code (Code) in effect for the years in
issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.
 - 3 -

Respondent determined the following Federal income tax

deficiencies, additions to tax, and penalties for petitioner

Erica Y. Wright’s (Mrs. Wright) 1999, 2000, and 2001 taxable

years:

Addition to Tax Penalty
Year Deficiency Sec. 6651(a)(1) Sec. 6662
1999 $34,194.00 $8,528.25 $6,838.80
2000 4,183.00 416.00 836.60
2001 10,495.00 -- 2,099.00

After concessions by respondent,3 the issues for decision are:

(1) Whether petitioners failed to report distributions in

excess of their basis from an S corporation, M. Wright &

Associates, Inc. a.k.a Wright & Associates, Inc. (Wright &

Associates), for their 1999, 2000, and 2001 taxable years in the

amounts of $8,774, $21,283, and $44,151, respectively;

(2) whether petitioners understated their income from Wright

& Associates by $50,000 for taxable year 1999;

(3) whether petitioners failed to include in income for

their 1999 taxable year $54,000 that they deposited into an

offshore account;

3
Respondent has conceded that health insurance premiums that
Wright & Associates paid on behalf of petitioners for 1999, 2000,
and 2001, in the amounts of $5,287, $6,625, and $9,208,
respectively, and for which petitioners claimed a 60-percent
deduction, should not be included in petitioners’ taxable income.
Respondent has also conceded that Mrs. Wright is not liable for
the sec. 6662 accuracy-related penalty on any portion of the
underpayment to which a sec. 6663 civil fraud penalty applies.
 - 4 -

(4) whether petitioners are liable for the addition to tax

pursuant to section 6651(a)(1) for their 1999 and 2000 taxable years;

(5) whether Mr. Wright is liable for the civil fraud penalty

pursuant to section 6663 for his 1999, 2000, and 2001 taxable

years;

(6) whether, in the alternative, if Mr. Wright is found not

to be liable for the civil fraud penalty pursuant to section 6663

on any portion of the underpayment for any of the years in issue,

petitioners are liable for the accuracy-related penalty, pursuant

to section 6662, on such portion of the underpayment.

FINDINGS OF FACT

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

The stipulations of the parties, with accompanying exhibits, are

incorporated herein by this reference. At the time this petition

was filed, petitioners resided in Sarasota, Florida.

A. General Background

Petitioners had been married for approximately 35 years as

of the time of trial. Mr. Wright has a bachelor of science

degree in business and a master’s degree in business

administration. Mr. Wright is a certified public accountant and

certified financial planner who worked in those capacities during

1999, 2000, and 2001. Mrs. Wright has a high school education.
 - 5 -

Mr. Wright is the sole stockholder of Wright & Associates

and during 1999, 2000, and 2001 owned and operated the S

corporation. A Form 1120S, U.S. Income Tax Return for an S

Corporation, was filed for Wright & Associates for the years in

issue. Petitioners are, and were during the years in issue,

officers of Wright & Associates. Mr. Wright also owns, and owned

and operated during 1999, 2000, and 2001, Consultation &

Mediation Services, L.L.C. (Consultation & Mediation), a single

member limited liability company. Consultation & Mediation did

not file Federal tax returns for the years in issue as it was a

disregarded entity4 and its relevant tax matters were reported on

Schedule C, Profit or Loss From Business, of petitioners’ joint

Form 1040, U.S. Individual Income Tax Return.

Mr. Wright performed accounting services for, and provided

tax advice to, clients of Wright & Associates, and Mrs. Wright

performed secretarial duties for Wright & Associates, for which

they were compensated during the years in issue. Mr. Wright also

provided investment advice to individuals, including, inter alia,

Jo Ann Mohr (Ms. Mohr).5 During 1999 and 2000, Mr. Wright taught

4
“A business entity with only one owner is classified as a
corporation or is disregarded; if the entity is disregarded, its
activities are treated in the same manner as a sole
proprietorship, branch, or division of the owner.” Sec.
301.7701-2(a), Proced. & Admin. Regs.
5
Jo Ann Mohr (Ms. Mohr) was not a client of Wright &
Associates. The record does not indicate whether Ms. Mohr was a
(continued...)
 - 6 -

an estate planning class at Nova Southeastern University for

which he was compensated. Mr. Wright also received compensation

from Security Mutual Life Insurance Company in 1999 and 2000,

although it is unclear what services he performed.

B. Filing of Federal Tax Returns

1. Petitioners’ Joint Returns

Petitioners requested an extension of time to August 15,

2000, to file their joint 1999 Form 1040 Federal income tax

return. On their request for an extension, petitioners estimated

their tax liability to be zero and remitted no payment.

Petitioners mailed their 1999 return on November 21, 2001, and

respondent received it on November 23, 2001.

Petitioners requested an extension of time to August 15,

2001, to file their joint 2000 Form 1040 Federal income tax

return, and subsequently requested a further extension to October

15, 2001. On their first request for an extension, petitioners

left the line for the estimate of their tax liability blank and

remitted no payment. Respondent approved petitioners’ second

request. Respondent received petitioners’ 2000 return on

December 3, 2001.

Petitioners requested an extension of time to August 15,

2002, to file their joint 2001 Form 1040 Federal income tax

5
(...continued)
client of Consultation & Mediation or a personal client of Mr.
Wright.
 - 7 -

return, and they subsequently requested a further extension to

October 15, 2002. On their first request for an extension,

petitioners estimated their tax liability to be $23 and remitted

no payment. Petitioners mailed their 2001 return on August 20,

2002, and respondent received it on August 23, 2002.

2. Wright & Associates’ Returns

Mr. Wright was responsible for filing Wright & Associates’

Federal tax returns for the years in issue. Respondent received

Wright & Associates’ Form 1120S for its 1999 taxable year on

November 23, 2001. Respondent received Wright & Associates’ 2000

Form 1120S on December 3, 2001. Wright & Associates requested an

extension of time to file its 2001 Form 1120S to September 15,

2002. Respondent received Wright & Associates’ 2001 Form 1120S

on August 23, 2002.

On Schedule B, Other Information, of the 1999, 2000, and

2001 Forms 1120S, both cash and accrual were checked as the

method of accounting. Wright & Associates did not list any trade

notes or accounts receivables on its balance sheets or on

Schedule L, Balance Sheets per Books, of its 1999, 2000, and 2001

Forms 1120S.

C. Distributions

During 1999, Wright & Associates distributed to petitioners

$64,601. Wright & Associates also issued checks totaling $5,580
 - 8 -

to petitioners’ children.6 Also during 1999, Wright & Associates

issued checks totaling $5,510 to Consultation & Mediation.

During 2000, Wright & Associates transferred to petitioners

amounts totaling $32,075 either by check or transfer to

petitioners’ personal bank account. Of the total amount

transferred to petitioners, $29,405 constituted personal

distributions. Wright & Associates also issued checks to

petitioners’ children totaling $14,715, and to Consultation &

Mediation totaling $1,250.

During 2001, Wright & Associates distributed to Mr. Wright

$87,864.64. In addition, for each of the years in issue, Wright

& Associates paid for petitioners’ health insurance. The

premiums for this insurance for 1999, 2000, and 2001, were

$5,287, $6,625, and $9,208, respectively, for which petitioners

claimed a 60-percent deduction.

D. Offshore Banking, Investments, and Transactions

During the years in issue, petitioners maintained an

offshore bank account and credit card. The offshore bank account

was at Leadenhall Trust Company, Ltd. (Leadenhall), in the

Bahamas. Leadenhall issued petitioners a Mastercard credit

card.7 In addition, Mr. Wright made offshore investments for

6
Petitioners’ children paid back $916 to Wright &
Associates.
7
The Mastercard credit card issue by Leadenhall operated
(continued...)
 - 9 -

petitioners and advised Ms. Mohr to make similar investments.

Petitioners and Ms. Mohr invested in Cash-4-Titles, an investment

scheme promoted and operated by individuals and business entities

in the United States, the Bahamas, and the Cayman Islands.8

Cash-4-Titles was in fact a massive illegitimate “Ponzi scheme”

later shut down by the Securities Exchange Commission (SEC),9 and

investigated as part of the Internal Revenue Service’s (IRS)

Offshore Credit Card project.10 Mr. Wright was apparently

7
(...continued)
similar to a debit card. The funds petitioners deposited in
their Leadenhall bank account were used to pay for the charges
they incurred on their Mastercard credit card.
8
The operation of Cash-4-Titles is explained in Ex parte
Dill, Dill, Carr, Stonbraker & Hutchings, P.C., 866 So. 2d 519,
522 (Ala. 2003), as follows: “‘ Messrs Homas and Gause raised
money from investors * * * that was to be loaned to C4T, which in
turn would finance the Cash 4 Titles’ stores to make car loans to
the general public.’ * * * ‘Messrs Homa and Gause agreed to pay
investors between 1% and 4% per month on funds loaned to C4T and
remit the interest payments to investors on a monthly basis.’”
In fact, “‘most, if not all of the investor funds were not used
by C4T * * * for the car title loan business. Instead, C4T * * *
transferred the funds to accounts at the Bank of Bermuda in the
Cayman Islands controlled by Messrs Homa and Gause and used the
funds, in classic Ponzi scheme fashion, to pay interest to
investors and pay personal expenses for Messrs Homa and Gause to
support their lavish lifestyle.’” Id. at 524.
9
See SEC v. Homa, 2004 WL 1474580 (N.D. Ill. 2004); SEC v.
Homa, 2004 WL 1093492 (N.D. Ill. 2004).
10
On brief and at trial, petitioners object pursuant to Fed.
R. Evid. 408 to the Court’s consideration of testimony by
Internal Revenue Agent Robert Sullivan (Mr. Sullivan) about an
alleged “deal” Mr. Wright attempted to make with Mr. Sullivan
during the examination process. The Court need not consider the
objection further because Mr. Sullivan’s testimony would not
(continued...)
 - 10 -

unaware that Cash-4-Titles was a Ponzi scheme, but was aware of

the offshore credit cards and the tax evasion opportunity they

offered, at the time he recommended it to Ms. Mohr and invested

himself.

Petitioners and Ms. Mohr made several investments in Cash-4-

Titles. The investments in which petitioners and Ms. Mohr both

participated resulted in class action lawsuits. Another

investment, in which only Ms. Mohr participated, resulted in a

National Association of Securities Dealers (NASD) claim by Ms.

Mohr against Mr. Wright for “violations of the Florida Securities

and Investor Protection Act; violations of federal securities

laws; breach of contract; common law fraud; breach of fiduciary

duty; negligence and gross negligence.”

1. Class Action Lawsuit

In the first type of investment in Cash-4-Titles,

petitioners and Ms. Mohr invested in offshore entities known as

“companies limited by guarantee” (CLGs).11 Mr. Wright paid an

10
(...continued)
affect the Court’s conclusions. Thus, notwithstanding the trial
ruling admitting Mr. Sullivan’s testimony, the Court has not
considered his testimony in that regard in deciding this case.
11
A company limited by guarantee (CLG) is an entity of
United Kingdom origin that does not have an exact counterpart in
U.S. tax law. Bahamian law defines a “company limited by
guarantee” as “a company [that] is formed on the principle of
having the liability of its members limited to such amount as the
members respectively undertake to contribute to the assets of the
company in the event of a winding up”. Companies Act 1992, Act
(continued...)
 - 11 -

application fee of $2,000 to create an offshore investment

package, which consisted of a legal opinion letter regarding the

U.S. tax law compliance of CLGs,12 and an investment portfolio

that included CLGs and petitioners’ Leadenhall bank account and

Mastercard credit card. Mr. Wright, acting through Hal Jones

(Mr. Jones), a Cash-4-Titles promoter, created the CLGs to be

conduits to funnel his and his clients’ funds to a new mutual

fund.

The mutual fund was set up and run in the Bahamas by

Cardinal International, which, in turn, was supposed to have

invested the funds in the U.S. title loan business a.k.a Cash-4-

Titles. Ms. Mohr invested in a CLG called Blues Brothers Limited

(Blues Brothers), and petitioners invested in CLGs called

Britannia, Footpaths Limited, and Sarasota Investment Club #2.

The Mastercard credit card that Leadenhall issued to, and that

was used by, petitioners was in the name of one of their CLGs,

Sarasota Investment Club #2.

Shortly after petitioners and Ms. Mohr made the investments,

Cash-4-Titles was shut down by the SEC. A class action lawsuit

and a lawsuit by the court-appointed receiver were commenced

against Bank of Bermuda by or on behalf of the American

11
(...continued)
No. 18, sec. 7 (1992).
12
The opinion letter was issued by Dean & Heimos, L.L.C., a
Colorado law firm.
 - 12 -

investors, in which petitioners and Ms. Mohr participated.13 The

lawsuits were settled, and petitioners and Ms. Mohr recovered

some of their invested funds.14

2. National Association of Securities Dealers Claim

The second type of Cash-4-Titles investment, which Ms. Mohr

made through Mr. Wright, was represented by Mr. Wright to be in

annuities and mutual funds. Mr. Wright received income from

selling the mutual funds, which income he assigned to Wright &

Associates. Ms. Mohr, per Mr. Wright’s recommendation, purchased

through her Prim Securities, Inc. (Prim Securities) account

promissory notes of Rolls Royce Ltd. (Rolls Royce), which was

another CLG used to raise funds for Cash-4-Titles. On January

11, 2000, shortly after the SEC began its investigation into

Cash-4-Titles, Ms. Mohr, through her attorney, requested by

letter that Mr. Wright return her invested funds. On May 11,

2000, Ms. Mohr instituted an NASD claim against Mr. Wright and

Prim Securities.15 Ms. Mohr’s claim was settled via NASD dispute

13
See Stenger v. Leadenhall Bank & Trust Co., 2004 WL 609795
(N.D. Ill. 2004); Wolff v. Cash 4 Titles, 2001 WL 34133833 (S.D.
Fla. 2001), affd. 135 Fed. Appx. 329 (11th Cir. 2005); see also
Wolff v. Cash 4 Titles, 351 F.3d 1348 (11th Cir. 2003).
14
The record does not indicate the amount of petitioners’ or
Ms. Mohr’s recovery.
15
Ms. Mohr’s NASD claim against Mr. Wright and Prim
Securities involved her investment in Rolls Royce Ltd. promissory
notes. It was separate from, and did not include, her investment
in the Blues Brothers Limited CLG that resulted in her
(continued...)
 - 13 -

resolution. In 2002, Ms. Mohr was awarded $159,575.82 by NASD,

of which Mr. Wright was responsible for $123,342.14.16

Mr. Wright made what he characterized as a $50,000

accounting adjustment to reflect and create a reserve for Ms.

Mohr’s NASD claim on Wright & Associates’ 1999 tax return. On

the 1999 Form 1120S, $50,000 was included in the $53,485 return

and allowance amount listed on line 1(b), which was subtracted

from gross receipts or sales on line 1(a). As a result, Wright &

Associates’ and ultimately petitioners’ taxable incomes were

decreased by $50,000 for 1999. The accounting adjustment

offsetting the debit entry to return and allowance was a credit

to a shareholder loan payable account for Mr. Wright.

3. Offshore Credit Card Account

Petitioners maintained an offshore credit card at Leadenhall

in the name of Sarasota Investment Club #2 for all of the years

in issue. On October 22, 1999, petitioners deposited six $9,000

checks, totaling $54,000, into their bank account at Leadenhall.

One Leadenhall deposit check was dated October 4, 1999, two were

dated October 5, 1999, and three were dated October 6, 1999.

Petitioners used their credit card to make personal expenditures

15
(...continued)
participation in the class action lawsuits.
16
Prim Securities settled with Ms. Mohr for $36,233.68,
which was deducted from Ms. Mohr’s award of $159,575.82.
 - 14 -

and paid for these expenditures with the $54,000 deposited in

their Leadenhall bank account.

E. Petitioners’ Health

Mr. Wright has experienced health problems in recent years.

In 2003, Mr. Wright had a stroke. In 2004, he developed chest

pressure and following a stress test underwent several procedures

including two heart catheterizations and placement of stents into

obstructed arteries. In 2005, Mr. Wright sought treatment for

memory loss and was scheduled to receive further memory testing

at the time of trial. Mrs. Wright also has health problems

having suffered from Crohn’s disease for more than 20 years.

F. Procedural History

On November 22, 2002, petitioners filed a joint bankruptcy

petition under chapter 13 of the Bankruptcy Code. On March 5,

2004, the bankruptcy court issued an order denying confirmation

and dismissing the case. In response, Mr. Wright on March 10,

2004, filed a voluntary conversion of his chapter 13 case to a

chapter 7 case. Mrs. Wright did not join in the conversion. As

a result, the bankruptcy court directed that the joint bankruptcy

case be separated on July 1, 2004. In September 2005, the

bankruptcy court adjudged Mr. Wright’s debts to Ms. Mohr, then in

the amount of $172,010.17, to be nondischargeable. Mr. Wright’s

chapter 7 case was discharged by the bankruptcy court on December
 - 15 -

8, 2004, pursuant to 11 U.S.C. section 727 (2000). Mrs. Wright’s

chapter 13 bankruptcy was closed on January 31, 2005.

The above-mentioned notice of deficiency was issued to

petitioners on November 23, 2004. Petitioners filed a timely

petition disputing the deficiencies, additions to tax, and

penalties, on February 22, 2005.17 As the petition was timely

filed, and was not filed during a period the automatic stay was

in effect, this Court has jurisdiction.18

17
A taxpayer has 90 days (or 150 days if the notice is
addressed to a person outside the United States) from the date
that the notice of deficiency is mailed to file a petition with
this Court for a redetermination of the contested deficiency.
Sec. 6213(a). Respondent mailed the notice of deficiency to
petitioners on Nov. 23, 2004. The 90th day thereafter was
Monday, Feb. 21, 2005, which was a legal holiday in the District
of Columbia. See Rule 25(b). “When the last day prescribed
under authority of the internal revenue laws for performing any
act falls on * * * a legal holiday, the performance of such act
shall be considered timely if it is performed on the next
succeeding day which is not a * * * legal holiday.” Sec. 7503.
Pursuant to sec. 7503, the last day petitioners could have filed
a petition with this Court was Tuesday, Feb. 22, 2005, one day
later than the date on the notice of deficiency.
18
The Bankruptcy Code, specifically 11 U.S.C. sec. 362(a)(8)
(2000), expressly bars “the commencement or continuation of a
proceeding before the United States Tax Court concerning * * *
the tax liability of a debtor who is an individual”. Unless
relief from the automatic stay is granted by order of the
bankruptcy court, see 11 U.S.C. sec. 362(d) (2000), the automatic
stay generally remains in effect until the earliest of the
closing of the case, the dismissal of the case, or the grant of a
denial or a discharge. 11 U.S.C. sec. 362(c)(2) (2000). The
normal 90-day period for filing a timely petition with this Court
is suspended for the period during which the taxpayer is
prohibited by reason of the automatic stay from filing a petition
in this Court and for 60 days thereafter. Sec. 6213(f).
 - 16 -

OPINION

I. Burden of Proof

As a general rule, the Commissioner’s determination of a

taxpayer’s liability for an income tax deficiency is presumed

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

determination is improper. See Rule 142(a); Welch v. Helvering,

290 U.S. 111, 115 (1933). A limitation on this general rule

potentially applies in this case. Courts of Appeals, including

that for the Eleventh Circuit, to which an appeal in this case

would normally lie, have indicated that before the Commissioner

may rely on the presumption of correctness in unreported income

cases the determination must be supported by at least a “minimal”

factual predicate or foundation of substantive evidence linking

the taxpayer to the income generating activity or to the receipt

of funds. Blohm v. Commissioner, 994 F.2d 1542, 1549 (11th Cir.

1993), affg. T.C. Memo. 1991-636; see also Palmer v. United

States, 116 F.3d 1309, 1313 (9th Cir. 1997); United States v.

Walton, 909 F.2d 915, 918-919 (6th Cir. 1990).

Where the Commissioner introduces such evidence to support a

determination that the taxpayer received unreported income, as

respondent did here, the burden generally is on the taxpayer to

show by a preponderance of the evidence that the determination

was arbitrary or erroneous. Hardy v. Commissioner, 181 F.3d

1002, 1004 (9th Cir. 1999), affg. T.C. Memo. 1997-97. Deductions
 - 17 -

are a matter of legislative grace, and the taxpayer bears the

burden of proving that he is entitled to any claimed deductions.

New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

However, pursuant to section 7491(a), the burden of proof on

any factual issue that affects the taxpayer’s tax liability may

be shifted to the Commissioner where the “taxpayer introduces

credible evidence with respect to * * * such issue”. The burden

will shift only if the taxpayer has, inter alia, complied with

substantiation requirements pursuant to the Internal Revenue Code

and “cooperated with reasonable requests by the Secretary for

witnesses, information, documents, meetings, and interviews”.

Sec. 7491(a)(2). In the instant case, petitioners did not

present any credible evidence at trial. Notably, the Court did

not find Mr. Wright’s testimony to be credible, as he often

provided inconsistent and implausible answers. In addition,

petitioners did not comply with the substantiation requirements

and failed to provide respondent with requested documents.19

Accordingly, section 7491(a) is inapplicable, and the burden

19
Respondent sent Wright & Associates Form 4564, Information
Document Request, on July 9 and Dec. 16, 2002, and Jan. 9, 2003,
to which petitioners failed to respond fully and properly.
Respondent then formally repeated the three requests by issuing
Formal Document Requests with a letter explaining the matter on
Dec. 5 and 19, 2002, and Jan. 27, 2003. Subsequently, during
discovery, petitioners failed to respond to respondent’s
interrogatories and request for production of documents, and
provided incomplete responses after the Court granted
respondent’s motions to compel. See infra note 20.
 - 18 -

remains on petitioners to prove that respondent’s determination

of income tax deficiencies is incorrect.

II. S Corporations

A. General Rules

An S corporation is a small business corporation that has an

S corporation election in effect for the taxable year pursuant to

section 1362(a). Sec. 1361(a)(1). Sections 1366 through 1368

govern the tax treatment of S corporation shareholders. Section

1366(a)(1) provides that a shareholder shall take into account

his or her pro rata share of the S corporation’s items of income,

loss, deduction, or credit for the S corporation’s taxable year

ending with or in the shareholder’s taxable year. Stated

otherwise, section 1366 establishes a regime under which items of

an S corporation are generally passed through to shareholders,

rather than being subject to tax at the corporate level. Section

1366(d)(1), however, limits the aggregate amount of such

flowthrough losses and deductions that a shareholder may claim to

the sum of (1) his or her adjusted basis in the stock of the S

corporation and (2) his or her adjusted basis in any indebtedness

of the S corporation to the shareholder.

As regards basis, section 1012 sets forth the foundational

principle that the basis of property for tax purposes shall be

the cost of the property. Cost, in turn, is defined by

regulation as the amount paid for the property in cash or other
 - 19 -

property. Sec. 1.1012-1(a), Income Tax Regs. Section 1367

specifies adjustments to basis applicable to investments in S

corporations. Basis in S corporation stock is increased by

income passed through to the shareholder under section 1366(a)(1)

and decreased by, inter alia, distributions not includable in the

shareholder’s income pursuant to section 1368; items of loss and

deduction passed through to the shareholder under section

1366(a)(1); and certain nondeductible, noncapital expenses. Sec.

1367(a).

B. Distributions

Section 1368 addresses the treatment of distributions and

differentiates S corporations having accumulated earnings and

profits by reason of prior periods of operation as a C

corporation and those without. For S corporations with

accumulated earnings and profits, dividend treatment applies in

enumerated circumstances. Sec. 1368(c). The typical rule for

entities without accumulated earnings and profits, such as Wright

& Associates, is that distributions are not included in a

shareholder’s gross income to the extent that they do not exceed

the adjusted basis of his or her stock (but are applied to reduce

basis), while any distribution amount in excess of basis is

treated as gain from the sale or exchange of property. Sec.

1368(b).
 - 20 -

A taxpayer must establish the basis of his or her stock for

purposes of determining the amount of gain he or she must

recognize. “Proof of basis is a specific fact which the taxpayer

has the burden of proving.” O’Neill v. Commissioner, 271 F.2d

44, 50 (9th Cir. 1959), affg. T.C. Memo. 1957-193. Internal

Revenue Agent Robert Sullivan and respondent both specifically

requested that petitioners provide information about Mr. Wright’s

stock basis in Wright & Associates.20 Petitioners, despite Mr.

Wright’s extensive experience with accounting and tax matters,

failed to comply.

Petitioners received $64,601, $29,405, and $87,864.64, as

distributions from Wright & Associates in 1999, 2000, and 2001,

respectively. Respondent determined that to the extent the

distributions exceeded basis, petitioners were required to

include them in their income in the amounts of $8,774, $21,283,

and $44,151, for 1999, 2000, and 2001, respectively.

20
Respondent served on petitioners interrogatories and a
request for production of documents on Aug. 26, 2005, requesting,
inter alia, that petitioners provide calculations of their basis
in Wright & Associates from its incorporation through 1998.
Petitioners failed to respond, and respondent filed with the
Court on Sept. 29, 2005, a motion to compel production of
documents and a motion to compel responses to respondent’s
interrogatories. The Court, by orders dated Sept. 30, 2005,
granted both of respondent’s motions to compel. Petitioners’
responses to the orders to compel failed to provide the requested
calculations or documents. Petitioners’ response to respondent’s
request for production stated that “Petitioners have no records
prior to 1999.”
 - 21 -

In the computation of Mr. Wright’s stock basis, respondent

did not allow the carryover of any basis that Mr. Wright may have

had in his stock for taxable years preceding 1999. It is

possible that Mr. Wright had a tax basis in his stock prior to

taxable year 1999. However, petitioners did not produce any

evidence or provide any documentation, other than old tax returns

without any substantiation of their numeric content, to establish

the basis of Mr. Wright’s stock. The Court therefore sustains

respondent’s determination that Mr. Wright was not entitled to

any carryover basis in his Wright & Associates stock for taxable

years preceding 1999. The Court also sustains respondent’s

determinations that petitioners received income in the amounts of

$8,774, $21,283, and $44,151 from Wright & Associates in 1999,

2000, and 2001, respectively.

C. Accounting Method

An S corporation may use either the cash receipts and

disbursement method (cash method) or the accrual method of

accounting, with certain limitations. See Rev. Proc. 2002-28,

2002-1 C.B. 815. Under the cash method, all items which

constitute gross income are to be included for the taxable year

in which actually or constructively received. Sec. 1.446-

1(c)(1)(i), Income Tax Regs. Expenditures are deducted for the

taxable year in which actually made. Secs. 1.446-1(c)(1)(i),

1.461-1(a), Income Tax Regs.
 - 22 -

Under the accrual method, “income is to be included for the

taxable year when all the events have occurred that fix the right

to receive the income and the amount of the income can be

determined with reasonable accuracy” (all events test). Sec.

1.446-1(c)(1)(ii), Income Tax Regs. A liability is incurred and

taken into account “in the taxable year in which all the events

have occurred that establish the fact of the liability, the

amount of the liability can be determined with reasonable

accuracy, and economic performance has occurred with respect to

the liability”. Id. In determining whether an expense amount

has been incurred, the all events test generally shall not be

treated as met any earlier than when economic performance occurs.

Sec. 461(h)(1).

“The all events test is based on the existence or

nonexistence of legal rights or obligations at the close of a

particular accounting period, not on the probability–-or even

absolute certainty--that such right or obligation will arise at

some point in the future.” Hallmark Cards, Inc. v. Commissioner,

90 T.C. 26, 34 (1988). Furthermore:

It is fundamental to the “all events” test that,
although expenses may be deductible before they have
become due and payable, liability must first be firmly
established. This is consistent with our prior
holdings that a taxpayer may not deduct a liability
that is contingent or contested. Nor may a taxpayer
deduct an estimate of an anticipated expense, no matter
how statistically certain, if it is based on events
that have not occurred by the close of the taxable
year. [Citations omitted; emphasis added.]
 - 23 -

United States v. Gen. Dynamics Corp., 481 U.S. 239, 243-244

(1987).

A deduction shall be taken for the year which is the proper

year under the taxpayer’s method of tax accounting. Sec. 461(a).

It is not entirely clear what method of accounting Wright &

Associates was using for its 1999, 2000, and 2001 taxable years.

Both cash and accrual method were checked on Schedule B of Wright

& Associates’ 1999, 2000, and 2001 Forms 1120S. Mr. Wright

indicated at trial that the returns were in error and that Wright

& Associates was on the accrual method. However, Wright &

Associates had no trade notes or accounts receivables on its

balance sheets or Schedule L of Forms 1120S for 1999, 2000, or

2001. Mr. Wright noted that hypothetically a business could be

on the accrual method and have no trade notes or accounts

receivables if they were all paid or collected. Based on Wright

& Associates’ lacking any trade notes or account receivables on

its 1999, 2000, and 2001 balance sheets and Schedule L of its

Forms 1120S, the Court concludes that Wright & Associates,

despite Mr. Wright’s knowledge of tax and accounting, had no

consistent method of accounting.

Mr. Wright contends that Ms. Mohr’s claim, although not made

against Wright & Associates, was a liability of that corporation,

which reduced its income for 1999 by $50,000, and as a result,

reduced petitioners’ 1999 taxable income by the same amount. It
 - 24 -

is noteworthy that no such liability was reflected on Wright &

Associates’ books and tax return.21 Nor was any liability

attributable to Ms. Mohr’s claim properly deductible for 1999 by

the corporation, or by petitioners, under either the cash or

accrual method of accounting. Under the cash method, no

deduction should have been recognized until an amount was paid to

Ms. Mohr. In 1999, no payment by Wright & Associates or Mr.

Wright was made to Ms. Mohr.

Under the accrual method, the all events test for

liabilities was not satisfied in 1999 for Ms. Mohr’s claim

against Mr. Wright, and there was never a claim against Wright &

Associates. Ms. Mohr did not make a demand for the return of her

invested funds from Mr. Wright until January of 2000, did not

file a formal claim with NASD until May 2000, and did not have a

fixed legal right to the return of her invested funds until the

dispute was resolved in 2002.

Mr. Wright seeks in the alternative to justify the $50,000

deduction for 1999 as an accrued liability of his own, for which

he allegedly made a reserve. Mr. Wright was not entitled to

21
On Wright & Associates’ 1999 Form 1120S, $50,000 was
improperly included in the $53,485 return and allowance amount
listed on line 1(b), which was subtracted from gross receipts or
sales on line 1(a). The notice of deficiency disallowed $50,000,
reducing the return and allowance amount to $3,485 and
eliminating the $50,000 alleged loan from Mr. Wright shown on
Wright & Associates’ books.
 - 25 -

accrue such a deduction under the all events test.22 See

Hallmark Cards Inc. v. Commissioner, supra at 34; United States

v. Gen. Dynamic Corp., supra at 243-244. Therefore, neither Mr.

Wright nor Wright & Associates was entitled to deduct $50,000 for

1999 in respect of Ms. Mohr’s NASD claim. Accordingly, the Court

sustains respondent’s $50,000 adjustment to petitioners’ taxable

income for 1999.

III. Offshore Accounts and Credit Card

A. Bank Deposits Method

A bank deposit is prima facie evidence of income, and the

Commissioner is not required to show a likely source of that

income. Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). The

taxpayer bears the burden of showing that respondent’s

determination is incorrect. Rule 142(a); Estate of Mason v.

Commissioner, 64 T.C. 651, 657 (1975), affd. 566 F.2d 2 (6th Cir.

1977). “The bank deposits method assumes that all money

deposited in a taxpayer’s bank account during a given period

constitutes taxable income, but the Government must take into

account any nontaxable source or deductible expense of which it

has knowledge.” Clayton v. Commissioner, 102 T.C. 632, 645-646

22
No economic performance, within the meaning of sec.
461(h)(2)(C) and the regulations thereunder, occurred with
respect to the alleged liability during any year in issue. Also,
no transfer was made such as would entitle Mr. Wright or Wright &
Associates to accrue a contested liability under sec. 461(f).
 - 26 -

(1994) (citing DiLeo v. Commissioner, 96 T.C. 858, 868 (1991)),

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

Respondent produced bank deposit records, as well as copies

of petitioners’ checks, showing that petitioners deposited

$54,000 into their Leadenhall bank account. Mr. Wright had

initially told the IRS agents assigned to his case that the

$54,000 was a loan from an investor who wanted to remain

anonymous. Petitioners’ reply brief filed with the Court further

contended that the $54,000 was a loan and not income. At trial

Mr. Wright claimed that the six $9,000 checks totaling $54,000

represented petitioners’ money, but stated: “I’m not saying they

came from previously reported income; I’m saying they are not

income.” Mr. Wright additionally stated that the $54,000 was

sent to Mr. Jones and then deposited by Mr. Jones into

petitioners’ Leadenhall account.23 Mr. Wright also claimed at

trial that he never opened a bank account at Leadenhall or

obtained a Mastercard credit card, which the Court did not find

convincing or credible.

Petitioners did not present any evidence to refute

respondent’s determination that the $54,000 was unreported

23
Mr. Wright asserts that petitioners and Ms. Mohr entered
into asset management contracts with Mr. Jones that included a
best efforts 6-percent return and that Mr. Jones transferred the
money from those contracts to CLGs. The Court did not find Mr.
Wright’s testimony on this issue to be convincing or credible.
Furthermore, petitioners did not provide the alleged contracts or
any other evidence regarding such an agreement with Mr. Jones.
 - 27 -

income, but instead espoused inconsistent and implausible

explanations. The Court concludes that the $54,000 deposited by

petitioners into their Leadenhall bank account was unreported

income. Accordingly, the Court sustains respondent’s

determination on this issue.

B. Money and Finance Regulations

Regulations prescribe that transactions involving the

transfer of more than $10,000 in monetary instruments at one time

from the United States to a place outside of the United States,

or vice versa, must be reported to the Secretary of the Treasury

by the individual involved. See 31 U.S.C. sec. 5316 (2000); 31

C.F.R. sec. 103.23 and 103.27 (2000). “Monetary instruments”

includes all negotiable instruments, such as checks. 31 C.F.R.

103.11(u) (2000). Violation of the reporting requirements

applicable to the exportation or importation of monetary

instruments can result in criminal penalties consisting of fines,

imprisonment, or both. See 31 U.S.C. sec. 5322 (2000).

In response to questioning regarding the avoidance of such

reporting requirements, Mr. Wright could not explain why he would

issue six $9,000 checks (all drawn on the same Sun Trust bank

account) over a period of 3 consecutive days, all to be deposited

on the same day in the Bahamas, instead of one check for $54,000.

The Court concludes that Mr. Wright structured petitioners’

deposit transaction so as to avoid the exportation of monetary
 - 28 -

instruments reporting requirements and to conceal $54,000 in

income.

IV. Penalties and Addition to Tax

A. Burden of Production

The Commissioner bears the burden of production in any court

proceeding with respect to an individual’s liability for

penalties or additions to tax. Sec. 7491(c). To meet this

burden, the Commissioner must present “sufficient evidence

indicating that it is appropriate to impose the relevant penalty”

or addition to tax. Higbee v. Commissioner, 116 T.C. 438, 446

(2001). In instances where an exception to the penalty or

addition to tax is afforded because of substantial authority,

reasonable cause, or similar provisions, the taxpayer bears the

burden of proof with regard to those matters. Id. at 446-447.

B. Section 6651(a)(1) Addition to Tax

Section 6651(a)(1) imposes a 5-percent addition to tax for

each month or portion thereof a required return is filed after

the prescribed due date (including extensions), not to exceed 25

percent in the aggregate, unless such failure to file timely is

due to reasonable cause and not due to willful neglect. Although

not defined in the Code, “reasonable cause” is described by the

applicable regulations as the exercise of “ordinary business care

and prudence”. Sec. 301.6651-1(c)(1), Proced. & Admin. Regs.;

see also United States v. Boyle, 469 U.S. 241, 246 (1985).
 - 29 -

“[W]illful neglect” is interpreted as “a conscious, intentional

failure or reckless indifference.” United States v. Boyle, supra

at 245.

Reasonable cause denotes an absence of fault. United States

v. Boyle, supra at 247 n.4. A taxpayer must prove that his

failure to file timely was the “result neither of carelessness,

reckless indifference, nor intentional failure.” Id.

“Generally, factors that constitute ‘reasonable cause’ include

unavoidable postal delays, death or serious illness of the

taxpayer or a member of his immediate family, or reliance on the

mistaken legal opinion of a competent tax advisor, lawyer, or

accountant that it was not necessary to file a return.” Marrin

v. Commissioner, 147 F.3d 147, 152 (2d Cir. 1998), affg. T.C.

Memo. 1997-24. While the Court is sympathetic that Mr. Wright

suffered health complications, all of these complications

occurred after the years in issue. Mr. Wright had a stroke in

2003 and sought treatment for memory loss in 2005. Petitioners

have not shown reasonable cause for filing their 1999 and 2000

tax returns late. The Court concludes that petitioners are

liable for the addition to tax pursuant to section 6651(a)(1) for
 - 30 -

1999 and 2000.24 Accordingly, the Court sustains respondent’s

determination on this issue.25

C. Section 6663 Penalty

In any case involving the issue of fraud with intent to

evade tax, respondent bears the burden of proof as to that issue.

Sec. 7454(a). The burden of proof must be carried by clear and

convincing evidence. Rule 142(b). Section 6663(a) imposes a

penalty of “an amount equal to 75 percent of the portion of the

underpayment which is attributable to fraud.” Section 6663(b)

specifies that if any portion of the underpayment is attributable

24
The notice of deficiency apparently calculates
petitioners’ 1999 sec. 6651(a)(1) addition to tax based on an
Aug. 15, 2000, due date despite petitioners’ failure to
reasonably estimate their tax liability on their request for an
extension. The notice of deficiency calculates petitioners’ 2000
sec. 6651(a)(1) addition to tax based on an Oct. 15, 2001, due
date, respondent having granted petitioners’ second request for
an extension despite petitioners’ failure to reasonably estimate
their tax liability on their first request for an extension.
Respondent failed to raise these issues in his answer and only
subsequently raised them on brief.
25
The Court sustains respondent’s determinations in the
notice of deficiency. See supra note 24. The Court notes that
because 25 percent is the maximum addition to tax allowed under
sec. 6651(a)(1), the validity of the extension request is moot
for petitioners’ 1999 taxable year (petitioners filed their 1999
return on Nov. 23, 2001, which is more than 15 months late using
an Aug. 15, 2000, due date and more than 19 months late using an
Apr. 15, 2000, due date). The Court concludes, based on
respondent’s granting petitioners’ second request for an
extension, respondent’s claim in the notice of deficiency, and
respondent’s failure to raise this issue before trial which may
have prejudiced petitioners, that petitioners are liable for only
a 10-percent sec. 6651(a)(1) addition to tax for their 2000
taxable year.
 - 31 -

to fraud, the entire underpayment shall be treated as

attributable thereto except to the extent the taxpayer

establishes, by a preponderance of the evidence, that some part

is not due to fraud. Where taxpayers file a joint return,

section 6663 does not apply to a spouse unless some part of the

underpayment is due to the fraud of the spouse. Sec. 6663(c).

Respondent must prove on a year-by-year basis by clear and

convincing evidence that (1) Mr. Wright underpaid his taxes for

that year, and (2) that some part of that underpayment was due to

fraud. Parks v. Commissioner, 94 T.C. 654, 660-661 (1990);

Hebrank v. Commissioner, 81 T.C. 640, 642 (1983).

1. Underpayment of Tax

In satisfying the first prong of the fraud test, the

Commissioner cannot discharge his burden by simply relying on the

taxpayer’s failure to prove error in his determination of the

deficiency. Petzoldt v. Commissioner, 92 T.C. 661, 700 (1989);

Otsuki v. Commissioner, 53 T.C. 96, 106 (1969). The

Commissioner’s burden of proving an underpayment of tax

attributable to unreported and indirectly reconstructed income

may be satisfied in either of two ways: (1) By proving a likely

source of the unreported income, or (2) by disproving any alleged

nontaxable source. DiLeo v. Commissioner, 96 T.C. at 873-874.

Respondent has met his burden for all of the years in issue.

Petitioners and respondent stipulated the amount and source of
 - 32 -

the distributions that petitioners received from Wright &

Associates but failed to include in their income. In addition,

respondent has met his burden of disproving an alleged nontaxable

source for the $54,000 petitioners deposited into their offshore

bank account in 1999. Mr. Wright initially alleged that the

$54,000 deposited into petitioners’ Leadenhall bank account in

1999 was nontaxable as it was a loan. He claimed at trial that

the $54,000 was in fact petitioners’ money but was nontaxable.

He also claimed that the $54,000 was sent to Mr. Jones and that

Mr. Jones deposited it into petitioners’ Leadenhall bank account.

Mr. Wright’s numerous explanations are inconsistent.

Accordingly, the Court concludes that respondent has proved by

clear and convincing evidence an underpayment of tax--the first

prong of the fraud test--for each of the years 1999, 2000, and

2001.

2. Fraudulent Intent

To satisfy the second prong of the fraud test, respondent

must show that a portion of the underpayment is attributable to

fraud. For the purposes of section 6663, fraud, which presents a

question of fact, is defined as intentional wrongdoing by the

taxpayer with the specific purpose of avoiding a tax believed to

be owed. Fraud includes conduct intended to conceal, mislead, or

otherwise prevent the collection of such tax. Stoltzfus v.

United States, 398 F.2d 1002, 1004 (3d Cir. 1968); Recklitis v.
 - 33 -

Commissioner, 91 T.C. 874, 909 (1988). Fraud is never presumed

and must be established by independent evidence of fraudulent

intent. Petzholdt v. Commissioner, supra at 699; Recklitis v.

Commissioner, supra at 909-910. The taxpayer’s entire course of

conduct can be indicative of fraud. Stone v. Commissioner, 56

T.C. 213, 224 (1971).

As direct proof of a taxpayer’s intent is seldom available,

fraud may be established by circumstantial evidence and

reasonable inferences drawn from the record. Stoltzfus v. United

States, supra at 1005; DiLeo v. Commissioner, supra at 874.

Courts have developed a nonexclusive list of factors, or “badges”

of fraud, that support a finding of fraudulent intent. See Spies

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

Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), affg. T.C.

Memo. 1984-601. Although no single factor may be necessarily

sufficient to establish fraud, the existence of several indicia

may be persuasive circumstantial evidence of fraud. Solomon v.

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

Memo. 1982-603.

The “badges” of fraud include: (1) Understating income;

(2) maintaining inadequate records; (3) failing to file tax

returns; (4) providing implausible or inconsistent explanations

of behavior; (5) concealing income or assets; (6) failing to

cooperate with tax authorities; (7) engaging in illegal
 - 34 -

activities; (8) attempting to conceal illegal activities;

(9) dealing in cash; (10) failing to make estimated tax payments;

and (11) filing false documents. See Spies v. United States,

supra at 499; Bradford v. Commissioner, supra at 307-308.

Additional factors to be considered include the taxpayer’s

background, level of education, and prior history of filing

proper returns. Niedringhaus v. Commissioner, 99 T.C. 202, 211

(1992).

The instant case involves many “badges” of fraud.

Accordingly, the Court concludes that Mr. Wright fraudulently

intended to underpay taxes for 1999, 2000, and 2001. Notably,

Mr. Wright is sophisticated in tax matters. He is a certified

public accountant and certified financial planner, has a master’s

degree in business administration, and owns and operates an S

corporation that provides accounting services and tax advice to

its clients. Additionally, Mr. Wright failed to cooperate with

the tax authorities. Mr. Wright was not a credible witness as he

frequently gave inconsistent and implausible answers to questions

asked during trial.

Specifically in 1999, Mr. Wright concealed income by

transferring $54,000 to petitioners’ offshore bank account. Mr.

Wright structured petitioners’ $54,000 deposit transaction

specifically to avoid the exportation of monetary instruments

reporting requirements. Additionally, Mr. Wright constructed a
 - 35 -

phony offset of $50,000 against the gross receipts of Wright &

Associates on Form 1120S for 1999. Further, for all of the years

in issue, petitioners used an offshore credit card to make

personal expenditures in order to continue to conceal the $54,000

in unreported income.

For taxable years 1999, 2000, and 2001, Mr. Wright

understated petitioners’ income by failing to include

distributions petitioners received from Wright & Associates,

which the Court concludes is fraudulent in and of itself. Mr.

Wright also maintained inadequate records for all of the years in

issue. Additionally, Mr. Wright failed to make estimated tax

payments for all of the years in issue.

The Court concludes that respondent has proved by clear and

convincing evidence the second prong of the fraud test for 1999,

2000, and 2001. Respondent has shown that at least some part of

the underpayment for all of the years in issue is attributable to

fraud. Specifically, respondent has shown that petitioners

understated their income for all of the years in issue because

they fraudulently failed to include in their income distributions

from Wright & Associates. Respondent has also shown that

petitioners concealed their unreported income by utilizing an

offshore credit card for personal expenditures. The Court

concludes that Mr. Wright’s entire course of conduct relating to

petitioners’ offshore bank account and credit card is indicative
 - 36 -

of fraud. Mr. Wright has failed to challenge or explain

successfully why respondent’s showing of underpayment of tax and

fraudulent intent for each of the years in issue is inapplicable

or incorrect. The Court concludes that Mr. Wright is liable for

the civil fraud penalty pursuant to section 6663 for taxable

years 1999, 2000, and 2001. Accordingly, the Court sustains

respondent’s determination on this issue.

V. Conclusion

The Court sustains respondent’s determinations regarding

petitioners’ deficiencies, as adjusted to reflect respondent’s

concessions, for taxable years 1999, 2000, and 2001. Petitioners

failed to include in their taxable income distributions they

received from Wright & Associates that exceeded their stock

basis, as well as $54,000 they deposited in their offshore

account. Mr. Wright was not entitled to a flowthrough deduction

of $50,000 from Wright & Associates for 1999 on account of Ms.

Mohr’s NASD claim. The Court sustains respondent’s determination

that petitioners are liable for the section 6651(a)(1) addition

to tax for 1999 and 2000. The Court also sustains respondent’s

determination that Mr. Wright is liable for the section 6663

civil fraud penalty for 1999, 2000, and 2001.
 - 37 -

To reflect the foregoing and concessions made by respondent,

Decision will be entered

under Rule 155.