Patel v. Comm'r

T.C. Memo. 2008-223

UNITED STATES TAX COURT

BHARAT I. PATEL AND VIBHA B. PATEL, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 15491-06. Filed October 1, 2008.

Jon J. Jensen, for petitioners.

Melissa J. Hedtke, Trent Usitalo, and Blaine Holiday, for

respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

HAINES, Judge: Bharat I. Patel (Mr. Patel) and Vibha B.

Patel (Mrs. Patel) petitioned the Court for redetermination of

the following deficiencies in Federal income tax and penalties:
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Penalties
Year Deficiency Sec. 6663 Sec. 6662(a)

1995 $51,575 $26,149 $3,342
1996 106,621 66,389 3,620
1997 161,204 104,574 4,354

The issues for decision after concessions are: (1) Whether

the statute of limitations under section 6501(a) bars the

issuance of the notice of deficiency; (2) whether petitioners

failed to report gross receipts of $71,414 in 1995 and $173,292

in 1996; (3) whether petitioners failed to report on their 1997

Schedule E, Supplemental Income and Loss, income of $55,408; (4)

whether petitioners overstated their expenses in 1995, 1996, and

1997; (5) whether petitioners are entitled to deductions for

self-employed health insurance greater than $343, $543, and $743

for 1995, 1996, and 1997, respectively; (6) whether petitioners

are liable for fraud penalties under section 6663; and (7)

whether petitioners are liable for accuracy-related penalties

under section 6662(a).1 For all purposes hereafter, the years at

issue shall refer to 1995, 1996, and 1997.

FINDINGS OF FACT

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

The stipulation of facts and the supplemental stipulation of

facts, together with the attached exhibits, are incorporated

1
Unless otherwise indicated, all section references are to
the Internal Revenue Code, as amended, and all Rule references
are to the Tax Court Rules of Practice and Procedure. Amounts
are rounded to the nearest dollar.
 - 3 -

herein by this reference. At the time petitioners filed their

petition, they resided in North Dakota.

Petitioners are husband and wife. Mr. Patel moved to the

United States from India in 1980 at the age of 20. Mrs. Patel

moved from India to join him in 1985. Petitioners have owned and

managed hotels or motels in the United States since 1985.

Petitioners filed joint Federal income tax returns for the years

at issue.

In 1998 a civil audit of petitioners’ 1996 return was

initiated and later expanded to include their 1995 and 1997

returns. In 1999 petitioners’ returns for the years at issue

were referred for criminal investigation. On July 6, 2004, Mr.

Patel was convicted of income tax fraud under section 7206(1) for

1997.

On May 26, 2006, respondent sent petitioners a notice of

deficiency for the years at issue. Petitioners filed a timely

petition with this Court, and a trial was held on September 28,

2007, in St. Paul, Minnesota. On March 6, 2008, as a result of

evidence presented at trial, the Court granted respondent’s

motion for leave to amend his answer to increase the 1996

deficiency by $34,029 for a total deficiency of $140,650, and to

increase the fraud penalty under section 6663 by $25,522 for a

total fraud penalty of $91,911.
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I. Petitioners’ Motel Business

A. Motel Business

Petitioners owned three motels during the years at issue:

(1) Budget Inn in Dickinson, North Dakota (Budget Inn); (2) Super

8 Motel in Glendive, Montana (S8 Glendive); and (3) Super 8 Motel

in Dickinson, North Dakota (S8 Dickinson). S8 Glendive and S8

Dickinson (S8 Motels) were operated as sole proprietorships, and

petitioners reported income and expenses related to the S8 Motels

on their Schedules C, Profit or Loss From Business. Budget Inn

was operated as an S corporation.

Petitioners also held a partnership interest in BISK & BK

Partnership, L.L.P., and BI & SK Partnership, L.L.P. (the

partnerships) during the years at issue. BISK & BK Partnership,

L.L.P., owned and operated Super 8 Motel in Willmar, Minnesota,

while BI & SK Partnership, L.L.P., owned and operated Super 8

Motel in Winona, Minnesota (the partnership motels). The

partnerships were owned by petitioners and Mr. Patel’s relatives,

Dr. B.K. Patel and Dr. S.K. Patel.

B. Record Keeping

Petitioners performed the bookkeeping for the S8 Motels and

Budget Inn themselves during the years at issue. Petitioners

were also in charge of accounting, record keeping, and

management, including the hiring and firing of motel personnel,

at the S8 Motels and Budget Inn. Mr. Patel instructed the
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manager of S8 Glendive on how to run a motel. The manager of S8

Glendive, who had previous experience managing other hotels,

believed Mr. Patel was a competent and knowledgeable manager.

Petitioners received the business bank account statements

for the S8 Motels, Budget Inn, and the partnership motels during

the years at issue. Bank statements, checks, and deposit tickets

for S8 Glendive were mailed directly to petitioners in Dickinson,

North Dakota.

Each day during the years at issue petitioners received the

daily reports for the S8 Motels, Budget Inn, and the partnership

motels. The daily reports for each of the S8 Motels showed which

rooms were rented out, the amount received for each room, the

type of payment received, the amount of tax charged, daily video

income, and miscellaneous charges such as telephone and fax fees.

Petitioners reconciled the daily reports for each of their five

motels to the corresponding business bank statements during the

years at issue. Mr. Patel discussed the daily reports with

petitioners’ night auditor on several occasions. Mr. Patel

explained to the night auditor how to calculate the room tax.

Petitioners paid the bills for each of the S8 Motels, Budget

Inn, and each of the partnership motels during the years at

issue. Petitioners maintained a separate check register or check

listing for each of the S8 Motels, Budget Inn, and each of the

partnership motels during the years at issue.
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C. Video Rental Business

Petitioners operated a video rental business out of S8

Glendive called “Movies to Go”. During the years at issue

petitioners kept roughly 1,000 videos to rent or sell to hotel

guests and the general public. Customers desiring to rent videos

from Movies to Go would fill out a rental agreement, set up an

account, and pay a rental fee. Video rental fees were not

included in the S8 Glendive room rental bill, and guests paid for

video rentals separately.

Video rental and sale information was entered into a

separate computer at S8 Glendive that was used only for video

rentals. Petitioners used this computer to compile daily and

monthly video rental summaries showing daily and monthly video

sales and rentals at S8 Glendive. The S8 Glendive video rental

agreements were cross-checked each day with the computer-

generated daily video rental summaries.

The night auditor for S8 Glendive added up the income from

video rentals and video sales and recorded that amount on the

bottom of each S8 Glendive daily video rental summary for the

years at issue. At the end of each month during the years at

issue, the daily video rental summaries were attached to the

monthly video rental summaries and given to petitioners. A copy

of the S8 Glendive daily report was also faxed to petitioners
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each day, and the original daily reports were mailed to

petitioners each month.

D. Vending Income

Petitioners received income from vending machines at S8

Glendive during the years at issue. Income from vending machines

was not recorded on the S8 Glendive Daily Reports during the

years at issue. However, the daily reports for S8 Glendive show

income from the sale of coffee, which was not sold from a vending

machine.

E. Bank Accounts and Bank Records

Petitioners owned and maintained a personal checking account

as well as a personal savings account during the years at issue.

Petitioners paid some of their personal expenses from their

personal checking account.

Petitioners had a separate business bank account for each of

the five motels that they owned or in which they had an interest.

Petitioners maintained a business checking account at the

American State Bank & Trust in Dickinson, North Dakota, in the

name Super 8 Motel c/o Budget Inn of Dickinson (S8 Dickinson

account) during the years at issue. Petitioners maintained a

business checking account at the FirstWest Bank, now Stockman

Bank, in the name Super 8 Motel of Glendive (S8 Glendive

account), during the years at issue. Petitioners maintained a
 - 8 -

checking account at American State Bank & Trust in the name

Budget Inn of Dickinson, Inc. (Budget Inn Account), in 1997.

II. Petitioners’ Returns and Recalculation

A. Personal Returns

Larry Robinson, C.P.A. (Mr. Robinson), prepared petitioners’

individual income tax returns and the Forms 1120S, U.S. Income

Tax Return for an S Corporation, for Budget Inn for the years at

issue. When petitioners hired Mr. Robinson, they told him that

all of their business income was deposited into their business

accounts and that all business expenses were paid by check.

Mr. Patel prepared yearend income expense summary sheets

(summary sheets) for Budget Inn and the S8 Motels. Mr. Patel

prepared the summary sheets from bank statements and check

registers. However, he would also insert personal expenses, such

as the purchase of cars or gold bullion, on the summary sheets

under business expenses related to the operation of the S8

Motels.

Petitioners provided Mr. Robinson with summary sheets for

the S8 Motels and Budget Inn to use in the preparation of

petitioners’ personal income tax returns for the years at issue.

Mr. Patel told Mr. Robinson that the summary sheets for the S8

Motels and Budget Inn for the years at issue were a recap of his

bank statements and check listings. He did not inform Mr.
 - 9 -

Robinson that he had inserted personal expenses on the summary

sheets.

Mr. Robinson transferred all of the totals set forth on the

summary sheets for the S8 Motels and Budget Inn for the years at

issue to petitioners’ returns, either as single figures or as

combinations of figures. With the exception of payroll

information and a record of interest paid on bank notes, the only

information provided to Mr. Robinson regarding Schedule C income

and expenses during the years at issue was listed on the summary

sheets. Petitioners did not provide Mr. Robinson with the daily

reports for their S8 Motels or for Budget Inn.

Mr. Robinson did not recalculate the amounts listed on the

1997 summary sheet for the S8 Motels when he prepared

petitioners’ 1997 Form 1040, U.S. Individual Income Tax Return.

Mr. Robinson did not prepare balance sheets, transaction

details, or profit and loss statements for the S8 Motels or for

Budget Inn until he recalculated petitioners’ tax liability in

2000.

For each of the years at issue petitioners reported a loss

on their S8 Dickinson Schedule C. For 1995 and 1997 petitioners

reported losses on their S8 Glendive Schedules C.

B. The Partnership Returns

Petitioners were responsible for having the tax returns for

the partnerships prepared during the years at issue. These tax
 - 10 -

returns were prepared by Mr. Robinson. For preparation of these

tax returns, petitioners provided Mr. Robinson with bank

statements and check registers listing disbursements for each of

the partnership motels. Mr. Robinson reconciled the bank

statements and prepared yearend summaries, yearend balance

sheets, and yearend profit and loss statements for the

partnerships during the years at issue. Petitioners did not

provide Mr. Robinson with summary sheets for the partnership

motels to use in the preparation of the returns.

Petitioners reported a profit from each of their partnership

motels on their Schedule E for each of the years at issue.

C. Petitioners’ Recalculation of Their Tax Liabilities

In 1999, in response to the criminal investigation,

petitioners requested that Mr. Robinson recalculate their income

tax liabilities for the years at issue. For each of the years at

issue profit or loss was reported by petitioners on their

Schedules C and recalculated by Mr. Robinson as follows:
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Year S8 Glendive S8 Dickinson

1995

Reported ($18,366) ($1,174)
Recalculated 94,005 6,043

1996

Reported $15,111 ($46,198)
Recalculated 158,743 73,008

1997

Reported ($8,254) ($59,979)
Recalculated 137,167 14,496

Mr. Robinson determined that petitioners failed to report 75

percent, 90 percent, and 96 percent of their taxable income in

1995, 1996, and 1997, respectively. Mr. Robinson recalculated

petitioners’ income tax liabilities by obtaining the bank

statements, the check registers, and the reconciliation (check

listings) for each S8 Motel and entered the information into

Quick Books software. Mr. Robinson then reviewed the recap with

petitioners and removed any items from the check listings that

were questionable. Mr. Robinson also removed items from business

expenses that were confirmed to be personal. Mr. Robinson

estimated all credit card processing fees in his recalculation

and did not require petitioners to substantiate any of their

expenses.

After Mr. Robinson recalculated their income tax

liabilities, petitioners sent payments to the Internal Revenue
 - 12 -

Service (IRS) for 1995, 1996, and 1997 in the amounts of $62,400,

$120,800, and $91,800, respectively.

III. Unreported Income

Petitioners understated their adjusted gross income in 1995,

1996, and 1997 by 210 percent, 532 percent, and 1,417 percent,

respectively. For the years at issue Schedule C gross receipts

for the S8 Motels reported on petitioners’ returns, the corrected

amounts of gross receipts as determined by petitioners, the

corrected amounts of gross receipts as determined by respondent,

and respondent’s adjustments to originally reported gross

receipts are set out below:

Super 8 of Glendive, Schedule C Gross Receipts

Corrected Per Corrected Per Respondent’s
Year Per Return Petitioners Respondent Adjustment

1995 $466,043 $524,536 $531,330 $65,288
1996 471,846 563,627 645,138 173,292
1997 445,187 590,608 590,608 145,421

Super 8 of Dickinson, Schedule C Gross Receipts

Corrected Per Corrected Per Respondent’s
Year Per Return Petitioners Respondent Adjustment

1995 $67,818 $59,837 $73,944 $6,126
1996 458,252 515,956 515,956 57,704
1997 357,676 432,151 432,151 74,475

The following gross receipts were reported on petitioners’

Schedules C, recorded on the daily reports for petitioners’ S8

Motels, and recalculated by petitioners for each of the years at

issue.
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1995 S8 Glendive S8 Dickinson

Total gross receipts per return $466,043 $67,818
Gross receipts per daily reports
Room Rental 443,831 67,283
Tax 17,844 5,803
Telephone ---- 746
Miscellaneous 6,649 254
Videos 55,589 -0-
Total gross receipts per
daily reports 523,913 74,086
Total gross receipts per
petitioners’ recalculation 524,536 59,837

1996 S8 Glendive S8 Dickinson

Total gross receipts per return $471,846 $458,252
Gross receipts per daily reports
Room Rental 471,846 457,286
Tax 18,534 40,778
Telephone ---- 4,683
Miscellaneous 10,782 3,167
Videos 50,636 -0-
Total gross receipts per
daily reports 551,798 505,913
Total gross receipts per
petitioners’ recalculation 563,627 515,956

1997 S8 Glendive S8 Dickinson

Total gross receipts per return $445,187 $357,676
Gross receipts per daily reports
Room Rental 464,344 377,970
Tax 18,511 33,833
Telephone ---- 888
Miscellaneous 6,386 3,840
Videos 39,455 -0-
Total gross receipts per
daily reports 528,696 416,531
Total gross receipts per
petitioners’ recalculation 590,608 432,151
 - 14 -

A. 1995 Schedule C Income From S8 Glendive

Respondent calculated petitioners’ unreported gross receipts

from S8 Glendive in 1995 by taking the total gross receipts shown

on the S8 Glendive daily reports, adding unreported income from

vending machines in the motel, and adding a small amount of room

tax. Respondent estimated 1995 income from vending machines at

S8 Glendive by using a 100-percent markup on vending items for

total vending income of $9,072 in 1995. Respondent then

subtracted $1,662 in vending income already reported and

estimated that petitioners failed to report vending income in

1995 of $7,416.

B. 1996 Schedule C Income From S8 Glendive

Petitioners made total deposits into their S8 Dickinson

account in 1996 of $558,288, consisting of $588 of nontaxable

deposits and $557,700 of taxable deposits.

During 1996 Western Geco, f.k.a. Geco-Prakla or STC Geco-

Prakla, paid petitioners $160,351 by check for crew

accommodations at S8 Glendive. Western Geco was an oil and gas

exploration firm with a crew of 40-45 based at S8 Glendive during

1996. Petitioners deposited $72,913 in payments from Western

Geco into their S8 Glendive Account in 1996. However,

petitioners failed to deposit $87,438 in income from Western Geco

into their S8 Glendive Account in 1996.
 - 15 -

C. 1997 Schedule E Income From Budget Inn

Petitioners reported gross receipts on their 1997 Budget Inn

Schedule E of $164,389. Petitioners made total deposits into

their Budget Inn Account in 1997 of $200,882, consisting of

$7,000 of nontaxable deposits and taxable deposits of $193,882.

Petitioners failed to report gross receipts of $29,493 from

Budget Inn on their 1997 Schedule E. Petitioners also failed to

substantiate $25,915 in expenses claimed on their 1997 Form 1120S

for Budget Inn.

IV. Overstated Schedule C Expenses

Petitioners concede that they overstated their Schedule C

expenses for each of the years at issue in the following amounts:

Schedule C Overstated Schedule C Expenses

1995 1996 1997
S8 Glendive $53,878 $57,190 $85,939
S8 Dickinson 15,198 61,502 37,968
Total 69,076 118,692 123,907

Respondent determined that petitioners overstated their

Schedule C expenses for each of the years at issue in the

following amounts:

Schedule C Overstated Schedule C Expenses

1995 1996 1997
S8 Glendive $59,582 $73,556 $95,727
S8 Dickinson 16,775 75,689 42,153
Total 76,357 149,245 137,880

For each of the years at issue petitioners concede they

improperly deducted personal expenses as Schedule C business
 - 16 -

expenses. Neither petitioners nor their partners deducted

personal expenses as business expenses on their partnership

returns for the years at issue.

A. 1995 Expenses

Petitioners improperly deducted the following personal

expenses as business expenses under the following categories on

their 1995 S8 Motels Schedules C:

Expense Amount Deducted As Schedule C

Personal home
mortgage payments $6,134 ¹ S8 Glendive
Personal medical
expenses 3,014 ¹ S8 Glendive
Medical insurance
premiums 691 ¹ S8 Glendive
Family trip
to India 7,075 ¹ S8 Glendive
Car lease payments 7,714 Rent S8 Glendive
Personal health
insurance premiums 452 Insurance S8 Dickinson
Family trip
to India 762 ¹ S8 Dickinson
Auto & personal
homeowner’s
insurance premiums 1,120 ¹ S8 Dickinson

¹The Schedule C category under which this personal
expense was deducted is undetermined.

On June 30, 1995, petitioners took out a $134,400 home

mortgage loan on their personal residence located at 114 15th

Ave. West, Dickinson, North Dakota 58601, with Liberty Bank and

Trust. In 1995 and 1996 automatic monthly debits of $1,227 were

taken out of the S8 Glendive account and applied to petitioners’

home mortgage loan. On October 4, 1996, petitioners paid their
 - 17 -

home mortgage loan in full by making a payment of $127,957 out of

their S8 Glendive account. Petitioners did not deduct the

$127,957 home mortgage payment as a business expense on their

1996 S8 Glendive Schedule C. However, petitioners deducted all

of the other personal home mortgage payments that they made

during 1995 and 1996 as business expenses on their S8 Glendive

Schedules C.

Petitioners’ personal health insurance was provided by

Golden Rule Insurance Co. (Golden Rule). On March 7, 1995, Mr.

Patel signed a Personal Health Insurance Certification with

Golden Rule stating that he understood that the Golden Rule

coverage for which he was applying was personal health insurance

and could not be used by any employer to provide for any

employee. Mr. Patel also certified that he would not treat the

policy as part of any employer-provided health insurance plan for

any purpose, including tax purposes. Nevertheless, Mr. Patel

paid the Golden Rule premiums with business checks out of the S8

Dickinson account. Petitioners then deducted the premiums as a

business expense in each of the years at issue.

B. 1996 Expenses

Petitioners improperly deducted the following personal

expenses as business expenses under the following categories on

their 1996 S8 Motels Schedules C:
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Expense Amount Deducted As Schedule C

Personal home
mortgage payments $12,269 Rent S8 Glendive
Home mortgage
interest payments 7,926 Rent S8 Glendive
Family trip
to India 5,720 Travel S8 Glendive
Gold bullion
purchase 2,372 Utilities S8 Glendive
Personal health
insurance premiums 1,356 Insurance S8 Dickinson
Personal auto
insurance &
home owner’s
insurance on
personal residence 2,225 Insurance S8 Dickinson
Life insurance 19,429 Insurance S8 Dickinson
Family trip
to India 5,775 Travel S8 Dickinson
Car lease payments 8,760 Car expense S8 Dickinson

Petitioners deducted the home mortgage interest payment on

their personal 1996 return Schedule A, Itemized Deductions, as

well as on their 1996 S8 Glendive Schedule C under rent.

Petitioners subclassified the gold bullion purchase as a

garbage expense on the 1996 S8 Glendive summary sheet they

provided to Mr. Robinson.

Petitioners also overstated their insurance expenses by

$22,244 and their Super 8 Motels royalty payments by $4,718 on

their S8 Dickinson summary sheet.

C. 1997 Expenses

Petitioners overstated the following expense categories on

the summary sheets that they prepared and provided to Mr.
 - 19 -

Robinson for use in the preparation of their 1997 S8 Glendive

Schedule C:

Expense Amount per Total Set Forth Overstated
Addition of on Summary Sheet Amount
Figures on & Per Return
Summary Sheet

Credit card $530 $11,530 $11,000
Office
supplies 2,181 7,181 5,000
Electric/water 18,149 33,149 15,000
Breakfast
supplies 3,427 5,427 2,000
Super 8 Motel
royalties 27,707 32,707 5,000

Petitioners improperly deducted personal expenses as

business expenses under the following categories on their 1997 S8

Motels Schedules C:

Expense Amount Deducted As Schedule C

Diamond jewelry $13,500 Travel expense S8 Glendive
Life insurance 18,887 Insurance S8 Glendive
Personal medical
expenses 1,155 Guest supplies S8 Glendive
Jewelry 2,587 Guest supplies S8 Glendive
Payment to relatives 3,000 Laundry supplies S8 Dickinson
Orthodontic expenses 2,755 Insurance S8 Dickinson
Personal health,
auto & homeowner’s
insurance 3,766 Insurance S8 Dickinson
Jewelry 1,540 Office Supplies S8 Dickinson

V. Matters Pertaining to Fraud

A. Vehicles

On April 24, 1996, petitioners purchased a 1996 Dodge Grand

Caravan for $26,525. Mr. Patel received a trade-in allowance of

$12,400 for a 1990 Mazda and paid the remainder of the purchase
 - 20 -

price in full with a cashier’s check from his personal savings

account at Norwest Bank in the amount of $14,943. On June 8,

1996, petitioners purchased a 1996 Mercedes Benz S420 for

$68,250. Mr. Patel made a $2,000 downpayment on the Mercedes

through his Discover credit card and received a trade-in

allowance of $15,500 on a 1993 Mazda. Petitioners paid the

remainder of the purchase price in full with a check in the

amount of $54,220. Neither the check register for S8 Glendive

nor the check register for S8 Dickinson reflects a payment for

$14,943 in April 1996 or a payment for $54,220 in June 1996. On

October 31, 1996, petitioners also purchased a 1977 Ford Pickup

Truck for $500.

B. False Statements

On September 30, 1998, Mr. Patel and Mr. Robinson met with

Revenue Agent Karen Dassinger (Ms. Dassinger). At that meeting,

Mr. Patel falsely told Ms. Dassinger that he had never visited

the local IRS office in Dickinson, North Dakota. Mr. Patel was

familiar with the IRS agents who worked in the IRS office in

Dickinson, North Dakota, because he had been to the office

several times to get answers to tax questions. Mr. Patel later

admitted in private to Ms. Dassinger that he had been to the

local IRS office but had not wanted Mr. Robinson to know. Mr.

Patel also falsely told Ms. Dassinger in private that he supplied

videos for guests of S8 Glendive because there was no cable at S8
 - 21 -

Glendive. Cable was available to guests at S8 Glendive during

the years at issue, and petitioners deducted cable expenses on

their S8 Glendive Schedule C in 1995, 1996, and 1997.

In a meeting with Ms. Dassinger on November 5, 1998, Mr.

Patel stated that the only vehicles he owned in 1996 were a Dodge

Caravan and a Mazda.

During a meeting with Special Agent Andrew Smith on December

9, 1999, Mr. Patel stated that he did not use cash or cashier’s

checks to purchase goods for personal use.

C. Criminal Case

Mr. Patel admitted that for the taxable year 1997 he

willfully made and submitted a false tax return, made under

penalty of perjury and filed with the IRS, knowing it to be

false, in violation of section 7206(1). In his plea agreement

Mr. Patel admitted that he overstated business expenses on this

1997 Form 1040 by classifying personal expenditures such as

diamond jewelry, gold bullion, medical expenses, orthodontic

work, and house payments as business expenses.

OPINION

I. Burden of Proof

Respondent’s revenue agent first met with petitioners in

1998 after the start of his examination of their 1995, 1996, and

1997 returns. Because respondent’s examination of petitioners’

returns began before July 22, 1998, section 7491 does not apply.
 - 22 -

See Internal Revenue Service Restructuring and Reform Act of

1998, Pub. L. 105-206, sec. 3001, 112 Stat. 726. Respondent’s

determinations in the notice of deficiency are presumed correct,

and petitioners bear the burden of proving that respondent’s

determinations are incorrect. See Rule 142(a)(1). Respondent

has the burden of proof by clear and convincing evidence with

respect to his determination of fraud. See Rule 142(b).

Respondent also has the burden of proof with respect to the

increased deficiency for the year 1996. See Rule 142(a)(1).

II. Period of Limitations on Assessment

Petitioners contend that the 3-year period of limitations on

assessment in section 6501(a) expired before respondent issued

the notice of deficiency and respondent’s assessment is barred.

Respondent argues that the period of limitations in section

6501(a) does not apply because petitioners filed false or

fraudulent returns with the intent to evade taxes for the years

at issue. Sec. 6501(c)(1). Accordingly, our determination of

whether the period of limitations expired before the notice of

deficiency was issued depends on whether petitioners committed

fraud in the filing of their 1995, 1996, and 1997 returns. The

determination of fraud for purposes of section 6501(c)(1) is the

same as the determination of fraud for purposes of the penalty

under section 6663. Neely v. Commissioner, 116 T.C. 79, 85
 - 23 -

(2001); Rhone-Poulenc Surfactants & Specialties, L.P. v.

Commissioner, 114 T.C. 533, 548 (2000).

Mr. Patel’s guilty plea under section 7206(1) for

intentionally filing a false return does not in itself prove that

section 6501(c) applies; respondent must show that petitioners

intended to evade tax for each of the years at issue. See Wright

v. Commissioner, 84 T.C. 636, 643 (1985). For Federal tax

purposes, fraud entails intentional wrongdoing with the purpose

of evading a tax believed to be owing. See Neely v.

Commissioner, supra at 86. In order to show fraud, respondent

must prove: (1) An underpayment exists; and (2) petitioners

intended to evade taxes known to be owing by conduct intended to

conceal, mislead, or otherwise prevent the collection of taxes.

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

A. Underpayment of Tax

Respondent must first show by clear and convincing evidence

that petitioners made an underpayment of tax in each of the years

at issue. For 1995, 1996, and 1997, petitioners have conceded

that they made underpayments of tax of at least $62,400,

$120,800, and $91,800, respectively. Therefore, respondent has

satisfied his burden of proof for this issue.

B. Fraudulent Intent

Because direct evidence of fraud is rarely available, fraud

may be proved by circumstantial evidence and reasonable
 - 24 -

inferences from the facts. Petzoldt v. Commissioner, 92 T.C.

661, 699 (1989). Courts have developed a nonexclusive list of

factors, or “badges of fraud”, that demonstrate fraudulent

intent. Niedringhaus v. Commissioner, 99 T.C. 202, 211 (1992).

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. Id.; see

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

Commissioner, 419 F.3d 829, 832 (8th Cir. 2005), affg. T.C. Memo.

2003-332; Recklitis v. Commissioner, 91 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. Niedringhaus v. Commissioner, supra at 211.

Respondent must prove fraud for each year at issue. See id. at

210; Ferguson v. Commissioner, T.C. Memo. 2004-90.

Petitioners’ behavior with respect to their income shows 8

of the 11 badges of fraud, as follows.
 - 25 -

(1) Petitioners understated their adjusted gross income by

210 percent, 532 percent, and 1,417 percent in 1995, 1996, and

1997, respectively.

(2) Petitioners maintained inadequate records by failing to

substantiate a large portion of their Schedule C business

expenses.

(3) Petitioners concealed the true nature of their income

and expenses from their return preparer by providing inaccurate

summary sheets for their Super 8 Motels and not providing source

documentation. Petitioners completely omitted their income from

video sales and rentals.

(4) Petitioners engaged in a pattern of conduct that

indicates an intent to mislead. Critically, petitioners

disguised clearly personal items such as medical insurance

premiums, the purchase of gold bullion, and gifts to relatives as

business expenses under categories such as “utilities” and

“laundry supplies” on their summary sheets.

(5) Petitioners’ explanation for their behavior is

implausible and inconsistent. Mr. Patel testified that he

believed all personal expenses were deductible. However,

petitioners did not deduct major personal items, such as Mr.

Patel’s purchases of a Mercedes and a Dodge Grand Caravan in

1996. Petitioners also did not deduct personal items as business

expenses on their partnership returns.
 - 26 -

(6) Petitioners have failed to fully cooperate with tax

authorities. Mr. Patel twice lied to respondent’s revenue agent

regarding his income and assets.

(7) Petitioners’ testimony regarding their level of

sophistication and ability to comply with the tax laws is not

credible. Petitioners claim that they did not have any

significant sophistication with regard to tax matters and

attempted to voluntarily comply with the tax law when they

learned that they had made errors on their returns. We are

unconvinced by petitioners’ explanations. Petitioners kept

systematic (if incomplete) records of their finances and

personally compiled the summary sheets which they provided to

their return preparer. Mr. Patel’s experienced manager believed

him to be highly competent with regard to business matters, and

Mr. Patel visited the local IRS office in Dickinson on several

occasions to receive answers to tax questions. Petitioners’

assertion of ignorance is not credible.

(8) Petitioners filed a false tax return for 1997. Mr.

Patel pleaded guilty under section 7206(1) to willfully filing a

false tax return for 1997. As a result, Mr. Patel is estopped

from arguing that he did not willfully file a false return for

1997. See Wright v. Commissioner, supra at 639. Although the

estoppel is not extended to petitioners’ fraudulent intent to

evade tax, the factor militates toward a finding of fraud.
 - 27 -

As a result of the number of badges of fraud in this case,

we find that respondent has shown by clear and convincing

evidence that petitioners filed their 1995, 1996, and 1997

returns with the intent to evade tax. Therefore, the 3-year

period of limitations under section 6501(a) does not apply to

petitioners’ 1995, 1996, and 1997 years, and respondent is not

barred from assessing any deficiencies in petitioners’ tax for

those years.

III. Unreported Income

If a taxpayer has not maintained business records or its

business records are inadequate, the Commissioner is authorized

to reconstruct the taxpayer’s income by any method that, in the

Commissioner’s opinion, clearly reflects that taxpayer’s income.

Sec. 446(b); Parks v. Commissioner, 94 T.C. at 658; A.J. Concrete

Pumping, Inc. v. Commissioner, T.C. Memo. 2001-42. The

Commissioner’s reconstruction need not be exact, but it must be

reasonable in the light of all the surrounding facts and

circumstances. A.J. Concrete Pumping, Inc. v. Commissioner,

supra. Petitioners bear the burden of proving that respondent’s

determinations are erroneous. See Rule 142(a).

A. 1995 Gross Receipts

Respondent determined that petitioners failed to report 1995

gross receipts from S8 Dickinson and S8 Glendive of $6,126 and

$65,288, respectively. Respondent made his determination by
 - 28 -

totaling the income recorded on petitioners’ 1995 Daily Reports

and, in the case of S8 Glendive, combining the income recorded on

the Daily Reports with vending income. Petitioners argue that

respondent erred in using the Daily Reports to determine gross

receipts because the Daily Reports do not take into account

credit card processing fees that may be deducted by credit card

companies before making payment to petitioners. Petitioners also

argue that respondent miscalculated the S8 Glendive gross

receipts because income from vending machines was already

reflected on the 1995 S8 Glendive Daily Reports. For the reasons

discussed below, we disagree with petitioners.

The amount of a credit card processing fee is not relevant

to a determination of petitioners’ Schedule C gross receipts.

Gross income includes all income from whatever source derived.

Sec. 61. It is not necessary that the income be deposited or

received so long as the taxpayer has an unfettered right to

receive it. See Corliss v. Bowers, 281 U.S. 376 (1930).

Petitioners had an unfettered right to income at the time one of

their motel rooms was rented. Although deductible credit card

processing fees would reduce the amount of petitioners’ net

Schedule C profit or loss, they would not affect their gross

receipts.

Petitioners’ proposition that income from vending machines

is already reflected on the 1995 S8 Glendive Daily Reports is not
 - 29 -

supported by the record. Petitioners’ night auditor who prepared

the Daily Reports testified that income from vending machines in

the motel was not recorded in the 1995 Daily Reports, and we find

the auditor’s testimony credible. Additionally, petitioners did

not produce a single 1995 S8 Glendive Daily Report on which

income from vending machines was reported. Thus, petitioners

have failed to show that respondent’s calculation of 1995 gross

receipts is erroneous or unreasonable under the circumstances.

B. 1996 Gross Receipts

Respondent has the burden of proof with regard to the tax

increase resulting from his amended answer. See Rule 142(a). We

find that respondent’s burden has been met through trial

testimony and petitioners’ stipulations. The burden now shifts

to petitioners to show that respondent’s determination is

erroneous. Jones v. Commissioner, 29 T.C. 601, 614 (1957).

Respondent determined that petitioners failed to report 1996

S8 Glendive gross receipts of $173,292. Respondent made his

determination by using a bank deposits analysis supplemented by

an analysis of specific items not deposited. Petitioners argue

that respondent double counted Western Geco payments when

calculating unreported gross receipts from S8 Glendive in 1996

because undeposited payments from Western Geco were already

included in the 1996 S8 Glendive Daily Reports. Petitioners also

argue that respondent erroneously included undeposited Western
 - 30 -

Geco payments in gross receipts from S8 Glendive in 1996, because

all Western Geco income was deposited into the S8 Glendive

Account and reported on petitioners’ 1996 return. Petitioners’

position is not supported by the record.

Petitioners stipulated that they received $160,350 from

Western Geco in 1996. Respondent determined that petitioners

deposited only $72,913 of Western Geco payments into their 1996

S8 Glendive Account. The record indicates that this

determination is reasonable. None of the evidence presented at

trial shows that: (1) Any of the deposits determined by

respondent to be taxable were duplications or somehow tax exempt,

(2) the undeposited Western Geco income identified by respondent

had in fact never been received by petitioners, (3) the

unreported Western Geco income identified by respondent had in

fact been reported or deposited, or (4) the undeposited Western

Geco income identified by respondent was somehow tax exempt. As

a result, petitioners have failed to show that respondent’s

findings are erroneous, and we sustain respondent’s

determination.

C. 1997 Schedule E Income

Respondent determined that petitioners failed to report 1997

Budget Inn Schedule E income of $55,408. Respondent made his

determination by conducting a bank deposits analysis and
 - 31 -

disallowing $25,915 of business expenses that petitioners

conceded were unsubstantiated.

Nothing in the record indicates that respondent’s method of

calculating the unreported Schedule E income from Budget Inn was

erroneous or unreasonable. The bank deposits method is an

acceptable method of income reconstruction. Clayton v.

Commissioner, 102 T.C. 632, 645 (1994); DiLeo v. Commissioner, 96

T.C. 858, 867 (1991), affd. 959 F.2d 16 (2d. Cir. 1992).

Petitioners have failed to show that respondent’s method is

unreasonable, and thus respondent’s determination is sustained.

IV. Expenses

Respondent determined that petitioners overstated their S8

Dickinson Schedule C business expenses on their 1995, 1996, and

1997 returns by $16,775, $75,689, and $42,153, respectively, and

their S8 Glendive expenses by $59,582, $73,556, and $95,727,

respectively. Petitioners maintain that they overstated their S8

Dickinson Schedule C business expenses on their 1995, 1996, and

1997 returns by $15,198, $61,502, and $37,968, respectively, and

their S8 Glendive business expenses by $53,878, $57,190, and

$85,939, respectively. We sustain respondent’s determination.

Deductions are a matter of legislative grace, and the

taxpayer must prove he is entitled to the deductions claimed.

Rule 142(a); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440

(1934). Section 162(a) allows a taxpayer to deduct all ordinary
 - 32 -

and necessary expenses paid or incurred in carrying on a trade or

business. However, petitioners have failed to produce any

evidence showing that they are entitled to a deduction for

Schedule C business expenses greater than the amounts allowed by

respondent.

If a factual basis exists to do so, the Court may in another

context approximate an allowable expense, bearing heavily against

the taxpayer who failed to maintain adequate records. Cohan v.

Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930); sec. 1.274-

5T(a), Temporary Income Tax Regs., 50 Fed. Reg. 46014 (Nov. 6,

1985). However, in order for the Court to estimate the amount of

an expense, the Court must have some basis upon which an estimate

may be made. Vanicek v. Commissioner, 85 T.C. 731, 742-743

(1985). Without such a basis, any allowance would amount to

unguided largesse. Williams v. United States, 245 F.2d 559, 560-

561 (5th Cir. 1957).

The record provides no satisfactory basis for estimating

petitioners’ business expenses. Although petitioners’ accountant

recalculated petitioners’ tax liabilities, petitioners did not

produce at trial all of the source documents necessary to

ascertain the accuracy of their determinations at trial.

Additionally, petitioners’ accountant testified that he did not

require petitioners to substantiate the payment and purpose of
 - 33 -

each claimed expense. Accordingly, respondent’s determination

regarding petitioners’ business expenses shall be sustained.

V. Self-Employed Health Insurance Deductions

Petitioners failed to offer any evidence that they are

entitled to a deduction for self-employed health insurance

greater than the amounts already allowed by respondent.

Accordingly, respondent’s determination is sustained.

VI. Fraud Penalty Under Section 6663

If the Commissioner shows that any portion of an

underpayment is due to fraud, the entire underpayment will be

treated as attributable to fraud for purposes of the penalty

under section 6663(a), except any portion of the underpayment

that the taxpayer establishes by a preponderance of the evidence

is not attributable to fraud. See sec. 6663(b); Knauss v.

Commissioner, T.C. Memo 2005-6. As stated above, respondent has

shown that petitioners committed fraud in filing their 1995, 1996

and 1997 returns. Petitioners have not shown that any portion of

the deficiencies should not be subject to fraud penalties.

Therefore, with the exception of the overstatements of S8 Motel

expenses that respondent determined relate to negligence, the

deficiencies for the years at issue are subject to fraud

penalties.
 - 34 -

VII. Accuracy-Related Penalty Under Section 6662(a)

Respondent determined that petitioners are liable for

accuracy-related penalties under section 6662(a) for

underpayments related to the overstatement of S8 Motel expenses

by $16,710, $18,102, and $21,772 for the years at issue,

respectively. The penalty applies to any underpayment of tax

required to be shown on a return that is attributable to

negligence or disregard of rules or regulations under section

6662(b)(1).

Negligence is defined as any failure to make a reasonable

attempt to comply with the provisions of the Internal Revenue

Code. Sec. 6662(c). However, section 6664(c)(1) provides that a

penalty under section 6662 will not be imposed on any portion of

an underpayment if the taxpayer shows reasonable cause for such

portion of the underpayment and that the taxpayer acted in good

faith with respect to such portion. Reliance on the advice of a

professional, such as a certified public accountant, may

constitute a showing of reasonable cause if, under all the facts

and circumstances, such reliance is reasonable and the taxpayer

acted in good faith. Henry v. Commissioner, 170 F.3d 1217, 1219-

1223 (9th Cir. 1999), revg. T.C. Memo. 1997-29; Betson v.

Commissioner, 802 F.2d 365, 372 (9th Cir. 1986), affg. in part

and revg. in part T.C. Memo. 1984-264; sec. 1.6664-4(b)(1), (c),

Income Tax Regs. To prove reasonable cause based on the receipt
 - 35 -

of professional advice, a taxpayer must show that he reasonably

relied in good faith upon a qualified adviser after full

disclosure of all necessary and relevant facts. Collins v.

Commissioner, 857 F.2d 1383, 1386 (9th Cir. 1988), affg. Dister

v. Commissioner, T.C. Memo. 1987-217; sec. 1.6664-4(b)(1), Income

Tax Regs. The burden of proof rests with petitioners. See Rule

142(a).2

Applying these principles to the case before us, we conclude

that petitioners have failed to prove that respondent’s

determination is incorrect. Petitioners are unable to

substantiate the Schedule C expenses underlying the accuracy-

related penalty. Despite relying on Mr. Robinson to file their

returns, petitioners are also unable to show reasonable cause for

their errors based on the receipt of advice from a tax

professional. Although petitioners relied on their accountant,

Mr. Robinson, to prepare their returns, petitioners have conceded

that they provided Mr. Robinson with incomplete and false

information regarding their expenses.

Petitioners, having failed to show reasonable cause,

substantial authority, or any other basis for reducing the

2
As this case deals with examinations commencing before July
22, 1998, sec. 7491(c) does not apply to place the burden of
production on respondent. However, even if sec. 7491(c) did
apply, respondent has clearly met his burden by demonstrating
that petitioners overstated their Schedule C expenses for each of
the years at issue.
 - 36 -

underpayments, are liable for the section 6662 penalties for the

years at issue as determined by respondent.

In reaching our holdings herein, we have considered all

arguments made, and, to the extent not mentioned above, we

conclude they are moot, irrelevant, or without merit.

To reflect the foregoing,

Decision will be entered

under Rule 155.